With regard to particular assets — say, mortgage securities or Italian bonds — each bank knew only its own exposure to Long-Term [Capital Management]. Goldman Sachs had no idea that Salomon might be financing a similar trade; J. P. Morgan would not have known that Merrill Lynch was duplicating Morgan’s loans. So in theory, each bank had no notion of how big Long-Term was in any particular trade. But in practice, the banks were in a good position to estimate. The world of bond arbitrage is relatively small. Certainly the banks knew enough to ask for more specific disclosures. And of course they could have declined to do business with Long-Term if satisfactory answers were not forthcoming.But the banks were fighting to do more hedge fund business, not less. Five years into a bull market, the banks were awash in liquidity, and the hedge fund trade was a lucrative way for Wall Street to employ its surplus capital. The banks accomplished this by a practice known as “renting out the balance sheet” — literally, transferring their enormous borrowing power to hedge funds with lesser credit ratings,* a service for which they charged mere pennies on every $100 of credit. Long-Term, which was easily the Street’s biggest hedge fund customer, was reputed to be throwing off $100 million to $200 million in fees to Wall Street each year, and each of the banks wanted as big a share of the money as possible.
That’s from When Genius Failed, Roger Lowenstein’s very highly-regarded story of the rise and fall of the hedge fund Long-Term Capital Management. What was Long-Term’s business? Well, it carried out investments according to the vision of John Meriwether and his band of academics and traders, who brought to Wall Street in force the analytical subtlety and brilliance of advanced mathematics, wed it to modern computing power, and produced a dazzling new field of “financial technology.” They used their mathematical tools to identify tiny fractional irrationalities in bond markets, and then piled up enormous capital behind their bets through huge leverage.
Into this business banks and other financial institutions poured their surplus capital through most of the 1990s. It continues to this day. “High-frequency trading” and “dark pools of liquidity” the latest terms for this arbitrage of the infinitesimal.
The point to grasp here is that this has almost nothing to do with government policy. Meriwether’s quants were private enterprisers — enterprisers par excellence, if you make no distinction between property and remote abstractions from property. They developed a whole new field of speculative trading — except that it was fundamentally cautious and conservative. It dealt in historically demonstrable market opportunities. The classic example is premium that investors are willing to pay for a newly-minted 30-year Treasury bond over the now “off the run” 29 ½ -year Treasury. What possible reason could there be for that six-month difference to matter much in pricing? And yet it did; there is an unexpectedly big spread between the two, and the arbitrageur can exploit it.
My cousin teaches economics at the Air Force Academy. He is among a number of economists who point to the rescue of Long-Term as the moment when “too big to fail” was, as it were, codified. The irony is that the rescue was a purely private one. The New York Federal Reserve Bank organized the meetings by which private financiers absorbed Long-Term’s losses. No taxpayer capital was staked.
But the shock of Long-Term’s failure and the systemic fragility it exposed demonstrated something momentous: globalization had exposed everyone to everyone else. The integration of capital markets was accomplished. A Russian default on sovereign debt could lay waste to American hedge funds and banks. World finance was so interconnected and interdependent that no gambler with his wits about him would expect anything but government rescues in the event of crisis. It’s been generations since the West was led by men of laissez faire sensibilities on these matters. As early as 1998 the smart bet was on eventual rescue.
Put otherwise, from that moment globalization itself included a vital element of eventual government rescue. And it had almost nothing to do with Fannie and Freddie or subprime lending. Long-Term Capital Management did some trading in mortgage securities, of course, but its primary business was the refinement of engineered abstraction of financial assets.
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* This trick was used in 2008 by none other than the Federal Deposit Insurance Corporation, which rented its balance sheet (in other words, the credit rating of the US government) to banks and shadow banks in order to let them raise capital risk-free. I told my wife, only half-jokingly, that we could probably issue some sort of private family bonds, raising millions in capital on the open market, if only the FDIC would be so kind as to cosign for it.
Comments (15)
"It’s been generations since the West was led by men of laissez faire sensibilities on these matters."
Yes - I think that's right. (If, indeed, the West was *ever* led by such men.) And throwing little dollops of free market purism into the statist stew does no good at all. It's like mixing libertarian open-borders fundamentalism with the welfare state: purest folly.
Of course, much the same could be said of agrarianism/distributism: whatever the theoretical charms of such positions, they simply don't mix well with the reality we're unfortunately stuck with.
Posted by steve burton | January 2, 2010 8:45 PM
Your analysis would make sense if this were a market unhampered by government, but unfortunately you are talking about a market in which many of the very products are from governments, not to mention the buying, selling, and regulating the governments do. You keep blaming the fish for taking advantage of the conditions in the tank. Get rid of the artifice, and the fish go back to behaving like fish.
None of this has anything to do with capital, of course. You can use money and credit to purchase a capital good, but the high finance games come down to playing with numbers.
Posted by august | January 2, 2010 9:12 PM
Steve --
Coolidge maybe?
And throwing little dollops of free market purism into the statist stew does no good at all. It's like mixing libertarian open-borders fundamentalism with the welfare state: purest folly.
That is admirably well put, Steve. I'm not sure about your second statement, that the same is true of distributism.
August --
a market in which many of the very products are from governments, not to mention the buying, selling, and regulating the governments do
Heavily-regulated markets with a legacy of policy interference certainly played a role in this most recent crisis, but that is not true of the LTCM crisis in 1998.
Government bonds have been trading for centuries. It is a pretty radical position to say that the presence of government debt trading as securities alone is enough to degrade a free market from its principle, if indeed that is what you're saying.
Posted by Paul J Cella | January 2, 2010 9:38 PM
August writes: "you keep blaming the fish for taking advantage of the conditions in the tank."
Well, what does it matter whether it's the government or business that's ultimately *to blame* for their fatal embrace?
Posted by steve burton | January 2, 2010 9:55 PM
Paul,
"But the shock of Long-Term’s failure and the systemic fragility it exposed demonstrated something momentous: globalization had exposed everyone to everyone else."
Here I get to finally agree we might have a problem Houston! If purely private players can screw-up financial markets around the world -- then I agree this is not good. But the obvious question should become -- would the failure of LTCM really have provoked a world-wide depression? Isn't the lesson in hindsight that we should have let LTCM collapse or forced it to collapse if it posed such a systemic risk?
Or since the bailout was private, why does that bailout represent the "system fragility" of globaliztion -- couldn't one also say it represented smart global capitalists protecting their money?
Posted by Jeff Singer | January 2, 2010 11:57 PM
Isn't the lesson in hindsight that we should have let LTCM collapse or forced it to collapse if it posed such a systemic risk?
The "we" in question here is, of course, the executives of the big investment banks. And most were reluctant to let LTCM fail because they're own capital was so wrapped up in the fund (one technique is described in the quoted passage), and because they had all started to imitate the trading strategies of Long-Term. Just like after Lehman's collapse, everyone was looking around saying, "who's next?"
couldn't one also say it represented smart global capitalists protecting their money?
One could say that; and still say it also represented smart capitalists protecting their money above all by adopting the principle of Too Big to Fail.
Posted by Paul J Cella | January 3, 2010 9:09 AM
I think that's one of the most interesting questions. How well is this proposition supported?
And another question that comes to my mind: Would the potential crash and the need for the bailout have come when it did and as big as it did if it hadn't been for the Fannie Mae stuff, etc.? I mean, Paul, you're making a good case here (it looks to my semi-ignorant eyes) for an important degree of fragility caused by globalization independently of sub-prime lending. But I hope you wouldn't deny the connection of sub-prime lending with the _particular_ threatened crash *directly connected to the real estate market in the United States* that blew up in our faces last fall. If it hadn't been for that, might we have been looking at 10 years, twenty years, thirty years, or whatever before the fragility you are talking about came home to roost, and might it have been more containable and less urgent? It seems implausible that it would have had the intimate connection with people's defaulting on mortgages that it did have were it not for the push for sub-prime lending that we have seen--which is a _real_ thing and cannot and should not be ignored. In other words, it seems like the effects of the fragility you cite here would have taken some other and perhaps fairly unpredictable form and turn were it not for the other co-factors in the real estate market, co-factors directly related to government policy of bringing more people (specifically, people who really couldn't afford to buy homes) into the housing market, etc.
Posted by Lydia | January 3, 2010 12:26 PM
That's fair, Lydia. I certainly do not mean to deny the important role played by real estate in the current mess.
But the other side of that coin is that without the high-finance rocket science, the real estate crisis would have been far more easily contained. Certainly this is true of the sub-prime aspect of the real estate crisis. It is plausible to envision a situation where the sub-prime collapse would have been barely noticed -- if investment banks had not plunged so deeply into the business of bundling those mortgages into securities, writing swap contracts on them, and generally piling up leverage to profit on every available yield spread or swap spread. Recall that the reason the sub-prime mortgage securities were desirable is that they were backed by less creditworthy assets, which means a higher yield on the bonds, which means a wider spread, which means more profit.
A spread is determined by comparing a bond's yield to a "risk-free" US Treasury bond of a similar duration. So a mortgage-bond confected out of loans to upwardly-mobile middle class folks in a good neighborhood will have, ceteris paribus, a much smaller spread as compared to a bond made out of subprime mortgages. In other words, prime mortgages to reliable borrowers have a lot less to offer the financier whose business is to refine and capture risk.
Another way to put it is that a considerable portion of the demand for subprime lending came, not from government, not even from borrowers, but from Wall Street's insatiable thirst for more yield with which to ply its exotic securities trade.
Posted by Paul J Cella | January 3, 2010 1:48 PM
That's well worth mulling, Paul. If I understand you, you're saying that there was this new "stuff" in the finance world--these "financial products" that involve making money off of edge-of-the-knife risk--and that the people making money off of this "new stuff" actually kinda _liked_ all those risky Fannie Mae/Acorn mortgages to unreliable homeowners, because they could package them up and bet on them and do high-flying financial deals, always assuming that they, personally, would somehow not be the ones left falling on the floor without a chair when the music stopped. So they took the politically motivated minority, etc., mortgages, packaged them up into these high-falutin' "new stuff" financial "products," and bet on them, and then other people somehow bet again on those bets (you see, I'm afraid, that I'm only able to understand all of this in somewhat crude terms), etc., which metastasized and vastly increased the potential damage to the economy from the risky mortgages. And if this "new stuff" hadn't been around and hadn't become very popular as a way of making money by playing Russian roulette with the economy (or musical chairs, or whatever) in the first place--which had happened prior to and independent of the sub-prime push from Uncle Sam--then it wouldn't have been available to perform this cancerous function with the subprime mortgages.
Have I got this basically right?
I have a vague recollection that I read an article by a hard-line (aka crank?) gold standard guy when all this was happening over a year ago who advocated nullifying most of these credit-default contracts as fraudulent and therefore unenforceable. That's assuming I understood him correctly. How does that idea appeal to you as a weird form of non-regulation regulation for stopping what you are describing?
Posted by Lydia | January 3, 2010 3:39 PM
You've got it about right, Lydia. Your crude language is more than adequate. Let me add two minor clarifications, as far as I understand things.
(1) Especially in the case of Long-Term Capital Management, most of these bets were really not recklessly speculative. Russian roulette overstates it as an analogy. They were, at least at the beginning, good bets based historically observable trends, models, etc. Even AIG's swap portfolio (basically ground zero of the crisis this time around) was hugely profitable for quite awhile, because it was based on reasonable expectations. Ultimately both LTCM and AIG got too heavily committed to that morbid optimism that often bewitches capitalists, but I would not be prepared to say (to jump to your last question) that we ought to proscribe credit derivatives. Maximos would probably go for that, though. :-)
(2) Keep in mind the multiple levels of remoteness involved here. LTCM got its capital from rich individuals, from institutions like pension funds (or the Harvard Corp.'s investment arm), and from banks and finance firms. The hedge fund did not really disclose its strategies, except in the vaguest terms; it was a private hedge fund. Much of the capital is flowing in through intermediaries. It's just another thread in this tangle of abstraction. So when it comes to subprime mortgages, why, most everyone in the market was invested in that to some degree. Mutual funds brought the average middle class investor in. Public-sector pensions (government guaranteed) were huge players. It was the democratization of capitalism.
But I think anything so radical as a prohibition on certain classes of derivative -- well, it would have to be carried off masterfully to avoid disaster. My more moderate step would be to propose that a firm or fund have some holdings of the underlying security in order to enter into derivative contracts. Certainly I think it wise to get these contracts trading on official exchanges, which is I believe part of legislative proposals.
I discussed some other regulatory ideas in this thread: http://whatswrongwrongwiththeworld.net/2009/12/political_economy_and_human_mo.html#comment-89817
Posted by Paul J Cella | January 3, 2010 5:09 PM
"Recall that the reason the sub-prime mortgage securities were desirable is that they were backed by less creditworthy assets, which means a higher yield on the bonds, which means a wider spread, which means more profit."
As I recall, the bundled sub-prime loans were given top ratings by the rating agencies. The issuers pay for the ratings so there is a huge incentive for these entities to cook the ratings. The original lenders could unload the mortgages after collecting high fees and the buyers could insure themselves against loss with CDS and the guys who sold the CDS could point to the ratings and who cares if the whole thing blows up as long as the folks involved get to bank a few seven to ten figure paychecks. Requiring original issuers to retain some significant risk and mandating exchange trading and banning naked positions is a good idea. Also it should be impossible to become wealthy save for very long term capital gains.
"It’s been generations since the West was led by men of laissez faire sensibilities on these matters. As early as 1998 the smart bet was on eventual rescue."
Andrew Mellon had those sensibilities in 1930; things didn't work out so well. Bailouts date back to at least 1825 and the bank of England's intervention in the panic of that year. The problem wasn't the bailout last fall; it was the Paulsen's failure to impose terms that caused real pain to the guilty. That an economy could actually operate on "laissez faire sensibilities" is as fanciful as the notion that we could run an economy using Das Kapital as a blueprint.
Posted by al | January 4, 2010 12:27 PM
Yeah, the ratings firms sure played a role in the debacle. But I don't agree that "the problem wasn't the bailout last fall; it was the Paulson's failure to impose terms that caused real pain to the guilty." Paulson at least stood by the principle that the equity holders should get wiped out. This happened to Bear Stearns, Fannie and Freddie, Lehman and AIG. He was a lame duck though; his influence waned rapidly after the September crisis. Geithner deserves more blame, ultimately, for protecting the debtholders.
Posted by Paul J Cella | January 4, 2010 12:51 PM
"Government bonds have been trading for centuries."
But Paul, you do know that tradeable government debt was extremely controversial when it was introduced, and was viewed by many (e.g., the "Country" party in England) as a corrupting influence? Perhaps we are just habituated to it now.
Posted by Gene Callahan | January 5, 2010 8:54 AM
I think to a large extent the games played by high-finance rocket scientists depends upon the availability of cheap capital. The Federal Reserve and our fractional reserve banking system greatly, and artificially, lower the cost of capital by counterfeiting it. The Austrian economists will say that we don't have, certainly not since the creation of the Federal Reserve and likely even before that, anything close to a free market in money and banking. If we did, it would probably look like a 100% gold reserve system which the United States has never had. In such a system all capital would have to come from genuine savings and it would be too expensive for hedge funds and banks to leverage up multiple times. My guess is that in such a system most hedge funds probably would not exist and banks' balance sheets would be much smaller.
Posted by Andrew E. | January 5, 2010 7:14 PM
Bailouts date back to at least 1825 and the bank of England's intervention in the panic of that year.
In the U.S., it dates back to the Panic of 1792 when Hamilton intervened to save the banks from the speculative bubble created by William Duer.
Posted by Perseus | January 5, 2010 8:51 PM