Back in September 1998, Long-Term Capital Management -- a hedge fund run by Harvard Business School Professors and Nobel Prize winners -- was hovering on the brink of failure. LTCM's managers had created a massively leveraged portfolio comprised largely of derivatives. LTCM began suffering enormous losses and a decline in liquidity in September 1998; these problems were due to economic instability in emerging markets around the globe that caused many of its positions to plummet simultaneously.
The Federal Reserve Bank acted quickly and organized LTCM's bailout. All of Wall Street's major investment banks (with the exception of Bear Stearns, ironcially) contributed hundreds of millions of dollars to a fund that was used to unwind LTCM's positions. The banks feared that LTCM's failure would put them in jeopardy since they were counterparties to LTCM's derivatives contracts. And the Federal Reserve Bank feared that LTCM's failure would trigger a global financial meltdown. Disaster was avoided.
Ten years later we find ourselves once again hovering on the brink of a global financial meltdown. The cause of the problem is fundamentally similar -- too much exposure to risk. But this time the problem originates from several investment banks and insurance companies rather than from a single hedge fund. And this time the web of counterparties is much broader. The problem is much worse than it had been in 1998. The Federal Reserve Bank and the Department of the Treasury may not be able to prevent a meltdown this time.
Our government apparently learned very little from the LTCM fiasco. The government failed to enact legislation and regulations designed to prevent firms from endangering the financial system through their leveraged investments. Instead of improving regulation since 1998, the goverment continued with its hands-off approach and actually relaxed regulation. The government in effect placed Wall Street in charge of safeguarding the financial system; but firms lacked the incentive to manage even their own risk exposure prudently.
The securities industry is in dire need of smarter regulation. Firms cannot be permitted to endanger the financial system through their risky investments. Regulators must have the ability to recognize serious threats to our financial system, must be powerful enough to correct these problems through regulatory action, and must use their power sparingly.
Posted by Paul Malmfeldt on September 17, 2008.
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