Infectious Greed (46 page)

Other traders smelled blood at LTCM, and began betting against the hedge fund, trying to weaken its positions, just as Andy Krieger had traded against the central bank of New Zealand. LTCM was known as the “central bank of volatility,” and it began experiencing a classic run on the bank. John Meriwether, who rarely gave interviews, told reporter Michael Lewis, “It was the trades that the market knew we had on that caused us trouble.”
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Although the firm's investors were locked in and couldn't withdraw their money, LTCM's once-starstruck lenders were finally considering whether they should call in their billions of dollars of loans.

The final blow came in September, when volatility in nearly every market spiked upward, and LTCM sustained massive losses from its sales of long-dated stock options, mostly on the French and German stock indices. All the world's markets were moving in lockstep, and LTCM was losing on nearly all of its trades. On September 21, the firm's trades were worth less than $1 billion, and with leverage of more than 100-to-1, it would go under if the market even flinched.

Under the “gentle pressure” of the Federal Reserve, which was concerned that LTCM's failure might trigger a sequence of global defaults that would cause the entire banking system to unravel, LTCM's lenders met in the offices of the New York Federal Reserve Bank. Fed chief Alan Greenspan already had remarked that the financial crisis surrounding LTCM was the worst he had ever experienced; Treasury Secretary Robert Rubin said in September that “the world is experiencing its worst financial crisis in half a century.” U.S. government officials didn't want to bail out LTCM, so they bullied the banks to do so instead.

On September 23, 1998, after a potential buyout, involving billionaire Warren Buffett, fell through, fourteen major banks—including the banks that had given LTCM sweetheart terms on its loans—agreed to contribute $3.6 billion in return for a 90 percent stake in LTCM.
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With the regulators watching, and the alternative of a widespread international crisis, the bankers didn't have much of a choice. It was incredible, but no one had seen it coming.

Many commentators criticized U.S. regulators for assisting with another bailout, but the more troubling issue was the fact that the Fed had seemed powerless to do much more than offer cookies and a meeting room, as Alan Greenspan later admitted. The minutes of the Federal Open Market Committee, from September 29, 1998, stated, “The Committee discussed the limited role of the Federal Reserve Bank of New York in facilitating a private-sector resolution of the severe financial problems encountered in the portfolio managed by Long-Term Capital Management L.P. The size and nature of the positions of this fund were such that their sudden liquidation in already unsettled financial markets could well have induced further financial dislocations around the world that could have impaired the economies of many nations, including that of the United States. Against this background, the Federal Reserve Bank of New York had brought together key interested parties with the aim of increasing the probability of an orderly private-sector solution to the hedge fund's difficulties.”

To their credit, the regulators had learned at least a partial lesson about the moral hazard created by earlier bailouts. This time, they were involved only indirectly, and no government funds went to support either the Wall Street banks or John Meriwether's traders.

Meriwether and his crew kept their jobs, but lost most of their personal stakes in LTCM. In all, the fund had lost more than 90 percent of its value during 1998: less than 10 percent of the losses were from
emerging markets; $1.3 billion was from selling options, and $1.6 billion was from the convergence strategies that had generated 87 percent of the profits at Salomon Brothers just a few years earlier.
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F
rom Mexico to Barings to East Asia to LTCM, the international financial crises of the mid-to-late 1990s had become progressively more complex and far-reaching. By 1998, it was obvious that global markets were linked more closely than anyone had anticipated, so that a problem in Russia could lead to the collapse of a hedge fund in the United States. Now investors had plenty to talk about at Super Bowl parties, regardless of who was hosting. The open question was: where could they possibly put their money?

No one doubted that new financial instruments had created great benefits by enabling investors and corporations to manage risks more efficiently. But the instruments also had increased the frequency and potential severity of market crises, in part because they were so hidden from view. Commentators argued about whether the changes were for better or worse, but the argument was moot: the changes were permanent, and investors and regulators would need to deal with the new risks, or else.

Even the strongest supporters of deregulation recognized that market participants were not adequately monitoring their risks. The President's Working Group on Financial Markets blamed Wall Street for these risk-management failures, although it stopped short of recommending new rules. The Working Group's report on LTCM rebuked major U.S. banks for being complacent during good times, and warned them not to let the lessons of LTCM recede from memory. As a Sword of Damocles, the Working Group listed “Direct regulation of derivatives dealers unaffiliated with a federally regulated entity” as a “potential additional step.”
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Meanwhile, the derivatives activities of the top investment banks remained outside the scope of U.S. law.

These unregulated financial institutions were LTCMs-in-waiting. In many ways, the top investment banks looked just like LTCM. They had an average debt-to-equity ratio of 27-to-1—exactly the same as LTCM's (and that did not include off-balance-sheet debt associated with derivatives—recall that swaps were not recorded as assets or liabilities—or additional borrowing that occurred within a quarter, before financial
reports were due).
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They did many of the same trades, and used the same risk models. Now that LTCM was laying off employees, some investment banks would even hire the same traders.

The various international crises highlighted the fact that market participants were no longer able to assess their own risks. Investment funds didn't have a good understanding of the risks in Mexico or Thailand. Executives at Barings had no clue about Nick Leeson's trading. And, worst of all, the traders at LTCM had used computer models that simply did not work. When the President's Working Group on Financial Markets surveyed financial firms to see how they were managing risks, it reached the following chilling conclusion, buried in an appendix to its report on LTCM: “Most models do not incorporate all products traded by the firm. Firms initially included products they believed presented the highest risks to them, with the intent of including other credit sensitive products at some future date. Some firms do not have an ability to calculate and monitor aggregate exposure limits across all product lines in a VAR-based environment. For instance, some firms only include derivative and foreign exchange transactions, and not repurchase agreements, mortgage backed securities and forwards. A firm's inability to evaluate exposures across all product lines could considerably underestimate credit exposures during periods of extreme market volatility.”
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In other words, even firms that used Value At Risk—which calculated the maximum daily loss with a 95 percent confidence interval, based on historical data—were not able to track their own risks. In truth, VAR was dangerous. It gave firms a false sense of complacency, because it ignored certain risks and relied heavily on past price movements. In some markets, VAR actually increased risk, because every trader assessed risk in the same flawed way. In other markets, traders calculated VAR measures that varied “by 14 times or more.”
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Risk management was more art than science, and risk could not be boiled down to a single VAR number. LTCM's VAR models had predicted that the fund's maximum daily loss would be in the tens of millions of dollars, and that it would not have collapsed in the lifetime of several billion universes. Askin Capital Management's VAR had been only about $15 million just before it collapsed.
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Barings's VAR models said its risk was zero.

Yet even after LTCM collapsed, more than 80 percent of financial firms said they used VAR with a 95 percent confidence interval.
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This
was true even though, in 1998, almost anyone could buy much more sophisticated computer models—which would have required an army of Ph.D.s in 1994—for just a few thousand dollars, as a plug-in to a computer spreadsheet such as Microsoft Excel. But instead of using more sophisticated models, most firms used a simple VAR model. Companies paid Bankers Trust a million dollars each for access to the firm's VAR model, called RAROC 2020, based on the risk-adjusted rate of return Charlie Sanford had introduced at Bankers Trust many years earlier. In 1997, the credit-rating agencies—always slow to the game—finally adopted J. P. Morgan's benchmark model, called CreditMetrics, which relied on historical data and V AR.
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The names were fancy—VAR, RAROC 2020, CreditMetrics—but all these models really did was compare historical measures of risk and return. They were the models the President's Working Group on Financial Markets had said were seriously flawed.

Why were so many firms using such faulty models? Once again, the primary explanation involved legal rules. Although some firms stuck with VAR because they didn't know any better, the major reason firms used VAR—and even disclosed VAR measures in financial statements—was that regulators required them to do so. Just as regulators had inadvertently led CEOs to become mercenaries by tinkering with the rules for executive compensation and stock options, they were now inadvertently encouraging firms to misstate their own risks.

On January 28, 1997, the SEC had adopted a rule
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requiring companies to disclose more information about derivatives, and gave them three options, the easiest of which was to disclose a VAR measure with a 95 percent confidence interval. Likewise, the Bank for International Settlements also recommended the use of VAR, as did many international-banking regulators, including the Federal Reserve. Not surprisingly, companies used VAR.

Fed Chairman Alan Greenspan opposed any additional regulation. Although Greenspan publicly mouthed support for laws prohibiting financial fraud, in private he was willing to disclose his true opinion—that he believed there was no need for anti-fraud rules, either. In one lunch meeting in his private dining room at the Fed, he told a senior regulator, “We will never agree on the issue of fraud, because I don't think there is a need for laws against fraud.” Greenspan said his experience trading commodities early in his career had persuaded him that anti-fraud rules were unnecessary, because participants in the markets inevitably would
discover fraud. Market competition alone—without any regulation—was sufficient, because no one would do business with someone who had a reputation for engaging in fraud.

Given Greenspan's power and strong opinions, any new financial regulations were going to be market-based. Regulators began allowing financial institutions to use their own versions of models to assess whether they were complying with rules that required them to reserve a sufficient cushion of capital based on the risks they took. In simple terms, banks had been required to keep eight cents in reserve for every $1 of loans they made. That requirement was easy to administer when all banks did was make loans. But banks were now engaged in more complex businesses, and they weren't the only financial institutions with capital requirements. How much capital should a securities firm reserve against an inverse IO? What about an insurance company that owned a slice of a Collateralized Bond Obligation? How should a bank treat a complex swap with a hedge fund such as LTCM?

These were more difficult questions, and regulators knew that if they created specific rules for particular instruments, they would be drawing lines in the sand, where financial innovators would quickly find economically equivalent instruments that fell on the other side. So, instead, regulators abdicated to the market and permitted companies to use their own models—flawed or not—to determine whether they were in compliance with minimum capital requirements. In reality, there wasn't much they could do. As one regulator put it, “For $112,000 a year, we can't hire someone who can check the models of kids making ten times that.”
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All of these issues were much too complicated for average investors. Even if they scoured financial statements to assess a company's leverage and derivatives, and examine its VAR measures, they still wouldn't have an accurate picture. If Wall Street banks couldn't even get an accurate sense of their investments, or gauge their own risks, and if a sophisticated hedge fund such as LTCM could collapse because it had been using bad computer models, what hope did individuals have of accurately assessing the risks of their investments? In 1994, it hadn't made much sense to read lengthy corporate annual reports. Now, it didn't even seem worth bothering to look at anything other than the company's name, or perhaps its website.

In such a hopelessly complex environment, with all the various international crises, companies involved in speculative ventures related to the Internet and other new technologies seemed like reasonable investments.
If the alternatives were established companies that either were lying about their accounting data or were unable to manage their own risks, just about any new investment looked attractive. When technology companies began issuing shares to the public in Initial Public Offerings that shot up by hundreds of percent during the first day of trading, and then continued going up, these stocks looked like sure things.