Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (28 page)

—Alan Greenspan, FOMC meeting, September 29, 1998, upon learning that the counterparties that lent to LongTerm Capital Management did not monitor LTCM’s balance sheet

In the first three weeks of September 1998, LongTerm Capital Management (LTCM), a Greenwich, Connecticut, hedge fund, lost half a billion dollars a week, and everyone knew it.
²
Except, possibly, Alan Greenspan. In mid-September, in the midst of the turmoil, he told the House Banking Committee that “hedge funds [are] strongly

¹
Alan Greenspan, “Financial Derivatives,” speech at the Futures Industry Association, Boca Raton, Florida, March 19, 1999.
²
Nicholas Dunbar,
Inventing Money: The Story of LongTerm Capital Management and the Legends Behind It
(New York: Wiley, 2001), p. 210.

181

regulated by those who lend the money.”
³
He ignored the Federal Reserve’s responsibility, which is to regulate those who lend the money. The central bank had not done its job.

Four and a half months earlier, on May 2, 1998, Greenspan had given a speech in which he emphasized the advantages of “private market regulation.”
⁴
Greenspan explained, “[R]apidly changing technology has begun to render obsolete much of the bank examination regime established in earlier decades. Bank regulators are perforce being pressed to depend increasingly on ever more complex and sophisticated private market regulation. … [O]ne of the key lessons from our banking history [is] that private counterparty supervision is still the first line of regulatory defense.”

“Counterparty” may need an explanation. Banks have counterparty risk to their borrowers: the borrower may not repay a loan. That was a concern when the value of LTCM’s collateral fell below the amount of money it had borrowed. There is also counterparty risk in a derivative contract. A hypothetical example: when Citigroup and J. P. Morgan enter an interest-rate swap, Citigroup will receive floating-rate interest payments every six months, and J. P. Morgan will receive fixed-rate interest payments at the same time.
⁵
The interest-rate payments are computed based on a principal amount upon which the interest is earned: $100 million, for instance. The “counterparty” risk is that one of the participants fails and cannot pay back the $100 million of principal.

In his May speech, the chairman also noted that “[t]he complexity and speed of transactions and the growing complexity of the instruments have required both federal and state examiners to focus more on supervising risk management procedures, rather than actual portfolios.” The Fed now evaluated how banks monitored bank risks (e.g., their modeling techniques, the process used to supervise counterparties) in lieu of examining specific securities. It apparently never occurred to Greenspan, at least in any public statement, that maybe derivative structures should be reined in a bit, since government regulators could no longer understand the holdings in bank portfolios.

³
U.S. General Accounting Office,
LongTerm Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk
, GAO/GGD-00-3, October 29, 1999, p. 15, quoted in
Martin Mayer, The Fed: The Inside Story of How the World’s Most Powerful Financial Institution Drives the Markets
(New York: Free Press, 2001), p. 267.

⁴
Alan Greenspan, “Our Banking History,” speech at the Annual Meeting and Conference of the Conference of State Bank Supervisors, Nashville, Tennessee, May 2, 1998.
⁵
Citicorp was renamed Citigroup Inc. after it merged with Travelers Group in 1998.

Those Daffy Nobels

There had been plenty of warnings that not much had changed since the derivative failures in 1994. Ignorance was essential to derivative operations. We need look no further than LongTerm Capital Management and two of its employees, Robert Merton and Myron Scholes. The pair received the Nobel Prize in economic sciences in 1997 “for a new method to determine the value of derivatives.” Upon receiving his award in Stockholm, Myron Scholes “singled out two companies—General Electric and Enron—as having the ability to outcompete existing financial firms. He noted, ‘Financial products are becoming so specialized that, for the most part, it would be prohibitively expensive to trade them in organized markets.’ According to Scholes, Enron’s trading of unregulated over-the-counter energy derivatives was a new model that someday would replace the organized [and regulated] securities exchanges.”
⁶
Enron’s specialized derivatives left the company bankrupt in 2001, and General Electric’s financial ventures led it to government life support by 2008. The year after Merton and Scholes received their Nobel Prizes, the firm where they applied their theories collapsed.

John Meriwether had anticipated the derivatives boom by forming his Arbitrage Group at Salomon Brothers in 1977.
⁷
Meriwether left Salomon in 1991. In 1993, he formed LongTerm Capital Management (LTCM). He hired his top Salomon colleagues, including Merton and Scholes. By 1997, LTCM employed 25 Ph.D.s, who manufactured highly quantitative arbitrage trades. The fund rose 59 percent in 1995 and 44 percent in 1996, but then the law of diminishing returns kicked in.
⁸
The firm was managing much more money. The Ph.D.s were finding less opportunity to apply their skills. LTCM produced a 17 percent return in 1997.

⁶
Frank Partnoy,
Infectious Greed: How Deceit and Risk Corrupted the Financial Markets
(New York: Times Books, 2003), p. 303.
⁷
Roger Lowenstein,
When Genius Failed: The Rise and Fall of LongTerm Capital Management
(New York: Random House, 2000), p. 9.
⁸
Partnoy,
Infectious Greed
, pp. 254–255. It is not clear if the 1995 and 1996 returns are gross or net. The 1997 returns are after fees.

Its strategy “moved from highly quantitative arbitrage trades to outright gambling on currencies and stocks.”
⁹

LTCM proved to be too big to fail. The reason for its salvation was the same reason that its fortunes looked so dire: everybody who was anybody had a large stake in its solvency. If LTCM failed, the securities it held would not appeal to a very scared and skeptical market that showed no inclination to buy.

On September 21, 1998, LTCM lost $553 million in a virtuoso rejection of the Nobel laureates’ diversification models: all security prices went down.
¹⁰
The scientists from the classroom held a loose grip on the human mind. They forgot that “[d]uring a crisis, the correlation always goes to one.”
¹¹
This is the normal, time-tested reaction in such circumstances— everyone sells. This correlation never fails. This correlation is never modeled; if it were incorporated, banks would not trade leveraged derivatives.

The Fed Could Have Taken More Regulatory Initiative

The FOMC held a meeting on September 29, 1998. The staff and Fed governors briefed Greenspan on LongTerm Capital Management’s counterparties—the banks and brokers that lent to and traded with LTCM. When it became apparent to Greenspan that the risk management apparatus of the institutions he regulated operated at the level he should have expected (that is, expected from their history with loans to less-developed countries in the seventies and to commercial builders in the eighties), he was at a loss: “The question is why it happened in this case. Is it just that the lenders were dazzled by the people at LTCM and did not take a close look?”
¹²

From there, it grew worse. He was told that none of the banks, with the exception of Bankers Trust, had an up-to-date balance sheet for LTCM. Even Bankers Trust’s was “a relatively small piece of the whole action because so much of the latter is off-balance-sheet.”
¹³

⁹
Ibid., p. 255.
¹⁰
Lowenstein,
When Genius Failed
, p. 191.
¹¹
Martin S. Fridson, “Review of
When Genius Failed
, by Roger Lowenstein,”
Financial

Analysts Journal
, March/April 2001, p. 81.
¹²
FOMC meeting transcript, September 29, 1998, p. 107.
¹³
Ibid.

The need for supervision of the banks was obvious when a staffer commented: “It was something of a signature for [LTCM] to insist that if a counterparty wanted to deal with them, there would be no initial margin. Not many other firms have gotten away with that.”
¹⁴
For this reason alone, the Fed should have geared up its watchdogs to monitor the banks. There may be exceptions, but regulators should assume that large banks care more about profit than about risk. Banks chase the hot market until either the government bails them out (Citigroup—again and again) or they fail (Texas banks in the 1980s).

A staff member told the FOMC that LTCM’s counterparties only required the hedge fund to post collateral equal to the amount it had borrowed. Greenspan, a former director of J. P. Morgan, with 50 years of Wall Street experience, shared his perspective on collateral: “If I am a bank lender and I lend $200 million to a hedge fund, ordinarily I would be overcollateralized. I would hold more than $200 million in, say, U.S. Treasury bills.”
¹⁵
A staffer told the FOMC that LTCM’s collateral included “U.S. Treasuries, Danish government bonds, BBB credits— you name it.”
¹⁶
With all prices falling, BBB credits were weak collateral. Greenspan was learning how the “private counterparty supervision” actually functioned. It must have been obvious to the chairman that banks took a more casual approach to collateral than they did in his J.P. Morgan days.

Continuing with Greenspan’s example, suppose the value of LTCM’s collateral had fallen to $180 million, $20 million less than the amount it had borrowed. The counterparties would have demanded the hedge fund post $20 million more. By September 29, LTCM was unable to meet counterparty demands for additional collateral.

Greenspan was to receive more lessons in this application of modern finance. On September 21, when it seems (interpreting the transcript) the Fed first read LTCM’s balance sheet, its leverage was 55 to 1. A staffer offered more bad news: “The off-balance-sheet leverage was 100 to 1 or 200 to 1—I don’t know how to calculate it.”
¹⁷
The staffer wasn’t alone.

¹⁴
Ibid., p. 118.
¹⁵
Ibid., pp. 110–111.
¹⁶
Ibid., p. 108.
¹⁷
Ibid., p. 108.

Greenspan’s “first line of regulatory defense” didn’t know whether LTCM was trading interest-rate swaps or stolen cars.

Greenspan expressed his exasperation several times during the meeting: “It is one thing for one bank to have failed to appreciate what was happening to [LTCM], but this list of institutions is just mind boggling.”
¹⁸
So boggled was the man that Greenspan (and his successor Ben Bernanke) allowed the commercial banking system to leverage as never before, writing over $100 trillion worth of derivatives contracts between then and 2008—without so much as a dollar bill of reserves for these off-balance-sheet structures.

The FOMC discussed the adequacy of its own bank examinations. It was told that the Fed had not examined the banks since December 1997.
¹⁹
Vice Chairman McDonough said (at another point in the meeting): “It is not as if we were asleep.”
²⁰
But possibly they were dazzled. A Federal Reserve staff member mentioned banks’ risk management processes, but “[t]he question is how effectively the banks were implementing those policies and procedures.”
²¹
To the knowledge of the staffers at the meeting, no one at the Fed had taken the initiative to check.

In Greenspan’s remaining time at the helm, these gaps were left to fester despite the probability that the banks did have the information. The banks were often buying and selling on the trades made by LTCM. The trading desks of the banks had a good idea what the hedge fund owned.

The Rescue

Nicholas Dunbar, physicist, derivatives master, and author, described the atmosphere on the LTCM trading floor in the firm’s final week of independence: “Thirty years of financial theory has proved itself useless. Billion dollar track records and Nobel Prizes are now meaningless. … All that is left is a poker game.”
²²
As the poker game unfolded, Nobel Prize winner Robert Merton kept breaking into tears. He worried that LTCM’s fall would ruin the standing of modern finance.
²³
He had no need to worry. Americans worship experts, even when they are dismal failures. The reputations of Merton, Scholes, and the Nobel Prize in economic sciences were not in the least dented.

¹⁸
Ibid.
¹⁹
Ibid., p. 103.
²⁰
Ibid., p. 114.
²¹
Ibid., p. 103–104.
²²
Nicholas Dunbar,
Inventing Money: The Story of LongTerm Capital Management and the Legends behind It
(New York: Wiley, 2000). p. 214.

William McDonough coordinated the LTCM bailout. Twelve banks pledged $3.65 billion.
²⁴
The firm remained intact, although it was tethered to a short leash. Meriwether remained.

Greenspan’s decision to ignore what he had learned on September 29 was perplexing. It is common now to ascribe Greenspan’s neglectful regulation to his freemarket principles. But the transcript shows he was amazed that the banks did not monitor the hedge funds. From that moment forward, he knew that no one effectively regulated the hedge funds—not the government, and not the financial counterparties.

Justifying a Rate Cut? Or Two? Or Three?

By the end of the September 29 meeting, the FOMC voted to cut the funds rate by 0.25 percent, to 5.25 percent, with little concern for the economy. Greenspan later wrote, “it was highly likely that the U.S. economy would continue expanding at a healthy pace.”
²⁵
According to Greenspan’s book, the reason for the rate cuts (there were to be three, each of 0.25 percent) was the “small but real risk that the default might disrupt global financial markets enough to severely affect the United States.”
²⁶