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1998
and Today
Brian
Trumbore
President/Editor, StocksandNews.com
If you are in the least bit interested
in history, be it World history or Wall Street's past,
you're probably like me. Every now and then you find
yourself thinking "The more things change, the more
they stay the same." And so it is that some of us
look at the role of derivatives in today's financial
markets and can only marvel; we've been here before
and when we will ever learn?
I'm
one of those who constantly files interesting articles
for future reference and the other day I came across
a piece I had forgotten I kept; an article from the
December 1998 issue of Institutional Investor magazine
that dealt with the background and aftermath of the
Long-Term Capital Management (LTCM) debacle.
Then
I pulled out my copy of Roger Lowenstein's definitive
study of LTCM, "When Genius Failed: The Rise and Fall
of Long-Term Capital Management." For those who are
younger, and / or with short memories, it was just
about seven years ago that hedge fund LTCM's $100
billion balance sheet imploded, thus threatening the
health of the entire world financial system until
the Federal Reserve Board and Wall Street's leading
investment banks engineered a bailout.
So
I thought I'd pull a few quotes from each source as
a way of proving once again; the more things change,
the more they stay the same. When it comes to derivatives,
we've been down this road before and just as the sun
rises in the east, we'll repeat the same mistakes
all over again.
---
From
"Wall Street and the Hedge Funds" by Robert Clow and
Riva Atlas / Institutional Investor, December 1998.
"Over
the past decade, hedge funds became Wall Street's
biggest, and in many ways most lucrative, customers.
Rapidly growing, sophisticated, usually global in
outlook, highly transactional and often run by investment
banking veterans, hedge funds made ideal clients when
margins were under stress?.
"Wall
Street raises money, executes, clears and settles
trades for the hedge funds. But at the heart of the
relationship is leverage, the massive provision of
credit through swaps, options and other structured
products and through collateralized repurchase agreements.
This lucrative two-way activity came to be known in
Street parlance as 'renting out the balance sheet.'
Never before has so much credit been extended to so
many players in so many places with so few controls.
"The
amount of leverage-related activity is mind-boggling,
as critical to finance as wires to electricity and
just as invisible?.
"All
this credit creation has helped spawn the most-liquid
and efficient markets the world has ever known. Yet
in the light of near disaster, they appear now to
have been far more fragile than anyone realized. The
system turns out to have been built on a delicate
framework of trust, loose habits and mathematical
models that failed just when they were most needed.
Lenders rented out their balance sheets - and in some
cases actual office space - but didn't do very good
credit checks on their tenants. That's now changing?.
"[Leverage]
in the markets today is a relatively recent phenomenon.
Through most of the '80s, it was limited by regulatory
and cultural barriers, not to mention the absence
of stable, cheap financing. Short-term rates bounced
around, and the yield curve inverted periodically
- perilous conditions for traders financing long positions
overnight.
"In
the meantime, even as new markets opened, many of
Wall Street's business lines began to slip. Margins
compressed, competition increased, and customers became
more powerful and sophisticated. Products commoditized
rapidly. Large investment banks' pretax margins plunged?.
"[But
by the mid-90s, Wall Street's managers] discovered
the joys of dealing with hedge funds. Indeed, hedge
fund proliferation is one of the great growth stories
of finance."
---
[Assorted
tidbits on the industry?Wall Street's revenues and
hedge funds]
"Funds
pay banks and broker-dealers to raise capital, but
at the core of the relationship is prime brokerage,
invented when Neuberger Berman began clearing for
pioneering hedge founder Alfred W. Jones in the early
1950s. Prime brokerages are hedge funds' lifelines:
They clear trades, finance positions and provide lots
of helpful extras?.
"Close
relationships with the funds give Wall Street other
advantages, notably a greater ability to place securities.
That's particularly helpful for highly structured
instruments in the private-placement market, especially
if the issuer wants to keep a deal very quiet. More
than other investors hedge funds are comfortable deconstructing
and pricing complex investments, and they can buy
in bulk. Long-Term Capital bought $480 million of
the $3.1 billion bank debt Lehman underwrote in March
1998 on behalf of Starwood Hotels & Resorts - a massive
proportion of the deal for a single nonblank buyer.
"In
addition to commission business, hedge funds are great
sources of information. It's easy to overestimate
the extent to which Wall Street firms can replicate
hedge fund trading strategies - LTCM's policy of splitting
trades among many firms to get better pricing also
helped cloak its strategies - but dealers agree that
just seeing hedge fund flows has massive benefits.
'These guys help you manage risk,' says the head of
the hedge fund sales desk at one Wall Street firm.
Adds a Wall Street- trader-turned-hedge-fund-manager,
'You need to know if the whole market is going short,'
noting the dangers of a short- covering stampede.
"What
unites Wall Street and the hedge funds is their love
of leverage. It's a mutual affair.
"
'Wall Street does not provide hedge funds with liquidity,'
says [a leading hedge fund manager]. 'Hedge funds
provide liquidity to Wall Street. When things get
cheap, hedge funds are in there buying. The function
of arbitrage is always to provide liquidity.'"
---
From
"When Genius Failed: The Rise and Fall of Long-Term
Capital Management" by Roger Lowenstein.
"In
1990, there were $2 trillion worth of interest rate
swaps (just one type of derivative) outstanding. By
1997, the total had soared to $22 trillion. One offshoot
- largely unintended - of this tremendous growth was
that banks' financial statements became increasingly
obscure. Derivatives weren't disclosed in any way
that was meaningful to outsiders. And as the volume
of deals exploded, the banks' balance sheets revealed
less and less of their total obligations. By the mid-1990s,
the financial statements of even many midsized banks
were wrapped in an impenetrable haze.
"The
bankers were too busy making money to bother about
the risks or the shoddy disclosure in this fast-growing
business. The few who did voice caution, such as Henry
Kaufman, a noted economist who worked at Salomon in
the 1980s, were ignored. Kaufman recalled:
'I
still remember when Meriwether's group (LTCM) came
in and we started doing interest-rate swaps. There
was always a question of what type of limits we would
set. It just kept mounting and mounting. After we
had a billion it went to two billion. Then it went
to five billion. There was never an analytical framework
for saying how far we should go.'
"By
1995, when Meriwether's traders were happily ensconced
at Long-Term, the group had a total derivative book
worth $650 billion. Within two years, the total doubled,
to an astounding $1.25 trillion. Given the opaque
nature of Long-Term's (and everyone else's) disclosures,
it was impossible to pinpoint the fund's derivative
risks according to specific trades. And since many
of its contracts were hedges that tended to cancel
each other out, it was impossible to calculate Long-Term's
true economic exposure. One could say only that it
appeared to be growing very quickly - as were exposures
up and down Wall Street. Almost imperceptibly, the
Street had bought into a massive faith game, in which
each bank had become knitted to its neighbor through
a web of contractual obligations requiring little
or no down payment.
"Regulators
became increasingly worried. By the mid-1990s, Wall
Street had become accustomed to one or two derivative
'shocks' a year. Banks or institutions considered
healthy one day would go up in smoke the next due
to hidden derivative exposures. One by one, Orange
County, Bankers Trust, Barings Bank, Metallgesellschaft,
Sumitomo Bank, and others revealed sudden and massive
losses. As the list of individual traumas grew, regulators
began to fret about the possibility of a shock to
the entire system: pull on the right thread, and the
entire ball of string would unravel, they feared?.
"With
regard to derivatives, the policy-making arm of the
Fed took a laissez-faire approach - starting with
Greenspan, who was enamored with the seamless artistry
of the new financial tools. In public debates, Greenspan
repeatedly joined forces with private bankers, led
by Citicorp's John Reed, who were fighting tooth and
nail to head off proposals for tougher disclosure
requirements. Even as hedge funds increasingly used
swaps to dodge the Fed's own margin rules, Greenspan
cast an approving eye. Incredibly, rather than trying
to extend some form of margin rule to the derivative
world, Greenspan proposed to eliminate the margin
rules entirely. His 1995 testimony to Congress read
like a banker's brief. At its heart was a beguilingly
simple idea: that more trading (and hence more lending)
was always and inherently good because it bolstered
'liquidity.'
'Removal
of these financing constraints would promote the safety
and soundness of broker-dealers by permitting more
financing alternatives and hence more effective liquidity
management?.In the case of broker-dealers, the Federal
Reserve Board sees no public policy purpose in it
being involved in overseeing their securities credit.'
"A
bit of liquidity greases the wheels of markets; what
Greenspan overlooked is that with too much liquidity,
the market is apt to skid off the tracks. Too much
trading encourages speculation, and no market, no
matter how liquid, can accommodate all potential sellers
when the day of reckoning comes. But Greenspan was
hardly the first to be seduced by the notion that
if only we had a little more 'liquidity,' we could
prevent collapses forever."
---
Note:
Over the past few years, when given the opportunity
Fed Chairman Greenspan continues to praise hedge funds
for their ability to provide liquidity. It's only
recently that, in the case of Fannie Mae and Freddie
Mac, for example, he has begun to cover his butt when
it comes to the gigantic risks these institutions,
and others of their ilk, pose to the entire system.
Brian
Trumbore
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