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Posted by Larry Doyle on March 18, 2009 3:50 PM |

A precursor to the turmoil roiling our economy and markets today occurred on a smaller, but certainly very dramatic, scale in 1998. The meltdown of the hedge fund Long Term Capital Management brought the market to its knees at the time. LTCM was effectively taken over by a consortium of Wall Street banks at the behest of New York Federal Reserve Chairman, William McDonough. The firms injected approximately $3 billion dollars in order to stabilize LTCM and then unwound it in an orderly fashion.

The lessons learned in the LTCM crisis were obviously not learned well enough because we are experiencing them again a multiple hundred fold. The centerpiece of our current fiasco is AIG (known here at Sense on Cents as “Ain’t It Great”).

The dramatic story of Long Term Capital Management is captured in a book I strongly recommend for anybody interested in the history of the financial markets. When Genius Failed, by Roger Lowenstein, is a great read and truly captures the intrigue, egos, and tension of that period. As the current turmoil unwinds I look forward to the books published on this period as well.

While books can be entertaining, they are not the vehicle for learning real lessons. Personal experience is always the best teacher.

I dealt personally with the partners of LTCM during the development of their firm, throughout its 4 year duration, and its downfall. LTCM operated in a totally quantitative style where the models embedded in black boxes dictated transactions. AIG did the same.

LTCM thought they had a diversified book of exposures across foreign and domestic sectors of both the credit and equity markets. AIG did the same, although their greatest exposure centered on the sub-prime mortgage space.

LTCM viewed themselves as both bigger and smarter than the market itself. AIG did the same.

LTCM totally mispriced liquidity risk, that is the risk that another human being needed to provide liquidity for the unwinding of a trade. AIG did the same.

LTCM was not officially bailed out. Although the principals and investors in that fund were largely wiped out, the firm did not outright fail as the consortium of banks injected capital. Did the moral hazard of that experience play into the AIG debacle? This point will be debated in the months and years ahead.

One angle of the LTCM meltdown that has received very little public attention over the years was the manner in which Wall Street banks managed their own books and capital during that period. In short, the senior executives of the consortium of banks involved in saving the system during the LTCM meltdown became totally aware of LTCM’s positions. That confidential information was tremendously valuable because those positions obviously needed to be unwound. In layman’s terms, if I know you are in a position of having to sell something, I can drive the market lower in your face so you are forced to sell at an ever lower price. It is widely speculated that Goldman Sachs effectively front ran the unwinding of LTCM’s positions and made hundreds of millions of dollars in the process.

Fast forward to today’s situation with AIG. The Wall Street banks certainly know what AIG’s positions are along with the fact that the government is trying to unwind these positions. Do you think Wall Street traders are sitting idly by as AIG tries to unwind this mess? Why has AIG needed an ever increasing amount of government money? Very simply, the markets that AIG has exposure to are continuing to weaken as they try to exit positions. Why are they weakening? It would be naive to think that other Wall Street traders are not once again front running AIG much as Goldman Sachs’ traders supposedly front ran LTCM in 1998.

How can the government prevent any front running on behalf of Wall Street banks? Regulators should be scouring the trading records of every AIG counterparty on a regular basis. Are the regulators doing this? The government and regulators are certainly stretched very thin. Are Wall Street traders taking advantage of the situation? It would be naive to think they are not.

Trust but verify!! Actually, why should we trust a crowd that has provided no basis for trust to this point? Let’s just verify!!


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