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Wall Street History
https://www.gofundme.com/s3h2w8
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06/03/2005
1998 and Today
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.”
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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.
Wall Street History returns June 10.
Brian Trumbore
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