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March 5, 2010

General Counsel of Long Term Capital Management Says U.S. “Doubled-Down” On OTC Derivatives

Remember when Long Term Capital Management nearly blew up the world in 1998? When Wall Street did the exact same thing 10 years later, policy makers, regulators and bankers all claimed it came out of nowhere. Why didn’t they learn their lesson the first time around?

A few months back, Kate Welling published this interview with James Rickards, former General Counsel of LTCM, to get his take on the situation.

KW: Wall Street’s attempts to analyze and manage risk were a key part of what went wrong and led to the credit bust. That was an obvious lesson we failed to learn from LTCM.

JR: That’s right. Western capital markets came to the brink of collapse in 1998, when hedge fund Long Term Capital Management, with a trillion dollar web of counterparty risk at all the major banks and brokers of the time, failed. Then Fed Chairman Alan Greenspan and Robert Rubin, who at that juncture was Treasury Secretary, called it the worst financial crisis in 50 years. While the amounts involved and the duration of that crisis pale next to what we’ve been going through since 2007, it certainly didn’t feel minor at the time.

KW: You can say that again.

JR: I know, I was there. As general counsel of LTCM, I negotiated the bailout which averted an even greater disaster at that point. What strikes me now, looking back, is how nothing was changed; no lessons were applied. Even though the lessons were obvious, in 1998. LTCM used fatally flawed VaR risk models. LTCM used too much leverage. LTCM transacted in unregulated over-the-counter derivatives instead of exchange-traded derivatives. So risk models needed to be changed, or abandoned. Leverage had to be slashed. Derivatives had to be traded on exchanges or cleared through clearinghouses. Regulatory oversight needed to be ramped up.

KW: But none of that happened.

JR: Even worse, the government did just the opposite. Glass-Steagall was repealed in 1999, so that banks could become hedge funds. The Commodities Futures Modernization Act of 2000 permitted the creation of more unregulat- ed derivatives. The Basle II Accords and changes in SEC regulations in 2004 permitted more leverage. The U.S., in effect, stared near- catastrophe in the eye, with LTCM, and decided to double-down.

You can read the whole interview here.

P.S. WellingWeeden is consistently excellent. They even did a feature on us!

What’s our take on all this? To understand the actions of LTCM (and other large financial institutions) you have to look at their Mandate. Long Term Capital Management’s compensation structure incented them to leverage as highly as possible, enabling them to maximize returns on the upside, but leaving them open to a dramatic blow-up if their bets went sour. Sound familiar? It should. That’s exactly the same situation Wall Street faced in the run-up to 2008. With free money from the Fed, and a completely unregulated OTC derivatives market, the widespread excessive risk taking on Wall Street was not so much the result of an unconscious herding instinct, as it was a rational response to the institutional incentives they faced. Inadequate regulation creates bad incentives. It is society that foots the bill.

Hunt Brothers


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