Marginal Utility

by Tom Bozzo

The last few nights, I've been enjoying Roger Lowenstein's When Genius Failed: The Rise and Fall of Long-Term Capital Management. At least, I've been marveling at its parallels with the present crisis — not principally because of JM's latest round — in-between thinking that I might sleep better were I reading "Call of Cthulhu" as a chaser to a late-night screening of Alien.

The density of Famous Last Words and Unheeded Cautionary Lessons is too high as to make a comprehensive review possible (yet 'nobody' saw the current crisis coming), but here are a few favorites:

Removal of these financing constraints [margin rules] 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 overseeing their securities credit.

That's Alan Greenspan, testifying to Congress in 1995.

[Fama] argued that Black Monday had been a rational adjustment to a (one-day?) change in underlying corporate values. On the other hand, Lawrence Summers... told the Wall Street Journal after the crash, "The efficient market hypothesis is the most remarkable error in the history of economic theory." (p. 74)

And that's saying something?!

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... "Credit limits for customers are an essential tool for credit risk management," [The New York Fed] warned. [emphasis in original]

Shockingly, the warning was in a letter to Wall Street banks, not business undergrads.

Writing in the prestigious Journal of Finance, Andrei Shleifer of Harvard and Robert W. Vishny of Chicago presciently warned that an arbitrage firm of Long-Term's type could be overwhelmed if "noise traders" pushed prices away from true value... [T]hey predicted that, in such a case, arbitrageurs would "experience an adverse price shock" and be forced to liquidate at market lows. Merton... pooh-poohed the notion that markets could be overwhelmed. (p. 111)

Merrill's willingness to finance its client was part of a pervasive climate of financial laxity, palpable in Wall Street's eagerness to underwrite emerging markets. (p. 130)

Let's play "substitute the asset category!

The comforting notion that global financial cops would always be there to put matters right was now exposed as a fallacy. This time, there was no rescue by the IMF, no hurried bailout by Robert Rubin or the Group of Seven Western powers... It "punctured a moral hazard bubble" that had been inflating expectations... Investors, at first singly and then en masse, concluded that no emerging market was safe. In seventy years, Russia's Communists had not succeeded in dealing markets such a telling blow as did its deadbeat capitalists. (p. 144)

Most of us survived 1998, but we'll see if our deadbeat capitalists can one-up their Russian counterparts...

Labels: hedge funds, High Finance, Personal Finance Advice of Alan Greenspan