For the record, I do not agree with the bail-out of the LTCM. Contrary to a recent "doomer" post, however, Federal Reserve Chairman Greenspan did not say the financial systems was close to "collapsing."

Greenspan Comments

-- Ken Decker (kcdecker@worldnet.att.net), April 18, 2000

Answers

Ken. Thanks for the link. I had not read this before, and now I know much more about the situation.

What I found interesting was this quote:

"...to hold 40 percent capital against assets as they did after the Civil War, there would, of course, be far less moral hazard and far fewer instances of fire-sale market disruptions. At the same time, far fewer banks would be profitable, the degree of financial intermediation less, capital would be more costly, and the level of output and standards of living decidely lower. Our current economy, with its wide financial safety net, fiat money, and highly leveraged financial institutions, has been a conscious choice of the American people since the 1930s. We do not have the choice of accepting the benefits of the current system without its costs. "

One of the issues most talked about in the banking sector last year was fractional reserve banking. Many of us learned about it for the first time. I had started a thread about this about 6 weeks ago. Anyway. This quote speaks to that system directly, to wit, that our standard of living would be decidely lower if banks kept a larger percentage of capitol as a hedge against risk.

-- FutureShock (gray@matter.think), April 18, 2000.

As Alan Greenspan said in the testimoney that Ken Decker refers to in the post above;

This decade is strewn with examples of bright people who thought they had built a better mousetrap that could consistently extract an abnormal return from financial markets. Some succeed for a time. But while there may occasionally be misconfigurations among market prices that allow abnormal returns, they do not persist. Indeed, efforts to take advantage of such misalignments force prices into better alignment and are soon emulated by competitors, further narrowing, or eliminating, any gaps.

No matter how skillful the trading scheme, over the long haul, abnormal returns are sustained only through abnormal exposure to risk.

It was very interesting reading, the double talk to justify bailing out the "private-sector refinancing of the large hedge fund, Long-Term Capital Management (LTCM)".

Odd how they made sure that those who invested in risky funds were able to get a cut of the pie when it was bailed out. Oh, and the logic he used to explain why they should not be held responsibe for their mistakes, how important it was that they be "helped" through the losses they brought upon themselves, yet when they were making money hand over fist, they were not inclined to "help" others to their profits.

TCM is a hedge fund, or a mutual fund that is structured to avoid regulation by limiting its clientele to a small number of highly sophisticated, very wealthy individuals and that seeks high rates of return by investing and trading in a variety of financial instruments. Since its founding in 1994, LTCM has had a prominent position in the community of hedge funds, in part because of its assemblage of talent in pricing and trading financial instruments, as well as its large initial capital stake. In its first few years of business, it earned an enviable reputation by racking up a string of above-normal returns for its investors.

Yet when they screwed up, "this small group of unregulated, very wealthy individuals" were bailed out.

And senior citizens have to choose between eating and buying life saving medications. I am beginning to think TEOTWAWKI might just end up happening for some people after all. Hopefully a small group of unregulated, very wealthy individuals. **smirk**

Y2K has an effect on the market in many ways, do any investers realize it?

So much money was spent of Y2K remediation, on testing for Y2K problems, on new equipment in many cases, and in some updating equipment as well as software for the future along with Y2K. Less money was spent on new projects and a lot of projects were put on hold until everything with Y2K was over with. When companies spend money on making sure their equipment worked instead of investing it in profit making ventures, the money spent not bringing any return (due to remediation) then profits should be down if non-existant from the whole ordeal. Financial markets operate efficiently only when participants can commit to transactions with reasonable confidence that the risk of nonpayment can be rationally judged and compensated for.

Fear, whether irrational or otherwise, grips participants and they unthinkingly disengage from risky assets in favor of those providing safety and liquidity.

Quickly unwinding a complicated portfolio that contains exposure to all manner of risks, such as that of LTCM, in such market conditions amounts to conducting a fire sale. The prices received in a time of stress do not reflect longer-run potential, adding to the losses incurred. Of course, a fire sale that transfers wealth from one set of sophisticated market players to another, without any impact on the financial system overall, should not be a concern for the central bank. Moreover, creditors should reasonably be expected to put some weight on the possibility of a large market swing when making their risk assessments.

The scale and scope of LTCM's operations, which encompassed many markets, maturities, and currencies and often relied on instruments that were thinly traded and had prices that were not continuously quoted, made it exceptionally difficult to predict the broader ramifications of attempting to close out its positions precipitately. That its mistakes should be unwound and losses incurred was never open to question.

It was the judgment of officials at the Federal Reserve Bank of New York, who were monitoring the situation on an ongoing basis, that the act of unwinding LTCM's portfolio in a forced liqudiation would not only have a significant distorting impact on market prices but also in the process could produce large losses, or worse, for a number of creditors and counterparties, (who were aware that they were at risk, yet took that risk at the possibility of big profits) and for other market participants who were not directly involved with LTCM. How many "retirement funds" were invested in these risky ventures without the knowledge of the participants?

officers of the Federal Reserve Bank of New York contacted a number of creditors and asked if there were alternatives to forcing the firm into bankruptcy.

The troubles of LTCM were not a complete surprise to its counterparties.

Still, creditors as a whole most likely underestimated the size and scope of the market bets that LTCM was undertaking, an issue that is currently under review.

On September 23, the private sector parties arrived at an agreement providing a capital infusion of about $3-1/2 billion in return for substantially diluting existing shareholders' stake in LTCM.

And with markets currently volatile and investors skittish, putting a special premium on the timely resolution of LTCM's problems seemed entirely appropriate as a matter of public policy.

Any action by the government that prevents some of the negative consequences to the private sector of the mistakes it makes raises the threshold of risks market participants will presumably subsequently choose to take. Over time, economic efficiency will be impaired as some uneconomic investments are undertaken under the implicit assumption that possible losses may be borne by the government.

In otherwords, if the government helps bail out one entity who takes stupid risks in the hope of a big payoff, others will take just as stupid, if not stupider risks under the assumption the government will bail them out also. Could this possibly be the reason why the market has gone sky high since LTCM's bailout?

To be sure, investors wiped out in a fire sale will clearly be less risk prone than if their mistakes were unwound in a more orderly fashion.

In strait talk, if they have to eat their losses, they won't be as likely to take such stupid risks again, bail them out and they will make the same mistakes again.

But is the broader market well served if the resulting fear and other irrational judgments govern the degree of risk participants are subsequently willing to incur? Risk taking is a necessary condition for wealth creation. The optimum degree of risk aversion should be governed by rational judgments about the market place, not the fear flowing from fire sales.

quently willing to incur? Risk taking is a necessary condition for wealth creation. The optimum degree of risk aversion should be governed by rational judgments about the market place, not the fear flowing from fire sales. The Federal Reserve provided its good offices to LTCM's creditors, not to protect LTCM's investors, creditors, or managers from loss, but to avoid the distortions to market processes caused by a fire-sale liquidation and the consequent spreading of those distortions through contagion. To be sure, this may well work to reduce the ultimate losses to the original owners of LTCM, but that was a byproduct, perhaps unfortunate, of the process.

the creditors of LTCM apparently also understood the importance of some cushioning of the losses to the owners and managers of the firm.

No matter how skillful the trading scheme, over the long haul, abnormal returns are sustained only through abnormal exposure to risk.

He goes on to try to justify how the feasco was allowed to happen, but what basically did happen was due to a record of good profit, LTCM was left to make bad investements without question by those who should have questioned their digging themselves deeper and deeper when things started to go bad.

What has happened since then? How many others have been taking unreasonable chances under the assumption they would get bailed out if they went under? How many are in the process of going under right now because of the gambles they have been taking on high tech stocks that haven't lived up to expectations? Where do these investers think the profit they expect is going to come from?

If they took Y2K into consideration they would not expect a profit to show for a while at least. Yet they have driven up stock prices on the assumption that the involvement of these companies in high tech makes them potentially profitable. Actually the reverse should be true. High technology made them vulnerable to Y2K problems which cost them dearly.

Is it just me, or are they looking at things kinda backwards?

There is no way that the market will follow the trends it did in the past, with the lack of real understanding of how technology is effecting the economy, instant investing, day trading, indivuals trading for themselves following their personal whims instead of going through stock brokers and firms who, in the past followed a basic standard they were trained in for reasons they were taught to follow, the impatience of many don't want to invest for the long term-wanting fast profits, the instantainious worldwide information superhighway, as well as the the ease in which scams can be pulled on the internet as well as any number of other reasons.

There is just so much that Alan Greenspan and Co. will be able to do to control the volitility under these new conditions.

It's a whole new ball game and I don't know if anyone can predict where the market will go from here on. Electric co-op stocks are starting to look like safe long term investments.

-- Cherri (sams@brigadoon.com), April 18, 2000.

The Financial Economists Roundtable Statement on Long-Term Capital Management and the Report of the Presidents Working Group on Financial Markets

http://www.luc.edu/orgs/finroundtable/statement99.html

-- (Also@see.this), April 18, 2000.