George H. Blackford, Ph.D.

 Economist at Large

 Email: george(at)


It ain't what you don't know that gets you into trouble.

It’s what you know for sure that just ain't so.
Attributed to Mark Twain (among others)



Economic Papers
Political Essays



Where Did All The Money Go?

Chapter 9: LTCM and the Panic of 1998


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The story of Long Term Capital Management (LTCM) has been told by Roger Lowenstein in his captivating book When Genius Failed, but for those who have not had a chance to read this book I will, with a bit of elaboration, summarize it here.

LTCM was a hedge fund started in 1994 by John Meriwether, a legendary trader who made a fortune for himself and Solomon Brothers in the 1980s. (NYT) The fund was a limited partnership where the senior partners were Meriwether along with Myron Scholes and Robert Merton, both of whom were to receive the Nobel Prize in Economics in 1997; David Mullins, a former vice chairman of the Board of Governors of the Federal Reserve; Eric Rosenfeld, a former professor at the Harvard Business School; Greg Hawkins, a campaign manager for Bill Clinton in the 1980s; Victor Haghani, a former managing director at Solomon Brothers; William Kasker, a former professor at the Harvard Business School; and Larry Hilibrand along with a number of other former traders from Solomon Brothers.

This was a group of financial rock stars that claimed six Ph.D.s from MIT among their ranks and another from the University of Chicago. Wall Street was awed by their intellectual prowess and the depth of their financial expertise. They were the Dream Team of Wall Street when they began LTCM in 1994, but the saga of LTCM lasted only four years and ended as just another study in how the best and the brightest can lose their way.

Rise of LTCM

The partners raised capital by investing $50 million of their own money and soliciting an additional $1.25 billion from a group of investors for a total of $1.3 billion in equity capital—at the time, the largest amount ever raised by a startup company. Over time, they managed to borrow over $125 billion in the money market, mostly through six month repurchase agreements. (Rosenfeld) This gave LTCM an investment portfolio of over $130 billion. During the first three years of its existence the success of LTCM was spectacular. For the first two years the partners earned a 40% rate of return on their equity and in 1997 they earned 27%. By the end of 1997 LTCM’s equity had grown to $7 billion, and the partners decided to pay back $2.7 billion of LTCM’s capital to its investors so the partners could increase their returns. This brought its equity capital down to $4.3 billion.

Fall of LTCM

In April 1998 LTCM's fortunes turned. By August 16, LTCM had lost $800 million, and their equity had fallen to $3.5 billion. Then on August 17, Russia devalued its currency and defaulted on its treasury's debt. The Russian default panicked investors all over the world and led to a flight to quality, which means investors attempted to abandon more risky assets (such as speculative stocks and bonds) and purchase less risky assets (such as cash and Treasury securities). This led to turmoil in the world's financial markets as the prices of the assets investors wanted to sell fell. These were the very asset held by LTCM. The following Monday, LTCM lost $553 million in the markets, and their equity shrank to $2.9 billion. They continued to lose money through the end of the month as the Dow dropped 357 points on August 27 and then fell an additional 512 points as the market crashed on August 31.

By the beginning of September, LTCM'S equity had fallen to $2.28 billion—a staggering 44% loss during the month of August and a 52% loss from the beginning of the year. LTCM was rapidly approaching insolvency. What's worse, LTCM was having liquidity problems as well. Even though most of its financing was by way of relatively long-term six month repurchase agreements, it still had to roll over one-sixth of this financing each month. This was becoming more difficult. Creditors were demanding more favorable terms, and when on September 10 LTCM's clearing fund at Bear Sterns briefly dropped below its contractual minimum, Bear insisted that LTCM's partners open their books to reassure Bear that they would be able to meet their obligations in the future.

LTCM had always been a secretive company. Its partners had never opened its books to anyone, not even to its investors or its largest creditors. Now the partners had no choice. If LTCM defaulted on a single payment all of its loans would come due. They would be out of business instantly if Bear refused to clear their trades. It would then be forced into bankruptcy as its creditors scrambled to seize their collateral. In addition, by September 10, LTCM's equity had fallen below $2 billion, and it was clear that to avoid insolvency it would have to raise capital either through investors or by taking in new partners. The partners estimated they would have to raise at least $2 billion in additional capital to survive. There was no way they could raise that kind of money without opening their books to someone. After attempting to raise the funds from a number of individuals such as Warren Buffet, George Soros, Michael Dell, and a Saudi prince, LTCM contacted Goldman Sachs to assist with fundraising and—in the strictest of confidence, of course—on Monday, September 14 opened its books to Goldman Sachs.

As LTCM opened its books and the news of the tenuous nature of its solvency spread around Wall Street, LTCM's situation worsened. On Monday, September 14, the day LTCM opened its books to Goldman Sachs, LTCM lost $55 million. On Tuesday, $87 million more, and then on Wednesday, September 16, it lost an additional $122 million for a total of $264 million. That was fifteen percent of its capital lost in just three days!

The problem was that LTCM was a behemoth—four times the size of the next largest hedge fund. (GAO) It was obvious that if LTCM were driven into bankruptcy its assets would have to be liquidated. Since LTCM was so large, liquidating its assets would cause the prices of its assets to fall. Anyone who owned the same assets as LTCM would lose money if they still owned them in the event LTCM went under. This provided a powerful incentive for other institutions to sell their holdings of these assets before LTCM was forced to sell its holdings. Even worse, it was also obvious it would be possible to profit from LTCM's demise by trading against it, that is, by taking positions in the market that would make money if LTCM was forced to liquidate its portfolio. Both of these activities caused the prices of LTCM's assets to fall even faster than they otherwise would have. As a result, no one wanted to invest in, or be in debt to LTCM, and just about everyone who could was trying to make money from its demise.

By September 16 the partners’ equity had fallen to $1.5 billion, and the situation was becoming desperate. The partners estimated it would now take $4 billion in additional capital to save the company—twice what they thought it would take just three days before. At that point LTCM’s partners decided it would be best to brief the Federal Reserve on their situation. A call was made and a meeting was set for following Sunday, September 20.

Bailout of LTCM

LTCM was not the only institution losing money during this period that found itself in serious financial difficulties. Most of the other hedge funds lost money as well, and many folded. Investment banks, which by then were making money from the same kinds of investment strategies as LTCM, had financial problems as did commercial banks and bank holding companies, but none of these other institutions had LTCM's problems. Commercial banks had deposit insurance to protect them from a run and access to the lending facilities of the Federal Reserve to provide them with cash. Investment banks had sources of income other than their investment portfolios that were sufficient to tide them through. LTCM was not a bank; it had no insured source of funds and could not borrow from the Fed. The only source of funds available to it was its investment portfolio and the money market. (PWG) But what made LTCM unique was the size of its portfolio.

LTCM's portfolio was well over $100 billion on September 20, 1998, and the nominal value of the 60 thousand derivative contracts it had entered into was well over $1.5 trillion! (GAO) This amounted to around five percent of the entire world market. In addition, LTCM financed most of its $100 billion in assets with over 40 thousand repurchase agreements. To make things worse, LTCM's investments and derivative commitments—and the counterparties on the other side of these contracts—were in markets all over the world: in Great Britain, Denmark, Sweden, Switzerland, Germany, France, Italy, Spain, the Netherlands, Belgium, and Russia; in New Zealand, Hong Kong, China, Taiwan, Thailand, Malaysia, and the Philippines; and in Brazil, Argentina, Mexico, and Venezuela.

It was clear that if LTCM were to fail it would seriously disrupt financial markets all over the world. Not only did LTCM's seventeen largest creditors—banks such as Merrill Lynch, Morgan Stanley Dean Witter, Goldman Sachs, Salomon Smith Barney—stand to lose as much as $5 billion directly if LTCM were forced into bankruptcy, if LTCM was forced to liquidate its portfolio its collateralized creditors would be forced to claim and sell their collateral, and LTCM’s derivative counterparties would be forced to scrambled to protect themselves from the vulnerable positions they found themselves in as a result of LTCM's holdings of over a trillion dollars worth of derivatives. This kind of chaos in the financial market could potentially cause asset prices to spiral downward all over the world and where and when they would stop no one could know. It was feared that such an event would cause a worldwide recession and that something had to be done to keep this from happening. The question was what?

It was not at all clear that anything could be done to save LTCM. Investors and speculators all over the world were trading against LTCM making the situation worse by the day, and given its liquidity problem and the rate at which it was losing equity, it was unlikely LTCM could remain solvent for another week or liquid enough to avoid defaulting on one of its obligations and being driven into bankruptcy. It would be impossible to find outside investors willing to invest $4 billion under these circumstances. At the same time LTCM's portfolio was so large and so complicated that any attempt to liquidate it in an orderly way would cause a panic. The only option that seemed even remotely feasible was to get LTCM's major creditors together to see if they could find a way to raise the $4 billion in capital necessary to save LTCM, but there was no guarantee that LTCM’s creditors would be willing to do this.

Even though LTCM's major creditors, mostly large Wall Street banks, had the most to lose, at least directly, if LTCM went bankrupt, it was not at all likely they would be willing to put up the $4 billion in capital necessary to keep LTCM afloat. After all, that would be throwing good money after bad, and that's not how Wall Street bankers got to be Wall Street bankers. Their basic instinct would be to force LTCM into bankruptcy and feed on its carcass. Nevertheless, by Tuesday, September 22, the situation seemed desperate enough to make this straw worth grasping. LTCM had lost $553 million on Monday—an amount equal to its entire loss for the month of August—and by the end of the trading day on Tuesday it had lost $152 million more. Its equity capital now stood at $773 million. Given the circumstances, it was felt that at least an effort should be made to see if LTCM's creditors would bail it out, and an emergency meeting of LTCM's 16 largest creditors was scheduled for 8:00 that evening to take place at the Federal Reserve Bank in New York City.

A plan was presented at the meeting by which a consortium of the 16 banks present would attempt to save LTCM by investing $250 million each in order to raise the $4 billion needed to end the run on LTCM. Everyone agreed that the situation was serious, but there was little agreement on anything else. Some wanted to just let LTCM go down and take their chances, but no one could be certain the collapse of LTCM wouldn't take them down with it, and most were terrified by the prospect. By 11:00 only four banks were willing to commit to joining the consortium, and the meeting was adjourned until 10:00 the following morning.

On Wednesday morning the gathering was increased to include the president of the New York Stock Exchange and the executives of five British, Swiss, and French banks. In addition, the representatives of a German bank attended by way of a speakerphone. The meeting was at times acrimonious, and at a number of points the negotiations nearly collapsed. By the end of the trading day LTCM had lost another $218 million and its equity capital had fallen to $555 million. Gradually the bankers began to realize that this was the last chance they would have to deal with this problem, and an agreement on the terms of a takeover began to emerge. In the end it was agreed that a consortium of 14 banks would invest $3.65 billion in LTCM in exchange for 90 percent of the firm's equity. The partners would retain 10 percent of the equity and would run the firm under the supervision of the consortium. At 5:15 a phone call was placed to the partners to see if they would agree to these terms with the details to be worked out before the deal was to close on Monday, September 28. The partners agreed, and shortly after 7:00 the agreement was announced to the press.

While an agreement had been reached in principle, there was no agreement where the devil lies—the details had yet to be worked out. On Friday, 70 lawyers representing the 14 members of the consortium converged on Merrill Lynch to write the terms of the contract on a deal that had to be closed in three days—the kind of deal that usually took months. In spite of the pandemonium, after a marathon session they came up with a draft. In the meantime, LTCM lost another $155 million on Friday as its equity capital fell to $400 million.

When the partners read the draft early Saturday morning, they were furious. As far as they were concerned there was nothing in it for them. Later that morning the partners met at a prestigious Midtown law firm to negotiate with the consortium to finalize the contract, and another marathon session began—this time 140 lawyers showed up to argue on behalf of their clients. Throughout Saturday and Sunday the negotiations continued.

Ironically, even if a contract acceptable to all parties were obtained, there was no guarantee it would be put into effect. One of the conditions insisted on by the consortium was that all of LTCM's creditors sign a waiver relinquishing their right to immediate repayment of their loans to LTCM. Republic Bank, Nomura Securities, Credit Lyonnais, and Italy's foreign exchange office refused to sign. It wasn't until 5:30 on Monday afternoon that the problem of the holdouts was solved, all of the waivers that were coming in were in, and all of the disputes among the principals were resolved so that the deal to take over LTCM for $3.65 billion by the consortium of 14 banks could be closed.[44]

In the meantime, LTCM had another bad day. By the time the deal was closed its capital had fallen to $340 million. It lost an additional $750 million through the first half of October, then the markets rebounded, and by the end of October LTCM had stabilized. Within a year the fund was able to pay back the consortium, and by the end of 2000 LTCM had been systematically liquidated without any of the dire financial and economic consequences that were feared if LTCM had been forced into bankruptcy.[45]

What Went Wrong

How could the financial geniuses of LTCM bring the financial world to the brink of collapse? The answer is as old as finance itself. As with poorly managed banks throughout the history of finance, LTCM's partners over extended themselves by borrowing more than their equity capital could support in a crisis. When times were prosperous they managed to leverage their equity as much as 30 to 1. In so doing they took the risk that a financial crisis could wipe them out, but they thought that was extremely unlikely and, at the same time, for the first three years they made a fabulous amount of money. When the crisis came and their creditors became nervous—just as in the unregulated banking world of the nineteenth century—there was no way they could sell off their long-term assets and remain solvent as their short-term creditors refused to renew their loans. They were caught in a modern-day bank run in a nineteenth century financial environment, and there was nothing they could do to save themselves. Even the fact that they had borrowed for a relatively long time period, using six month repurchase agreements, was not enough to save them. As a result, the Fed was forced to orchestrate a takeover by a consortium of banks to head off a financial meltdown that threatened a worldwide economic catastrophe in its wake.

And it is worth emphasizing here that the geniuses at LTCM did not create a financial crisis that nearly caused a meltdown of the entire world's financial system because they were dumb. They knew the limitations of their models; they knew that some unpredictable event could cause an economic catastrophe that could drive them into bankruptcy. They didn't think it would happen, but they knew it could happen. They leveraged their equity in a way that ultimately led to their downfall in spite of the risk they knew they were taking for one very simple reason: There is no other way they could have made the enormous amount of money they were able to make in the first three years of their existence without leveraging their equity in this way. In other words, they took a chance that threatened the financial system of the entire world because they thought it was worth it for them to take that risk. What it would mean for the rest of the world if they failed disastrously never entered their minds, at least not until the very end when it was too late to do anything about it except to look to the government to find a way to clean up the mess they had created. What's more, there is no reason for them to have thought about what would happen to the rest of the world if they failed disastrously. No one ever got rich thinking about that sort of thing. That sort of thing is left to philosophers and is beyond the purview of free-market capitalists.

It is also important to emphasize a second reason why the partners at LTCM leveraged their capital the way they did: They leveraged their capital 30 to 1 because they could. There was no one there to stop them from doing what they thought was best for them—not the government and not their creditors—irrespective of the danger their actions posed for the rest of the world. The financial markets they operated in were unregulated. There was no law or regulation to prevent them from doing what they did, and the regulators at the time had a Panglossian faith in the efficacy of free markets to create the best of all possible economic worlds. As for their creditors, they just wanted a piece of the action. They made fortunes of their own doing business with LTCM during the good times, and they too thought it was worth it to take the risks they were taking when they lent to LTCM at ridiculously low margins.

Contrary to the propaganda of the Conservative Movement, there is no reason to believe unregulated free markets must work to the advantage of society as a whole if people are allowed to seek their own advantage in the marketplace or even that they will work in this way. There are innumerable ways in which markets can fail to accomplish this end, [46] and this is particularly so when it comes to financial markets. It has been demonstrated time and again that if the participants in these markets see an opportunity to make a personal fortune by leveraging themselves to the hilt and are given the opportunity to do so, they will do so. It has also been demonstrated time and again that when they are allowed to do this during prosperous times the financial system inevitably gets overextended, and sooner or later a crisis develops that threatens the economic system as a whole. (Fisher Keynes Polanyi Kindleberger Minsky Phillips Morris Dowd Reinhart Johnson Skidelsky Kindleberger Kennedy MacKay Graeber Galbraith White) The problem is that when the great men of finance overextend themselves it is not only their own economic fortunes they put at risk. It is the entire economic system they put at risk along with the wellbeing of all of the people who depend on the smooth functioning of that system for their survival.

No one, but no one, should be allowed to put the economic system at risk for their own personal gain, and most certainly not in the name of Free-Market Capitalism or any other ideological abstraction. That was the lesson learned by the generation that lived through the Great Depression of the 1930s when they took on the free marketeers and created the comprehensive system of financial regulation that served us so well until we began to dismantle it in the 1970s. It is the lesson that should have been reinforced in the minds of the generation that witnessed the Savings and Loan Crisis of the 1980s which in addition to threatening the stability of the economic system cost the American taxpayer $130 billion. And it is also the lesson that should have been reinforced in the wake of the LTCM crisis which seriously threatened the entire world economy. Unfortunately, that is not how things turned out.

President's Working Group Report

In response to the LTCM crisis, the President's Working Group on Financial Markets was tasked with examining the circumstances surrounding the LTCM crisis. This working group was created by an executive order of Ronald Reagan ten years earlier on March 18, 1988. It is made up of the Secretary of the Treasury and the chairpersons of the Board of Governors of the Federal Reserve, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC). The individuals who held these posts in 1998 were Robert Rubin, Alan Greenspan, Arthur Levitt, and Brooksley Born, respectively. The Working Group's report—Hedge Funds, Leverage, and the Lessons of Long-term Capital Management—was submitted to Congress on April 28, 1999.

It is clear from their report that the working group understood most of the factors that entered into the collapse of LTCM and that these factors posed a threat to the system as a whole. They understood that "excessive leverage in the financial system" was a serious problem and "that excessive leverage can greatly magnify the negative effects of any event or series of events on the financial system as a whole." They saw that in the face of excessive leverage "problems at one financial institution could be transmitted to other institutions, and potentially pose risks to the financial system." (PWG) They also saw that the problem was not limited to hedge funds, but that other "financial institutions, including some banks and securities firms, are larger, and generally more highly leveraged, than hedge funds" and, consequently, posed the same problem posed by LTCM. In support of this they noted that at the end of 1998 LTCM's leverage ratio stood at 28 to 1 while "the five largest investment banks' average leverage ratio was 27 to 1.” (Emphasis added.) The working group also seemed to be aware of the way in which "[h]edge funds obtain economic leverage . . . through the use of . . . derivative contracts" and that this kind of “economic leverage” can create systemic risk in the same way that balance sheet leverage (debt to equity ratio) can cause systemic risk. They saw all of this, and, yet, given the ideological blindness of all but one member of this group, Brooksley Born, it was impossible for this group to recommend that hedge funds and the rest of the shadow banking system be brought under the regulatory umbrella of the federal government.

The struggle between the convictions of the Working Group's conservative members regarding the efficacy of markets and the reality of the LTCM crisis—a reality that was undoubtedly pointed out to them at every turn by Brooksley Born—is evident in the compromise embodied in the recommendations put forth in the Working Group's report:

Market history indicates that even painful lessons recede from memory with time. Some of the risks of excessive leverage and risk taking can threaten the market as a whole, and even market participants not directly involved in imprudently extending credit can be affected.

Therefore, the Working Group sees the need for the following measures:

1. more frequent and meaningful information on hedge funds should be made public;

2. public companies, including financial institutions, should publicly disclose additional information about their material financial exposures to significantly leveraged institutions, including hedge funds;

3. financial institutions should enhance their practices for counterparty risk management;

4. regulators should encourage improvements in the risk management systems of regulated entities;

5. regulators should promote the development of more risk-sensitive but prudent approaches to capital adequacy;

6. regulators need expanded risk assessment authority for the unregulated affiliates of broker-dealers and futures commission merchants;19

7. the Congress should enact the provisions proposed by the President’s Working Group to support financial contract netting in the United States; and

8. regulators should consider stronger incentives to encourage off-shore centers to comply with international standards. (PWG)

It would appear from this set of recommendations that instead of looking at the real problem—namely, that the shadow banking system had been allowed to come into being in such a way that it was outside the regulatory system put in place to prevent financial crises—the Conservative members of this group were looking at the details of the LTCM crisis and attempting to find causes for this crisis that could be fixed without having to regulate the shadow banks. Judging from the recommendations listed above, they came up with four:

1.     Decision makers did not have enough information to make an accurate assessment as to the degree of risk associated with lending to LTCM. Hence, recommendations 1 and 2 calling for more frequent and detailed information from hedge funds and exposure to hedge funds be made public.

2.     Risk management was inadequate on the part of LTCM and its counterparties leading up to the crisis. Hence, recommendation 3, 4, and 5 that institutions and regulators enhance, encourage, and promote better risk-sensitive approaches to capital adequacy.

3.     The bankruptcy laws were inadequate to deal with repurchase agreements and derivative contracts making it very difficult to efficiently liquidate a company such as LTCM in the event of bankruptcy. Hence, recommendation 7 to provide for contract netting in the United States.

4.     The lax regulatory standards in off-shore centers encouraged American companies to register in these centers to avoid the American regulatory system. Hence, recommendation 8 that regulators consider stronger measures to encourage these centers to comply with international standards.

The only recommendation in this report that related directly to the shadow banking system are numbers 1 and 6 which would require that more information be made available on hedge funds and that expand the risk assessment authority of the SEC and CFTC to the unregulated affiliates of regulated institutions for the purposes of examining their operations. If broadly interpreted, this would give the SEC and CFTC the authority over virtually all the shadow banks for the purpose of examining their operations though not the power to regulate them. This recommendation was undoubtedly insisted on by Chairperson Born of the CFTC in accordance with a much stronger recommendation put forth by the CFTC a few months earlier in a concept release that had been blocked at the time by the conservative members of the Working Group. (Frontline)

Footnote 19 at the end of recommendation 6 emphasized Greenspan's objection to this recommendation for the record:

On the issue of expanding risk assessment for the unregulated affiliates of broker-dealers and FCMs, Chairman Greenspan of the Federal Reserve Board declines to endorse the recommendation but, in this instance, defers to the judgment of those with supervisory responsibility.

While the Working Group did not recommend bringing the shadow banking system under the umbrella of federal regulation they did state:

Although the Working Group is not making additional recommendations at this time, if further evidence emerges that indirect regulation of currently unregulated market participants is not working effectively to constrain leverage, there are several matters that could be given further consideration to address concerns about leverage.

The "matters that could be given further consideration" included:

1. Consolidated supervision of broker-dealers and their currently unregulated affiliates, including enterprise-wide capital standards. . . .

2. Direct regulation of hedge funds. . . .

3. Direct regulation of derivatives dealers unaffiliated with a federally regulated entity.

In struggling to find a way to not regulate the shadow banks, the conservative members of the Working Group had to explain why their faith in the efficacy of free markets to provide the discipline necessary to avoid serious financial crises was justified. At the same time they had to explain why the financial crisis caused by LTCM was so serious that the Federal Reserve was forced to intervene to resolve the situation. This was not an easy task. In searching for a way out of this conundrum they found that the traders in the market didn't behave in the way they were supposed to behave in that they made mistakes, did not have enough information to make informed decisions, and their risk management was inadequate. They also found the bankruptcy laws were inadequate to allow for a timely resolution of LTCM through bankruptcy and that off-shore centers were not living up to international standards.

In other words, it wasn't the market that failed. It was the actors in the market that failed. The traders in the market weren’t behaving the way they were supposed to behave when it came to managing risk. The government hadn't provided adequate bankruptcy laws, and those pesky off-shore centers were mucking up the works. Thus, to keep this sort of thing from happening again the Working Group recommended the traders in markets be educated as to how they were supposed to manage risk and that they be provided with enough information to enable them to manage risk properly. It then recommended the bankruptcy laws be changed and something be done about the off-shore centers. And just to drive the point home they noted that if the actors didn't clean up their act the Working Group would “consider” direct regulation sometime in the future. This is bizarre! You would think they were dealing with children who got caught with their hands in a cookie jar.

The actors in the LTCM drama made over $5 million a day as they rode roughshod over the world's financial system and threatened the economic stability of the entire world. LTCM's counterparties made fortunes in their dealings with LTCM as well. Who in their right mind could possibly believe that information, education, fixing the bankruptcy laws, and threatening to “consider” regulation in the future if the financial community doesn't behave are the kinds of things that would have stopped LTCM's partners and their counterparties from doing what they had done or would somehow keep others from doing the same thing in the future? [47]

General Accounting Office Report

The General Accounting Office (GAO) was also tasked with examining the circumstances surrounding the LTCM crisis. Unlike the President's Working Group, which is made up of political appointees, the GAO (which was subsequently renamed the U.S. Government Accountability Office in 2004) is an independent, nonpartisan agency within the federal government. The president of the GAO is the Comptroller General of the United States and is appointed for a 15 year term by the president from a list of candidates proposed by Congress. It was created 1921, and its mission statement is as follows:

Our Mission is to support the Congress in meeting its constitutional responsibilities and to help improve the performance and ensure the accountability of the federal government for the benefit of the American people. We provide Congress with timely information that is objective, fact-based, nonpartisan, nonideological, fair, and balanced.

The professionals at the GAO were not hindered by ideological blinders when they took a look at the LTCM crisis. Their report entitled LONG-TERM CAPITAL MANAGEMENT Regulators Need to Focus Greater Attention on Systemic Risk was released in October 1999 and went right to the core of the matter. After observing that:

1. The LTCM case illustrated that market discipline can break down and showed that potential systemic risk can be posed not only by a cascade of major firm failures, but also by leveraged trading positions. . . .

2. [A]s shown by the inability of regulators to identify the extent of firms’ activities with LTCM, the traditional focus of oversight on credit exposures is not sufficient to monitor the provision of leverage to trading counterparties. . . .

3. Changes in markets that have blurred the traditional lines of market participants’ activities will continue to create risks that cross institutions and markets, thus making the need for effective coordination even more critical.

4. Gaps in SEC’s and CFTC’s regulatory authority impede their ability to observe and assess activities in securities and futures firms’ affiliates that might give rise to systemic risk. . . . [I]mprovements in examination focus and in information gathered may give bank regulators a better opportunity to identify future problems that might pose systemic risk. Without similar authority over the consolidated activities of securities and futures firms, SEC and CFTC cannot contribute effectively to regulatory oversight of potential systemic risk, because a large and growing proportion of those firms’ risk taking is in their unregulated affiliates.

5. The President’s Working Group has recommended granting new authority for SEC and CFTC over the affiliates. However, the new authority would not grant capital-setting or enforcement authority and would not involve the type of examination of their risk activities and management that would allow a thorough assessment of potential systemic risk. . . .

The GAO then made two succinct and to the point recommendations:

1. We recommend that the Secretary of the Treasury and the Chairmen of the Federal Reserve, SEC, and CFTC, in conjunction with other relevant financial regulators, develop better ways to coordinate the assessment of risks that cross traditional regulatory and industry boundaries.

2. In an effort to identify and prevent potential future crises, Congress should consider providing SEC and CFTC with the authority to regulate the activities of securities and futures firms’ affiliates similar to that provided the Federal Reserve with respect to bank holding companies. If this authority is provided, it should generally include the authority to examine, set capital standards, and take enforcement actions. . . .

The GAO not only supported the position Brooksley Born had put forth in the original CFTC concept release, it had gone far beyond it in arguing that “Congress should consider providing SEC and CFTC with the authority to regulate the activities of securities and futures firms’ affiliates” and this authority should “include the authority to examine, set capital standards, and take enforcement actions,” though, in tune with the ideological temperament of the times, the GAO only recommended that “Congress should consider” taking these actions rather than that Congress should actually take these actions. In any event, given the ideological proclivities of the Republican Congress and Clinton administration, there was little hope that legislative action would be taken on any of the GAO's recommendations.

Lessons Not Learned

Instead of the increased regulation of the financial system called for in the GAO's October 1999 report, within a month of that report Congress passed the Financial Services Modernization Act (FSMA) on November 4, 1999 which was signed into law by President Clinton on November 12. As has been noted, this act further deregulated the financial system by repealing those portions of the Glass-Steagall Act of 1933 that prevented commercial bank holding companies from becoming conglomerates that are able to provide both commercial and investment banking services as well as insurance and brokerage services.

By the end of the year it was clear that Brooksley Born was not going to be reappointed as chairperson of the CFTC, and she was effectively driven from office on January 19, 2000. (Frontline) That same year Congress passed the Commodity Futures Modernization Act (CFMA) on December 14, 2000 which Clinton signed into law on December 21. This act explicitly prevented both the CFTC and state gambling regulators from regulating the derivatives markets which Brooksley Born had fought so valiantly to bring within the regulatory fold.

When on December 12, 2000 the Republican dominated Supreme Court appointed George W. Bush President of the United States it meant that on January 21, 2001 the Republican Party—with its ideologically inspired mantra of lower taxes, less government, and deregulated markets along with its disdain for government—would gain control of all three branches of the American government for the first time since 1954. At this point there was no hope of curbing the era of deregulated finance that began in the Nixon administration with the abandonment of the Bretton Woods Agreement and was honed to perfection during the Clinton years.

If truth be told, it probably would not have mattered who won the 2000 election. Even if a Democrat had been elected to the presidency, Republicans still would have controlled Congress. And even if the Democrats had been able to take over Congress as well as the presidency there is no reason to believe it would have made a difference. While a majority of the Senate Democrats opposed FSMA and probably would have opposed CFMA if there had been a separate vote on this bill rather than having been included in an omnibus emergency appropriations bill, 75% of the House Democrats voted for FSMA. At the same time, the Republicans were virtually unanimous in their support of these two bills, and a Democratic president signed them into law. (House Senate)

Thus, even if the Democrats had taken over both Congress and the presidency in 2000 we would have been in the same position we were in during the first two years of the Obama administration where the united opposition of the Republicans joined by a number of "moderate" Democrats would have been able to stop any attempt to repeal FSMA and CFMA or to pass legislation that would regulate the shadow banking system and the markets for derivatives. And given the shift of the leadership of the Democratic Party during the 1990s toward the belief in the magical powers of deregulation, there is no reason to believe the changes in regulatory rules (discussed in Chapter 10) that followed the 2000 election could have been avoided if the Democrats had won the presidency and taken control of Congress in 2000 rather than the Republicans.[48] Given the ideological temperament of the times, it would have taken a miracle to avoid the economic train wreck that was about to take place.



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Where Did All The Money Go?

How Lower Taxes, Less Government, and Deregulation Redistribute Income and Create Economic Instability






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[44] The 14 banks that took control of LTCM were: Chase Manhattan Corporation; Goldman Sachs; Merrill Lynch; J.P. Morgan; Morgan Stanley Dean Witter; Salomon Smith Barney; Credit Suisse First Boston Company; Barclays; Deutsche Bank; UBS; Bankers Trust Corporation; Société Generale; Paribas; and Lehman Brothers. (GAO)

[45] This is the story of LTCM as told by Roger Lowenstein in When Genius Failed as elaborated, where noted, by Rosenfeld and the President’s Working Group’s and General Accounting Office’s reports on this incident.

[47] There can be no doubt that, PWG report or no PWG report, if the founders of LTCM had the option of starting up another LTCM and doing it all over again they would start up another LTCM and do it all over again. Not only would they do it all over again, they did. On October 22, 2009 the Financial Times reported that John Meriwether had embarked on his third hedge fund (JM Advisors Management) after his second fund (JWM Partners which he began less than two years after the LTCM debacle) went bust in the 2008 financial crisis. And the world is full of John Meriwethers.

[48] See G. William Domhoff’s The Myth of Liberal Ascendancy: Corporate Dominance from the Great Depression to the Great Recession (2014) for a cogent analysis of the way in which the decision-making power structure in the United States leads to these kinds of results.


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