View From a Height

Finance Fault Line?

Steve Liesman wrote his last Macro Investor column for the Wall Street Journal yesterday, musing on the current state of hedge funds. At the end, comes this:

Former New York Federal Reserve Bank President Gerald Corrigan ... doesn't believe another meltdown like Long Term Capital Management is likely. Mr. Corrigan is now at Goldman Sachs and heads a private-sector group, The Counter-Party Risk Management Group II, set up to offer guidelines for assessing risk in the derivatives market that is often the playing field for hedge funds. He believes the finance world has learned much from the LTCM meltdown and that leverage in the hedge-fund industry is not as great as it was.

Yet he acknowledges that there is simply no way for any individual banker or regulatory agency to know and he wouldn't rule out a significant shock from a hedge-fund blowup. The best regulators can do is try to limit both the concentration of a single banks' lending to a single fund and into a single asset class or trade.

This is curious, because massive leverage was only one reason for the LTCM meltdown that gave financial markets a glimpse at the abyss. As important was the fact that there were, by 1998, many players in the same game, all using the same exit criteria. Leverage itself, even without the Archimedean levels required by LTCM's bets, was enough to close the feedback loop. Once prices began to fall or, in this case, once spreads began to widen, the only way out was to unwind positions, the effect of which was to further widen spreads.

This is exactly the same dynamic that caused the 1929 crash and the 1987 crash. In 1929 it was people buying on margin, using the stocks as collateral; in 1987 it was people shorting stocks as insurance. Both of these crashes occurred not because the magnitude of the leverage was particularly large, but because too many people were playing the same game at the same time.

I'll have much more to say about hedge funds in general, and LTCM in particular, in succeeding posts. I've just finished reading both Inventing Money and When Genius Failed, and am working my way through a raft of academic papers on the subjects raised. But for the moment, I'll just say that Mr. Corrigan's statement leaves me less than comforted.