BY ROB COX

The wedding-industrial complex tries to convince couples to celebrate their nuptials every year with a traditional gift. The quality of each present increases with longevity. In year one it’s just paper for the spouse. After 50 it’s glittering gold, and so on. The same could be said for commemorating financial crises: The further away from the anniversary, the more valuable the lesson to be learned.

In that sense, recalling Long-Term Capital Management’s implosion in 1998 may be more worthwhile than dwelling on next month’s anniversary of the collapse of Lehman Brothers. The financial and economic fallout that followed the Wall Street firm’s bankruptcy in 2008 was certainly larger and more severe than the one that preceded it by a decade. But as the world discovered to its dismay 10 years after LTCM, some of the glaring deficiencies that led to that crisis were repeated – and at scale.

The key takeaway is simple, if somewhat meta: There are always blind spots. Whatever regulators, bankers, policymakers and investors think they learned during the last crisis may not be correct at all – or may simply be forgotten. That may not be comforting. But greater humility is always preferable to excessive confidence.

A more specific lesson, though, is the recognition that without sharp regulation, leverage tends to increase in the system until it becomes so interconnected that emergency measures become the only feasible way to contain the damage. Secondly, though reforms are often rolled out in the heat of panic, they historically do little to radically change the structure of the financial industry. Banks may have more capital today, but they still marry riskier activities with the potential to upset their more normal ones – lending and transactions management – in ways that pose a danger to the economy.

Take a journey back to the summer of 1998. As “The Boy Is Mine” by Monica and Brandy topped the Billboard Hot 100 charts, Russia’s economy was melting down. On Aug. 17, Moscow devalued the ruble and, in a surprise move, defaulted on its domestic debt. Investors dumped risky assets, like developing-country securities, which are often thinly traded. And they piled into safer ones, like U.S. Treasury bonds, which can be bought and sold with relative ease.

The reaction to Russia’s default upset the trading strategy of a hedge fund in Greenwich, Connecticut founded by John Meriwether. As a jacked-up version of the arbitrage desk of his former employer Salomon Brothers, LTCM made its name exploiting inefficiencies in the prices of assets that, over time, should naturally converge. Sometimes these discrepancies, say in a bond coming due in 30 years compared to another maturing in 29-1/2 years, were minuscule.

To magnify the difference, LTCM had to pile on debt. As Roger Lowenstein wrote in “When Genius Failed,” his chronicle of LTCM’s rise and fall, one of Meriwether’s first trades was to borrow 25 times the firm’s capital to structure a trade that took advantage of the difference between two nearly identical U.S. government bonds with slightly different maturity dates. And as the boss of a big, prestigious fee-payer to Wall Street banks, he could tap into their greed, and their fear of missing out, to play them off against each other – usually keeping them in the dark about their rivals’ involvement as well as the full scope of LTCM’s trades.

Markets, though, are not always as efficient as LTCM’s smarty-pants partners believed. Especially when fear runs riot, as was the case following the Russian meltdown 20 years ago this Friday. By the start of September 1998, the market turmoil had caused a $2.5 billion loss, or half of LTCM’s capital, as investors piled into liquid securities and dumped riskier ones. Over the ensuing weeks, LTCM was forced to dump assets at fire-sale prices to meet collateral requirements, incurring greater losses still.

Within a month of Russia’s default, Meriwether and his traders – including Nobel Prize-winning economists Myron Scholes and Robert Merton – were facing insolvency. After a series of private investors baulked, the New York Federal Reserve pulled together a consortium of investment and commercial banks who rightly feared what might happen if LTCM was forced to liquidate its $125 billion portfolio, not including the derivative positions it held off its balance sheet.

Fourteen banks pooled their money, injecting just over $3.6 billion of fresh capital into LTCM and parachuting in a team to oversee the fund’s liquidation.

Here is where a critical lesson should have been imparted to the financial industry. Instead, many of those banks who saw firsthand how leverage kills spent the next decade effectively transforming their own balance sheets to mimic the one that crushed LTCM. The Securities and Exchange Commission aided and abetted by relaxing capital requirements for investment banks early in the new millennium.

Maybe the fact that the banks ultimately got their money back convinced them of the merits of LTCM’s model – along with the false surety that, though their employees lacked Nobels in economics, they were savvier traders. Perhaps it was the comforting spectacle of seeing the Fed spring into action, coordinating the operation and swiftly cutting interest rates days after the bailout that led them to believe that whatever happened with their own trades, there would always be a lender of last resort.

Funnily, two of those called upon by the Fed to lend a hand, Lehman Brothers and Bear Stearns, kicked up a fuss over participating. That has fueled speculation ever since they both went under that their rivals – or even the Fed – had it in for them.

Whatever the case, it took another decade, and the Lehman catastrophe, for the broader banking industry, its watchdogs and policymakers to get the bigger message on the danger of leverage. Banks are now loaded up with capital. But the need for that was crystal clear in 1998, too. Which raises a question: What lesson should have been obvious from 2008, but has not yet been imparted or ignored? Maybe there isn’t a very satisfying answer, apart from simply recognizing what 20 years of hindsight teaches: We don’t yet know.

First published Aug. 15, 2018

(Image: REUTERS/Kevin Coombs/Files)