With regard to particular assets — say, mortgage securities or Italian bonds — each bank knew only its own exposure to Long-Term [Capital Management]. Goldman Sachs had no idea that Salomon might be financing a similar trade; J. P. Morgan would not have known that Merrill Lynch was duplicating Morgan’s loans. So in theory, each bank had no notion of how big Long-Term was in any particular trade. But in practice, the banks were in a good position to estimate. The world of bond arbitrage is relatively small. Certainly the banks knew enough to ask for more specific disclosures. And of course they could have declined to do business with Long-Term if satisfactory answers were not forthcoming.
But the banks were fighting to do more hedge fund business, not less. Five years into a bull market, the banks were awash in liquidity, and the hedge fund trade was a lucrative way for Wall Street to employ its surplus capital. The banks accomplished this by a practice known as “renting out the balance sheet” — literally, transferring their enormous borrowing power to hedge funds with lesser credit ratings,* a service for which they charged mere pennies on every $100 of credit. Long-Term, which was easily the Street’s biggest hedge fund customer, was reputed to be throwing off $100 million to $200 million in fees to Wall Street each year, and each of the banks wanted as big a share of the money as possible.
That’s from When Genius Failed, Roger Lowenstein’s very highly-regarded story of the rise and fall of the hedge fund Long-Term Capital Management. What was Long-Term’s business? Well, it carried out investments according to the vision of John Meriwether and his band of academics and traders, who brought to Wall Street in force the analytical subtlety and brilliance of advanced mathematics, wed it to modern computing power, and produced a dazzling new field of “financial technology.” They used their mathematical tools to identify tiny fractional irrationalities in bond markets, and then piled up enormous capital behind their bets through huge leverage.
Into this business banks and other financial institutions poured their surplus capital through most of the 1990s. It continues to this day. “High-frequency trading” and “dark pools of liquidity” the latest terms for this arbitrage of the infinitesimal.
The point to grasp here is that this has almost nothing to do with government policy. Meriwether’s quants were private enterprisers — enterprisers par excellence, if you make no distinction between property and remote abstractions from property. They developed a whole new field of speculative trading — except that it was fundamentally cautious and conservative. It dealt in historically demonstrable market opportunities. The classic example is premium that investors are willing to pay for a newly-minted 30-year Treasury bond over the now “off the run” 29 ½ -year Treasury. What possible reason could there be for that six-month difference to matter much in pricing? And yet it did; there is an unexpectedly big spread between the two, and the arbitrageur can exploit it.
My cousin teaches economics at the Air Force Academy. He is among a number of economists who point to the rescue of Long-Term as the moment when “too big to fail” was, as it were, codified. The irony is that the rescue was a purely private one. The New York Federal Reserve Bank organized the meetings by which private financiers absorbed Long-Term’s losses. No taxpayer capital was staked.
But the shock of Long-Term’s failure and the systemic fragility it exposed demonstrated something momentous: globalization had exposed everyone to everyone else. The integration of capital markets was accomplished. A Russian default on sovereign debt could lay waste to American hedge funds and banks. World finance was so interconnected and interdependent that no gambler with his wits about him would expect anything but government rescues in the event of crisis. It’s been generations since the West was led by men of laissez faire sensibilities on these matters. As early as 1998 the smart bet was on eventual rescue.
Put otherwise, from that moment globalization itself included a vital element of eventual government rescue. And it had almost nothing to do with Fannie and Freddie or subprime lending. Long-Term Capital Management did some trading in mortgage securities, of course, but its primary business was the refinement of engineered abstraction of financial assets.
* This trick was used in 2008 by none other than the Federal Deposit Insurance Corporation, which rented its balance sheet (in other words, the credit rating of the US government) to banks and shadow banks in order to let them raise capital risk-free. I told my wife, only half-jokingly, that we could probably issue some sort of private family bonds, raising millions in capital on the open market, if only the FDIC would be so kind as to cosign for it.