Moody's: An LTCM Type Failure Possible

Yves Smith of Naked Capitalism submits:

According to Bloomberg, Moody's has alerted investors to the possibility of a repeat of the 1998 Long Term Capital Management hedge fund crisis.

We should be so lucky. As we have said before, the LTCM crisis has been widely, and in our opinion, mistakenly seen as a vindication of the workings of the financial system. The perps suffered, the markets were saved.

Reality is more complicated. It was lucky indeed that the risks, however great they were, were confined to one massive player. This enabled the powers that be to understand the situation (LTCM had to go over all its positions with its counterparties) and devise a bail-out.

If you read any of the books that covered this event, such as Roger Lowenstein's "When Genius Failed," you will see how this exercise consumed a tremendous amount of senior management attention at all the top Wall Street firms, and also required a lot of legal horsepower. It's hard to imagine Wall Street having the managerial capacity to run several operations like that in parallel.

What happens if you have several large firms coming unglued at more or less the same time? In a calmer market, you might have the same result as with the Amaranth failure: some good news copy, a bit of schaudenfreude, and then back to business as usual. But as with the subprime mess and seize up in the commercial paper market, given how opaque hedge fund holdings are, any fund trading in a similar style to a hedge fund that got in trouble would be at risk of having its credit facilities cut, which would lead to forced selling, which would deepen the crisis (the alternative is that the funds would have to go expose their positions to their prime brokers to prove their solvency, something they have refused to do).

So all things considered, we should be glad if all we have is an LTCM-style problem.

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