I just got done reading When Genius Failed, as one of the selections for the 800-CEO-READ upcoming best of business books project. In the book, writer Roger Lowenstein profiles Long-Term Capital Management. In 1998, it was the largest hedge fund and nearly brought down several Wall Street firms when the trades it made went the wrong way. The bailout required the intervention of the Federal Reserve as they herded fourteen banks to pledge $3.65 billion.
Ten years later, we are seeing the same illiquid markets that crippled LTCM. For them it was interest rate swaps; this time it is mortgage-based securities, but on a scale that is two orders of magnitude larger.
I have long argued that Enron and Long-Term Capital were not crises well-understood by the general public. In part because the drama lay in the personal stories of the affected. And there were certainly victims in the employees that worked at these firms, but the biggest causalities were in the balance sheets of large firms who are in the business of lending money. Risk is a part of that game.
We don't pay much attention to things we don't understand and the average American doesn't have a lot of experience with such large-scale financial terms as debits and credits, derivatives or bond spreads. If we are nation fixated on markets and always talking business, we as a whole don't understand balance sheets or Black-Scholes modeling. This lack of knowledge exacerbates the problem. And it is a problem.
The media reports the stories. The trouble is their viewership has a hard time assessing the magnitude of the story in the 24-hour news cycle. Cable channels report with the same passion the fall of Eliot Spitzer, the disappearance of a young mother, and the Federal Reserve loaning $200 billion to banks.
The final news item in that list is one to concentrate on. This meltdown is mostly being caused by fear and trading will loosen again.
Pay attention though to what our leaders in business and government are doing to deal with the crisis. The Treasury offering new lending guidelines. The Fed offering more and more lenient terms to its customers. Banks lending to other banks. There are broad implications to all of these.
Lowenstein uses a Mark Twain quote to that fits with these unfolding events--"“History rhymes; it does not repeat."
