See also on LTCM: Wall Street's Changing Culture

Something Very Bad is brewing out there in the financial structure – and the story of the LTCM bail-out is providing more clues.  

The saga of the Long Term Capital Management hedge fund - its rise, fall, and the peculiar circumstances surrounding its rescue in September 1998 - more and more appears paradigmatic of Clinton Era finance. Esoteric and secretive in action, operating through special relationships and understandings, involving greed and ambition on astonishingly uninhibited scale, and ultimately giving rise to suspicions of ominous fusion between private commercial objectives and the formulation of public policy, it lays out a pattern likely to become all too familiar as documentation of the period becomes more available.

Nicholas Dunbar's book Inventing  Money: The Story of Long Term Capital Management and the Legends Behind It, makes an important and unique contribution to elucidating the story. Written in London by a journalist specializing in derivatives, it was actually published some months before Roger Lowenstein's When Genius Failed (For my comments see here.). Not benefiting from the mutual assistance habits of Lowenstein's Wall Street Journal circle, the book was little noticed. I, like others, only became aware of it via the increasingly valuable "similar titles" component of Amazon.com. It is worth the additional effort.

Appropriately, given the importance of the subject, Inventing Money is as remarkable a book as When Genius Failed. But it is very different. A first time author, Dunbar obviously fell victim, as so often happens, to a domineering but simple-minded publisher's sales force over the matter of his books' title. Something boring like "Engineering with Money: The Advent of Financial Derivatives in the era of LTCM" would have far better communicated the book's wide range and emphasis.

Inventing Money in fact, reminds one of the old aeronautical engineering jokes that according to the science a bee cannot fly. Dunbar cheerfully undertakes to explain from first principles the concepts behind modern financial derivatives, scrupulously tracing their historical development and current status. Even few experienced writers would have attempted such an ambitious structure.

Acres of jargon and forests of buzz words fall to his axe and are neatly stacked in lucid paragraphs.  This whole book is only a little more than 200 pages.  Anyone slightly hazy on this arcane subject should use the book as a painless refresher; any humane finance professor  (if such an animal exists), could reasonably prescribe it to incoming classes.  It is an astonishing technical achievement.

Inevitable with such a broad canvas (in which he includes elegant brief accounts of the derivatives disasters which destroyed the independence of Union Bank of Switzerland and Bankers Trust), the LTCM discussions itself is quite short, and is really only supplementary to the Lowenstein account.  But it is supplementary in a very significant way.

Dunbar directly asserts, and supports with a detailed discussion, what can only be inferred from Lowenstein: that the Italian authorities in effect hired LTCM to groom or manipulate the Italian bond market, in order to accelerate convergence with the other European Monetary System bond markets and to reduce the Italian government interest burden. This permitted the achievement of the Maastricht criteria and allowed Italy to adopt the Euro.

"According to some observers...the Bank of Italy provided LTCM with market access and privileged information denied to Italian Banks - which would yield a massive profit. In return, LTCM - and a handful of others - would engineer the convergence of Italian debt..."

Dunbar lays out in considerable detail how this was done. One element was the overlooking by the Italians of LTCM's repeated cornering of Italian bond auctions, greatly to the dismay of small local players.  Of course, the U.S. Treasury had, since 1989, capped the proportion available to a single buyer at the American auctions at 35%. (It was a subordinate's flouting of this regulation which caused Merriwether's fall at Salomon.) The Italians were not so scrupulous.

How many other such cozy arrangements were there? As mentioned in my discussion of Lowenstein's book, the credit department of UBS took comfort in the fact that about 31% of LTCM was owned by "generally government-owned banks in major markets" who could supply LTCM with market intelligence.  Dunbar seems to imply that other ECU markets received LTCM's ministrations. And he directly says of LTCM that by the end of 1997

"Governments treated it as a valued partner, to be used whenever markets weren't efficient enough to achieve macroeconomic goals."

(In this context, of course, "efficient" means "obedient" and "macroeconomic" means "political.")

This leads directly to the question of gold.  Dunbar, like Lowenstein makes no reference at all to gold, not even to repudiate the rumors of a large LTCM short position.  And indeed such a position must have either been eliminated or else been very well hidden by the time LTCM was invaded by hordes of Goldman and J.P. Morgan investigators in late September '98.   But what Dunbar does reveal is very important: that in the latter part of the 90s, Central Banks did indeed strike what he describes as "devil's bargains" with hedge funds, who were essentially hired as mercenaries to achieve certain effects. 

And they did so in extreme secrecy.  So well had LTCM disguised its activities that the Italians were able with a straight face to sanction Credit Suisse-First Boston for squeezing the Italian Post Office bond sale in '96, while its protege LTCM was discreetly doing the same thing  (a profitable bit of protection for LTCM.)  On the evidence of Dunbar's book, if a major Central Bank had decided  it wished to repress gold, discreet private sector agents were readily available to perpetrate the deed.

Inventing Money also adds an interesting perspective on the role of equity derivatives in the LTCM crisis. In late 1997, with equity markets gyrating because of the Asian crisis, the price of insuring against volatility rocketed to astonishing levels. This was important because a sizable industry had grown up in London selling options on various indices. By November of that year, J.P. Morgan estimated the sellers faced a mark to market loss, if they had to cover their positions, of over $3 billion. At this point, LTCM began, in effect, offering them reinsurance by selling long-dated equity options. This must have greatly relieved certain investment banks (and regulators).

But gratitude, it seems, has no derivative. In September 1998 with volatility back up to even higher levels as the Russian/LTCM problems impacted, it dawned on some LTCM "counterparties" (purchasers of the equity options) that if the hedge fund failed, and their contracts became null, in effect they would have re-established a short volatility position with volatility levels at unsustainable heights (and of course just as the underlying cause was dealt with).  So some of these counterparties began to actively push for LTCM's demise. 

"Banque Nationale de Paris also declined [to contribute to the LTCM rescue fund]" reports Dunbar "although BNP officials deny this was due to any large index volatility positions being held by the Bank".  And there were others.

By now the reader is wondering about the wisdom of allowing these financial nuclear weapons to fall into the hands of such children.  Dunbar leaves no room for doubt that these instruments could be immensely powerful.  A quarter of the flow of outstanding  Italian floating rate Treasury Certificates passed through LTCM's accounts in a two-year period. At the end, Morgan Stanley estimated LTCM had synthesized a British gilt position larger than the entire market. And Dunbar is not at all willing to accept the peculiar but common argument that because the numbers are so huge they must be meaningless.

"In the case of LTCM derivative notionals are real numbers indicating the real economic effect of the fund.  The actions of Alan Greenspan in October [1998 –cutting interest rates three times] would bear this out".

(This comment, is by a man who is on the staff of Risk Magazine, which specializes in covering the derivatives industry, sheds an interesting light of the gold derivatives debate which arose following the discovery of ballooning gold derivative exposure on the books of certain banks in 4Q'99.)

Dunbar thus resoundingly confirms what Bill McDonough, President of the New York Fed, has said in Congressional testimony:  When his investigators first visited LTCM on Sept 20, 1998, they

"came to understand the impact which Long Term Capital's positions were already having on markets around the world and that the size of these positions was much greater than market participants imagined".

This book provides further documentation that derivatives have put immense surreptitious power in the hands of privileged individuals, not always without official knowledge. It makes the furious efforts by Rubin and Greenspan to block closer supervision of derivatives look, in the words of Alice in Wonderland, curiouser and curiouser.

January 21, 2001