The quip was characteristically Rubinesque humor, of course, but behind the Joke was a serious question about whether Wall Street had changed so much since Rubin’s day that it was no longer unusual for firms to have positions measured in the trillions. “Bob, I left Goldman, Sachs a year ago,” Gensler replied, “but that is a number that is as significant as [the size of the derivative position held by] any money-center commercial bank and maybe a handful of investment banks.”
Rubin was asking about a type of trade that allowed Long-Term to place a bet on trends in stock prices, bond prices, interest rates, and other financial phenomena without actually buying or selling stocks or bonds. “Derivatives,” as the name implies, derive their value from movements in underlying securities. Options on stocks are one of the best-known forms of derivatives; for a couple of hundred dollars an investor can obtain the option (the right) to buy or sell thousands of dollars worth of a company’s shares at a certain price in the future. Whereas options trade on organized exchanges, other forms of derivatives are so specialized that they involve custom-tailored contracts that change hands in private transactions. One example is an interest-rate swap, in which, say, Bank X agrees to pay Bank Y the interest that would be earned on $500 million if it were invested at a floating rate over the next five years, and Bank Y agrees to pay Bank X the interest that would be earned on $500 million if invested at a fixed rate. The $500 million is called the “notional value,” because neither bank owes the other $500 million, and neither can be sure how much it will owe or receive until it sees what happens to interest rates.
This sort of financial engineering, which started in the 1980s and burgeoned in the 1990s, may seem to have no purpose other than rank speculation, and that is true in some cases. But many of Long-Term’s derivative activities provided genuine service to the smooth functioning of capital markets—though obviously, the firm was not motivated by altruism. Consider, for instance, a particularly arcane trade that Long-Term engaged in called “shorting equity volatility.” This involved bets that the U.S. stock market would maintain its historical pattern of rising and falling no more than about 15 percent a year, and that the magnitude of foreign stock market fluctuations would likewise stay within historical trends. It isn’t necessary to know the precise mechanics of how Long-Term made its wager; suffice to say that Long-Term sold option contracts on the Standard & Poor’s 500 stock index and on foreign stock indexes. In effect, Long-Term was selling insurance, or hedges, to investors who wanted protection against unusually violent downward swings (and in some cases upward swings) in the prices of the stocks they held. Just like an insurance company that believes it can make a profit by selling high-priced flood insurance to anxious homeowners living along major rivers, Long-Term thought it could make a profit by looking at the historical odds of a catastrophic series of events in the stock market and selling high-priced stock insurance to anxious investors. The odds, unfortunately, had proved a bad basis for such a decision, since stock market volatility was exceptionally high in 1998.
On the morning of Sunday, September 20, Gensler met Fisher and two other Fed staffers at Long-Term’s Greenwich headquarters, which was empty except for a handful of top Long-Term partners, including Meriwether, and a team from Goldman examining the firm’s files. Long-Term had once been a notoriously arrogant firm, demanding the highest of fees from its investors, maintaining the tightest of secrecy about its strategies, and generally acting as if it were the greatest repository of financial brains in the world. Now its style was changing. When Gensler asked to be shown to the men’s room, Meriwether politely ushered him to his personal, wood-paneled bathroom—a gesture that Gensler couldn’t help thinking symbolized the firm’s comeuppance. Gensler also got a more substantive sense of how desperate the partners were when he questioned one of them, Eric Rosenfeld, about their personal finances. Surely, Gensler asked, their personal holdings would be reasonably safe even if Long-Term went down? An ashen-faced Rosenfeld explained that on the contrary, many of the partners were facing probable personal bankruptcy because of loans they had taken out on their investments in the firm.
In a large conference room, Fisher and Gensler sat through several presentations in which Long-Term’s partners showed them page after page of computer printouts, with notations like “USD_Z+D-shift,” and explained what the data meant. Both men had heard a fair amount about Long-Term before going to Greenwich, but much of what they saw that day left them shaken. For one thing, a number of Long-Term’s individual positions were much larger than they had anticipated, so large that the firm held a huge share of the total market in certain financial instruments—examples being Danish mortgage-backed bonds and futures contracts on British ten-year government bonds. Gensler was particularly struck by the size of Long-Term’s position in equity volatility; he told Rubin and Summers that it was at least ten times greater than he had ever seen at Goldman, Sachs, one of the Street’s richest firms.
One key question was how many days remained before Long-Term would be thrown into default. A conversation Fisher and Gensler had with a representative from the Wall Street firm of Bear Stearns suggested that Long-Term probably had only two or three days left. Bear Stearns was Long-Term’s “prime broker,” meaning that it cleared the firm’s trades and handled the daily flow of cash as money from winning positions came in and money on losing positions went out. Once the amount of cash Long-Term held on call at Bear Stearns dipped below $500 million, Bear was planning to stop clearing for Long-Term, which would effectively pull the plug. And Long-Term was already having difficulty meeting that requirement.
Readers who have a passing familiarity with bankruptcy procedures might find it puzzling that all this should matter so much. For most companies, a bankruptcy filing is designed to stop the rush by creditors to seize assets, and to give the debtor some breathing space to work out a new business plan or dispose of its assets in an orderly fashion. But Long-Term was not like a department store or a steel company that, upon going bust, would liquidate its inventory over a few weeks and parcel out the proceeds to creditors standing in line. Under the financing arrangements Long-Term used, most of its assets were already in the hands of creditors in the form of collateral that the creditors were legally entitled to sell as soon as Long-Term was declared in default by any single one of them.
Fisher and Gensler envisioned the nightmare that would unfold once Long-Term failed to pay a sum owed to one of its creditors or to Bear Stearns or to one of the counterparties to its thousands of trades. Since Long-Term was subject to a web of cross-default clauses in which default to one constitutes default to all, the fax machines at the firm’s Greenwich headquarters would begin spitting out notices from the counterparties declaring their intention to sell the collateral they held. Then would come the coup de grâce—the fire-sale liquidation of bonds, stocks, and other securities worth tens of billions of dollars, all at the same time. The derivatives posed the most significant problem of all: how the counterparties would react once Long-Term was no longer able to fulfill its obligations under its derivative contracts. If the “insurance company” providing insurance to investors could no longer pay off its “policyholders,” investors would suddenly realize how they and many others were exposed to the same risk, and they would Join in the selling spree.
What would such a fire sale mean? A lot of red ink on Wall Street, definitely; probably nothing more than that—but no one could be sure. Long-Term had estimated the losses its seventeen largest counterparties would suffer at $2.8 billion, not by any means an impossibly big sum for the Street to swallow. But that was Just the “first-order loss,” as Gensler put it later; the estimate didn’t account for the fact that markets were in an overwrought state already, thanks to the Russian default, the flight to quality, the drying up of liquidity, rumors about troubles at other firms, and worries that a new crisis was brewing in Brazil. So although a failure of Long-Term might simply depress prices a great deal, the question weighing on Fisher and
Gensler’s minds was whether it might cause something much worse, a malfunctioning in the market mechanism that would impede the funneling of credit to American businesses. The magnitude of the potential problem, Gensler told his Treasury superiors, looked every bit as great as previous bankruptcies of financial houses—such as the collapse of Drexel Burnam Lambert and Barings Securities—in which government authorities had felt obliged to intervene in trying to limit the damage; and Long-Term had a uniquely worrisome facet, the size of its derivatives portfolio, which made the impact all the more uncertain.
In conversations with McDonough, Fisher estimated that the odds were perhaps one in ten that Long-Term’s collapse would disrupt the U.S. government bond market—that is, effectively shut it down for some period of time. Although obviously imprecise, this estimate nevertheless suggested that the risks to the overall financial system were plenty high.
A shutdown in the Treasury bond markets would be different from a trading halt on an organized exchange like the New York Stock Exchange. Buying and selling continues on a twenty-fourhour basis in the Treasury bond market, with scores of broker-dealer firms around the world making bids and offers on U.S. government securities, so nobody can turn the lights off. But if those dealers were to stop making bids and offers for a day or two, nobody could be sure whether it would take a week, or a month, for them to feel confident enough to start again, given the staggering losses they might incur by making a faulty guess on price levels. Since investors use Treasuries to hedge their risks on corporate bonds, a prolonged hiatus in Treasury-bond trading would likely destroy price-setting in the corporate bond market as well, rendering it impossible for pension funds, mutual funds, and other institutions to buy corporate bonds.
For Fisher, a seminal event was seeing the evidence at 5 A.M. on Monday, September 21, and later that day as well, that a fire sale was already under way in U.S. and overseas markets among traders who were merely anticipating a Long-Term default. Long-Term dropped another half billion dollars that day, reducing its capital below $1 billion. There was no more time to lose if the Fed was going to help prevent default from occurring.
A major step toward a Fed-organized rescue came on the afternoon of September 21. After extensive conversations with executives of firms that ranked among Long-Term’s top counterparties, Fisher agreed to meet several of them for breakfast at the New York Fed’s headquarters the next morning. They included Jon Corzine, chief executive of Goldman, Sachs, and Goldman’s chief financial officer, John Thain; David Komansky and Herbert Allison, Merrill Lynch’s chairman and president respectively; and Roberto Mendoza, vice chairman of J. P. Morgan & Co. Fisher got approval for his actions from McDonough, and Greenspan was being kept informed in Washington.
The Fed’s first choice, naturally, was a rescue in which wellheeled private investors, acting entirely on their own, took over Long-Term’s assets or provided the firm with the capital injection it needed to survive. But the chances for an outside rescuer materializing looked unpromising, so during the September 22 breakfast, Fisher and the Goldman, Merrill, and Morgan executives discussed other possible avenues that would avert the dreaded “disorderly closeout.” Hopes were not high; the executives figured the odds were thirty to one against avoiding it.
Fisher told them that if they produced a plan that looked fruitful, and if all four stood behind it, he would invite other major firms to the New York Fed to listen to a presentation. By late afternoon, after being Joined by a fourth large counterparty, the Swiss bank UBS, they coalesced around the simplest approach, a proposal advanced by Merrill Lynch for the Street’s sixteen largest firms to form a consortium that would provide Long-Term with a $4 billion cushion—$250 million per firm. An emergency meeting to consider the consortium plan was called for eight o’clock that evening.
Shortly after the appointed hour, an extraordinary cavalcade of about twenty-five financial executives trooped into the New York Fed’s stately boardroom and seated themselves at a conference table surrounded by ornately framed paintings of the reserve bank’s past presidents. In addition to the executives who had been at breakfast, the group included Deryck Maughan, co-chief executive of Salomon Smith Barney; Philip Purcell, chairman of Morgan Stanley Dean Witter; James Cayne, chief executive of Bear Stearns; Thomas Labrecque, president of Chase Manhattan; and Allen Wheat, chief executive of Credit Suisse First Boston. Meanwhile, McDonough was racing back from delivering his speech in London. The New York Fed chief landed in New York around eleven that evening and spent much of the night briefing central bankers in Europe about developments.
Fisher opened the meeting, saying as little as possible and choosing his words with care. He told the group that he had convened the session because four of them—Merrill, Goldman, Morgan, and UBS—had a proposal to put forward aimed at preventing a default by Long-Term; it was their proposal, he stressed, not the Fed’s, but the Fed thought the other firms should listen to what the four had to say. The Fed, he said, had an interest in seeing a private-sector solution that avoided a disorderly liquidation. He didn’t have to tell the group he was concerned about systemic risk; the mere fact the meeting was taking place showed the Fed saw Long-Term’s woes as a systemic issue.
“No Federal Reserve official pressured anyone, and no promises were made,” McDonough emphasized in his congressional testimony a few days later. “Not one penny of public money was spent or committed.” Yet even by furnishing the meeting room, the Fed was crossing an important threshold. The Fed had the power to make life difficult for any of the firms represented at the meeting—by turning down a bank seeking regulatory approval for a merger, to take a particularly obvious example. Subtle and tacit though the pressure may have been, it was not entirely absent.
The meeting soon dissolved into disputes over particulars. Why should all firms in the consortium put up $250 million each when their exposures to Long-Term differed? If Long-Term were to be saved, how much of a stake should its partners be allowed to keep, if any, to provide them with an incentive to continue operating it? The meeting adjourned around 11 P.M., with plans to reconvene the following morning, though it wasn’t certain that Long-Term would survive until then. Gensler, briefed by Fisher on the state of play, told Summers late that night that the chances of success were slim. Too many players were involved, with too many different interests and too many legal hassles to get agreement in the time remaining, Gensler thought. But McDonough and Fisher, who were keeping top Treasury and Fed officials in Washington apprised of developments, took the view “that if you can Just keep these guys in a room talking, you had a shot, and they would see it as being in their self-interest to work something out,” Gensler recalled.
A larger group of executives representing seventeen firms arrived at the New York Fed when the meeting resumed at 10 A.M. on Wednesday, September 23, to make one last stab at keeping Long-Term from going under. After about only a half hour, the meeting took an unexpected turn when McDonough appeared in the boardroom and said he was suspending the proceedings. A bid for Long-Term’s portfolio was coming by fax from Warren Buffett, in conjunction with Goldman and the insurance giant AIG as minority participants. To McDonough, the Buffett deal was manna from heaven, since it wouldn’t embroil the Fed. But the bid came with extremely tough conditions: The Long-Term partners would be fired, and since they had borrowed against their share of the firm’s capital, they would be destroyed financially. Moreover, the offer would be withdrawn at 12:30 P.M.—less than two hours after it was received at Long-Term’s headquarters. Meriwether turned it down, telling McDonough he was legally unable to accept such an offer under the terms of the firm’s partnership agreement.
Talks resumed in the early afternoon on the original proposal for each firm to pony up $250 million toward a $4 billion bailout. Although most of the executives present were willing to go along, Bear Stearns’s Cayne refused, asserting that his firm was already exposed because of its role in clearing Long-Term’s trades. Two French banks said they
would ante up no more than $125 million, and Lehman Brothers said it could manage only $100 million. Much bickering ensued, including a “What the fuck are you doing?” bellowed by Merrill Lynch’s Komansky at Cayne of Bear Stearns.
Finally, with time running short, Merrill Lynch’s Allison said the other eleven firms would have to put in $300 million each for the deal to work—and they grudgingly agreed. That brought the total to $3.65 billion, which together with Long-Term’s remaining capital was enough to top the $4 billion goal. The deal would take another five days to finalize—and it would nearly blow up again amid wrangling over details—but on September 23, the immediate crisis was averted.
The next morning, with newspaper front pages blazing the story of how the meeting at the New York Fed had kept Long-Term afloat, Gensler came in for some ribbing at the Treasury’s senior staff meeting from department colleagues who had been principally responsible for overseeing the rescues in Asia and Russia. “So, you had to do a bailout too, huh?” Tim Geithner Joked. Retorted Gensler: “Well, you guys were getting too much attention.”
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