We Forget That the Financial Crisis Had a Trial Run

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The article discusses about the fall of a hedge fund which occurred in September 1998 and the underlying reasoning was repeated in 2008 financial crisis. The 1998 crisis occurred for Long Term Capital Management (LTCM), a strong hedge fund company which tried to seek profit opportunities by defining new way to invest capital and kept 26-to-1 leverage ratio at its peak. A similar situation occurred in 2008 and thus, it would be true to say that the financial crisis of 2008 had a trial run, but nobody learnt from earlier mistakes.

The management team at LTCM had later accepted their wrong investment strategy in the search of profits few unusual scenarios. In fact, they had started accumulating profits for few months, with annualised increases after charges of 21, 43 and 41% in the initial three years. The group had the appearance, as indicated by columnist Roger Lowenstein, of being a ‘$100 billion cash making juggernaut'(Bloomberg, 2018).

Even though LTCM’s directors were splendid and had won future Nobel Victors award signifying their huge contribution in the organizational progress, still they settled on some of the risky choices that an investment banker should always avoid. It clearly reflected that the bankers had taken huge risk and leverage and carried very less humility. As point by point by Lowenstein in the magnificent book ‘When Genius Failed: The Rise and Fall of Long-Term Capital Management,’ the repetition of such tactics during financial crisis of 2008 reflects that investment bankers are more driven by profits than hedging the risks (Bloomberg, 2018).

The investment bankers at LTCM had identified few small overlooked opportunities. Though, there could create profits but the number of such opportunities were not worthwhile after considering the expenses. Therefore, company kept increasing leverage to compensate for the expenses. At its pinnacle, LTCM held $124.3 billion of assets against the $4.72 billions of equity, reflecting a 26-to-1 proportion. There exists a huge similarity between LTCM’s actions and the financial crises of 2008. In the recent crisis, the investment bankers kept bundling the subprime mortgage documents to create CDOs, which they only could decipher. The small opportunity of getting some benefits by purchasing the bad loans of bank and selling them to other entity, seemed quite attracting to the bankers though the underlying risk and the expenses to hedge that risk were many. Finally, the pile of bad assets or too much leverage bloated.

LTCM had faced decreasing interest rates and made their fund managers to focus on yield. In fact they also tried to look for illiquid credit markets (resembling with CDOs of 2008). These derivative positives were complex and had huge exposure resulting in increased debt obligations on the shoulders of LTCM. When it fell down, the lenders of Wall Street also faced the agony and finally Federal Reserve had to intervene. Same story repeated in 2007-08 when large investment banks, insurance companies and manufacturing organizations fell in the darkness of derivative products and associated bad loans making Federal Reserve and US government to bail them out.

However, those large brains pulled in billions of dollars; used that up enough, and delved into a fundamental hazard position. Before the finish of September 1998, as the company’s financials started to unwind, capital had contracted to a negligible $400 million while resources were still more than $100 billion, resulting in leverage to equity ratio of 250-to-1. The huge leverage ratio and rapidly exhausting investment values (because of low gains), implied the need of upcoming liquidation or bankruptcy. The Federal Reserve, under the direction of Alan Greenspan, sorted out a gathering of 16 money-related organisations to horse up $3.6 billion to keep LTCM above water while the subordinates and illiquid property had been lost after some time (Bloomberg, 2018).

In an email conversation, Lowenstein expressed that the implosion of LTCM was not as fierce and bad as that of 2007. He said, ‘In 1998, it didn’t feel like a dry run’ but in 2007 ‘It felt like the apocalypse.’ Lowenstein added that while the Fed’s rescue of LTCM worked to “soothe traders and numb investors,” it also taught the wrong lesson to the investment bankers that in worse situation government will help them out of the crisis. In this way, the problem of LTCM seems to be highly correlated to a moral hazard that makes the investment bankers to design, develop and then explode a financial crisis.

It also showcases that a hedge fund would have better chances to get bailed out if it has taken so much leverage the whole Wall Street is intertwined with the failure, and so the government would have to intervene and show socialistic steps, to cover up the damage done by capitalistic mind-sets. In this way, it could also be said that Greenspan did not understand that the socialized losses were trying to preserve the private gains. This precedent was set, and later on repeated in 2008 also.

Thus, the article provides a glimpse of financial crisis that occurred in 2008. It also shows that investment banks repeat the history thinking that government will help them out, and the whole burden is later on faced by common man in terms of lost employment opportunities, low pay scale, low housing prices and loss of assets and related ripple factors. It also highlights the need of a stronger corporate laws that could stop investment banks to involve in highly risky deals and follow a hedging strategy. It can only be done by more vigilance by Federal Reserve as well as SEC.

These institutes would need to create frequent audits about the investment strategies, risk portfolio and underlying asset worth shown by the banks. At the same time, the auditing of credit rating agencies is also needed. They are considered as the monitoring authority of other private companies, and if these credit rating agencies collaborate with private companies then the false activities would never uncover till a crisis is built and ready to explode. So, a stronger vigilance and tough corporate laws are necessary to avoid such crisis situations.

Cite this paper

We Forget That the Financial Crisis Had a Trial Run. (2021, Aug 24). Retrieved from https://samploon.com/we-forget-that-the-financial-crisis-had-a-trial-run/

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