Bear Stearns and the good old LTCM

Looking at Bear Stearns‘ current trouble reminded me of the mess that Long-Term Capital Management (LTCM) created in 1998. Both companies received bailouts because, as the justification goes, the potential risk of starting a chain reaction that may lead to a meltdown is too high. A failure of one may lead to defaults of the counterparties of the derivative contracts.

Quoting the WSJ (emphasis added),

Of course, the Fed has sponsored bailouts of entities outside its purview before, as when it herded banks to unwind Long-Term Capital Management a decade ago. Then, too, it was concerned about banks’ counterparty exposure to the hedge fund.

That kind of exposure has increased a lot since then through the ballooning derivatives markets. Credit derivatives, which barely existed when LTCM ran aground, now constitute a $50 trillion market, though much of that consists of offsetting contracts. Other derivatives markets have also grown.

This Bloomberg article is a good read as well. Here is an excerpt (emphasis added),

“Lehman has probably the best risk management and has been diversifying for years,” said Mark Williams, a former Federal Reserve official who teaches finance at Boston University School of Management. “But this is no longer about Bear or Lehman. It’s about the erosion and lack of confidence in the financial system. The Wall Street business model is based on ready capital. With rumors, that liquidity they rely on dries up very fast.”