Olivier Crottaz CEFA

In 1998, sixteen people nearly took down the global financial system, and you have probably never heard their names. Long-Term Capital Management ran out of Greenwich, Connecticut, founded by John Meriwether after he left Salomon Brothers under a cloud. He stacked his roster with prestige. Myron Scholes and Robert Merton, two men who would win the Nobel Prize in economics in October 1997 for pricing options, sat on the masthead. David Mullins, former vice chairman of the Federal Reserve, joined too. Picture the brochure. Nobel laureates, a central banker, the smartest bond trader on Wall Street. What could possibly go wrong? Everything, as it turned out. The strategy was convergence arbitrage. LTCM found tiny price gaps between similar bonds, bet that the gaps would close, and made pennies. To turn pennies into a fortune you need leverage, and leverage they had. By early 1998 the fund controlled positions of roughly $125 billion on about $4.7 billion of capital. Add the derivatives book and the notional exposure ran past $1.25 trillion. They were levered around 25 to 1 on the balance sheet, and astronomically more once you counted the swaps. Their models told them this was safe. The math, built on the assumption that markets move in tidy normal distributions, said a catastrophic loss would happen once in several billion years. Reality holds different opinions. In August 1998 Russia defaulted on its ruble debt and devalued. Investors fled to safety everywhere at once. The price gaps LTCM bet would narrow widened instead, all of them, in the same direction, on the same day. Correlations the models had treated as independent snapped together. The fund lost $1.9 billion in a single month and bled toward zero. Here is the part that should make you angry. When the fund collapsed, the Federal Reserve Bank of New York, under William McDonough, summoned the heads of the major banks to a conference room on September 23, 1998. Bankers Trust, Goldman Sachs, Merrill Lynch, J.P. Morgan, and the rest were pressed to assemble roughly $3.6 billion to take over LTCM's positions and unwind them slowly. Alan Greenspan's Fed did not write the check directly. It did something arguably worse: it organized the rescue, lending its authority to the proposition that a private hedge fund run by multimillionaires was too important to fail. Consider what that taught everyone watching. Take wild risk with borrowed money. Keep the gains when you are right. When you are wrong on a scale that threatens the system, the central bank will herd your creditors into a room and arrange a soft landing. Profits stay private. Losses get socialized. The people who built the bomb walk away with their houses in the Hamptons intact. Free market economists call this moral hazard, and LTCM is the textbook case. Greenspan had already cut rates and flooded markets with liquidity after the 1987 crash. He did it again in the autumn of 1998, three cuts in seven weeks. Each rescue convinced the next generation of traders that the floor was permanent. The dot-com mania followed immediately. Then the housing bubble. Then 2008, which made the LTCM intervention look quaint, a $3.6 billion rounding error compared to the trillions that came later. The lesson nobody in Washington wanted to learn sat right there in 1998. You cannot price risk honestly when a central authority stands ready to absorb the downside. Scholes and Merton won a Nobel for a formula that assumed away the very tail events that destroyed them. The men who should have lost everything lost almost nothing. You paid, eventually, in inflated dollars and serial bubbles, for a bailout you never voted on.

Gold Price Adjusted for US M2 Money Supply