Ghosts of LTCM

It has only been a few days since the Federal Reserve stunned the market and announced that it would not taper its $85 billion bond buying program, but it has been long enough to show that the US central bank is a house deeply divided. Since Mr. Bernanke’s press conference on September 18th, four Fed governors have given their own opinion on whether the Fed should extend their bond buying program and continue to provide additional stimulus to the economy.

After the market reacted positively to Bernanke’s comments, James Bullard pulled the carpet out from under the market on Friday with his take on the decision. The Federal Reserve Bank of St. Louis President suggested that the decision to continue the purchasing program “was a borderline decision” after “weaker data came in,” and that some data change could make the committee be comfortable with a small taper in October.”1 This was enough to spook the gold and silver markets into erasing all the gains it had made over the previous two days.

So we ask what roadmap is the Federal Reserve following for monetary policy now? Why would an easy money policy need to be extended after guiding the market for months that monetary stimulus would be removed, albeit slowly, over the next nine months? Bernanke, in his press conference, said that despite growth proceeding at a moderate pace, “federal fiscal policy continues to be an important restraint on growth and a source of downside risk.”2 Could the FOMC be providing easy money in an effort to pre-empt the impact of the debt ceiling debate on the US economy? For some answers we look back to a financial event that happened 15 years ago yesterday. The story sounds all too familiar and strikes a chord we have heard many times in recent memory.

A hedge fund borrows billions of dollars to make large bets on esoteric securities to “vacuum up nickels that everyone else had overlooked”3. Long Term Capital Management’s (LTCM) objective was to identify arbitrage opportunities using massive databases along with the insights of two Nobel Prize-winning economists. Started in 1994 with initial capital of $1 billion dollars and buoyed by their success, LTCM in 1998 borrowed $125 billion with only $5 billion in assets. In August of 1998 Russia defaulted on their debt and set off a chain of events that could not be predicted by computer models, causing the fund to hemorrhage cash. Almost overnight, the firm lost most of its capital, and Wall Street suddenly shunned it. Seeing no options left, the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. History is not without its sense of irony, as many firms that were employed by the Federal Reserve to rescue LTCM were themselves teetering 10 years later and necessitated a rescue of their own.

The crisis had been averted through a Federal Reserve intervention and a new policy instrument had been perfected for the Federal Reserve’s toolkit – the ‘Greenspan Put’. The term was coined in 1998 after the Fed lowered interest rates following the collapse of Long Term Capital Management. The effect of this rate reduction was that investors could borrow funds more cheaply to invest in the securities market, thereby averting a potential downswing in the markets. In other words, the Federal Reserve would not let the financial markets fall too far, hence the term ‘put’. This template has been used over and over again to cut interest rates and pump liquidity into markets.4 After several bailouts for other stricken financial institutions over the preceding decade, it appeared that traders and executives believed there would always be a rescue from the Federal Reserve if they needed it. Fast forward to this past week’s events and the strategy of the current Federal Reserve becomes much easier to understand. You see the Federal Reserve is once again facing an issue that nearly cratered the markets, and the economy; the debt ceiling debates.

In approximately seven days, we approach the limit of the US government’s borrowing capability and the threat of a government shutdown and the “debt ceiling” debate once again takes center stage. As he mentioned in his press briefing, Bernanke is fearful of such a repeat event given an already weak economy, coupled with rising interest rates. Any shutdown of the government, fear of “default” or restrictive fiscal policies could collapse what incremental recovery there has been to date.“ Upcoming fiscal debates may involve additional risks to financial markets and to the broader economy,” Bernanke said at a September 18 news conference after the FOMC minutes were released. If you recall, the last time Obama and Congress were at a stalemate over the debt ceiling, in 2011, Standard & Poor’s lowered the U.S. federal government credit rating. The S&P 500 stock index fell 16.8%between July 22, 2011, when talks on a broad deal faltered, and August 8, the first trading day after the government’s AAA debt was downgraded. The index rebounded to close with a gain of about 12%for the year. However gold over the same time period returned 7% and then continued rising to an all-time high of $1,921/oz. on September 6 in the process. Therefore, it would appear that tepid economic data and fear of a prolonged debt ceiling debate forced the hand of the FOMC to extend quantitative easing for the time being, providing investors this time a ‘pre-emptive-Bernanke-put’.

It’s as if the ghosts of LTCM bailout have returned 15 years later reminding investors that the ‘Greenspan put’, delivered in a new incarnation, is alive and well. While the price of gold appears to be range bound, an extension of the Fed’s quantitative easing program or a prolonged fiscal debate have the ability to raise gold’s spirits as well.

1 Fed’s Bullard says tapering still possible next month after ‘very close call’ in September.
2 Transcript of Chairman Bernanke’s Press Conference September 18, 2013.
3 Long Term Capital Management: Summary of the Nature of LTCM.
4 Moral Hazard and the US Stock Market :Analyzing the “Greenspan Put”.
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