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When Genius Failed: Lowenstein Talks LTCM

Brett D. Fromson: The derivatives, in a sense, are pure credit.

Roger Lowenstein: They're bets.

Brett D. Fromson: You believe that I will pay you back because I tell you that.

Roger Lowenstein: If you agree to pay me a certain amount of money for every run that the Red Sox score this season and we have no idea how many runs they're going to score, and I have no idea if you made the same bet on the Indians and the Tigers, too.

Brett D. Fromson: And, ultimately, the only guarantee you have that I'm going to pay you is that I tell you I'm going to pay you.

Roger Lowenstein: Right.

Brett D. Fromson: Or you can sue me in court.

Roger Lowenstein: Right. But it hasn't cost you anything to make that bet. So that's my concern.

Brett D. Fromson: Now, with regard to disclosure on derivatives, the bank regulators do see some information themselves because there's a difference between bank disclosure and brokerage firm disclosure.

Roger Lowenstein: Yes, they do see some and investors see some, but it's not broken down for the average or even the pretty sophisticated investor who really understands. It's not in a form that the average investor could say, "OK, if rates in Germany do this, this institution is going to have this much exposure." There are also no limits on that exposure. Don't forget, a regulated bank has limits on the loans it can make as a portion of its capital. Why not with derivatives as well?

Brett D. Fromson: Are there any regulations on banks regarding their derivative positions?

Roger Lowenstein: No.

Brett D. Fromson: Now the Securities & Exchange Commission has agreed to accept a voluntary disclosure from the big Wall Street houses, I believe. But it's not required. The SEC has not pushed that hard on that. Frankly, none of the financial regulators have pushed that hard on disclosure in terms of making it required.

Roger Lowenstein: Derivative or hedge fund disclosure?

Brett D. Fromson: Derivative.

Roger Lowenstein: Yes, there is some, there certainly is some derivative disclosure required. The SEC has a pretty full plate. The Federal Reserve has been champion of the need that derivative transactions introduced, and has been pushing to relax requirements.

Brett D. Fromson: Now doesn't this attitude on the part of the Fed also reflect a belief in markets as potentially perfect vehicles? Which is funny, coming from a regulator.

Roger Lowenstein: Yes, well certainly as self-correcting vehicles. Greenspan was asked about hedge fund risk shortly before LTCM went under and he said that these funds will be regulated by the people who finance them. And that was an astonishing comment, because as it happened, the case of LTCM was nothing but a demonstration that the banks exercised no control at all. They created the problem.

"They apologized, but I never got a strong sense of what they were apologizing for."

Brett D. Fromson: The irony there is that the Fed, at the same time that it's arguing and self-correcting aspects of the financial markets, itself has to organize the corrective mechanism.

Roger Lowenstein: I guess my feeling is, where would you rather have the government? Would you rather have them jumping in when there's a problem, or would you have them mandating enough sunlight so the problems are less likely to occur? I mean, I would say obviously the latter. Disclosure works pretty well. I mean, if the shareholders of J.P. Morgan (JPM) and Merrill Lynch and Goldman Sachs (GS) either know enough to get nervous when those institutions extend too much credit to hedge funds, you're going to see those institutions extending less credit to hedge funds. That system's not perfect; people will still make mistakes.

Brett D. Fromson: Since Long Term Capital's downfall, has there been any improvement in derivative disclosure?

Roger Lowenstein: No. Greenspan has continued to push for a relaxation.

Brett D. Fromson: Meanwhile, the SEC, I believe Arthur Levitt personally, expressed the desire to try to do something, but I always had the feeling that he never really could make it happen, he just didn't have the political support.

Roger Lowenstein: Yes, I think the Fed has taken the lead on this one.

Brett D. Fromson: I think they've also, to a certain extent, elbowed the SEC out of the way, because even with regard to disclosure for the brokerages, where you would think the SEC might have grand purview, the SEC I think agreed to essentially voluntary disclosure. Now, what do you think that the partners at LTCM learned, if anything?

Roger Lowenstein: That's a good question. They did a long roadshow after The Event, as they call it.

Brett D. Fromson: The Event? Great euphemism.

Roger Lowenstein: Yes, it's a great euphemism. After Waterloo, they visited all their investors explaining, in their view, what had happened and thus preparing the way to raise new money. A dream that was living from the moment they went down, even before they went down, they were thinking of resurrecting themselves with a new fund and the gist from many retellings, and that is to say, conversations with the people who heard their pitches, was that they had been done in by a perfect storm, a 100-year storm, and also by people who had front-run them. They apologized, but I never got a strong sense of what they were apologizing for.

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