Wall Street Whispers About Fed's Hand in LTCM Bailout

No public money was used. So goes the official word on the rescue of Long Term Capital Management.

Federal Reserve Chairman Alan Greenspan and New York Fed President William McDonough each reiterated that point during testimony before the House Banking Committee yesterday.

Additionally, the governors of the Federal Reserve Bank of New York reported that discount-window borrowing increased just $125 million for the week ended Sept. 30, a level Fed watchers say is neither unusual nor indicates any untoward activities.

The discount window is usually reserved for emergency borrowing by banks faced with insolvency, but some critics wondered whether the Fed might have nudged firms involved in the LTCM rescue to borrow at the window where -- as the name implies -- rates are lower than the prevailing fed funds rate. That apparently was not the case.

A New York Fed spokesman reiterated the bank's previous statements that the Fed did nothing more than facilitate a meeting and referred to McDonough's testimony as "a full explanation of what we did and why we did it." Furthermore, many market participants say they are taking the Fed at its word and support the actions taken.

'There are other things the Fed could have done'

Regardless, speculation persists that the Fed did more than just organize meetings and serve coffee. The meetings, you'll recall, resulted in a 14-bank consortium that spent $3.5 billion to $3.6 billion to buy 90% ownership in Long Term Capital and forestall a liquidation of the fund's ailing positions.

"I'd be very surprised if you have any pick-up in discount-window borrowing, but there are other ways," said one analyst at a foreign bank, who asked not to be identified. "There are other things the Fed could have and has done to help relieve pressure. The Fed and Treasury have accounts at different banks. In the late 1980s and early '90s, when Citicorp (CCI Quote) was rumored to have troubles, the talk in the market was the Fed increased their balances with them to put deposits on their books."

Rather than providing funds or cut-rate loans, other observers said the Fed's "participation" in the consortium did not come until this week, when the Federal Open Market Committee lowered interest rates for the first time since January 1996.

"If you were the Fed and your objective was to use your powers to be supportive of this, one thing you might do is ease policy aggressively to steepen the yield curve to the point the parties involved would have economic incentive to holding those positions," said one Fed watcher, who also requested anonymity. "One might argue the recent easing is not blind to that situation."

Jim Bianco, president of Bianco Research, agreed but said the impetus may not necessarily have been Wall Street's exposure to Long Term Capital or other hedge funds.

"The Street has this trade where they are long spread product and short Treasuries," Bianco said. "It sounds a little bit conceptually like Long Term Capital. The problem is, we hit an environment where spreads widened out and they got killed. I think this is what [brokerage] stocks are fearing so much."

Report shows a wobbly brokerage community

The New York Fed's dealer position report provides evidence of the brokerage community's precarious position, Bianco said. As of Sept. 2 -- the last date for which such information is publicly available -- the four-week moving average for the 31 primary dealers in the Fed system was a short position of $59.8 billion Treasuries and a long position of $62.8 billion in mortgage-backed securities and $33 billion in government-agency securities.

Bianco further argued that as investors in and lenders to Long Term Capital, Wall Street firms knew exactly what John Meriwether and friends were up to and sought to mimic the ill-fated strategies of the once-revered hedge fund.

"It was a good trade for much of the 1990s," Bianco said. "Now the rally in Treasuries, and the lack of rally or outright decline in spread product, is killing them. What the Street needs is a rally in credit and the Fed was going to come through. But it blew up in their faces because the market wanted 50" basis points instead of the 25-basis-point ease delivered Tuesday.

The problem, he continued, is that the dealer community faces an absence of "positive carry" because it has borrowed at the fed funds rate to buy lesser-yielding Treasuries on margin. To induce positive carry, the Fed would have to lower the funds rate below the lowest point on the yield curve, currently 4.07% for the five-year note.

If the Fed maintains its current approach of meting out 25-basis-point moves at FOMC meetings, it will take 30 weeks to get to that position, Bianco said, assuming market rates don't move in the interim. "The game is going to be over by then."

Bianco said announcements like those this week from Bankers Trust (BT Quote), Chase (CMB Quote) and Merrill Lynch (MER Quote) -- detailing hedge-fund exposure and levels of collateralization -- obscure the real issue.

"What they didn't tell me is what's the size of their proprietary book and how much it looks like Long Term Capital's," he added. "It's not how much did they lend to hedge funds but the fact [the Street's] proprietary desks are the biggest hedge funds out there."

Some insight will arrive when the industry reports its third quarter earnings in the coming weeks, the researcher said. Until then, the brokerage stocks could continue the stumble that drove the American Stock Exchange Broker/Dealer Index down 45% from July 17 through yesterday's close. (The XBD rose 4.1% today.) The S&P 500 was down 16.9% over the same time frame.

"Wall Street wants more than press-release denial," Bianco said. "They want, 'Tell me you're not going to zero,' and I don't think they can deliver that."