J.P. Morgan's Warning Is So 1998

Updated from 4:54 p.m. EDT

The echoes of Long Term Capital Management still reverberate on Wall Street, and not just because the Dow Jones Industrial Average is again below 8000, just as it was when the implosion of the notorious hedge fund almost burst Wall Street's bubble in September-October 1998.

Four years later, recent announcements by J.P. Morgan (JPM Quote) and Fannie Mae (FNM Quote) suggest some firms are still vulnerable because they are prepared only for the expected. In sum, they have missed the core lesson of Long Term Capital's shocking fall: At extreme junctures in the market, such as those occurring in the fall of 1998 and this past July and August, financial models based on historic norms are worthless, if not cancerous.

Because of its early successes and high-profile partners, Long Term was able to leverage its roughly $2 billion capital base by a factor of more than 20 to 1 (some press reports in 1998 said as much as 80 to 1). After the Asian financial crises in 1997 and Russian debt default in 1998, Long Term Capital faced huge trading losses, prompting the Federal Reserve to arrange a bailout by its Wall Street lenders, whose own financial health was perceived to be at risk. ...