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DEREGULATION REDUX 

included Merrill Lynch, JP Morgan, Morgan Stanley, Lehman Brothers, Goldman
Sachs, and Chase Manhattan. The previous four years, LTCM’s leveraging strategy
had produced magnificent returns: ., ., ., and ., while the S&P
 yielded an average . 
But leverage works both ways, and in just one month after Russia’s partial default,
the fund lost more than  billion—or more than  of its nearly  billion in capi-
tal. Its debt was about  billion. The firm faced insolvency. 
If it were only a matter of less than  billion, LTCM’s failure might have been
manageable. But the firm had further leveraged itself by entering into derivatives
contracts with more than  trillion in notional amount—mostly interest rate and
equity derivatives. With very little capital in reserve, it threatened to default on its

obligations to its derivatives counterparties—including many of the largest commer-
cial and investment banks. Because LTCM had negotiated its derivatives transactions
in the opaque over-the-counter market, the markets did not know the size of its posi-
tions or the fact that it had posted very little collateral against those positions. As the
Fed noted then, if all the fund’s counterparties had tried to liquidate their positions
simultaneously, asset prices across the market might have plummeted, which would
have created “exaggerated” losses. This was a classic setup for a run: losses were likely,
but nobody knew who would get burned. The Fed worried that with financial mar-
kets already fragile, these losses would spill over to investors with no relationship to
LTCM, and credit and derivatives markets might “cease to function for a period of
one or more days and maybe longer.” 
To avert such a disaster, the Fed called an emergency meeting of major banks and

securities firms with large exposures to LTCM. On September , after considerable
urging,  institutions agreed to organize a consortium to inject . billion into
LTCM in return for  of its stock. The firms contributed between  million


and  million each, although Bear Stearns declined to participate. An orderly
liquidation of LTCM’s securities and derivatives followed.
William McDonough, then president of the New York Fed, insisted “no Federal

Reserve official pressured anyone, and no promises were made.” The rescue in-
volved no government funds. Nevertheless, the Fed’s orchestration raised a question:
how far would it go to forestall what it saw as a systemic crisis?
The Fed’s aggressive response had precedents in the previous two decades. In
, the Fed had supported the commercial paper market; in , dealers in silver
futures; in , the repo market; in , the stock market after the Dow Jones In-
dustrial Average fell by  percent in three days. All provided a template for future
interventions. Each time, the Fed cut short-term interest rates and encouraged finan-
cial firms in the parallel banking and traditional banking sectors to help ailing mar-
kets. And sometimes it organized a consortium of financial institutions to rescue
firms. 
During the same period, federal regulators also rescued several large banks that
they viewed as “too big to fail” and protected creditors of those banks, including
uninsured depositors. Their rationale was that major banks were crucial to the finan-
cial markets and the economy, and regulators could not allow the collapse of one