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FINANCIAL CRISIS INQUIRY COMMISSION REPORT
large bank to trigger a panic among uninsured depositors that might lead to more
bank failures.
But it was a completely different proposition to argue that a hedge fund could be
considered too big to fail because its collapse might destabilize capital markets. Did
LTCM’s rescue indicate that the Fed was prepared to protect creditors of any type of
firm if its collapse might threaten the capital markets? Harvey Miller, the bankruptcy
counsel for Lehman Brothers when it failed in , told the FCIC that “they [hedge
funds] expected the Fed to save Lehman, based on the Fed’s involvement in LTCM’s
rescue. That’s what history had proved to them.”
For Stanley O’Neal, Merrill’s CFO during the LTCM rescue, the experience was
“indelible.” He told the FCIC, “The lesson I took away from it though was that had
the market seizure and panic and lack of liquidity lasted longer, there would have
been a lot of firms across the Street that were irreparably harmed, and Merrill would
have been one of those.”
Greenspan argued that the events of had confirmed the spare tire theory. He
said in a speech that the successful resolution of the crisis showed that “di-
versity within the financial sector provides insurance against a financial problem
turning into economy-wide distress.” The President’s Working Group on Financial
Markets came to a less definite conclusion. In a report, the group noted that
LTCM and its counterparties had “underestimated the likelihood that liquidity,
credit, and volatility spreads would move in a similar fashion in markets across the
world at the same time.” Many financial firms would make essentially the same mis-
take a decade later. For the Working Group, this miscalculation raised an important
issue: “As new technology has fostered a major expansion in the volume and, in some
cases, the leverage of transactions, some existing risk models have underestimated
the probability of severe losses. This shows the need for insuring that decisions about
the appropriate level of capital for risky positions become an issue that is explicitly
considered.”
The need for risk management grew in the following decade. The Working Group
was already concerned that neither the markets nor their regulators were prepared
for tail risk—an unanticipated event causing catastrophic damage to financial institu-
tions and the economy. Nevertheless, it cautioned that overreacting to threats such as
LTCM would diminish the dynamism of the financial sector and the real economy:
“Policy initiatives that are aimed at simply reducing default likelihoods to extremely
low levels might be counterproductive if they unnecessarily disrupt trading activity
and the intermediation of risks that support the financing of real economic activity.”
Following the Working Group’s findings, the SEC five years later would issue a
rule expanding the number of hedge fund advisors—to include most advisors—that
needed to register with the SEC. The rule would be struck down in by the
United States Court of Appeals for the District of Columbia after the SEC was sued
by an investment advisor and hedge fund.
Markets were relatively calm after , Glass-Steagall would be deemed unnec-
essary, OTC derivatives would be deregulated, and the stock market and the econ-
omy would continue to prosper for some time. Like all the others (with the exception
