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Here is an interesting account of what happened in 1998 when the Federal Reserve orchestrated the primary dealers to bail out Long Term Capital Management…

~~~~ ” … I want to talk about the word “liquidity” as it applies to the bond market.  

I want to focus on what has happened over the last three or four months. How do we assess Long Term Capital and its relationship to the bond market? Where do we go from here? The financial press has not done a good job in my opinion in telling the story of what happened in the financial markets, primarily fixed income. This is all my opinion.

 The unraveling of the emerging markets really started with the Russian debt deal. The Euro dollar debt financing in June of a billion plus. Three, four or five weeks later the owners of this paper realized that they have some paper that could possibly have a default or a very major devaluation. The problem was what do you do with that paper? You go back to the Goldman or Salomon or Morgan trading desk and say, “Make a bid”. We are talking now about the emerging markets desk. The trader says, “Make on bid on what?” The trader is very shy about being too aggressive. They got hung, as the expression goes. This started the whole stampede of the emerging markets becoming unraveled.

That desk trades all the emerging market paper. This incorporates the Eastern European, the Russian, the Asian and the Latin American papers. If that trader is forced by his salesmen or firm to make a bid, that trader has to short something to neutralize his position. The real dynamic was that there was no paper to short in the Asian market. All the financing in Asia was through the banks. This was the disequilibrium.  Also, because everything was done through the banking system in Europe there was very little paper that you could short there. So you are back to Brazil, because the Brazilian “C” bond , the Brady, which is the sovereign credit risk of Brazil, is the paper of real liquidity. You can only short one emerging market paper and that was the Brazilian “C” bond.

The fixed income market is nothing more than a spread relationship. Everything is linkage. All Brady bonds interrelate. The Argentine Bradys and the Mexican Bradys all relate to the Brazilian Bradys.  The corporate paper relates to the sovereign credit because there ought to be a stated relationship or spread.

Then you had the Long Term Capital situation which further unraveled the market. They owned some of this paper but that really wasn’t the issue. The issue was the real big money made by the big guys was through their proprietary book. I am talking about the five, six or seven major firms. The proprietary book, their prop book as it is called, is nothing more than the firm capital. It is run on a hedge fund basis.

In other words, a firm in its prop book was doing nothing more than replicating everything that LTC had in its book. It set up its positions or its models  and strategies as a global macro player. These are not stock hedge funds where its long against shorts or the pairings or any of those particular strategies. These are the global macro games where it is currency, debt, equities.

LTC certainly had this mystique about them. There wasn’t any black box as it later turned out. It was the same kind of trades that anybody could do. As a matter of fact, a ten year old could have done them. There was no great science to any of this. This really disturbed a lot of people on the street because they paid a lot of money to have an insight into what they were doing. As it turned out, there was nothing that arcane or exotic that gave them a particular edge.

In any event, all these street firms had the same trades on. That is why these firms had to step up and bail out LTC. They would have been pulled under in the same way. We didn’t dodge a bullet here, we dodged a bazooka. This is not my original statement. There is no doubt in my mind we would have had the financial apocalypse. Absolutely the financial apocalypse. This is strong language. I understand that. But any number of firms would have gone under. There would have been sheer paralysis in the financial markets if the New York Fed had not stepped up and brokered this transaction. I happen to think it was the Fed’s greatest day.     

It really hasn’t been fully appreciated in the marketplace what the Fed did. Every firm on Wall Street, the big guys, had the same trade. There was no liquidity in the market. The reason there was no liquidity is simply this. You have the prop book over here. You are trying to protect your positions in your prop book and you know that you are going to have to be selling some of these positions to reduce your exposure. Over here you have your market making.

Market making means that I am taking an inventory. There is no way in the world I want to be positioning any bonds during this period of tremendous stress in the marketplace. I am more worried over here with respect to my proprietary book and getting out of these positions with honor over time. What you do is you tell your traders who are the ones responsible for market making, “Do not take on any inventory.” As a result,  the street started to trade on an agency basis. This is what dried up the liquidity. The interplay between the prop book and the market making.

There was absolutely nothing wrong with the underlying credits. Fundamentally these are all very sound credits. You had a wide spread as the yield levels backed up from 7 ½  or 8 percent to 10 percent. You had an extraordinary opportunity of 240 or 250 points over 500 basis points. What is happening now is that prices are gapping up the same way they gapped down. They are gapping up because there are no offerings in the market. Liquidity is coming back into the market on the bid side but there aren’t any offerings. It is the same thing in the emerging markets. You can’t buy good corporate credits in Argentina, Brazil or Mexico.

We are getting to a position now where the market is healing. The recovery has been way beyond expectations. Market making will recover because there is money to be made in the market. The salesmen are making tremendous sums of money today in brokering these trades because nobody knew where the levels were. Now the levels are starting to return to some normalcy….” ~~~~