Fisher on credit meltdown

The WSJ interviews Peter Fisher, the man who led the Fed intervention during the LTCM crisis. He's now an MD at Blackrock.

WSJ: What similarities or differences do you see to previous market crises?

Mr. Fisher: Big market events that pose systemic risks tend to reflect collective mistakes in which most market participants are offside in the same direction. In the summer of 1998 there was a collective misunderstanding about credit risk: Everyone underestimated sovereign risk and lived in the fantasyland were sovereigns did not default. Remember? "Russia won't default, they have missiles." It turned out not be about missiles but about cash flows. It turned out that credit mattered and then we had to revalue a lot of sovereign paper that was being used as collateral.

WSJ: So in 1998, there were problems with collateral. And this time, there are even more problems with collateral, right?

Mr. Fisher: Yes, indeed. Until the week before last, nobody seemed to be focused on the uncertainty surrounding the value of mortgage-related and structured-finance paper and, then, suddenly, everyone did. The late MIT Professor Rudi Dornbusch sagely observed that in financial markets things always take longer to happen than you expect but once they happen, events unfold much more quickly than you expect and this perfectly describes the events of mid-August.

WSJ: The conventional wisdom was that globalization would lead to a dispersion of risk. And yet, the market seems so spooked with announcements of problems from Australia to Germany as well as in the U.S. How do you see the costs and benefits of globalization in the financial markets?

Mr. Fisher: The benefit of course is risk diversification and dispersion but this comes with an offsetting cost. This is the cost of proxy or imperfect hedging, where market participants sell what they can rather than what they wish, which leads to higher linkages and less benefit of dispersion. In 1998, after Russia's default, there was selling pressure in Mexican bonds not because the market thought a Mexican default was likely but because the Mexican bonds were liquid.

WSJ: What else feels different this time?

Mr. Fisher: In September of 1998 there were a lot fewer people who thought they saw a buying opportunity -- famously, in the case of LTCM, only Warren Buffett and Hank Greenberg. It took until October and November of that year for more people to see a buying opportunity and for the markets to find a bottom.

Buffet and LTCM

Interesting tidbit for students of the LTCM meltdown, as relayed by Wharton professor Jeremy Siegel.

Apologies to people who believe in efficient markets and similar orthodoxy ;-)

Long Term Capital Management

One student asked about Berkshire’s role in the Long-Term Capital Management (LTCM) crisis that rocked the financial markets in 1998. It was obvious that Warren wished that he had been able to buy LTCM’s positions when the Fed forced a resolution of the crisis that was crippling the government bond market.

The LTCM crisis was a ready-made example of Warren’s philosophy of buying firms when the economics was right, yet fear ruled the markets. He noted that “off-the-run” (non-benchmark) government bonds were selling to yield 30 basis points more than the “on-the-run” (benchmark) bonds that were maturing just six months later. He rightly claimed that this made no sense economically.

LTCM had taken a huge leveraged position in these bonds when the spreads were much smaller, but didn’t have the collateral to hold on to it when the spread widened. Buffett quoted John Maynard Keynes, who wrote in 1931 that “The market can stay irrational longer than you can stay solvent.” As the spread widened, Keynes’ dictum became devastatingly relevant for LTCM. But Berkshire, with its huge cash hoard, could withstand the pressure of even more market irrationality before the spread eventually returned to normal.

Unfortunately, Warren was never able to consummate the deal. He had been invited by Bill Gates to vacation in Alaska when the crisis broke and it was hard to negotiate such a deal on a cell phone. Eventually the banks holding the collateral made a deal with LTCM and Berkshire didn’t have a chance to top their offer.

Warren is philosophical about the loss of this opportunity, noting it was the most expensive vacation he ever took. “Bill Gates cost me about $3 billion,” he shrugged. But that incident certainly has not soured their friendship and didn’t prevent him from giving the Bill and Melinda Gates Foundation the lion’s share of his wealth.