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At this point, in September 1998, any of several banks could bankrupt LTCM by calling in its loans.
The Federal Reserve, which is the central bank of the United States and is responsible for
guaranteeing the stability of the American banking system, monitored the predicament. Though
LTCM‟s equity was shrinking precipitously, on account of its borrowed funds and the inherent
leverage of its derivatives positions, the notional principal of its positions was about $1.4 trillion. To
put this quantity into perspective, the gross national product of the United States was about $8.8
trillion in 1998. Total bank assets in the United States stood at $4.3 trillion. It was feared that if LTCM
went bankrupt, it would probably default on its derivatives positions, triggering a domino effect of
defaults and bankruptcies throughout the world‟s financial markets. It was decided that LTCM was
too big too fail.
The Federal Reserve orchestrated a plan for LTCM‟s creditors to buy the hedge fund‟s portfolio.
Each of 14 banks ponied up money in exchange for a slice of the portfolio. The $3.65 billion paid by
the bank syndicate for the portfolio was clearly greater than the value of the portfolio by then, but this
infusion of capital prevented defaults that would have cost the banks much more. The money was used
to pay off debts and shore up the trading accounts so that existing positions would perform without
default. Very little was left over for the original partners, who were required to run the fund until it
was ultimately liquidated in 1999. The bottom line is that LTCM had lost $4.5 billion since the start of
1998. These losses included the personal fortunes amassed so quickly by the founding partners, which
totaled $1.9 billion at one point but were completely wiped out by the end.
The Casualties of Credit Default Swaps
Many factors contributed to the financial market meltdown of 2008 and 2009, and further research is
required to arrive at a full understanding of all the causes. However, the early analysis points to
derivative instruments known as credit default swaps as being partly responsible. Credit default swaps
are essentially private insurance contracts linked to the credit status of a third party‟s outstanding debt.
For example, a bank and an investor may enter into a credit default swap tied to the credit
performance of XYZ, Inc.‟s corporate bonds. If XYZ defaults on the bonds, under the terms of the
credit default swap the bank would have to pay some specified amount of money to the investor. In
this case, the bank is acting like an insurance company, and the investor is buying insurance on XYZ‟s
bonds.
Financial engineers designed a wide variety of credit derivatives to accommodate the particular
needs of various investors, issuers, and speculators. For example, some credit derivative structures
were designed to pay off when the credit rating of the underlying bond is downgraded even if no
default occurs.
Many credit default swaps were linked to mortgage bonds, which are bonds backed by pools of
mortgages rather than issued against the cash flows earned by corporations. Credit default swaps were
used to enhance the credit ratings of bonds issued against risky mortgage pools—that is, pools of
subprime mortgages. In theory, a pool of low-rated mortgages coupled with the insurance of a credit
default swap should be just as safe as a pool of high-rated mortgages. If the subprime mortgage bond
defaults, the payment from the credit default swap would make up the loss.