The Fed Steps In: Will It Work?

The world is being drained of liquidity. America's moves to ease the crunch may not be enough

You'd think that Alan Greenspan & Co. would be lapping up the praise about now. After all, in the space of a week's time the Federal Reserve steered the U.S. financial system away from a potential disaster by "facilitating" a rescue of Long-Term Capital Management and followed up with a rate cut aimed at calming a global financial system reeling from emerging-market meltdowns. By helping head off the failure of LTCM, the Fed may have prevented a largescale selling panic that might have severely destabilized the already shaky credit markets, sending prices plummeting and perhaps even propelling the U.S. into a liquidity crunch.

But this may not turn out to be much of a victory. Greenspan's Fed, which has been deified on Wall Street for policies that helped produce a 7 1/2-year economic expansion, may have done too little too late this time. True, the Fed organized the bailout by 14 banks and brokerages, once it perceived that LTCM's failure could be devastating. With markets still reeling from Russia's August devaluation, the Fed feared that a forced liquidation of LTCM would create massive financial instability, a Fed official says.

"MICROCOSM." Now, LTCM has quickly segued from financial neutron bomb to corporate orphan with 14 foster parents. But there are still concerns that other disasters are lurking. While many Wall Street executives insist LTCM was a rogue operation--undone by leverage beyond what other hedge funds would dare--others aren't convinced. In fact, one Fed official privately concedes that he's surprised that there haven't been other blowups. Says Donald Denton, a general partner at Chilian Partners in Boca Raton, Fla.: "LTCM was a microcosm of every bank under the sun."

Indeed, on Sept. 30, shares of banks and brokerages fell again on worries about their exposure to emerging markets--continuing a slide that in three months has halved stock prices of many global banks. In addition, Chase Manhattan Corp. disclosed it had $3.2 billion in loans and derivatives out to hedge funds--leading to speculation that other banks would disclose similar positions.

Nor are the bigger threats to the U.S. economy receding. With the spreading emerging-markets mess choking off demand and deflating prices, a parade of blue-chip companies including Coca Cola, Unocal, and Gillette has issued dire warnings for third-quarter earnings. Many have started to rethink expansion plans, restructure, and lop costs. That, combined with early signs of evaporating liquidity in certain sectors of the economy, has some economists talking recession. "The risk is a lot higher than it was six months ago, maybe on the order of 25%," says Mellon Bank Corp. Chief Economist Richard B. Berner.

That helps explain the lukewarm reaction to the Sept. 29 rate cut. Traders, who had bid up the market in anticipation, were disappointed that it wasn't larger. Instead of rallying, investors hit the exits, sending the Dow Jones industrial average tumbling 238 points, to close at 7,843 on Sept. 30th. They sought safety in Treasuries, which soared, leaving the 30-year bond with a yield of 4.97%, the first dip ever below 5%.

That was not a ringing endorsement of Greenspan's rate-cut agenda. Testifying before Congress on Sept. 23, Greenspan stressed that a rate cut might help inoculate the U.S. from the global mess. At the same time, the Administration was pushing lower rates as a way to relieve the pressure on struggling economies in Asia and elsewhere.

LONE MOVE. But markets around the world shrugged off the cut. One important reason: Despite efforts to coordinate rate cuts among Group of Seven countries, only Canada joined the U.S. action. That, says Michael J. Howell, managing director of CrossBorder Capital, a London-based investment firm, will dampen the effects of Greenspan's cut.

Certainly, many factors are beyond the Fed's control: The rest of the G-7 nations have other agendas. For instance, the new European Central Bank may keep rates high to prove its credibility and give the Euro a solid footing. And few could have foreseen the ruble crisis--and the ensuing virus that infected world debt markets, leading to losses such as LTCM's.

Fed officials say now that they were alert to heightened dangers after the ruble collapsed. Yet on Sept. 16, Greenspan was still calmly assuring Congress that there was no reason to be alarmed by the billion-dollar bets of hedge funds such as LTCM. "Hedge funds are very strongly regulated by those who lend the money," the Fed chief assured the House Banking Committee. Besides, "they are not all that large in the total context of the system."

Now, the Fed is taking the heat. LTCM's huge leverage was "a failure of banking supervision," says one top regulator. And the central bank's role in the rescue was "a huge mistake" that could encourage other funds to take big risks, says a former senior Fed official.

The Fed declined to comment officially prior to an Oct. 1 congressional hearing on the LTCM matter. Privately, however, Fed officials are pointing the finger at the banks themselves. These lenders, they say, failed to accurately assess the risks they were taking on. The official stance is that the system works: The Fed watches over the banks and the banks manage their own risk.

In LTCM's case, though, that seems not to have worked. Bankers apparently fell under the sway of fabled trader John Meriwether--and the fevered competition to squeeze out some fat profits by lending late in an economic boom. And neither the banks nor the Fed itself realized the total amount of leverage involved. Further, it didn't help that many of the lenders' top executives were investing their own cash in the firm. "It just takes your breath away that these great bastions of capitalism didn't do basic due diligence," says an Administration official.

SYSTEMIC RISK? With Congress hoping to adjourn on Oct. 9, lawmakers won't have time to launch any major effort to regulate hedge funds. But the LTCM deal has even conservative Republicans wondering whether Congress should put the brakes on the new world of finance. "If there was systemic risk and the Fed felt it had to step in to prevent contagion, then we have to step in with prudential regulation" of hedge funds, says an aide to House Commerce Committee Chairman Tom Bliley (R-Va.). And, says an aide to a GOP Senator: "Maybe we ought to look at whether the concentration of authority in the Fed is wise."

Other regulators are ready. Since May, for example, the Commodity Futures Trading Commission has been pushing to extend its authority over futures and options exchanges to cover instruments such as interest-rate swaps and other over-the-counter derivatives. With LTCM's meltdown, "these issues--whether to impose reporting rules, capital ratios, or margin requirements--are all front and center now," says CFTC General Counsel Daniel Waldman.

But the CFTC's proposals "would not have prevented this event," asserts Securities & Exchange Commission Chairman Arthur Levitt Jr. Like Greenspan, he sees no need for additional oversight.

Behind the scenes there may be efforts to figure out how to curb excessive leverage and other risky strategies. Regulators are especially concerned about banks' exposure to derivatives, many of them off-balance sheet. U.S. commercial lenders currently hold derivatives whose prices are tied to assets with a value of $28.2 trillion, according to the Office of the Comptroller of the Currency.

Meanwhile, neither the Fed's program to rescue LTCM nor its modest rate cut has soothed the markets. From Japan to Russia and now Europe, prices are falling, credit is tightening, and markets are teetering. What's still needed, say many economists, is a concerted global effort to finally deal with the corrosive effects of the emerging markets meltdown. "A massive reliquefication and restructuring of the world financial system is needed," says Howell of CrossBorder.

CRIPPLING SPREADS. Policymakers must figure out how to stop the free fall of developing economies--and get liquidity back into global markets. Since the Russian ruble tanked in August, investors have been recoiling from all but the safest securities. That has produced a widening gap--or spread--between the yields on Treasuries and other debt that is taking its toll with higher borrowing costs, plunging bond prices, and cutbacks in investment.

The spreads can be crippling. For example, spreads on emerging-market debt relative to Treasuries reached 17% in mid-September and now stand at 11%, up from 6% when Russia devalued. Junk-bond issuance in the U.S., which was running at a healthy $2.5 billion per week at the start of 1998, has ground to a virtual halt.

Equity financing is also getting tighter. After peaking at more than 50 deals a month during the summer, only four initial public offerings were able to fight their way to market in the U.S. in September, raising a measly $91 million in total. Many would-be IPOs have been shelved. The most powerful sign of the times: On Sept. 28, Goldman, Sachs & Co. scuttled its long-awaited IPO, fearing a poor market reception.

Real-estate financing is drying up, too. New issues of commercial mortgage-backed securities, bonds backed by mortgages on commercial properties, fell from a high of $11 billion a month in June to $5 billion through Sept. 28. Issuers that want to get their deals done are having to offer buyers higher yields. For example, Nomura Securities Co.'s commercial mortgage-backed security division, Capital America, brought a $1.25 billion issue to market the week of Sept. 25. Some lower-rated parts of the offering aren't selling at all. And the AAA-rated issues are yielding 1.55% over the 10-year Treasury bond--double the risk premium on similar deals done at the beginning of the year.

Real estate investment trusts, once a charmed sector of the bull market, are finding themselves cut off from new capital, thanks to their fallen share prices. "You can't believe the number of deals that are falling apart," says Chicago financier Sam Zell. "We've got a serious, serious credit crunch."


In some quarters, tighter credit is a welcome sign--an indication that excess is being purged. The robust U.S. economy and soaring markets have attracted investment from all over the world. And that influx accelerated in the past year as other investment options appeared too risky. Flush with capital, banks, brokers, and hedge funds lent aggressively--perhaps too aggressively--both to businesses and consumers. In a September report, the Office of the Comptroller of the Currency warned that the competition among banks was leading to dangerously lax loan policies.

The tricky part is to squeeze out dangerous risk without choking the economy. Ridding the economy of dicey loans could backfire if it leads banks and investors into a wholesale retreat that pushes the economy into recession. That is the wretched scenario that has decimated most of Asia. So, here's the challenge for U.S. policymakers: Instead of lecturing the developing nations on how a well run capitalist system heads off economic disaster, show them.

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