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How the SEC killed Long-Term Capital Management (LTCM)


Below follows an extended soliloquy by my friend and mentor Fred Feldkamp, who was a partner at Foley & Lardner in Detroit, about how the SEC’s changes to Rule 2-a7 in 1998 caused the failure of LTCM.

Here's a comment on your presentation that you and your team should understand. It makes a big difference in what "should" be done.

If you look at the front cover of the 2005 book I wrote, you'll note that the "Rule 2a-7 Amendments Take Hold" balloon is right at the seam (on the bottom). That's because the amendments were adopted in March or April of 1998, before LTCM got in trouble, NOT because of that trouble..

If you focus on the red line of that chart (spreads between high grade and high yield debt, you'll see that I began an entirely new (and very disastrous) market phase at the point then the amendments took hold.

THE AMENDMENTS WERE NOT ADOPTED IN "RESPONSE" TO LONG TERM CAPITAL'S DIFFICULTIES, CHRIS, THEY CAUSED THOSE DIFFICULTIES!!

The jump in spreads that killed LTCM is the one that starts at that seam of the book cover and does not trend down until late Sept. of 1998 (on that cover, credit spreads are INVERTED so "up" is actually "down"--to show the inverse correlation between spreads and equity prices).

The uptrend that killed LTCM began about 60 days before the 1998 amendments took hold. The trigger event was a requirement that "new" MMF investments in ABCP had to track "10% obligors" for commercial paper (CP) that the money market fund (MMF) would hold as of July 1, 1998.

The definition of what was and was not a "10% obligor" was totally indiscernible in practice (for reasons far too complex to put in writing--I did a PowerPoint presentation to explain that when the SEC finally asked my client to come to DC and explain what the heck happened to all short-term credit markets, starting in May 1998).

I explained to them that was when lawyers representing sponsors of MMF's told their clients they'd need to ask CP sellers from which the funds bought paper whether there were any 10% obligors supporting any new asset-backed commercial paper (ABCP) investment (if it would mature after July 1, 1998).

When ABCP sellers would ask the fund "What the heck is a 10% obligor?" the usual response was "I don't know, but my lawyer says we need to know that and to track those obligors."

The ABCP issuer would then reply: "What will you do with that information?"

The KEY response then was: "Since we don't know how to track those things, we'll just have to refuse to buy any ABCP from you."

AS A RESULT, CHRIS, ANY INVESTOR THAT WAS FUNDING LONGER TERM MORTGAGE BACKED SECURITIES (MBS) OR ASSET BACKED SECURITIES (ABS) ASSETS USING ABCP SUDDENLY LEARNED THAT THEY'D BE CUT OFF FROM FUNDING IF THEY HAD DIVERSIFIED THEIR INVESTMENTS BY WELL-STRUCTURED SECURITIZATIONS.

In short, the SEC's division of investment management TOTALLY CUT OFF ANY NON-BANK ABCP ISSUER AND FORCED EVERY MONEY MARKET FUND TO RELY ENTIRELY ON BANKS AND BANK-SPONSORED SIVs FOR THEIR CP INVESTMENTS.

It was totally misguided. The cause was the support of bank SIVs by the ASF. That commitment of bank-dominated attorneys and issuers did not dissolve until the market finally rejected Paulson's "super SIV" in 2007-8. THE REASON WE HAVE NEVER OVERCOME THE DRAG CREATED IN 1998 IS THAT WE HAVE NEVER FUNDAMENTALLY CHANGED THAT 1998 RULE.

That failure can be attributed to the fact that they guy who did the rule did not leave the SEC until the Dodd-Frank rules were done (2012). Failure to see through that guy is THE FAULT OF ART LEVITT AND THE BUSH/OBAMA TEAM PEOPLE WHO LISTENED ONLY TO BANKERS FOR FAR TOO LONG.

At the start of my client's SEC August/Sept. presentations to explain how the div of inv. mgmt. had entirely destroyed the nation's non-bank funding mechanisms, the arrogant jerk in charge of that area said "You know, we can't do anything for you that we won't do for everyone else."

To which my client (which long-predated the SEC's existence) responded "We'd never make that request."

At the point in my PowerPoint when it became entirely obvious that the SEC had, in fact, destroyed not just LTCM but the entire ability of productive sector firms to access MMFs, this same numbskull actually looked at my client and said: " Mr. ______, WHAT CAN WE DO FOR YOU?" (During the presentation, moreover, he actually said he found no problem with restricting MMFs to only buying paper from banks. He had no concept of how markets should work.)

NOW, BACK TO THE COVER CHART. The reversal of trend that occurred in Sept. 1998 (the point where the red line on that cover chart turns "up") occurred on the day that we and the SEC agreed to a "grandfathering" of MBS/ABS that existed on the day the dumb regs were effective (July 1, 1998).

We know that because as we worked out the last details, the SEC told us they wanted to finish the work quickly because lots of NYC people were blasting them for details of the relief that the SEC told them was forthcoming.

This made it clear that the SEC knew it was THE cause of the 1998 crisis.

Since that relief coincided with the purchase of all LTCM's assets by a Fed-arranged consortium of big banks, the investing banks profited because of the relief my client arranged.

We told those SEC blockheads who wrote that idiotic rule that the impact of grandfathering was merely a delay in the crisis they caused (for about a year and a half or so). If you look at the red line on the chart for the year 2000, you'll see that failure to substantively change the Rule 2a-7 mistake caused a much bigger crisis that year.

STILL, the SEC staff never proposed to change the rule's impact to create a bank monopoly/monopsony of MMFs.

That is what caused non-banks to issue garbage deals that met the garbage reg (e.g., the famous Lehman 105 fraud) in 2000-2005. It is, in turn those disastrous speculations that caused the debacle of 2007-9 and, since the SEC has never gone back to look at the substance of their 1998 blunder, it is now causing the US to have absolutely no creativity in debt funding.

So, all we have is an out of date bank-controlled lending system that, as it always has, simply cannot get the nation out of a rut.

THE JERK THAT REFUSED TO MAKE SUBSTANTIVE CHANGE IN THE 1998 RULES ACTUALLY ACKNOWLEDGED THAT THEY CAUSED THE 1998 PROBLEM. HE "JUSTIFIED" REFUSAL TO DO WHAT WAS RIGHT BY SAYING: "Since the Commission so recently adopted the rules, it's too embarrassing for them to reverse that now."

He was really saying "I'd be fired if they learned what we actually did by those rules."

Since the guy left the SEC in 2012, there is "hope" that the SEC may change course and fix that mess, but it will do so only if it has realized just how destructive that guy was and is trying to fix whatever mistakes he made.


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© 2003-2020 | Whalen Global Advisors LLC  All Rights Reserved in All Media | ISSN 2692-1812 | Terms & Conditions