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We follow the article with more on financial crises to help calm any worries you may have. This article summarizes two interest rate-related crises, Long Term Capital Management and the lesser-known Financial Crisis of 1966.
The world-renowned hedge fund fell victim to the surprising 1998 Russian default. As a result of the unexpected default, there was a tremendous flight to quality intoTreasury bonds, of which LTCM was effectively short. Bond divergences expanded as markets were illiquid, growing the losses on their convergence bets.
Given the potential chain reaction to its counterparties, banks, and brokers, the Fed came to the rescue and organized a bailout of $3.63 billion. A much more significant financial crisis was avoided. As Minsky argued, “By the end of August, the disorganization in the municipals market, rumors about the solvency and liquidity of savings institutions, and the frantic position-making efforts by money-market banks generated what can be characterized as a controlled panic. The situation clearly called for Federal Reserve action.”The Fed came to the rescue before the crisis could expand meaningfully or the economy would collapse. The problem was fixed, and the economy barely skipped a beat.
Making the system ever more susceptible to a financial crisis are the predictable Fed-led bailouts. In a perverse way, the Fed incentivizes such irresponsible behaviors.The tide is starting to ebb. With it, economic activity will slow, and asset prices may likely follow. Leverage and high-interest rates will bring about a crisis.
The Fed halted the crises of 1966 and LTCM. They ultimately did the same for every other crisis highlighted in the opening graph. Given the amount of leverage in the financial system and the sharp increase in interest rates, we have little doubt a crisis will result. The Fed will again be called upon to bail out the financial system and economy.
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