In his book – When Genius Failed: The Rise and Fall of Long-Term Capital Management,
With traders scrambling to pay back debts, Neal Soss, an economist at Credit Suisse First Boston, explained to the Journal, “You don’t sell what you should. You sell what you can.” By leveraging one security, investors had potentially given up control of all of their others.
This verity is well worth remembering: the securities might be unrelated, but the same investors owned them, implicitly linking them in times of stress. And when armies of financial soldiers were involved in the same securities, borders shrank.
The very concept of safety through diversification—the basis of Long-Term’s own security—would merit rethinking.
Steinhardt blamed his losses on a sudden evaporation of “liquidity,” a term that would be on Long-Term’s lips in years to come.
But “liquidity” is a straw man. Whenever markets plunge, investors are stunned to find that there are not enough buyers to go around. As Keynes observed, there cannot be “liquidity” for the community as a whole.
The mistake is in thinking that markets have a duty to stay liquid or that buyers will always be present to accommodate sellers. The real culprit in 1994 was leverage. If you aren’t in debt, you can’t go broke and can’t be made to sell, in which case “liquidity” is irrelevant. But a leveraged firm may be forced to sell, lest fast-accumulating losses put it out of business. Leverage always gives rise to this same brutal dynamic, and its dangers cannot be stressed too often.
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