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From theory, alternative investments require a premium return because they are less liquid than market investments. This liquidity premium varies considerably over time as a function of preferences, leverage technology, the developments in financial technology, and changes in institutional arrangements. The dynamics of the liquidity premium depend on institutional reactions to financial crises. During 1997-1998, we have seen the movement of a financial crisis around the world. It started in Southeast Asia, moved through Latin America, and then visited Russia and returned again to South America. The financial crisis has also infected Europe and the United States, especially during August-October 1998. The increase in volatility (particularly in the equity markets) and the flight to liquidity around the world resulted in an extraordinary reduction in the capital base of the firm that I was associated with, Long-Term Capital Management (LTCM). This reduction in capital culminated in a form of negotiated bankruptcy. A consortium of 14 institutions, with outstanding claims against LTCM, infused new equity capital into LTCM and took over it and the management of its assets. They hired LTCM' s former employees to manage the portfolio under their direct supervision and with sufficient incentives to undertake the task efficiently. Although the Federal Reserve Bank (FRB) facilitated the takeover, it did not bail out LTCM. Many debtor entities found it in their self-interest not to post the collateral that was owed to LTCM, and other creditor entities claimed to be ahead of others to secure earlier payoffs. Without the FRB acting quickly to mitigate these holdup activities, LTCM would have had to file for bankruptcy-for some, a more efficient outcome, but a far more costly outcome for society. If there was a bailout, it failed: LTCM has been effectively liquidated. Because of LTCM, the press and others have taken the opportunity to criticize financial modeling, and in particular, the value of optionpricing models. In truth, mathematical models and option-pricing models played only a minor role, if any, in LTCM' s failure. At LTCM, models were used to hedge local risks. LTCM was in the business of supplying liquidity at levels that were determined by its traders. In 1998, LTCM had large positions, concentrated in less liquid assets. As a result of the financial crisis, LTCM was forced to switch from being a large supplier to being a large demander of liquidity, at a cost that eliminated its capital. Although the Russian default, the LTCM bankruptcy, and the financial difficulties of other financial-service firms are the most visible manifestations of the crisis of the late summer and fall of 1998, to this day we observe much greater volatility and lack of liquidity in many debtrelated and equity-related financial markets. For example, during the summer of 1999, 3-5-yearlong dated volatility on the Standard and Poor's (SP Bengt Holmstrom, Massachusetts Institute of Technology; Jeremy Stein, Massachusetts Institute of Technology. |
