Because of this, during the first two weeks of September, concern about LongTerm Capital was a widespread topic of conversation in financial markets. It is a traditional and essential role for the President and senior officers of the New York Fed to be talking to, and receiving calls from, market participants regarding significant developments and potential dislocations. In fact, the partners at Long-Term Capital called me early in September to notify me of their difficulties and their discussion with investment houses about plans to raise new capital. By Friday, September 18, with the efforts to raise new capital still unsuccessful and with an increasing number of people now aware of Long-Term’s plight because of the efforts to bring in new investors - events seemed to come to a head. With market conditions particularly unsettled that day, I made a series of calls to senior Wall Street officials to discuss overall market conditions. Let me take a moment to put those calls in context. One important objective of the Federal Reserve is to assure financial stability. Particularly in times of stress, it is essential that the Federal Reserve continue to take the pulse of the market. One way to do that is through candid and open communication with key market participants. Everyone I spoke to that day volunteered concern about the serious effect the deteriorating situation of Long-Term could have on world markets.
There are several ways that the problems of Long-Term Capital could have been transmitted to cause more widespread financial troubles. Had Long-Term Capital been suddenly put into default, its counterparties would have immediately “closed-out” their positions. If counterparties would have been able to close-out their positions at existing market prices, losses, if any, would have been minimal. However, if many firms had rushed to close-out hundreds of billions of dollars in transactions simultaneously, they would have been unable to liquidate collateral or establish offsetting positions at the previously-existing prices. Markets would have moved sharply and losses would have been exaggerated. Several billion dollars of losses might have been experienced by some of Long-Term Capital’s more than 75 counterparties. These direct effects on Long-Term Capital’s counterparties were not our principal concern. While these losses would have been considerable, and would certainly have adversely affected the firms experiencing them, this was not, in itself, a sufficient reason for us to become involved. Two factors influenced our involvement. First, in the rush of Long-Term Capital’s counterparties to close-out their positions, other market participants - investors who had no dealings with Long-Term Capital - would have been affected as well. Second, as losses spread to other market participants and Long-Term Capital’s counterparties, this would lead to tremendous uncertainty about how far prices would move.