The hedge fund meltdown that rescued your stock portfolio
Summary
Long-Term Capital Management’s collapse 25 years ago started a habit hard to break—the ‘Fed put.’Before there was Silicon Valley Bank or Lehman Brothers or the housing meltdown, Long-Term Capital Management set the tone for every crisis that would come after it.
The hedge fund, with its dream team of finance luminaries, including Nobel Prize winners, thought it had found a way to make a bundle with what seemed like hardly any risk. The banks that lent it tens of billions of dollars believed them. When the fund’s strategy fell apart, Federal Reserve officials coordinated an unprecedented rescue, and cut interest rates in a bid to shore up a falling stock market. Even 25 years later, the effects are with us. If there was a time the “Fed put" was born, it was during the LTCM crisis.
The basic idea: By cutting rates in response to a drop in the stock market, the Fed had in effect provided investors with something similar to a put option, an instrument used by traders to insure against losses. Moreover, because the Fed was slow to raise rates again even as stocks surged, it was as though that put kept getting repriced higher, giving investors a pass to take on risks they wouldn’t otherwise stomach.
Other episodes followed, such as the rate cuts following the dot-com bust, and the cuts and enormous liquidity infusions that came following the 2008 financial crisis. Now maybe—just maybe—the Fed is weaning the market off of Fed-put thinking. It has only taken a quarter century.
The Fed’s first rate cut in 1998 came on Sept. 29, just six days after the Federal Reserve Bank of New York helped arrange a $3.5 billion bailout of LTCM by a consortium of financial firms. Judging from economic reports from the time, the cut didn’t make much sense. The reports showed that the job market was strong and that Americans’ incomes and spending were growing robustly.
But stocks had taken a mighty tumble. At the end of August, the S&P 500 was down 19% from the record high it had logged in mid-July, and even though words from Fed Chairman Alan Greenspan had helped soothe markets somewhat since then, the index was still down 12% from its peak. The central bank saw this as a big problem, not so much because it viewed stocks as forecasting trouble for the economy, but rather because it worried about what the selloff could do to the economy.
In material prepared for the September policy-setting meeting, Fed staffers calculated that the rise in wealth powered by the booming stock market had added more than a full percentage-point to annualized consumer spending in both the second half of 1997 and the first half of 1998. What would happen if that wealth effect went into reverse?
The trouble in markets wasn’t finished—with the S&P 500 returning to its August lows in early October—and neither was the Fed: The central bank dropped its target rate by another quarter point after an emergency meeting on Oct. 15. Stocks were already storming back, though, by the time it cut rates again on Nov. 17. On Nov. 23, the S&P 500 surpassed the record high it hit in July. On June 30 the next year, when the Fed finally started to reverse course, raising its target rate by a quarter point, the index was 13% above its old high.
In early 2000, when stocks—especially tech stocks—were even higher and the Fed had only recently lifted its target rate back to the pre-LTCM level, former Merrill Lynch derivatives strategist Steve Kim and former Pimco fund manager Paul McCulley came up with a name for what they saw as the situation: the Greenspan put. They argued that an expectation that the Greenspan Fed would ride to the rescue had led investors to take on more risk, swelling stock valuations.
As we know, the rally soon ended, with the dot-com bubble turning into the dot-com bust, but the idea of the Greenspan put—redubbed the “Fed put" after Greenspan retired from the Fed—endured. And perhaps with reason: Economists Anna Cieslak and Annette Vissing-Jorgensen found that stock returns are a powerful predictor of changes in the Fed’s interest-rate target.
Moreover, when they analyzed Fed meeting transcripts and other documents they found that officials weren’t looking at stocks as a forecasting tool for the economy so much as they were worrying that a drop in the stock market might damage the economy, primarily through negative wealth effects.
The Fed might now have less cause to worry about the effects of falling stocks. Stock-market wealth effects appear much less pronounced: Last year, the S&P 500 fell by about 25% from its January peak to its October low, but that drop didn’t provoke much discussion about how the bear market might affect ordinary Americans’ spending, and it didn’t dissuade the Fed from raising rates. A new financial conditions index made available by the Fed this year, meant to measure the economic effects of mortgage rates, the dollar and so forth, puts notably less weight on stocks than similar measures produced by Goldman Sachs and others.
The Fed will probably never stop looking at the stock market. And declines that coincide with severe economic shocks—the 2008 financial crisis, the early days of the pandemic in 2020—will be followed by rate cuts. But investors who think that a market selloff on its own is enough to bring the Fed rushing in might find the net they expected under them is no longer there.
Write to Justin Lahart at Justin.Lahart@wsj.com
