Money and Banking

873 Words Jan 19th, 2013 4 Pages
1. Briefly explain the rise and fall of LTCM. What was the moral hazard issue the fed was worried about? How did they try and get around the moral hazard issue? What specifically was the Fed's role in the bailout? What roles specifically did Bear play and not play in the LTCM's life and death?
LTCM’s board of directors included many geniuses in from the financial world, who collectively created complex models allowed them to calculate risk of securities much more accurately than others. LTCM’s trading strategy was featured by the divergence in price between long-term U.S. Treasury bonds. It shorted the more expensive “on-the-run” bond and purchased the “off-the-run” security at the same time to exploit the price divergence. In order
…show more content…
In order to get around this potential moral hazard, Fed acted as an advisory role and invited major investment banks to help LTCM, instead of directly pouring funds into LTCM.

2. Is market perception of liquidity more important for an investment bank that it is for a traditional manufacturing or distribution business? Why or why not?
Yes, market perception of liquidity is more important for an investment bank than for traditional manufacturing or distribution business. In terms of liabilities, most investment banks fund themselves in the interbank markets where they borrow money from each other, and this type of funding is usually short-term. The assets on the investment bank balance sheet are generally more long-term. Therefore, it is essential that these investment banks have enough liquidity in their assets to compensate for the maturity mismatch between their assets and liabilities. When investment banks, like Bear Stearns, were being funded in the interbank market while holding illiquid mortgage backed securities, the perceived illiquid situation would trigger the phenomenon of “run on the banks” as the others banks doubted their ability to pay back liabilities in time. Institutions will start to stop lending and ask for money which will increase liquidity need with limited methods to fund for this need.

On the other hand, a traditional manufacturing or distribution business is generally funded by equity or long-term debt. So