No firm had a closer view of Long-Term Capital than Bear Stearns, the broker that cleared its trades. And it was Bear that sounded the first shot in the current mortgage crisis. In summer 2007, amid a sharp rise in delinquencies on subprime mortgages, two hedge funds sponsored by Bear that invested in high-rated mortgage securities imploded. As foreclosures kept rising, other institutions suffered losses and the crisis spread.

Bear was warned to raise more capital by selling stock, but its senior executives, led by James E. Cayne, the chief executive, thought the company’s stock was cheap and refused. Mr. Cayne, who was an original investor in Long-Term Capital, should have remembered that the hedge fund’s most obvious flaw was its excessive borrowing, or leverage. Before its annus horribilis, Long-Term had intentionally reduced its equity to a mere 3 percent of assets. It was a fatal mistake.

This time around, Bear gambled that it could survive with a weak balance sheet — its equity-to-assets ratio was an identical 3 percent. By March, worries that Bear was overleveraged prompted a run on its stock and pushed it to the brink of bankruptcy. Again, Wall Street feared that a chaotic collapse could jeopardize the financial system, and the Fed orchestrated a rescue.

Bear isn't the only one who was/is in that position, either. Banks have become even more adept than hedge funds at taking on massive leverage, much of which is through off-balance-sheet vehicles the regulators have winked at for years.

Further good points (Lowenstein clearly "gets it"):

When perceptions change, liquidity evaporates quickly. Indeed, the belief that one can safely get out of a “liquid” market is one of the great fallacies of investing.

This lesson went unlearned. Banks like Citigroup and Merrill Lynch felt comfortable owning mortgage securities not because they knew anything about the underlying properties, but because the market for mortgages was supposedly “liquid.” Each firm would write down the value of its mortgage investments by more than $40 billion.

A point on this:

But Long-Term Capital’s influence on regulatory practice is anything but forgotten. Alan Greenspan conceded at the time that the fund’s rescue could lead to “moral hazard,” meaning it could tempt financial players to take excessive risk. The warning was ignored. And the notion that a private hedge fund with but 16 partners and fewer than 200 employees could cause lasting harm was never truly examined. It was simply accepted.

We might opine that it was "accepted" because it had to be. To not accept it is to conclude that the only solution is to permit the impact of failure. Instead, the authorities tried to keep the apple cart upright by orchestrating an intervention (regardless of whether public funds were put at risk). This same misguided philosophy rules the current crisis, with both public and private entities scrambling to make minimal concessions every time a new crack appears in the firmament.

It won't work -- the aggregate structure is itself flawed. It needs to be allowed to meet its destiny, which is to fail terminally.

And lest you think Lowenstein credits Greenspan too much:

Incredibly, six months after the Long-Term Capital affair, Mr. Greenspan called for less burdensome derivatives regulation, arguing that banks could police themselves. In the last year, he has been disproved to a fault.

Not surprising from the guy who's PhD dissertation was about housing bubbles, but he claimed he couldn't recognize one in practice.

Perhaps a new nickname is needed for the "Maestro". We suggest "Mr. Non-Sequitur".

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