Potential Market Impact of Disorderly Liquidation
The credit losses that LTCM's creditors and counterparties would have suffered, a default also could have had broader consequences for the markets in which these firms were active. First, the liquidation and closing out of positions could have generated significant movements in market prices and rates, affecting the market value of positions held by the LTCM Fund's counterparties as well as by other market participants. Second, the resulting rush by the Fund's counterparties and others to reappraise their credit risks, coupled with an increase in uncertainty, could have exacerbated the broader decline in market liquidity, making it more difficult for market participants to manage risks. Third, those firms with exposures to LTCM could have encountered increased concerns about their own credit standing, with a resulting rise in their cost of obtaining funds. The LTCM Fund's counterparties and creditors were facing the risk posed by the impact of a default by the LTCM Fund in the unusual market environment prevailing in late September. During the previous month, interest rate spreads had widened substantially, while equity markets around the world had suffered significant declines. The level of economic uncertainty as measured by market volatility had risen while liquidity was declining. Finally, most major market participants had already suffered significant trading losses during August and September, and were anxious to avoid further losses. The LTCM Fund's counterparties would have had to manage the effects of the direct credit losses from the default as well as further indirect effects if the default accelerated a flight to safety and liquidity that was already occurring. The Effects of the Use of Collateral by LTCM's Trading Partners The parties to many of the transactions referred to in this section often rely on collateral from their counterparties. Current credit exposure under OTC contracts can be...
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