While hubris may have set them up for a fall, it was the extraordinary events of August in global markets that appears to have tripped them. On August 17, the Russian government announced an effective devaluation of the ruble and declared a debt moratorium, shocking investor confidence all over the world. Over subsequent days and weeks, equity and debt markets the world over became increasingly volatile, BIS Review 78/1998  -2-  with US equity markets falling and the spreads between US Treasury securities and higheryielding debt instruments widening sharply. The correction of stock prices was not of exceptional size or concern and, indeed, had been anticipated by a number of astute market observers. However, the abrupt and simultaneous widening of credit spreads globally, for both corporate and emerging-market sovereign debt, was an extraordinary event beyond the expectations of investors and financial intermediaries. The unusual widening of credit spreads also caused significant losses at LongTerm Capital. As markets around the world moved in the same direction at the same time, the diversification on which Long-Term had previously relied failed them utterly. Instead of offsetting positions, their losses were compounded. At the same time, the volatility in equity markets caused further losses. On September 2, the partners of Long-Term Capital sent their investors a letter acknowledging 52 percent losses on the year through August 31 and that they were seeking an injection of capital to sustain the firm. The existence of this letter became widely known and reported within a few days.

When the crisis materialized and firms began to experience material distress or even fail, US law did not have a framework for achieving an orderly resolution of a systemically important institution at the corporate level. It had tools that have proved highly effective in managing corporate restructuring and depository institution receiverships, but none tailored for a major financial group. Instead, when large financial groups began to fail, policymakers relied on ad hoc interventions. Some of the immediate interventions involved use of the Federal Reserve’s “lender of last resort” functions. It was at this point that “Section 13(3)” entered the lexicon of modern central banking. For those few who are unaware, Section 13(3) was added to the Federal Reserve Act during the Great Depression. It gave the Board of Governors broad authority to permit a Reserve Bank to lend in exigent and unusual circumstances provided that the Reserve Bank was secured to its satisfaction. Prior to the crisis, Section 13(3) loans had last been made during the Depression, to such enterprises as a typewriter manufacturer and a vegetable grower. 4 Fed policy makers and their advisors pulled Section 13(3) back off the shelf, perhaps brushing some metaphorical dust off its cover. In 2008, loans made pursuant to Section 13(3) facilitated JPMorgan Chase’s purchase of Bear Stearns. Loans under 13(3) also prevented the potentially catastrophic failure of American International Group (AIG). Innovations under 13(3) also underpinned many of the Fed’s broad-based facilities to provide market liquidity.