Over the years, I have frequently disagreed with Tyler Cowen. I always find his subject matter intriguing, but I invariably seem to end up on the opposite side of the trade from him, most notably on the subject of Predatory Borrowing.
Today, however, I find nothing in Professor Cowen’s NYT article — Bailout of Long-Term Capital: A Bad Precedent? — to disagree with. I reach the exact same conclusion in Bailout Nation — that LTCM was a missed opportunity to discuss Moral Hazard, to send the markets a clear message.
Long-Term Capital Management is actually the better part of one chapter in the book — Chapter 6. The Irrational Exuberance Era 1996 – 1999, and a healthy part of another — Chapter 13: Moral Hazard: Why Bailouts Cause Future Problems.
For your Sunday morning reading pleasure, here is an excerpt:
About the same time Easy Al was cutting rates that September, William J. McDonough, the president of the New York Federal Reserve Bank, was having a little get together one Tuesday evening at the Fed’s fortress like building on Maiden Lane. He called for a meeting of the pater familias – the heads of 16 largest banks, along with the New York Stock Exchange Chairman. The discussion was over what to do about the imminent collapse of Long Term Capital Management.
Roger Lowenstein’s narrative, “When Genius Failed”, is a fascinating read for anyone interested in the grisly details of LTCM. For our purposes, we need only note :
a) The Fed was cutting rates, and;
b) The Fed was using its authority and prestige to help work out the demise of what was a private partnership.
The central bankers jawboned the 14 largest banks — with the notable exception of future bailoutee Bear Stearns — into kicking in $3.65 billion dollars to buy out the assets of LTCM. These included leveraged assets of over $100 billion, and derivatives with a notional value of over $1 trillion dollars.
The belief that LTCM had to be bailed out was widely held. It was 1987 redux, and the media accolades poured in. In the aftermath of the LTCM rescue, TIME put Greenspan, Robert Rubin and Larry Summers on the cover as “The committee to save the world.”
The chaos surrounding a liquidation of LTCM would cause the markets, in Chairman Greenspan’s words, to “seize up.”
But this raises uncomfortable regulatory questions. If this huge leveraged fund presented such systemic risk, then why weren’t there regulations limiting the size and the leverage hedge funds could use?
There is no middle ground. Either these funds are too dangerous to be allowed to exist without strict controls, or this was not a case of systemic risk.
Of course, that’s not how Greenspan saw it. The failure of LTCM would have had a very negative impact on psychology. Woe to the Fed Chair who allows traders to become morose! That was how Mr. Atlas Shrugged rationalized the intervention. (Thank goodness Ayn Rand was already dead).
Whether that would have turned out to be true is a matter of much dispute. The evidence leads me to surmise that not only would LTCM’s demise not have caused the system to collapse, it would have done a world of good.
Consider what was at stake: First, LTCM’s portfolio had a $100 billion dollars in leveraged paper. But it wasn’t all Russian debt going to zero, and it had some real value. The problem wasn’t the quality of the overall assets, rather, it was using $1 to buy $100 dollars worth of paper. It doesn’t take much spread widening to lose a substantial amount of capital when you are running that much leverage. As we shall see in Part III, that would have been a ripping good lesson for the investment banks to have learned circa 2004.
The other issue was the trillion dollars in derivatives. How did an unregulated, three-year old, heavily leveraged partnership manage to have so much in insurance entrusted to them by counterparties? The only answer I can deduce is that the number of idiots on the planet is greater than previously believed by several orders of magnitude.
This was yet another lesson sorely not learned.
What would have happened had this notational amount of derivative paper become worthless? Short answer: Not a whole lot. The loss would have been the premiums paid to LTCM, not the trillion dollar notational value. If your car insurance company disappeared tomorrow, you wouldn’t lose the value of your vehicle — only the premium payments you made. This is why it’s advisable to do business with firms such as GEICO or Allstate, and not “Billy Bob’s Auto Insurance and Bait Shop.”
The penalty for getting into bed with a counterparty that was young, untested, highly leveraged and reckless should have been expensive. Instead, it was a minor inconvenience. It was yet another lesson not learned from LTCM, and contributed mightily to moral hazard. Future repercussions would be severe.
Had LTCM been allowed to fail naturally, perhaps a lesson might have been learned: risk and reward are each sides of the same coin. Alas, it was a missed opportunity for the traders and risk managers at major banks and brokers to learn this simple truism. The parallels between what doomed LTCM in 1998 and forced Wall Street to run to Washington for a handout in 2008 are all there, and the significance of these missed opportunities are now readily apparent.
Long Term Capital Management was the predecessor for the great credit crisis of 2008.
That seems just about right to me . . .
McGraw-Hill, February 12, 2009
Bailout of Long-Term Capital: A Bad Precedent?
NYT, December 26, 2008