Moral Hazard and the LTCM Bailout

Today is an auspicious anniversary, though it’s one I suspect many people may not recall. On Sept. 23, 1998, former Federal Reserve Chairman Alan Greenspan and William McDonough, then president of the Federal Reserve Bank of New York, managed to orchestrate the rescue of the hedge fund Long Term Capital Management.

It was a strange exercise in both herding cats and moral hazard. It wasn’t a government bailout, since no taxpayer money was involved. More than a dozen Wall Street banks, many of which had exposure to LTCM, ponied up $3.65 billion to unwind the fund’s complex leveraged bets.

Still, the lesson learned was that in the event of troubles, the Fed could be counted on to lend a hand to a) avoid disruption; b) add liquidity and; c) protect the Street against catastrophic losses. In hindsight, it looks like the lessons learned were the wrong ones.

Recall the summer of 1998 when Russia — a hot investment for bond underwriters — defaulted on its ruble-denominated debt. This triggered a chain reaction of losses for anyone who either held Russian debt or had assets denominated in rubles.

The biggest of those suffering losses was the wildly overleveraged giant hedge fund. Continues here

 

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