Was bailing out Long-Term Capital Management a good idea?

by on December 27, 2008 at 10:14 am in Economics | Permalink

Here is my latest NYT column.  It starts as follows:

The financial crisis is a result of many bad decisions, but one of them hasn’t received
enough attention: the 1998 bailout of the Long-Term Capital Management
hedge fund. If regulators had been less concerned with protecting the
fund’s creditors, our current problems might not be quite so bad.

Bear Stearns, Merrill Lynch, and Lehman Brothers were all major creditors of LTCM.  Given that regulation is inevitably imperfect, and cannot foresee or prevent every firestorm in advance, this was one chance to send a very stern message to those creditors.  Perhaps no LTCM bailout would have meant dire consequences at the time, but still:

…Fed inaction might have had graver economic consequences,
especially if a Buffett deal had fallen through. In that case, a rapid
financial deleveraging would have followed, and the economy would have
probably plunged into recession. That sounds bad, but it might have
been better to have experienced a milder version of a downturn in 1998
than the more severe version of 10 years later.  In 1998, there was no collapsed housing bubble, the government’s budget
was in surplus rather than deficit, bank leverage was much lower, and
derivatives markets were smaller and less far-reaching.

I’ve been reading much about LTCM in recent times, and in so many ways it was a micro- dress rehearsal for our later problems.  This column also criticizes the current now-standard practice of "regulation by deal."

Addendum: Matt Yglesias adds: " At the time I think everyone was clear on the idea that if
institutions such as LTCM were “too big to fail” that they had to be
brought into a regulatory umbrella. But as soon as it was clear that
disaster had been averted, a lot of people became complacent about
operationalizing this determination to expand the scope of regulation
and some of the key participants – especially Alan Greenspan – in the
bailout only redoubled their opposition to regulation."

1 Mercutio.Mont December 27, 2008 at 11:12 am

I can’t wait for someone ten years down the line to cite our current set of bailouts as cause for their own “current and much worse disaster.”

2 sort_of_knowledgable December 27, 2008 at 1:28 pm

Since the money was put in by the creditors, including Merrill Lynch and Lehman Brothers and not by the government, the increase moral hazard seems marginal.

Merrill Lynch didn’t seem to remember the observation in its annual report that mathematical risk models, “may provide a greater sense of security than warranted; therefore, reliance on these models should be limited.† Especially ones that say housing, or any other prices, never go down.

The equity holders were wiped out by LTCM but didn’t learn the lesson that to vote for management that uses less leverage.

3 Bill December 27, 2008 at 3:08 pm

Written in 2004: By functioning as a “lender of the last resort” in order to guarantee “financial system stability,”… This provision establishes an incentive for the governments to expand without end and for the financial intermediaries to opt for size at the cost of prudence in order to become “too big to fail.” As bailout institutions with the promise of unlimited liquidity, it the central banks themselves that lay the groundwork for “financial distress” to emerge—not just as “episodes,” but in a way that makes the modern financial system permanently fragile. “Mr. Bailout” http://mises.org/story/1627

4 Barkley Rosser December 27, 2008 at 3:52 pm

Chris is right. No government money involved at all, and there were quite a few private individuals who were creditors who took some very large hits, with lawsuits that went on for several years out of the whole mess, not all of these hitting the media screens, but billions of dollars involved in some of them (I know, small change indeed by today’s standards).

The sign of what we had gotten into was Timothy Geithner’s speech in Hong Kong in Sept. 2006, in which he effectively invoked that earlier crisis, which was managed by the then-NY Fed prez, with Greenspan on the line. Geithner in 09/06 in efect said, “no way we can do another deal like 98 if this baby blows; way too complicated and globally entangled.”

5 athEIst December 27, 2008 at 4:59 pm

Wasn’t the first dress-rehearsal the S&L bailout? $200 billion gone(where?)no one went to jail except the hapless Keating and he went not for losing(?) the money but falsely claiming the Lincoln S&L bonds were insured.

6 Murali December 27, 2008 at 9:23 pm

Pardon my naivete…10 years later will you be writing in a similar vein about the current bailout ? i.e., fed and government could have avoid a 10 trillion bailout in 2018.
In any case i am reading roger lowenstein’s “when genius failed”. It is unbelievable that post LTCM very little system change was enforced.

7 greenback December 27, 2008 at 11:37 pm

Unless there’s been some damning quotes from Fuld or Mozilo or so on (something like “Hey, if it goes bad, the Fed will save us”), this is ultimately psycho-analysis. My dealings with these kinds of folks has suggested a different sense of their psyches, that they probably didn’t give much thought to what would happen if their schemes failed. CEOs tend to be the type who put their heads down and charge forward. And, to make their psyche even worse, they also tend to have had a great deal of success, even if it’s Taleb-ian pre-blowup success, when they’ve charged forward in the past.

If they are thoughtful and immoral, their primary consideration would be their compensation, which they should expect to tank, regardless of whether their employer is bailed out. So it’s hard to see the LTCM-related behavior as increasing moral hazard beyond the fact that Merton, Scholes et al didn’t go to jail.

8 StreetWalker December 28, 2008 at 1:13 am

Tyler, I must agree with Chris & Barkley. I just don’t think it’s a bailout if the gov’t doesn’t kick in bucks or use regulatory power to force a merger. LTCM involved neither, so at best you might call this a “workout.”

In true Hansonian fashion here, I’m questioning authority, but raising my hand. I’m worried that you’re mistaken here, and I’m arguing that this flawed premise dashes the parallel you attempt in your article. You would be so kind as to come back and give us a def of bailout that works?

In your piece Tyler you say “Bolstered by this sense of security, bad loans mushroomed,” but you provide no evidence that links LTCM to the current crisis. It seems like a plain assertion on your part. Do you have any connecting evidence?

The bad loans were mortgage loans, which could hardly be connected to anything LTCM was doing. Countrywide wasn’t a hedge fund. IndyMac wasn’t a hedge fund. Fannie & Freddie weren’t hedge funds run by quants. Can you make this connection explicit? How do you know LTCM was on anyone’s minds when they bought a CDS? Did or did not the mortgage loans have other kinds of implicit gov’t guarantees? If so, wouldn’t those have been the guarantees on the mind of Fannie et al?

Further you say, especially if a Buffett deal had fallen through” I’m not sure what you mean by this. In the LTCM situation, wasn’t the Buffet+AIG+Goldman offer rejected? I don’t believe Buffet was a major player in the final workout? Have I misunderstood you here? Could you clarify this point as well please? Weren’t the major players mostly investment banks? So why was Buffet unusually important?

I will agree with you that “Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery.” Yet the uncertainty here is not how the government will bail, or the lack of a set of fixed rules for bailing, but rather that the government, by seemingly randomly letting Lehman die in possibly the Bush Administration’s only attack of principle, has convinced people it’s crazy and unreliable.

You might get a bailout, you might get the boot – no one is still 100% sure who among the non-bailed is actually solvent and since the government has had one attack of principle omigod we still have little idea who we can lend money to now. They may be alive tomorrow, they may be dead, they may get a bailout – who knows? Letting Lehman die is proving to have just been the worst thing so far.

Regulation by deal might not be so bad, since each firm has a different situation and might reasonably need a different package based on that. The problem with regulation by deal as practiced so far is the lack of transparency and recordkeeping.

If I have materially failed to understand you here, please forgive in advance.

9 bgc December 28, 2008 at 5:21 am

Allsion said: “We keep putting off the pain. And the amount of pain we need to put off keeps increasing. ”

That is it, precisely.

We all need indoctrinating in Creative Destruction.

Failure of some firms is necessary, failure is the engine of productivity and of progress – failure is good. It is when there are no failures that we should worry.

Short term harm is the driver of long term benefit – by contrast seeking always short term benefit will be fatal to any economy (or fatal to pretty much any complex system).

Putting off the pain only accumulates more pain until it cannot be put off any longer.

Selective failure is the price of overall success: if selective failure is prevented, then will will inevitably get overall failure.

10 Steve Sailer December 28, 2008 at 6:08 am

Pets.com went under and shareholders didn’t get bailed out.

So, for the next bubble, the smart money went where the President and Congress were pointing: into mortgages, especially for lower-income / minority buyers.

In 2002-2004, Bush denounced down payments on home mortgages as the chief obstacle to his goal of allowing 5.5 more million minority households to attain the American Dream of homeownership. Giant amounts of mortgage money poured into the highly Hispanic states of California, Nevada, Arizona, and Florida. The mortgage dollars for home purchases going to Hispanics increased 691% from 1999 to 2006.

11 Curt Fischer December 28, 2008 at 11:59 am

Do Chris, Barkley, and StreetWalker have any comments on on the GAO report I excerpted? It was written in 2000. My name on my 5:42:22 post yesterday links to the report, and you can also find it on Wikipedia.

As early as 2000 some “industry officials” were already thinking like Tyler. The interesting question to me is “why”? Why did these industry officials assume that if the FRBNY was willing to call up the private parties involved in LTCM and buy some coffee and sandwiches, that next time around FRBNY would be willing to put its balance sheet where its coffee was?

The report makes it clear that industry officials did assume. So at least in my mind there isn’t much room to facially challenge Tyler’s NYT piece. If I am wrong, I would love to hear StreetWalker, Chris, or Barkley explain what I have missed.

12 Barkley Rosser December 28, 2008 at 1:10 pm

Curt,

I do not have much of an answer. It may well be that the banks involved in the
meetings in 1998 somehow took this as some guarantee that their behinds would be
covered, which turned out not to be the case for Lehman. However, it was well known
long before the 1998 meeting that the Fed did not like to see very large banks fail,
and would make efforts to do something to prop them up if it could by one method or
another. The phrase, “too big to fail” long predated 1998, and the US government has
intervened to prop up various firms openly on more than one occasion, including Chryler.

BTW, probably a more dangerous outcome of the 1998 “bailout,” which is not really what
it was, was that the low interest rates put in place for some months following the crisis
may have been the initial trigger of the housing bubble. If you look at Chap. 2 of the
second edition of Shiller’s Irrational Exuberance, he dates the beginning of the housing
bubble to 1998. If you want a real culprit, that is it, not those darned meetings.

13 Greg December 28, 2008 at 1:20 pm

Curt,

I think the GAO report you cite is a little too vague. Sure, we can assume there was some moral hazard created just by the Fed bringing the creditors together, but it’s orders of magnitude less than a true bailout would have created. I think the bigger lesson from LTCM is the one that others have mentioned. Once you decide that a large number of unregulated financial institutions are too big to fail and can bring down the global financial system, what do you do about it? The answer may not be as straightforward as more regulation, but you have to start taking a more conservative view of risks. And no one did.

14 Curt Fischer December 28, 2008 at 3:03 pm

[Did typepad eat my earlier attempt at posting this? If not, sorry for reposting — CF.]

Thanks to all for the comments. Very informative! Barkley notes that LTCM was not the origin of “too big fail”. So maybe it is wrong to point to the LTCM “bailout” as the seed of moral hazard which blossomed oh so horribly 10 years later. But even then in my mind, and (I think) Greg’s too, while LTCM may not have been a seed, it should have still been a reminder to everyone that moral hazard was out there.

Streetwalker seems to say that most hedgers and IBers don’t really think in these terms, but just tend to put their head down and go for it. Makes sense to me, but that doesn’t mean moral hazard isn’t a problem, and it doesn’t mean that (some of the) moral hazard does not stem from implicit Fed guarantees. To use Streetwalker’s hypo, a dog is still a dog, even if it doesn’t know it.

15 Jason December 28, 2008 at 9:35 pm

Yglesias nails it better. Bailing LTCM was the right thing to do at the time. The essential follow-up would have been to insert regulatory measures to prevent future LTCMs from happening. But the follow up never occurred. THAT was the crucial mistake, not the bailout itself.

16 Phillip Huggan December 29, 2008 at 10:13 am

Brainwave. Whatta dork. To elaborate, a shadow company wouldn’t solve the main problem that presented itself recently where you have investment banks that are insolvent because of too much bad debt.
It does solve a tiny little bit of the conflict of interest issues that arise as bad debt is being accumulated. Most employees could still get rich ripping off a bank’s investors and quitting. But some might wish to keep their jobs longterm and would’ve be afraid of getting fired and replaced with shadow-employees.
More importantly, when massive sums of money are being handed out as bailouts, a shadow-bank would have mangement different and presumably less likely to make the same mistakes over again. These bailout sums are more than the market caps of the banks. When the financial sector is managed this badly, why not boot out those who can’t responsibly handle the power of leverage?

17 Martin December 29, 2008 at 5:40 pm

I think Chris, Barkley, and StreetWalker are focusing on the wrong party guilty of moral hazard. StreetWalker correctly points out that Fuld was desperately trying to find a merger partner rather than sitting around and waiting for a Fed rescue, it is also true that a bailout is super-humiliating.

However, I have strong feeling that Lehmans creditors expected some sort of a bail out from the Feds. The creditors are the ones that were poisoned by the LTCM response, this was most clearly seen by the AIG fall out. The credit default swaps were purchased blindly with the same faith one buys auto or life insurance. The faith that if the insurer does not pay up, someone, anybody, or Uncle Sam if neccessary, shall make good on the agreement.

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