Monday, December 29, 2008

Was the LTCM Bail-In a Mistake?

Tyler Cowen, in his Sunday New York Times column, says yes. His reasoning, however, leaves much to be desired. Tyler argues that by saving Long-Term Capital Management (LTCM), regulators missed a golden opportunity to teach the markets a much-needed lesson in moral hazard:

With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.
The problem with this argument is that no taxpayer money was put on the line for LTCM — it was a "bail-in" involving a consortium of LTCM's 14 largest creditors, all Wall Street banks. If no taxpayer money was put on the line, how could the LTCM rescue set a precedent that "loans to unsound financial institutions would be made good by the Fed"? There was no indication during the LTCM crisis that if the private-sector bailout couldn't be hammered out, then the Fed would step in with taxpayer money. No one ever thought that was a realistic scenario. Indeed, that's what made that weekend at the New York Fed in 1998 so unbelievably tense and dramatic: everyone knew the government wasn't going to ride to the rescue if they couldn't hammer out a deal, so everyone realized that it was an all-or-nothing proposition. Remember, Bear Stearns pulled out of the LTCM bail-in fund at the last minute, which almost doomed the rescue (Poetic-Justice Alert). If the major players in the LTCM bail-in actually thought that the government would ride to the rescue if they didn't agree to a private-sector bail-in, why didn't they all abandon the bail-in when Bear pulled out? Why didn't they just say, "screw it," and let the government sort it out? Because a government bailout wasn't on the table that weekend. That's a big reason why a private-sector rescue was still finalized, despite the very conspicuous absence of LTCM's second-biggest creditor and clearing bank, Bear Stearns. The precedent the LTCM rescue set was that if an instution was too-big-to-fail and a private-sector bailout could be negotiated by the New York Fed, then it would probably get a private-sector bailout. We can argue about whether that was a good precedent to set, or whether it contributed to the current financial crisis. But you can't, as Tyler does, blame the LTCM rescue for setting a precedent that it plainly did not set. I also want to take issue with something else Tyler says, because this is a myth that has long outlasted its expiration date:
What would have happened without a Fed-organized bailout of Long-Term Capital? It remains an open question. An entirely private consortium led by Warren E. Buffett might have bought the fund, but capital markets might still have frozen because of the realization that bailouts were not guaranteed.
First of all, the consortium that bought LTCM was also "entirely private," so I don't know what point he's trying to make there. Second, I distinctly remember that the offer from the Warren Buffet-led group was aptly characterized by one lawyer that weekend as "a publicity stunt masquerading as an offer." It was not a serious offer: it was all of one page, and required shareholder approval even though Buffett knew quite well there was no time for shareholder approval at that point. Third, Tyler fails so mention who the other two members of the Buffett-led consortium were: Goldman Sachs and American International Group (AIG). Does anyone really think it would have been a good thing if AIG had acquired a hedge fund with $100 billion in derivatives positions way back in 1998? I didn't think so.



to many bailouts

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