Bailout of Long-Term Capital: A Bad Precedent?

NYT ^ | 12/28/08 | TYLER COWEN

[TigerLikesRooster]

December 28, 2008

Economic View

Bailout of Long-Term Capital: A Bad Precedent?

By TYLER COWEN

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.

Long-Term Capital was advised by finance quants, or quantitative analysts, who made a number of unsound, esoteric bets, including investments in interest rate derivatives. When Russia’s inability to pay its debts roiled global markets, the fund, saddled with high-leverage and off-balance-sheet obligations, was near collapse.

Because Long-Term Capital owed large sums to banks and other financial institutions, the Federal Reserve Bank of New York organized a consortium of companies to buy it out and cover the debts. Alan Greenspan, then the Fed chairman, eased monetary policy to restart capital markets, which were starting to freeze up. Long-Term Capital’s shareholders were wiped out, but none of the creditors took losses.

At the time, it may have seemed that regulators did the right thing. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. 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.

[TigerLikesRooster]

It has been my view that they should have let LTC go under. We may have had some bad recession, but we would have been out of it in a few years and now in much better shape.

If you forgo some regulation and go for rapid growth of earning at the expense of financial stability, you should be willing to take the harsher setback when things do not work out. That is a free market. Market under less stable financial system is inherently riskier. One of the risks involved is that the gains and losses would be more unpredictable and drastic. Small success would pay off with big gains or no gains, or small mistakes could create severe loss or no loss.

You cannot set system-wide parameters to only work in one way, i.e. in favor of wild earning growth all the time. That sort of biased view would inevitably implies bailout when things do not work out.

We all realize by now that big market players take big successful payoff but others will shoulder the huge cost of their failure in this less stable market.

Another reason they went all-out for LTCM bailout could be that it could have markedly set back globalization process. For emerging transnational elites, that would have been unacceptable.

[TigerLikesRooster]

Ping!

[Uncle Ike]

” A Bad Precedent? “

Haven’t seen many *good* precedents lately......

[ninonitti]

For emerging transnational elites, that would have been unacceptable.

You don't mean the people that the Republidemo Corps work to take care of?

[jamaksin]

Add to this the association with the 1997 Nobel Prize winners in Economics (Merton and Scholes).

Scholes, along with Black (decease in 1995) developed the so-called "Black-Scholes formaula" - a model for option pricing; an analytical tool using stochastic processes - elegant partial differenial equations.

[dennisw]

I remember all the fuss in 1998 about LTC and it dragging down the financial system. Todays problem is 300x worse and the bailouts are 300x larger. No taxpayer funds were used to bail LTC

The undoing of LTC was derivatives. The same problem at the center of today’s crisis. No one listened to Warren Buffet in 2002 when he said —

**** “Derivatives are weapons of mass financial destruction”

[dennisw]

It has been my view that they should have let LTC go under. We may have had some bad recession, but we would have been out of it in a few years and now in much better shape.

IIRC that bailout was 3-4 billion
So small that I doubt it would have done much if allowed to fail outright
Plus would have scared people off the then emerging derivatives market

LTC was 100% private money bailout. Major Wall St firms chipped in collectively. Ones that had greater entanglements chipped in more

[TigerLikesRooster]

Right. It got quants excited, and launch the whole new area.

[rodguy911]

Free Market Capitalism is based on risk reward. When the govt. interferes and changes the equation to all reward and little risk,the game changes. Rewards get smaller as the cost of such interference has to be paid by those who were previously rewarded.

When govt. becomes the biggest player we have Socialism headed towards Marxism. This is where we are headed.

[spetznaz]

It has been my view that they should have let LTC go under. We may have had some bad recession, but we would have been out of it in a few years and now in much better shape.

I think one has to be careful of hindsight bias. Now it seems that bailing out LTCM was a boo-boo, but back then when it was threatening global shock, things looked dire enough for the principals to decide that they had no option. Based on what they had at hand, and what they knew, and the fact that they could not look at the future, they decided to act. Also consider political pressures borne by the effects of a fiscal contraction.

Now things are more clear, but it is because we can use hindsight.

For instance, I am VERY SURE that if the people who have implemented the 700 billion to 7 trillion (depending on what metric you use) bailouts could see the future, they would NOT have implemented those bailouts. Sooner or later the piper has to be paid, and sooner or later he will be paid.

6 years from now people will probably be saying that we probably should not have implemented the Bush-Paulson bailouts ....but then it will be hindsight.

[TigerLikesRooster]

There would have been a global consequence, which comes with the market arrangement at the time.

This is what happen when intervention mechanism is so available and ready. Investors were bailed out and no much damage to those participated. The game went on.

When you face unexpected disaster, it will always look bad enough. If you champion free market, you should keep your hands off the market even if it goes ugly.

Things were getting already bad since 1996. I mean people's psychology got really disturbing. You can yank them off their hallucination without painful jolt.

If we don't have the institutional discipline to rein over intervention temptation, we are asking for regulated market in the end.

When people get excited about market with few regulations, they insist they can handle the downside. Apparently, they can't. Then they are not up for free market yet.

When people champion free market, they all say market's correctional mechanism, or invisible hand, is more effective than any regulation, even if it is frequently noisy and not necessarily proportionally calibrated. LTCM failing was the market's correctional mechanism, and they decided to offset it. Thus market gets pathological. It is no longer efficient as so many champions claim.

This LTCM issue will be around for quite a while. It will serve as the test of how much people tolerate market in the real sense.

[TigerLikesRooster]

What you saying does almost sound like what Greenspan said. That is, we don't know whether we are in recession until we get out of it.

Everything is in hindsight. So we won't learn much from past experience after all.

Lastly, let me give you one example how disturbing the psyche of people was at the time. Right until LTCM crisis, every experts on media was saying that economy is in fantastic shape. Virtually no voice of caution. Except myself. Of course, there must have been others. But they were not talking in public. Then, LTCM crisis broke. Suddenly, Bob Rubin turned up on TV, short of his breath, and uttering, "It is the greatest crisis since WWII." Huh? It was perfect until yesterday, and we were about to fall off the cliff the next day? Greenspan did not act immediately. Up to that time, not a day went by without somebody lionizing him on media for his wisdom and foresight(right!) As soon as big boys noticed that Greenspan is not acting fast, insults started to being hurled toward him. This was also a shock to me. The hero and genius yesterday and the target of angry insults today? All these incidences were really disturbing. Wall St. folks lost it.

I sort of hoped that LTCM would go down, and get people out of this insanity. It did not happen.

Such drastic flipflop overnight was surely the sign of real trouble.

[TigerLikesRooster]

Correction: You can't yank them off their hallucination without painful jolt.

[dennisw]

Correction: You can't yank them off their hallucination without painful jolt.

Also known as breaking the spell.
Listen to this if you can

http://www.fhu.com/america-mesmerized/video-part2-high.html

 

[GOPJ]

Thanks for the ping.

[spetznaz]

To be honest with you it is all rather interesting ...and more and more the level of 'interesting' gets more scary. Right now I am reading Nassim Nicholas Taleb's books (Fooled by Randomness and The Black Swan) at the same time, and I am finding them fascinating. In Fooled by Randomness, he compares some fool playing Russian Roulette (and winning) with people in high finance taking some major risky stake (and winning), and mistaking that for skill or what-not ....and then continues the game (I am so heavily paraphrasing it is not fair) to show that if you play the game long enough you will come across the chamber with the bullet. In some ways we have been playing R.R for quite some time, and we eventually came to the chamber with the round.

But then, what do we do?

I believe people have gotten so attuned to not having to undergo pain that, even though logic would necessitate market ups and market downs, they are not willing to accept market downs. This has percolated all the way from the highest levels of politics and high finance to the small-time consumer going to a pay-day loan shark in Edmond Oklahoma! They all want the benefit, but not the risk (and especially not the loss).

Now, let's say you are Mr Politician rather than a thinking FReeper ....what do you do? You can do the right thing, have the market act as it should, and for short-term small pain avoid major-pain down the road. However, doing so will lead to your constituency voting you out the next cycle for 'letting them down.' Now, that is the prudent thing to do, damn the consequences. However, you are not Mr Thinking FReeper ...you are Mr Average Politician. Thus, you decide to take the 'stimulus approach' (there is nothing wrong with a stimulus ...it is just that the Bush-Paulson Bailouts are not stimulii in the traditional sense, but rather simply an attempt to throw as much money at an issue and hope it goes poof like Casper). In so doing, you gain the praise of your constituency, and secretly hope that when the big bang comes by years from now you will have moved on and the ball will be on some other person's court!

This is as much a human behavioral concept issue as it is a political concept issue or a finance concept issue, and the problem with human behavior is that people will select the most illogical option, and will defer pain for a later period (even when the deferement necessitates greater pain, at times much greater pain, down the road). You also have to consider finance people who have a major positive stimuli (large bonuses) with relatively small negative stimuli (loss of a job for example, which may seem bad but is not that bad when compared to a bonus that could have many zeroes in it). At this, although throw in a political cabal (for lack of a better word) that also has a very skewed positive-negative benefit curve (oh, and to those that blame Democrats for this mess ....well, it is as much in the lap of the so called 'conservative' Republican party, and the 'compassionate conservative' president George Bush has outspent EVERY Democrat president in living memory, and some of his fiscal actions may end up having such dire ramifications on the USA that they would almost make Osama bin Laden hang a bl@@dy poster of bush in his cave as a sign of respect and admiration to a fellow enemy of America. Yes ya Bushbots out there, I said what you just read! President Bush has honestly outdone Osama bin Laden, and now all we can do is wait and see whether Barack bin Obama can outdo George bin Bush ...and marvel at how George bin Bush led to the election of Barack bin Obama in much the same way that Jimmy 'bunny' Carter led to the election of Mr and President and Honorable Ronald Reagan).

Anyways, this is all about human behavior, and as logical as what you say may be (and even though what you say is true), those in power will always act to defer pain (even though by doing so they are building a more cataclysmic end-game event downstream).

I doubt even you in the late 90s, even after seeing what happened with LTCM, would have believed that the Government (particularly one headed by a Republican president) would have presided over the level of 'bailout' that we are currently looking at. Yet here we are.

[plenipotentiary]

If some financial institutions can be too big to be allowed to go under, then the US and others will have to start limiting the institutions size, by market share or total value, so they can be allowed to fail.

[Travis McGee]

In other news, water is wet and the sky is blue.

These moron reporters act as if this is rocket science.

[ishmac]

Ping for later

[curiosity]

Excellent article. I am a great admirer of Tyler Cowen. As usual, he hits the nail on the head.

Bailing out financial institutions for fear of systemic breakdown only breads more systemic risk. This should be obvious to anyone who's ever studied basic concept of moral hazard.

Unfortunately, too many policy economists forget the basic lessons they learned in undergraduate micro.