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.The notion that if only the Fed had not organized negotiations that led to a private consortium -- composed primarily of large LTCM creditors -- bailing out LTCM creditors, we would have been spared the excesses of the past few years is far from persuasive.
On the other hand, the more commonly held take-away -- that the LTCM near-disaster demonstrates the need for more hedge fund regulation -- is, to my mind, no more sensible.
The facts of the LTCM near-disaster were these: The heavily regulated pillars of our financial economy lent far more money then prudent to an unregulated high risk small business. The unregulated high risk small business failed, threatening the well being of its pillars-of-our-financial-economy creditors and, by extension, the broader economy. In effect, an orderly bankruptcy was negotiated.
It takes a certain narrow minded-ness to take away from that scenario the conclusion that particular high risk small businesses need to be regulated. A more sensible observer would be more afraid of the overly-risky loans the heavily regulated pillars of our financial economy were apparently making that put our economic well-being in jeopardy.
The most sensible course of action then -- and the one that could have safely averted our current crisis -- would have been to rethink banking regulation in light of its failure.
What this argues for now, as our fearless leaders dream up a financial regulation Patriot Act, is to remember that regulation works best when its results (effectiveness/cost) are carefully monitored.
Far more persuasive from Professor Cowen:
The ad hoc aspect of the bailout created a precedent for what has come to be called “regulation by deal” — now the government’s modus operandi. Rather than publicizing definite standards and expectations for bailouts in advance, the Fed and the Treasury confront each particular crisis anew. Decisions are made as to whether a merger is possible, whether a consortium can be organized, what kind of loan guarantees can be offered and what kind of concessions will be extracted in return. So far, every deal — or lack thereof, in the case of Lehman Brothers — has been different.
While there are some advantages to leaving discretion in regulators’ hands, this hasn’t worked out very well. It has become increasingly apparent that the market doesn’t know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery.
John Maynard Keynes famously proclaimed that “in the long run we are all dead.” From the vantage point of 1998, today is indeed the “long run.”
We’re not quite dead, but we are seriously ailing. As we look ahead, we may be tempted again to put off the hard choices. But perhaps the next “long run,” too, is no more than 10 years away. If we take the Keynesian maxim too seriously, and focus only on the short run, our prospects will be grim indeed.
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