Tyler Cowen argues that the “Committee to Save the World” made a mistake in 1998 by, well, saving the financial world. They thus missed an opportunity to teach the banks a lesson in sound risk-management.
He specifically argues that the Fed (actually the New York Fed) shouldn’t have called the big banks together to recapitalize LTCM. The recapitalization didn’t require any Treasury funds or draw on the Fed as a lender of last resort, so calling it a bailout obscured the meaning of the term bailout – the fed catalyzed a private bailout of LTCM but it didn’t do a true government bailout. You might even say that the Fed catalyzed a bail-in of LTCM’s creditors. But by acting, Cowen argues that the Fed set a precedent that creditors of big financial institutions don’t take losses, and thus encouraged bad bets.
I am not totally sure. The big banks called to the New York Fed were the creditors of LTCM and they were in some sense “bailed-in.” To avoid taking losses on the credit that they had extended to LTCM, they had to pony up and recapitalize LTCM.*
It just so happened that the market recovered and it was possible for LTCM to exit many of its positions without taking large losses, or in some cases any losses. The banks that took control of LTCM when LTCM was on the ropes were able to unwind LTCM’s portfolio in a way that didn’t result in additional losses. But the result Cowen desired — large losses for the banks and broker-dealers who provided credit to LTCM – was quite possible if LTCM’s assets weren’t sufficient to cover all its liabilities. No creditor of LTCM was able to get rid of its exposure as a result of the Fed’s actions.
Lehman’s creditors didn’t get a chance to do a similar deal. There were too many of them — and there was too little time. I suspect, though, that Lehman’s creditors and counter-parties would be far better off if they had all agreed to pony up say 10% of the money they had lent to Lehman and in the process had provided Lehman with enough equity to allow it to be unwound in a more orderly way.** They still would have taken losses, but those losses might well have been smaller – even counting the new money they put in – than the losses that Lehman’s creditors will incur as a result of Lehman’s bankruptcy filing.
Moreover, it seems a bit strange to look at LTCM in isolation.