Relitigating 1998 at the end of 2008
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.
LTCM, remember, came just after Russia defaulted.
And Russia was at the time considered the quintessential moral hazard play.
A host of financial institutions thought it was too nuclear to fail, and thus concluded that that they could safely pocket the high coupon on Russia’s GKOs (short-term Ruble denominated Russian securities) …
Bad bet. Then Treasury Secretary Robert Rubin concluded that it wasn’t possible to save Russia without effectively turning Russian credit into US credit. He wasn’t willing to do that. He wasn’t willing to support the disbursement of the second tranche of Russia’s IMF program after Russian burned through the first tranche really quickly.
Not providing Russia more money then was a risky call. Kind of like letting Lehman fail. Russia, remember, had nukes. Lots of them. The national security types weren’t thrilled by the prospect of a bankrupt nuclear power.
Russia’s creditors (including Lehman) took large losses at the time. That presumably should have taught them a lesson or two about managing risk – it was more or less what I suspect Dr. Cowen would have prescribed.
It also implies that LTCM wasn’t the Lehman of 1998.
It was more like one of the institutions found to be swimming naked after Lehman defaulted.
Nor was LTCM the only big borrower that got a bit of help after Russia’s defautl.
Brazil, like Russia, had a lot of short-term debt that had to be rolled over. Now it so happens that most of Brazil’s domestic debt was owed to domestic banks not foreign investors – and that really helped. The analogy isn’t perfect. Brazil also had a pegged exchange rate. It, like Russia, had pegged to the dollar at too high a rate to be sustained after Asia’s crisis cut into global demand for commodities and reduced private capital flows.
Brazil not surprising came under a lot of pressure. But it also got a decent sum of money from the IMF. That loan supplemented Brazil’s reserves and allowed for a more orderly exit from its fixed exchange rate than otherwise would have been the case. They delay made possible by the IMF (and the government’s heavy intervention) in the foreign exchange market allowed a lot of Brazilian firms to hedge their dollar exposure, so they didn’t go bust when the real eventually was devalued. And Brazil didn’t default. Not in 98. Not in 99. And not in 2002, when it also had to draw on the IMF after Argentina’s default.
Ending moral hazard consequently would have implied letting Brazil go – not just letting LTCM go. The odds are that a Brazilian default soon after Russia’s default would have brought done a major financial institution or two, and brought about a major systemic crisis.
I am personally though glad that this wasn’t what happened. Brazil actually was suffering from a liquidity crisis as much as a solvency crisis. Or rather the IMF provided it with a cushion that allowed it to make the fiscal adjustment needed to assure its long-term solvency — and that was something it was willing to do. That kept its liquidity crisis from morphing into a solvency crisis. The line between the two often isn’t as clean in practice as in theory (apologies for all the detail; I wrote an equation-free book on this with Dr. Doom before he was Dr. Doom).
I doubt Brazil would be better off today if it had defaulted in 98 or early 99. Defaulting on domestic government debt does bad things to the long-term health of any country’s domestic banking system. It creates a really bad hangover – and leaves a country permanently more vulnerable to a run.
Nor am I convinced that Dr. Cowen’s solution – standing aside as LTCM failed – would have ended moral hazard.
LTCM after all was an unregulated hedge fund. It wasn’t a regulated bank. Or a big – and sorta-regulated- broker-dealer.
If LTCM had failed, I suspect that policy makers would have stepped in to prevent any major regulated financial institutions from failing as a result of its exposure to LTCM, or its own LTCM-style bets. Rather than ending the expectation that big banks and big broker-dealers were too big-to-fail, the failure of LTCM might have reinforced that sense.
The real moral hazard in the financial system – in my view – comes not from expectations that if a firm like Goldman (or Lehman) makes a bad bet on a country like Russia (or a bad bet on US commercial real estate) the government will come in and protect the firm from losses on those investments. Rather it comes from the expectation on the part of those lending to places like Lehman and Goldman that these institutions are too big and too important to the financial system to fail, and thus it is safe to lend to them at low rates … no matter how leveraged they are or how many risky bets they are making.
If that is right, ending moral hazard in 1998 would have required allowing an institution like Lehman to fail. And, well, right now a lot of people think allowing an institution like Lehman to go bankrupt was a mistake.
To me the real failure during the last crisis was the failure of regulators to clamp down more seriously on leveraged institutions once the markets calmed.
Losses in Russia – and a close call with LTCM did lead to a bit more prudence for a while. Regulators did start to pay more attention to the financial firms that were providing a lot of credit to big hedge funds. But that started to seem a bit superfluous in a context where (for a period) the banks actually were lending less to hedge funds, in part because the big hedge funds were shrinking. Not just LTCM. Tiger too … even Soros.
And when the party got going again this decade — and hedge funds and private equity firms and the broker-dealers and the banks (through off balance sheet vehicles) all started to gear up — there was a team at the Treasury that wasn’t at all interested in regulating the financial sector. And the Fed – Greenspan especially – was never very keen on tight regulation.
Given all the scale of this year’s crisis, I certainly cannot rule out the possibility that Dr. Cowen is right and we would all be better off now if we had had a deeper crisis in 1998. A crisis that scarred the banks as deeply as it scarred most emerging markets might have produced a world where the banks wanted to increase their capital as badly as most emerging markets wanted to increase their reserves.
But I doubt that that outcome would have been possible without standing by and watching a lot more institutions than just LTCM fail. One big borrower — Russia — did fail rather spectacularly in 1998. Its failure created large losses for a lot of banks (far more than most were expecting, as some banks’ risk models at the time didn’t allow for a default on ruble denominated debt … ). The yen carry trade also unwound in ways that led to big losses at a lot of hedge funds in 1998. And that wasn’t enough.
A lot of the institutions that took lent large sums to Russia in 1998 were lending even larger sums to Russia in early 2008.
My bottom line: Forcing creditors to evaluate the real risk of lending to a large, highly leveraged financial institution — i.e. the big banks and broker-dealers — would have required a lot more that letting the market sort out LTCM without a gentle nudge from the Fed. It would have required allowing some solvent but illiquid institutions (and countries) to fail. That is a bit further than I would be willing to go.
*Bear Stearns excepted. Bear didn’t participate in the equity injection.
** Lending here should be read as shorthand for all credit exposure, even if it isn’t structured as a loan. And no doubt one complication of a plan based on “recapitalization from Lehman’s creditors” was that a lot of Lehman’s creditors had lent on a secured basis, and thus had little direct exposure to Lehman (though lots of exposure to a firesale of Lehman’s assets in the secondary market).
Relitigating 1998 …
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 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 a bailout – the fed catalyzed a private bailout but it didn’t do a true government bailout. 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 creditors of LTCM were the big banks, and they were in some sense “bailed-in.” To avoid taking losses on the credit that they extended to LTCM, they had to put equity into 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. The banks that took control of LTCM 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 in the cards if LTCM’s assets weren’t sufficient to cover all its liabilities.
Lehman’s creditors didn’t get a chance to do a similar deal. There were too many of them — and too little time. I suspect, though, that Lehman’s creditors and counterparties 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 capital to allow it to be unwound in an 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 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.
LTCM, remember, came just after Russia defaulted.
And Russia was at the time considered the quintessential moral hazard play.
A host of financial institutions thought it was too nuclear to fail, and thus concluded that that they could safely pocket the high coupon on Russia’s GKOs (short-term Ruble denominated Russian securities) …
Bad bet. Then Treasury Secretary Robert Rubin concluded that it wasn’t possible to save Russia without effectively turning Russian credit into US credit. He wasn’t willing to do that. He wasn’t willing to support the disbursement of the second tranche of Russia’s IMF program after Russian burned through the first tranche really quickly.
Not providing Russia more money then was a risky call. Kind of like letting Lehman fail. Russia, remember, had nukes. The national security types weren’t thrilled by the prospect of a bankrupt nuclear power.
Russia’s creditors (including Lehman) took large losses at the time. That presumably should have taught them a lesson or two about managing risk – just as Cowen wanted.
It also implies that LTCM wasn’t the Lehman of 1998.
It was more like one of the institutions that was found to be swimming naked after Lehman failed.
The kind that are now truly getting bailed out. Many large financial institutions would be bust right now if not for Treasury capital injections and Fed liquidity support.
Nor was LTCM the only big borrower that got a bit of help after Russia didn’t get bailed out.
Brazil, like Russia, had a lot of short-term debt that had to be rolled over. Now it so happens that most of Brazil’s domestic debt was owed to domestic banks not foreign investors – and that really helped. The analogy isn’t perfect. Brazil also had a pegged exchange rate. It, like Russia, had pegged to the dollar at too high a rate to be sustained after Asia’s crisis cut into global demand for commodities and reduced private capital flows.
Brazil not surprisingly came under a lot of pressure. But it also got a decent sum of money from the IMF. That loan supplemented Brazil’s reserves and allowed for a more orderly exit from its fixed exchange rate than otherwise would have been the case. They delay made possible by the IMF (and the government’s heavy intervention) in the foreign exchange market allowed a lot of Brazilian firms to hedge their dollar exposure, so they didn’t go bust when the real eventually was devalued. And Brazil didn’t default. Not in 98. Not in 99. And not in 2002, when it also had to draw on the IMF after Argentina’s default.
Ending moral hazard consequently would have implied letting Brazil go – not just letting LTCM go. The odds are that a Brazilian default soon after Russia’s default would have brought down a major financial institution or two, and brought about a major systemic crisis.
I am glad that this wasn’t the course chosen at the time. Brazil actually was suffering from a liquidity crisis as much as a solvency crisis. Or rather the IMF provided it with a cushion that allowed it to make the fiscal adjustment needed to assure its long-term solvency — and that was something it was willing to do. That kept its liquidity crisis from morphing into a solvency crisis. The line between the two often isn’t as clean in practice as in theory.
And I doubt Brazil would be better off today if it had defaulted in 98 or early 99. Defaulting on domestic government debt does bad things to the long-term health of any country’s domestic banking system. It creates a really bad hangover – and leaves a country permanently more vulnerable to a domestic run.
Nor am I convinced that Dr. Cowen’s solution – standing aside as LTCM failed – would have ended moral hazard among financial institutions.
LTCM after all was an unregulated hedge fund. It wasn’t a regulated bank. Or a big – and sorta-regulated- broker-dealer. If LTCM had failed, I suspect that policy makers would have stepped in to prevent any major regulated financial institutions from failing. Rather than ending the expectation that big banks and big broker-dealers were too big-to-fail, the failure of LTCM would have reinforced that sense.
The real moral hazard in the financial system – in my view – comes not from expectations that if a firm like Goldman (or Lehman) makes a bad bet on a country like Russia or a bad bet on US commercial real estate the government will come in and protect the firm from losses on those investments. Rather it comes from the expectation on the part of those lending to places like Lehman and Goldman that these institutions are too important to fail, and thus it is safe to lend to them at low rates … no matter how leveraged they are or how many risky bets they are making.
If that is right, ending moral hazard in 1998 would have required allowing an institution like Lehman to fail in a way that imposed large losses on Lehman’s creditors. Not just allowing LTCM to fail in a way that imposed large losses on firms like Lehman.
And, well, right now a lot of people seem to think allowing an institution like Lehman to go bankrupt in 2008 was a mistake.
To me the real failure during the last crisis was the failure of regulators to clamp down more seriously on leveraged institutions once the markets calmed.
Losses in Russia – and a close call with LTCM did lead to a bit more prudence for a while. Regulators did start to pay more attention to the financial firms that were providing a lot of credit to big hedge funds. But that started to seem a bit superfluous in a context where (for a period) the banks actually were lending less to hedge funds, in part because the big hedge funds were shrinking. Not just LTCM. Tiger too … even Soros.
Most macro funds got burnt on the yen carry trade in 98.
And when the party got going again this decade — and hedge funds and private equity firms and the broker-dealers and the banks (through off balance sheet vehicles) all started to gear up — there was a team at the Treasury that wasn’t at all interested in regulating the financial sector. And the Fed – Greenspan especially – was never very keen on tight regulation.
Given all the scale of this year’s crisis, I certainly cannot rule out the possibility that Dr. Cowen is right and we would all be better off now if we had had a deeper crisis in 1998. A crisis that scarred the banks as deeply as it scarred most emerging markets might have produced a world where the banks wanted to increase their capital as badly as most emerging markets wanted to increase their reserves.
But I doubt that that outcome would have been possible without standing by and watching a lot more institutions than just LTCM fail. One big borrower — Russia — did fail rather spectacularly in 1998. Its failure created large losses for a lot of banks (far more than most were expecting, as some banks’ risk models at the time didn’t allow for a default on ruble denominated debt … ). The yen carry trade also unwound in ways that led to big losses at a lot of hedge funds. And that wasn’t enough.
We shouldn’t forget: A lot of the institutions that lost a lot of money in Russia in 1998 were back lending huge sums to Russia in early 2008.
My bottom lines:
Getting rid of all moral hazard – and forcing creditors to evaluate the real risk of lending to a large, highly leveraged financial institution rather than bet that some large institutions were too big and too complex to fail – would have required a lot more that letting the market sort out LTCM without a gentle nudge from the Fed. It would have required allowing the kind of institutions that were lending to LTCM to have failed … and thus made it harder for the broker-dealers to expand their balance sheets and take on more credit risk in this decade.
And I suspect it would ultimately have meant allowing solvent but illiquid institutions (and countries) to fail. That is a bit further than I would be willing to go.
NOTE: I edited the post a bit to take out some repetition, though no doubt I could (and perhaps should) edit more …
*Bear Stearns excepted. Bear didn’t participate in the equity injection.
** Lending here should be read as shorthand for all credit exposure, even if it isn’t structured as a loan. And no doubt one complication of a plan based on “recapitalization from Lehman’s creditors” was that a lot of Lehman’s creditors had lent on a secured basis, and thus had little direct exposure to Lehman (though lots of exposure to a firesale of Lehman’s assets in the secondary market).
Thanks for the thought provoking post Brad … for all us wanna-be Minsky process modelers.
Happy New Year.
It seems that the post is repeated several time, as slow minded repeats do not hurt.
The difference of bail out (in) 1998 and now is the exclusivity of macro theme in 98, as written in your post , unbalances in the macro aggregates of emerging economies (Indonesia, Thailand, Russia posting large current accounts deficits) the bond markets were happy to oblige throughout Asia and Central Asia until they did not. The impact came then at micro level with few spectacular bankruptcies (Peregrine HK,LTCM).
Saving LTCM has left many wondering why, even though his promoter was alleged to say very often « I make the markets right » may be Lehman was not making the markets right and the survivors are?
Initiated at the behest of then US Treasury Secretary Robert Rubin, LTCM was a member of the cabal of Hedge Funds that destroyed the economies of the Southeast Asian and South Korean economies through massive currency and derivative manipulation. After the collapse of the Soviet Union, the high-growth Asian economies were viewed by the Washington Consensus as the primary threat to US Global hegemony by the Washington Ceonsensus elites. The Asian state-driven economic model was to be discredited to be replaced by the laizze-faire Neo-liberalism model. A cabal of Wall Street Hedge Funds closely politically connected to the Clinton-Rubin Administration destablised the monetary regimes of Southeast Asia and South Korea (ie. Long Term Capital, Quantum Fund, Tiger Fund, and others). Across Indonesia, hundreds of million of former middle class women and children were left destitute while Rubin’s cronies on Wall Street pocketed tens of billions of dollars. Indonesia national energy assets were privatized to Wall Street investment banks. The IMF under the control of the US Treasury Department dismembered the South Korean industrial base to a Neo-liberalism financial regime. To this day, the symbol IMF across Asia represents the acronym, “I aM Fired!”. Then Fed Chairman Alan Greenspan and Treasury Secretary Robert Rubin even refused to take phone calls from Asian Central Bank governors complaining about gross market manipulation and irregular market trading activities. Long Term Capital was heavily involved in shorting the Hong Kong dollar and stock market under the direct authority of Robert Rubin and Alan Greenspan. LTCM foreign exchange positions were exposed upon the China PBoC’s massive intervention in the Hong Kong markets creating a massive short squeeze on LTCM and several other Wall Street Hedge funds. In order to conceal the market manipulation to the world community, Robert Rubin arranged for the non-transparent bailout of LTCM by the US Treasury and Federal Reserve. The destabilizing financial attack on the monetary stability of the Hong Kong economy by the Clinton-Rubin Administration represented a de facto declaration of economic warfare on the Chinese government. A federal grand jury has yet to investigate the numerous criminal activities by the former Clinton-Rubin Administration. To date, not a single penny of illicit profits by Wall Street Hedge funds has been repatriated to the millions of destitute Indonesian families.
Brad,
There was a competing proposal to buy LTCM books. It was headed by Goldman with support from Buffet and AIG. LTCM positions were potentially profitable, they had problems with mark to market (insurance companies did not need mark to market those positions). This is another angle to look at previous crisis through the lenses of current one.
Happy Holidays,
I think you are looking for the wrong kind of bailout in 1998 Brad. The nature of the bailout was that the Fed cut interest rates “to address the seizing up of financial markets”, despite having warned about “irrational exuberance” in the stock market and then about tight credit spreads. As I recall, at the time, almost all the economic indicators were suggesting that interest rates were, if anything, too low, but the Fed cut. The chart in my blog post on the Greenspan put suggests that 1998 led to a paradigm shift in market expectations. Risky asset prices began to drive interest rate expectations, rather than the other way round. The moral hazard that was engendered is macro and cultural rather than institutional.
Fantastic analysis, Brad. One of your best.
What I like about it is that you demonstrate that these issues are more subtle and complex than the “let ‘em crash and burn”-ers like Tyler Cowen think it is. Actions (and lack thereof) have reactions and ramifications, and these need to be extrapolated and analyzed, exactly as you have done here. This is precisely the kind of thinking we need right now.
While certainly we must allow capitalism to work and bring failures, and of course we must restrain moral hazard as much as we can, simplistic Austrian cheerleading for collapse is both intellectually vacant and dangerous.
Today in the U.S., with both corporate bonds and stocks suffering massive losses and over $2 trillion of taxpayers’ dollars doled out by the Federal Reserve to shore up Wall Street firms in various stages of insolvency, we finally grasp the true meaning of “the ownership society:” the Wall Street execs absconded with the so-called profits; the little people own the losses; the next generation owns the bailout debt. This scheme makes Ponzi artist Bernie Madoff look like a piker.
On November 25th 2008, the New York Post featured a photo spread of Citigroup’s Board of Directors (which included Robert Rubin and Deutch) and a full front page titled “Citi of Fools.” The same issue carried an editorial urging an ouster of the Board (“Bounce These Bozo Bankers”) or perhaps a stronger remedy (“Off with their heads”).
The uproar at The Post was over a weekend confab that saw the Federal Reserve guarantee upwards of $300 billion of taxpayer money to bail out Citigroup for the second time in a month and a half. Of that amount, $20 billion was for a paltry equity stake for taxpayers when the whole company could have been bought for $20.5 billion at the prior Friday’s closing price, and that was $4.5 billion less than taxpayers had dumped into the company in October. (It’s not a good omen that the man who helped put this deal together, Tim Geithner, President of the Federal Reserve Bank of New York, has been selected by President-elect Barack Obama to be the new U.S. Treasury Secretary; neither is it promising that Robert Rubin was standing at the elbow of the President-elect in his first press conference, signaling he’s a key advisor.)
Is it any wonder we have watched union membership collapse? Or have seen a giant swell in the ranks of corporate mandatory arbitration systems that block both the employee and the consumer’s right to redress in a court of law? Is it any mystery why serious investigations of what led to these massive banking bailouts are missing in Congress; why there has been an absence of large-scale mobilizations and street protests, even in the face of losing an average of 48 to 54 per cent of one’s retirement assets in one year. Should we be surprised that the crooked and incompetent remain in their positions and get a bailout from taxpayers.
By PAM MARTENS
http://www.counterpunch.com/
One thing this analysis misses is that this time hedge funds *didn’t* blow up in ways that threatened the financial system. People looked at LTCM, learned a lot of lessons, changed the way business was done, and you now have hundreds of hedge funds blowing up and people hardly notice.
The big lesson of LTCM is to not extend too much credit to hedge funds, to watch them carefully, and to wind them down while the losses are relatively small.
The LTCM banks were bailed in the same way that JP Morgan was bailed into the Bear Stearns rescue. Stomping out moral hazard requires letting the market dole out punishment. Cowen’s argument is that not enough punishment was delivered as a precedent in the case of LTCM. Others might argue that the alternative then and in the case of Bear more recently was too much punishment for the system. As for Lehman, who knows right or wrong? And was the Great Depression not enough punishment for risk takers? Why have risk taking cycles and busts since then been mini-repeats until now?
The answer is that you can’t provide the right moral hazard signals to the financial system simply by manipulating a single interest rate. The real moral hazard is that central banks still haven’t learned after several hundred years that some regulation of broadly defined credit growth is required in addition to setting interest rates. But why will they learn from this episode any more than they did from the Great Depression?
Also playing “regulatory chicken” when there is a crisis is too late. If people have any suspicion that there will be a bailout before the crisis, then you’ve already lost the battle. Saying “we will under no circumstances bail out X” doesn’t work because people just will not believe you. Even having a meeting to discuss the possibility of a bailout means that you’ve already lost the argument.
Rather than (unsuccessfully) trying to convince people that the regulators would rather cause the world to blow apart than to do a bailout, or worse yet risking the end of the world to “teach people a lesson” the prudent thing to do is to just say “yes, we will probably have to bailout institution X if it goes under, and given that reality, we are going to regulate the heck out of institution X to make sure that it doesn’t go under.”
LTCM is a very interesting case study because I think it marks an example of a successful regulatory system. Hedge funds today are much larger than LTCM, and there have been dozens of LTCM-size failures over the last few months and none of them have made the news. This is good. The reason for this is that when an hedge fund fails, it doesn’t have the huge amount of leverage that LTCM have, so it doesn’t threaten the entire financial system.
Also looking at the difference between LTCM and hedge funds today is why I’m rather optimistic about China’s ability to weather a crisis. There may be lots of corporate failures, but the corporations aren’t hugely leveraged.
The danger in leverage is that it allows for a “martingale” strategy. What this involves is flipping a coin. If you win you keep your money. If you lose you double your bet. The danger in this strategy is that eventually you will have a run of bad luck that will eat up all your money, no matter how big your pool of money is.
If you let someone start with a $1 bet and give them infinite credit, and let them double the bet each time they lose, then eventually, they will be in a situation where they are betting all of the money in the world and threatening the entire financial system, which is what basically happened with LTCM. The solution is to set a limit, and once that threshold is crossed to tell the bettor that they’ve just lost and to go home. These limits are now set by prime brokers with oversight from the Fed.
Third attempt to post…
“Nor am I convinced that Dr. Cowen’s solution – standing aside as LTCM failed – would have ended moral hazard.”
It would certainly have helped. My bank estimated its loss at 2 years of its then IB profit should LTCM have gone under. It is pretty much a given that our IB would have had its risk profile drastically reduced; instead it was increased.
Also, there was a knock-on effect, e.g. Goldman Sachs, which also reportedly was going to take huge losses if LTCM had gone under.
As to whether it was a bail-in or bail-out, does it matter? Cowen’s point is invalid if there is a causal connection: if the Fed had not acted (by calling its meeting), then LTCM would have gone under, and then risk-taking would have been subsequently diminished.
Privatverkauf, keine Garantien, Sie kaufen was sie sehen! Bei Fragen oder mehr Fotos bitte rechtzeitig melden!!!
Albion — you are right about the repetition; i need to edit this post a bit…
RN — thanks. you got my message exactly. the issues here are incredibly complex, and unless you are prepared to end all government liquidity provision, it is going to be hard to rely entirely on market discipline/ big crashes / etc to avoid excesses.
anon1 — The fed took on risk (by financing maiden lane/ a set of bears’ assets) to facilitate JPM’s takeover of Bear. There was no analogous Fed financing of LTCM’s positions in 98. LTCM’s was overlevevaged but some of its bets weren’t fundamentally bad (the on the run v off the run arb for example); they just couldn’t be sustained through a global liquidity crisis as LTCM was systematically short the liquid security and long the illiquid security ….
anon — sorry about the difficulties posting. it is often a good idea to copy your comment before posting so you can paste it back in if you have trouble.
Your point about how your IB’s trading desk would have had its risk profile cut if LTCM had gone bust in a disorderly way is interesting. I would though note:
a) Some banks did take big losses on Russia, which presumably led to some reduction in their ability to take risks (it certainly felt that way at the time, credit in EM-land dried up for a while)
b) the banks would have taken large losses on LTCM (via their equity injections) if the markets didn’t bounce back.
c) that is a key difference between a bailout and a bail-in (and yes, i think it matters –). A bailout shifts risk to the public sector, as the government ends up funding an institution or country (allowing the institution to repay private creditors who are exiting)/ ends up injecting capital into an institution and thus being on the hook for large losses; A bail-in keeps the risk in private sector hands. If things work out, they don’t take losses; it things go bad they do. Banks who were “bail-in” as a result of the Korean rollover agreement in late 97 never took losses. But they saw short-term claims transformed into long-term claims and thus were on the hook if Korea did spiral downward. Same with LTCM’s creditors (who became LTCM’s owners after the recapitalization).
Big losses on Russia were covered under country risk at my bank, so was not considered to reflect either market risk or counterparty risk. So even though the IB lost a sizable amount on Russia (but much less than it would have under LTCM…), it didn’t have any impact on market risk taking. You may think that’s silly, but I don’t think we were the only bank with that kind of “accounting”.
I agree there’s a big difference between a bail-in and a bail-out, just that it’s not relevant to the point at hand: whether intervention by the Fed in the case of LTCM contributed to LTCM not going to bust. I think it pretty clearly did.
Bear Stearns was a hybrid. The Fed funded some assets. But JP Morgan took on the bulk of the institution and was itself essential to avoiding the systemic risk meltdown alternative. JPM was the bail-in component in this sense – very similar to the LTCM operation. And there’s lot’s of conjecture that JPM itself would have been severely damaged by a Bear failure.
The NYFed knew in advance that this time they could not do what they did in 1998. Geithner gave a speech in Sept. 2006 in Hong Kong that essentially said that. Things so entangled and complicated no way to get the main players in a single room to work it all out.
I agree that the real “bailout” was the interest rate cuts following the crisis. Shiller’s Irrational Exuberance 2nd edn argues that the housing bubble started in 1998, and it is quite likely that this rate cut was the initial trigger, or “displacement” to use Minsky-Kindleberger language, that set it off and running. This looks more important than the moral hazard arguments claimed by Cowen.
anon2 — fair points. I agree that absent Fed intervention (moral suasion in this case, not cash … ), it is likely that LTCM would have failed in a disorderly way. Barring a sale to Buffet …
Barkley — the rate cut was also directed at getting funds flowing to EMs, not just the’ street. All that Latins were begging for rate cuts then … this isn’t to say that the rate cut was a good idea, only that there was an international component that an argument that draws a straight line from the post LTCM rate cuts to the .com bubble to the post .com rate cuts to the housing bubble seems to leave out. At the time the theorized exit from the IMF/ Treasury’s lending to emerging economies was a resumption of private capital flows to those economies, not adjustment that created semi-permanent current account surpluses in many EMs.
I don’t get the rate cut commentary re LTCM.
The Fed effective rate was the same at the end of 99 as it was at the beginning of 98, and then it went up. Rates plummeted in 2001, but this had nothing to do with LTCM.
Here’s the monthly Fed effective time series:
01/1998, 5.56
02/1998, 5.51
03/1998, 5.49
04/1998, 5.45
05/1998, 5.49
06/1998, 5.56
07/1998, 5.54
08/1998, 5.55
09/1998, 5.51
10/1998, 5.07
11/1998, 4.83
12/1998, 4.68
01/1999, 4.63
02/1999, 4.76
03/1999, 4.81
04/1999, 4.74
05/1999, 4.74
06/1999, 4.76
07/1999, 4.99
08/1999, 5.07
09/1999, 5.22
10/1999, 5.20
11/1999, 5.42
12/1999, 5.30
01/2000, 5.45
02/2000, 5.73
03/2000, 5.85
04/2000, 6.02
05/2000, 6.27
06/2000, 6.53
07/2000, 6.54
08/2000, 6.50
09/2000, 6.52
10/2000, 6.51
11/2000, 6.51
12/2000, 6.40
01/2001, 5.98
02/2001, 5.49
03/2001, 5.31
04/2001, 4.80
05/2001, 4.21
06/2001, 3.97
07/2001, 3.77
08/2001, 3.65
09/2001, 3.07
10/2001, 2.49
11/2001, 2.09
12/2001, 1.82
p.s. by early 00 fed funds were back above 6 — more than reversing the post LTCM cuts. So I am not sure that you can draw a direct link to the post LTCM cuts and the housing bubble. Presumably the 00 hikes should have also had an impact …
I would put a lot more emphasis on the post .com cuts — and the broader fall in long-term rates during this period. Home prices didn’t fall during the downturn, which meant that losses on a host of newish, risky mortgage “products” (including subprime) were less than expected. And a a result lending against housing looked better and better — as it seemed like lending v housing collateral was a good bet. There wasn’t a lot of history with some of these products, and they survived their first stress test a bit too well — which meant that everyone piled in the next time.
Corporate lending to emerging economies incidentally had a lot of similar features. Argentine firms performed better in 01 than the government of argentina (higher recovery values in default) even though corp credit was carried a spread over gov bonds for historical/ institutional reasons. The result was that a lot of banks concluded that you could make money lending to EM firms and shorting the government debt and picking up the spread. That kind of portfolio backtested well …
and of course this time around the turkeys will be housing lending as home prices fell and losses were large, and likely EM corporate lending … at least in some places.
Brad: “…I am not sure that you can draw a direct link to the post LTCM cuts and the housing bubble.”
There’s a simple link among all these crises. When supply of money to the economy is choked off, economic activity comes to a standstill and crises result. This facilitates those with influence to consolidate their ownership. Think Baron Rothschild and his family.
@anon:
Why is it so complicated to understand?
Step 1: Higher and higher interest rates
Step 2: Oil/commodity price shock
Step 3: ‘Bubble bursts’: Here you have to understand correctly. Whatever be the dominant eco activity, whether it’s internet stocks, LTCM trading, Housing, etc … it will get renamed as a bubble and it will ‘burst’.
Step4: Interest rate cuts.
Step 5: Re expansion of credit, this time the winners will be those who really control the money.
@Brad:
Here’s an interesting thought to start your new year with:
You imagine that you are a free individual in a free society. In reality, you are actually a serf! You have to spend something like 12 hours of your day working on something or other that pays you enough for a house mortgage and a car; and you have to do that for around 30-40 years to finally own the house and the car.
Casting your vote doesn’t make you free because the next morning you have to be back at your desk again.
The real reason you are a serf is that the things you produce with your skills aren’t owned by you. They are owned by the international bankers and their stooge pigeons. If people had been free to own the things they produce then with ever better technology they would have achieved wealth and leisure within a short span of time and then been financially free.
Of course fascism and socialism are higher forms of serfdom where even the narrow freedoms in a capitalist/democratic society aren’t available.
I am a Hindu Brahmin priest by birth and my forefathers invented the methods to domesticate human beings like animals and use them for their benefit in prehistoric times.
The human race consists of a population of domesticated human animals who work as serfs for their Lords. This is as true today as it was at any time in history or prehistory, with marginal and narrow changes in degrees of freedom.
Forget moral hazard. Your post assumes that you do not believe in free markets, that you do not trust market participants to distingush between illiquidity & insolvency.
The Fed’s priming the pump in 1998 was intergral to the Dotcom bubble. Investment demand would have increased interest rates to moderate the boom…if we had market determined rates rather than Fed-determined rates.
With the government having intervened to sew the Dragon’s teeth of credit bubbles, you seem to be saying it must intervene again to fix it. Just keep on distorting the market till it comes out right?
bsetser: Given all the scale of this year’s crisis, I certainly cannot rule out the possibility that Dr. Cowen is right and we would all be better off now if we had had a deeper crisis in 1998.
I think you underestimate the power of human greed and institutional amnesia. Suppose you had a deeper crisis in 1998. I really don’t see how this would have prevented people from behaving in silly ways in 2008.
Ten years is more than enough time to forget the lessons from the last crisis. Did losing money from the dot-com crash keep people from paying real estate?
One thing here is that institutions don’t learn lessons. Individual people learn lessons, and if you set up the incentives in the wrong way, the lesson becomes “I don’t care what happened in 1998, I care about my bonus and not getting fired now.”
The mistake here is assuming that you can get read of human greed and stupidity. You can’t. The trick is 1) setting up the system so that stupid and greedy humans don’t end the world when things blow up and 2) setting things up so that people who aren’t stupid and greedy don’t get burned when things fall apart.
The later is particularly important because if you set the system up so that mistakes and bad behavior on the part of others burn you, you might actually end up teaching the lesson that the mistake was to have behaved prudently but rather not to participate in the bad behavior.
People talk so much about “moral hazard” that they are forgetting about “collateral damage.” Most of the people that are getting hit by the recession are people that have nothing to do with the bad behavior of banks or mortgages. Letting financial institutions fail left and right will just create a system of constant financial misery as someone else blows up right when you recover from the last blow up.
Let’s get serious. The government was just not going to let “Freddie/Fannie” go under or else let the mega-banks go under. If the choice is do a bailout versus destroying the world, it’s silly to think that the government will not do the bailout, and the only way that the government can do convince people otherwise is to be constantly destroying the world.
Rather than talk about this “moral hazard” non-sense, I think it is better to start with the premise that the government *WILL* do a bailout if the alternative is letting the world self-destruct, and the design a regulatory system that starts with this as an assumption.
“Did losing money from the dot-com crash keep people from paying real estate?”
The wrong people lost money in the dot-com crash. The IBs made enormous sums in the run-up, and didn’t lose much in the subsequent crash – they made *less*, but no counterparties went under, and nothing had to change in their business model. A blow-up in LTCM would have changed their business model.
“I think it is better to start with the premise that the government *WILL* do a bailout…” Exactly what the IBs assumed these past 10 years. Exactly, exactly, exactly. You couldn’t win an argument in an IB that maybe the bank should prepare for a major counterparty going under; the counterargument was always, “But the Fed/government will step in.”
“..nothing had to change in their business model…” I mean here, nothing had to change in their business model for activities involving market- or counterpart-risk. The part of the business which involved analysts pushing new stocks, was of course changed. But that was a *separate* part of the business.
@anon:
The fed/govt doesn’t step in to save everybody.Only friends. Besides triggering a major financial tsunami like the credit crisis of 2008 involves some self sacrifice as well. That means only *close* friends.
Anon2: A blow-up in LTCM would have changed their business model.
I’m more skeptical. If you look closely at the investment banks, each focused on different things and had slightly different business models. As long as one had a bad business model, then you still would have ended up with a crisis.
Anon2: ” Exactly what the IBs assumed these past 10 years. Exactly, exactly, exactly. You couldn’t win an argument in an IB that maybe the bank should prepare for a major counterparty going under; the counterargument was always, “But the Fed/government will step in.”
And in the end with the exception of Lehman, they were right, weren’t they?
And given the experience of Lehman, I think one could argue that if the same thing happened again, the government would be far more likely to step in than to let things fall apart.
I think the focus shouldn’t be to assume that there would be a bailout (since I can’t think of any credible way of doing that) than to assume that there will be, and then develop the system based on that premise.
The logic should be “well since we the government are going to have to bail you out if you get into trouble, we are going to make damned sure that you aren’t going to get into trouble.”
@Twofish:
Can you please look up the owners of the investment bank you work in? It should give you a nice clue as to whether it will go bust or get saved. Most of the hedge funds etc will continue to go bust.
By any chance do you know who all are recipients of financing from the Fed’s new credit crisis response lending programs?
Nifty, the Indian National Stock Exchange Index of 50 stocks, is likely to make a move upwards or downwards this January. I’d be happy if any expert economists could provide a view on how long it could take a stock market to recover after the direction of an economic trend changes.
[...] Relitigating 1998 at the end of 2008 [...]
“And in the end with the exception of Lehman, they were right, weren’t they?”
Exactly! The Fed, by saving LTCM (and by other actions in the face of financial crises), made it clear to financial players that it will save the major institutions. So financial players have never worried about systemic risk. They’ve traded options and CDSs and CDOs and the whole alphabet soup, and have booked products mark-to-market, taking out huge amounts of p&l, without setting aside proper reserves for systemic risk, because it’s not their problem. That inevitably led to huge increases in systemic risk, because it was free. The risks at my firm easily multiplied by 20 if not more from 1998 to 2008. What happened at yours?
Saving LTCM was a mistake and led directly to the end-of-the-world scenarios the financial world faced this past year.
“And given the experience of Lehman, I think one could argue that if the same thing happened again, the government would be far more likely to step in than to let things fall apart.”
Maybe, but that’s not what clients believe. There are just very few clients out there today willing to buy a 10-year product from any major bank, because they are unsure that the bank will be there in a decade. This is putting a squeeze on p&l and the books will be getting smaller. This is a good thing – it’s what should have happened as an aftereffect of the LTCM crisis. Nonetheless, this salutary process has been (IMHO, reasonable people can differ) more than counteracted by the Fed’s encouragement of bigger banks (BOA + Merrill, etc.) and the increase in the Fed’s own balance sheet.
The “bail-in” of LTCM involved the Fed encouraging its creditors to collude in a way that I think would otherwise be illegal. Market competitors are not allowed to talk to each other that way.
Certainly not with everyone else excluded.
If the discussions had taken place in broad daylight, confidence in the proportionality of actions might have been enhanced. Or not even then. Short sellers are entitled to fair treatment too.
This did set a precedent that the Fed can step in and pick winners and losers. The winners have been fairly predictable, and they continue to receive Fed help. (They have failed in spite of it, but most of them are still in business anyway, because of that aid and additional special assistance from the Treasury.)
So, is it OK for the Fed to favor some market participants consistently over others? This is the basic question; the answer to this will imply the answer to most others.
a system that relies on pain versus risk to enforce stability will occasionally be up against the boundary of stability.
that’s the fundamental point here. it’s not where the boundary is.
if you don’t allow intervention you will still be up against that bound. the bound will be at a lower $ notional, but it will cause the same problems. without intervention you will not be able to move the bound.
Babar — Good point.
World Dev. LTCM was in no sense close to the Treasury. The Treasury actually had a lot closer contact with the “Russian reformers” than it did with LTCM. LTCM was in its own world.
2fish:
“I think the focus shouldn’t be to assume that there would be a bailout (since I can’t think of any credible way of doing that) than to assume that there will be, and then develop the system based on that premise.
The logic should be “well since we the government are going to have to bail you out if you get into trouble, we are going to make damned sure that you aren’t going to get into trouble.””
I agree. I more or less came to the same conclusion when working on EM bailouts. Claims that you weren’t going to do bailouts in the future so didn’t need to prepare for them weren’t credible (This is my main critique of John Taylor’s framework for managing crisis — see Bailouts and Bail-ins. And I would note that the bush admin hasn’t stuck with its “no big imf loans/ stick to normal access limits” in the current crisis, just as it didn’t stick to them in Argentina/ Brazil/ Uruguay/ Turkey). The pain/ collateral damage was considered too great — as some illiquid but solvent countries would go down.
we are left with a world where there will be bailouts. And thus we have to regulate accordingly.
Anon2 — I take the point you raised about the difficulty convincing any bank to take counterparty risk serious very seriously — despite my support for 2fish.
It seems to me that one of the core failures of the past ten years was that the government was counting on markets to discipline big players (in part b/c of the difficulty the government faces regulating complex institutions; in part b/c of ideology). And key players in the market were assuming that there was no point in worrying about the health of big player b/c the government would step in and thus there was no risk holding their s-term paper/ accepting a big bank as a long-term counter-party/ etc. The result was that there wasn’t market discipline in any meaningful sense — even as a lot of players really really geared up to keep profits up as spreads fell.
that was a huge problem.
it also is relevant for a host of other current policy debates. folks like calomoris want to rely more on market discipline instead of regulation by forcing the banks to do things like issue more subordinated debt. but it always seemed to me that this would only work if there was a credible threat that a big bank would be shut down and holders of subordinated debt would take losses. And with the government doing recaps of the biggest institutions through preferreds that dilute common rather than closing a bank and taking it over, that threat doesn’t seem to be there.
bottom line: the government thought the market would discipline big leveraged institutions, and the market though the government would always bailout big leveraged institutions do there was no need for discipline. The result was an unholy mess.
But at this stage (and for that matter even before) I don’t think saying we won’t bailout big institutions in the future is a credible solution to the problem.
I believe LTCM mattered, but not in these conspiracy theories about friends of the establishment. The Fed cut during the Russia/LTCM crisis because they like to be liked. You might even go further back for the explanation, to the “irrational exuberance” episode. Even for such an innocuous comment, Greenspan got vilified in the more popular financial media, whereas when he spoke of a “new paradigm” he was lauded as a maestro. The truth is that investors in general share responsibility for the succession of bubbles.
And, for similar reasons, I do not believe that regulation is the answer. As long as caution is delegated to a minority, some of the gamblers will find loopholes. By contrast, busts engender widespread caution, and frequent, modest busts are probably optimal.
This is why I believe that the moral hazard that built up was cultural.
Anon2: They’ve traded options and CDSs and CDOs and the whole alphabet soup, and have booked products mark-to-market, taking out huge amounts of p&l, without setting aside proper reserves for systemic risk, because it’s not their problem. That inevitably led to huge increases in systemic risk, because it was free. The risks at my firm easily multiplied by 20 if not more from 1998 to 2008. What happened at yours?
I can’t talk about what happened at my firm, but I can talk in general about financial markets.
Risks at some firms were kept under control, because 1) the Fed was looking over their shoulder and 2) some CEO’s were just more competent and risk-sensitive than others. As far which firms did things right and which one’s didn’t, I can’t tell you and I don’t have to. Just open up the Wall Street Journal and pull up Bloomberg to see how everyone is doing.
However, it might not help much if you get fired. The economic downturn is hitting both saints and sinners and even the firms that did things right are having massive layoffs.
This might end up teaching the wrong lessons. If you are a trader at a firm that did everything right, you made less money in the boom times, and now when things go bust you are in the streets just like everyone else. Something that does cross your mind if you get into this situation is that you were an idiot for doing things the right way and should have been part of the party.
bsetser: . And key players in the market were assuming that there was no point in worrying about the health of big player b/c the government would step in and thus there was no risk holding their s-term paper/ accepting a big bank as a long-term counter-party/ etc. The result was that there wasn’t market discipline in any meaningful sense — even as a lot of players really really geared up to keep profits up as spreads fell.
The problem here is that people are thinking about markets and firms as big abstract entities. Ultimately, the people doing things don’t care about the health of the economy or the health of the firm. They care about “what is my bonus”, “what will get me promoted”, “what will get me fired.”
Looking back, one big problem was a big change in the way that investment banks were structured in the 1990’s. Before the 1990’s, they were most partnerships in which the partners had unlimited liability for losses of the firm. In the 1990’s, they got changed into joint-stock corporations. This meant there was no one in the firm that would get personally hit if the firm went down. (And this was the second major change, the first occurred around the 1960’s, when the firms stopped being family run businesses. It wasn’t so long ago that Lehman Brothers was run by brothers named Lehman.)
So what happened was that the rational thing to do was to boost risk, since you made more money if things went well, but if things went badly, the worst that could happen is that you get fired. The bonus system meant that these skewed rewards went all of the way down the line. It also meant there was huge pressure to cater to the front office, and if risk management brought up a problem, it was ignored because risk wasn’t where the money was being made.
Right now people are figuring out ways of changing the compensation system including things like clawbacks. It really is a hard problem. If you reduce bonuses, then you have to boost salaries to keep people, and that means that you then can’t adjust compensation to reflect market conditions.
RebelEconomist: And, for similar reasons, I do not believe that regulation is the answer. As long as caution is delegated to a minority, some of the gamblers will find loopholes.
Sure people will find loopholes, but the fact that someone might squeeze in a tiny loophole doesn’t mean that you should leave the barn door open.
The reason I think that regulation *is* the answer is that it worked. You look at the entities that were regulated by someone that cared (IB’s associated with mega-banks which were overseen by the FBNY) and those that weren’t (mortgage brokers), and you see a huge difference how the faired.
Quinn: The “bail-in” of LTCM involved the Fed encouraging its creditors to collude in a way that I think would otherwise be illegal. Market competitors are not allowed to talk to each other that way.
And they don’t. One thing that surprises people about Wall Street is how seriously people take financial regulation. There are rules that certain people aren’t allowed to talk to each other without a “chaperone” in the room, and they don’t.
One important function of the FBNY during LTCM, Bear-Stearns, and Lehman, is that it allows some conversations to take place that otherwise could not take place. The CEO’s of the major banks simply will not and cannot meet to coordinate action without a government regulator and lots of lawyers present.
Quinn: If the discussions had taken place in broad daylight, confidence in the proportionality of actions might have been enhanced.
If you have reporters in the room then the conversation just wouldn’t take place. At some point during these crises, someone from the Fed and Treasury got people in a room and basically said “All right, tell me what the hell is going on here.” If you have a reporter taking notes than everyone will shut up.
To World Development:
I think you are wrong that this all some great big plan. As far as I can tell, the people that are running things are as confused and scared as everyone else is.
In some ways, I’d be less worried if there was some master plan. There isn’t.
“Scam of the Century” => Dollar and USA Treasury.
Brad, I was wondering if you had seen this post by Yves Smith at nakedcapitalism (citing a Michael Pettis post) on the eventuality of a trade war based on the fact that most countries with their economic stimulus plans and search for sources of demand are in effect restoring their previous unsustainable domestic consumption and external trade deficit/surplus levels even though most parties accept tacitly the need for change. For example, China’s support of it’s export industry, the U.S. trying to stimulate demand, etc.
http://www.nakedcapitalism.com/2008/12/groundwork-for-trade-conflict-being.html
When one speaks of “ending moral hazard,” one must put a time value on that action. This is often ignored – as time effects often are. A simple question follows: how long would the effect last and thus how would one weight LTCM or Russia and their potential moral hazard effects on events today? Would one discount by 40%? 60%? 95%? I have not compiled the relevant facts but a casual glance at history suggests that moral hazard effects are completely gone in 20-25 years, which implies a significant time value factor.
To take a relevant example other than those cited above, people went to jail and many lenders went completely under – many times the number today – because of S&L lending issues and yet the effects wore off within 20 years. In other words, any conforming effect on behavior by individuals and institutions did not last.
So for example we might hoist Secretary Paulson from a lamppost and think that matters but the time effect is significant.
As a note, if you look at time effect that roughly controls for ancillary issues such as odds of getting caught, of getting punished, of litigation costs, etc. But only roughly.
jonathan,
How long moral hazard lasts is a fascinating question, which I think should be a vital issue for central banks. My own view is that it lasts much longer than you suggest. I suspect that the bust we have just seen represents the end of a cycle that last peaked in the Wall Street Crash – ie about two generations in length.
@Twofish:
The Fed hasn’t revealed information on recipients of the newly extended credit (~ $ 2 Trillion), and details of the collateral received. Purchase of equity stakes by the Treasury has clearly been quite selective.
This leaves out the guarantee details.
Obviously it’s a selective bailout.
The crisis will result in the dominant cartel consoldiating its control and ownership of American businesses.
Brad,
I agree with you that the Fed’s actions vis a vis LTCM were neither a bailout, nor inappropriate. In fact, the Fed’s conduct in that instance is a pretty reasonable example one of its responsibilities as originally conceived, i.e. to use its institutional powers of suasion to facilitate ‘gentlemanly’ deals. I furthermore agree that looking at LTCM in isolation is silly- the excesses at that time, from the fledgling securitization/mortgage debt and speculator bubbles to the full fledged equity and emerging market bubbles, were all conspiring to that moment. What happened to LTCM was not the case of a single leveraged speculator heading for bankruptcy, as was, say, Amaranth, but rather of system excess coming home to roost for a whole host of characters, LTCM merely chief among them, (albeit excess a few orders of magnitude less to that which prevailed before this crisis).
And that is why I have difficulty with the broader gist of your post. You say, “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”. But that recovery wasn’t remotely happenstance- it was policy. LTCM, and lets not forget huge chunks of the rest of Wall Street in the form of myriad prop desks and hedge funds that were in the same trades (as LTCM principals contemporaneously lamented), was short liquidity and long credit while the Fed was lowering interest rates and Freddie and Fannie, with the encouragement of the Greenspan Fed, was using its US government-esque cost of capital to balloon their balance sheets to the tune of 30% in 1998, and 23% in 1999, (as the policy response to the crisis came late in 98, much of the necessarily ‘reliquification’ fell to the following year), underpinning critical debt instrument prices with six hundred some odd billion of purchases, no drop in the bucket back then (I recently heard a quote from a GSE executive which explicitly implied that the agencies understood one of their obligations to buy mortgages during times of duress). The latter factor is still to this day, remarkably given all that has happened and the role they continue to play as life support for the mortgage and credit markets, vastly underappreciated. In other words, Wall Street and the leveraged speculating community was in effect directly subsidized by the federal government, even if that subsidy had nothing to do with the meeting of the heads of the five some odd families in New York in September 1998.
It also is probably fair to say that a focus on 1998 in isolation is off the mark, (though for a number of reasons I tend to view that episode as something of a point of no return). Both the S&L crisis, and bond market crisis of 1994 saw much the same policy response, with the GSE’s expanding their balance sheets 15% in the latter case. All of which points up that what we are really talking about is the fruition of an extended period of policy making underpinned by a single philosophy, ironically in some contexts referred to as a ‘risk management’ approach, whereby counter-cyclical policy (both monetary and fiscal) is affected with overwhelming force on the downside while nothing is done on the upside. As Jeremy Grantham has pointed out, that is a working definition of moral hazard. It’s difficult to understand how the intelligent people that masterminded all this never recognized as much.
I’d be interested to hear the extent to which you disagree with all of that, as I find it very persuasive.
PS in other news, 1+8 != 9
In Cowen’s favor though, I just came across this is from a 2001 BIS assessment of the LTCM rescue:
which, of course, would not have been good considering the scale of risks the B/Ds were about to pile on, and the dependency of those positions on the shadow banking system’s access to credit on tap in the repo, bond and money markets. That is a pretty strong argument against the against the ‘bail-in’, however, had the Fed organized the creditors meeting and pressed its moral suasion without bailing out the speculating community with the other hand, I continue to believe the market would’ve got the right message from the sum total of policy responses.
Brad,
Interesting post. I am a bit disturbed that you are comparing bailouts of nations and hedge funds as if they are in some way equivalent.
There are much bigger humanitarian issues involved in decisions of whether to bailout nations (usually poor, third world).
As is clear from the comments, moral hazard is really tricky and possibly unavoidable. The only reasonable solution is to strictly firewall banks and regulated financial institutions and impose dramatic caps on compensation within these firms. Hedge fund speculators can do what they want, but we need to ensure that banks are not exposed to these entities via leveraged lending.
I suspect that under these conditions the hedge fund/private equity industries will dramatically shrink. This is as it should be. It is rather obscene when 33% of all corporate profits come from the useless sectors of real estate and finance, as it did in 2005-2006.
[...] Setser is not entirely sure this is the case. “If LTCM had failed, I suspect that policy makers would have stepped in to prevent any major [...]
observor — hedge funds and poor countries can be similar in one respect: they both borrow money from the same set of folks, and consequently actions that help poor countries repay their debts risk rewarding bad credit decisions, just as actions to help a troubled hedge fund avoid a disorderly default help its creditors and arguably reward bad credit decisions.
Majorajam — interesting comment/ thanks for digging up the BIS study. A few points in response:
a) If I am right and LTCM’s failure would have been followed by a set of measures to stabilize the b/ds/ bigger rate cuts/ more freddie and fannie securitization (the whole shebang) then I am not sure that letting LTCM fail would in the end have disciplined the b/ds and systemically important institutions. The key question is whether their creditors would have become less willing to lend them money, and on that I am not sure. Or rather I suspect that getting that outcome would have taken more than letting LTCM fail.
b) I agree that the assymetric policy response to financial excess (no restraints on the way up b/c there is no way of knowing what is a bubble/ all hands on deck to limit the fallout if things go wrong) is a problem. And I fully support efforts to use regulatory policy to reign in excesses. I don’t think it is credible to assume that the government will allow big institutions to fail, and I think that has to be reflected in how we regulate said institutions. market discipline won’t work in that context. I think that is one of many things that we have learned.
c) I agree that Freddie and Fannie have been used as tools of countercyclical policy (or at least as tools to try to limit downturns). that was long seen as one of the strengths of the US system: if the banks were in trouble, capital market players could step in and vice versa. It just turned out this time that the banks had become capital market players/ there was no healthy balance sheet left in the system …
that said, Freddie and Fannie were reigned in a bit in 04, 05 and 06 as a result of the accounting scandals and thus were scaling back during much of the housing boom (i.e. they weren’t fueling the boom). they started up again in 06/ 07 if memory serves. And then in late 07/ the first part of 08 they grew their balance sheet like gangbusters in an attempt to offset the fall in private securitization/ keep credit to the households flowing. That was one reason why there wasn’t a sharper downturn in late 08/ early 08. It also though seems to have only deferred a bigger crisis.
d) i am curious how far you would have gone in 98 in terms of not bailing out the speculative community.
speculative bets on russia ($10-20b or so, ballpark, in direct foreign exposure GKOs if memory serves plus a decent amount exposure — say $30-50b in exposure to Russia’s longer-term $ bonds/ soviet era $ loans) clearly were not bailed out. that wasn’t enough.
LTCM wasn’t bailed out with federal $. Though there was an effort to coordinate creditors (reasonably in my view/ no risk was assumed by the feds) and macro policy was loosened to try to avoid a broader slump (arguably set a bad precedent, as macro policy wasn’t tightened in the face of the speculative excesses of the post-Mexico EM/ US stock boom but was loosened as insurance against a bust)
But what about Brazil? Should it have gotten bailed out then? Absent a big chunk of IMF and G-10 support, a disorderly exit from its $ peg that produced Asian style distress in its banks and firms (meaning losses for all those who lent to them) was possible, and the government’s finances were a bit shaky so losses on speculative bets on brazil were also possible. Would you have stopped at LTCM or also let Brazil go down?
And if LTCM’s failure had say led to big trouble at one of the broker-dealers (say LEH — which was a smaller firm at the time), would you have bailed it out or let it fail?
And if it fails, what would you have done if there was a broader run on all the b/ds a la 08/ a full withdrawal of all credit to all EMs?
My argument was that it is hard to draw the line in practice. Runs are real – and can be disruptive. THat is why i am in the end willing to risk moral hazard with some intervention on the condition that the associated risk is offset by regulation.
In retrospect the biggest failure — apart from not recognizing a housing bubble and trying to limit the financial system’s exposure to it whether by more monetary tightening or tighter regulation — was a failure to recognize that a lot of big players in the financial system were not borrowing on the basis of their own financial strength but rather borrowing on the basis of the assumption that they were too big to fail, and as a result the large profits made possible in good times by high levels of leverage ultimately should have belonged to the taxpayer who was backstopping the risk/ allowing the leverage …
Brad,
I don’t disagree with a). My point was probably more the reverse, that the bail-in of LTCM by moral suasion was appropriate, while the broader bailout was not. More on that in answer to d).
As regards b), the bailout that followed, I don’t doubt that letting the financial markets implode, or even marginally risking this, was not politically feasible. However I assume we are interested in more than just the feasible, but also the optimal, (and while we are likely to be 100% in agreement as to what is most appropriate of what is feasible, i.e. mass bailout and mass regulation, I don’t have confidence those policies will be successful).
One thing I certainly do disagree as regards b) is that it is impossible to perceive a bubble contemporaneously. GMO’s asset allocation guys have quite reasonably quantified a definition- one standard deviation around a sound historical measure of value- subject to regime change- (Tobin’s Q, cyclically adjusted price multiples, median home price to median income, etc.), and in any case, like obscenity, it is somewhat the case that ‘you know it when you see it’. Be that as it may, the fuel for a bubble, wayward underwriting practices, are far less difficult to spot (80’s commercial real estate terms, 90s corporate and investment leverage, this decades residential mortgage and other consumer credit abuses, etc. etc.). So I do not for a second sympathize with the defense that counter-cyclical policy cannot be implemented on the upside. And if I did sympathize, I would also believe that the implication of that assertion is that there can be no counter-cyclical policy full stop, something I am unwilling to fully concede as yet. As you can probably tell, anything remotely sounding like Greenspan rhetoric gets my blood up.
On c) I don’t disagree with what you’ve written, though again, I don’t see that these uninterrupted expansions punctuated by crises that lead to still greater crises are likely to be redeemed by virtue of the former. More on this in d). And I do think Fannie and Freddie were entirely critical ingredients on delivering us to the doorstep of oblivion, but in no way is that opinion consistent with some of the politically expedient but factually laughable spin that has been spawned to affix the blame for this crisis to ‘government’ and ‘Democrats’, (this also means I don’t think the Community Reinvestment Act has anything to do with subprime, in fact I’m pretty confident on that point, nor really do Freddie and Fannie, though they have some). No, my opinion stems from the fact that these guys were effectively spending federal tax dollars all along without anything like Congressional oversight or approval, (there is of course a regulator, but this is not the same thing), to bailout the plutocrats that were getting obscenely wealthy speculating in securities (of course, not expressly to that end, but what difference does it make?).
Why were they critical elements in the brewing of this crisis? Because, as we have seen vividly illustrated by the recent crisis, it takes more than buying treasuries with freshly minted reserves to resuscitate markets- it takes backstop bids by risk takers. When the market became risk averse in bouts of crisis, situations that can quickly spiral out of control into panics that are both self-fulfilling and self-sustaining. For 15 years, in these circumstances, Freddie and Fannie would come in- en mass relative to the then scale of trading volume in the mortgage and credit markets- and be that backstop where private functionaries couldn’t (as they weren’t real money investors and were up to their ears) or wouldn’t (as they lost confidence). All that happened during that time is that the financial house of cards they were instrumental in building became too much larger than the GSE’s ability to swamp them (though I agree with you that their activity during the latest crisis has kept us afloat, as I noted in my first post). As something I read recently went, institutions like Fannie and Freddie, (and Deutche and Fortis etc. etc.) went from being too big to fail, to being too big to save. It simply isn’t easy for a country to organize a bail-out for an institution whose assets are close on 100% of GDP or greater in the case of Fortis, (or much greater in the case of the Icelandic banks).
Which after too many words brings me to d). You asked how far I would’ve gone in 98, with respect to letting all hell break loose. Now, don’t get me wrong, I don’t underestimate the scale of the fallout from permitting emerging market defaults or permitting runs on the B/Ds (although my recollection was that the IMF did bail-out Russia, at least to some extent). In fact, I think the fallout from the S&L crisis alone, which was blunted substantially by the burgeoning bubbles in Wall Street finance, (noted I believe in the literature by comparison with Japan and with the wrong lessons learned), could have been dramatic, but obviously wasn’t.
However, the answer to your question is nothing short of all the way. And I will tell you why: because problems grow exponentially with time. I am in my mid-thirties now, with a nearly 15 year career in finance, that now seems moot. That human capital is patently wasted, and it is conceivable I will not be particularly useful to society again for some time. I may not even ever again be able to fully apply the fruits of my education (I’m still employed but let’s say with less than full confidence, and the point is academic- the industry will shrink massively). Now, of course, that will have been true in 1998, but the industry has mushroomed from there, and not just on Wall Street.
Moreover, here we are 20 years into a credit bubble, by which time generations of adults have never known what a sustainable US/global economy would look like. That cannot be a good thing. What exists now begins to resemble a museum exhibit, or Fatapur Sikri; a snapshot of a world in terminal decline. There are five million ways to spend money and a massive swath of the workforce dependent on wealthy consumers, and financing them, yet very little in the way of a workforce that build tradable goods, let alone one whose productivity justifies its relative consumption. And of course there is the mirror image of this in the surplus nations. The scale of those real costs over 20 some odd years has become near on inconceivable, and scary. And I simply don’t believe in a social rate of time preference that remotely justifies putting off these adjustments at the cost that procrastination bears.
Does that mean a crash is necessary to remedy the situation? I certainly think it’s possible. Dramatic circumstances are required to change people’s behavior. I would argue that the political will to regulate a booming marketplace in 1999 had as much chance politically as letting these companies to their own devices- and failure- perhaps less so. It is simply very difficult to get people to believe something when their wallet depends on their not understanding, and many people’s did for some time.
So that’s where I come out, and sorry for the length. On a related, but unrelated note, this is an absolutely brilliant column in case you missed it. This by the same author is good too…
[...] Setser is not entirely sure this is the case. “If LTCM had failed, I suspect that policy makers would have stepped in to prevent any major [...]
on b) just to be clear, i was trying to summarize the standard argument that bubbles are impossible to identify ex ante. I actually disagree with that view –or rather with the policy application of that view. it is perhaps impossible to identify a bubble with total confidence, but a bubble in key variables (homes for example) can do enough damage that it seems the costs of not acting and letting a bubble develop are higher than the costs of acting to try to limit the bubble with some risk of being wrong.
as for the broader point, i still would rather not have had a systemic crisis in 98 just to have avoided the 08 crisis by forcing leverage out of the system in a permanent way. we might have ended up in 08 (or 09 — which is shaping up as really really grim — with global output falls of the kind we haven’t seen in a long time). i do though think that the world lost sight of how close a call 98 was — and stopped worrying about risks.
incidentally (and see Krugman today on economists behaving badly) I was reluctant to articulate my concerns with the assymetric fed policy response in 04/05 (unlike say Roubini) b/c of the deference given to greenspan, and concern that i lacked the stature/ academic credibility to articulate successfully a contrary view. i was/ am more of an expert on bop issues/ capital flows than monetary policy, and the “monetary policy/ asset bubble” issue was the key debate in that field.
good luck holding on to your job too …
WD: The Fed hasn’t revealed information on recipients of the newly extended credit (~ $ 2 Trillion), and details of the collateral received.
It hasn’t, but I doubt that there are going to be much in way of surprises once the numbers come out.
There is one reason for this sort of secrecy, in that having a financial institution saying “I am getting money from the Fed” can often create a confidence crisis that leaves the institution worse off, which means that institutions don’t go to the Fed for money even when they need to.
WD: Purchase of equity stakes by the Treasury has clearly been quite selective.
This leaves out the guarantee details.
Obviously it’s a selective bailout.
Yes, but anyone in the industry can probably figure out who is getting money and how much. It’s very unlikely that the Fed would choose one investment bank over another investment bank because at this point all of the other investment banks would start screaming. The areas were there is bias would be industry based (i.e. IB’s versus hedge funds, finance versus autos), but those biases are fairly open.
WD: The crisis will result in the dominant cartel consoldiating its control and ownership of American businesses.
That’s not how the US economy and political system works. There is a “power elite” in the United States, but there is quite a bit of infighting within that power elite, and if one group gets too strong, the other groups start ganging up against it.
The way that economic policy is made in the United States isn’t hugely different from the way that it is made in China, largely because China copied key ideas from the United States, namely Glass-Stegall and the Banking Holding Act.
In particular the “financial elites” and “business elites” in the US and China are kept pretty separate from each other, which is very different from the structure that you see in Germany or Japan, where the banks either own the businesses (Germany) or the businesses own the banks (Japan).
Curiously a lot of the structure of US/China has been designed with the express purpose of keeping the business and financial elites separate so that they do not challenge the control of the political elite, whereas in Germany and Japan, a post WWII political vacuum allowed business and financial to gather much more power than they could in either the US or China.
Brad,
I think it was pretty clear from your writings that you were deeply concerned about the state of affairs, so I wouldn’t feel too badly. It’s not as though anyone looking for comfort would’ve found it in your stuff- quite the opposite. And I do understand your preference to keep your commentary in areas of your own expertise, largely by way of my vice for not doing so. Having said that, your instincts and insight are quite good, so perhaps the vice is yours. As to 1998, we’ll have to agree to disagree. My reading of things tells me the bailout, i.e. inflate, and regulate approach has problems (although I personally have benefited from it, at least this time around). It’s better than bailout and not regulate approach, but with significant drawbacks of its own. Norman Gall’s articulation of that argument is far better than my own, so I’ll link you to it. Plenty to chew on in there from this:
and his five recommendations were uncannily prescient:
Especially 2 and 5. He’s written a post-Bear pre-Lehman version, though I’ve yet to read it all. In any case, I’ve taken enough of your time. Thanks for the discussion.
The link to Gall broke. Here it is again: http://www.normangall.com/brazil_art6eng2.htm
Majorajam: The trouble with this idea, which some economists incorporated into development theory in the 1950s and 1960s, is that inflation creates powerful vested interests and institutional mechanisms of its own and, once unleashed, is very hard to control…
This is precisely what I’m worried about with respect to China. The problem with inflation is that once it is entrenched, you completely destroy the financial system and any ability to save, which is what has happened in Latin America and Russia. China and India have many differences but the one similarity is sensible inflation rates.
In the Chinese situation you have two lobbies, the “inflation hawks” in the People’s Bank of China and the “inflation doves” in the local officials, and the fighting between these two lobbies keeps Chinese policy in balance. Victor Shih has written a very brilliant book about the dynamic, but for reasons that I can’t quite understand, he considers it a bad thing that needs to be changed.
One thing about Chinese policy is that so much of the economy is dependent on savings that it is impossible for there to be massive inflation without the government being overthrown.
3. Eliminate offshore financial centers by international agreement, with the United States and Britain taking the lead in refusing to enforce contracts registered in these jurisdictions.
I’m not sure this will do anything useful. Pretty much all of the contracts that are done by offshore entities are actually registered in either London or New York. People register companies off-shore mainly for tax reasons and secondarily for privacy results, but very few contracts are actually registered off-shore.
One reason is that you want things to be opaque if you are registering a company, but if you want to enforce a contract, you want things to be extremely transparent.
4. Restrict sales and trading of derivatives to public futures exchanges where contracts are registered, records of large positions are kept and prices published under regulated capital-adequacy provisions.
Really tough to do considering that most sales and trading of non-derivatives are done over the counter.
5. Banks should not be allowed by regulators to supervise their own risk profile with “risk control” software, which can generate dangerous macroeconomic effects by failing to anticipate political and credit risk as well as random events.
Actually this works quite well if the bank regulator really is about to look at the internals of the software. If you have a regulator like the Fed that is willing to look at the software, mandate scenarios to be run, and then looks very skeptically at the results, it works really well.
If you have a regulator that just turns a blind eye like the SEC, then you have a problem.
Also, risk software doesn’t try to anticipate events. What you do with it is to use the software to crash test different scenarios.