Since they were leveraged, Long-Term Capital owed large amounts of fund to various banks and financial institutions.The Federal Reserve Bank of New York then, organized a consortium of companies to buy it and cover the debts. The shareholders suffered, but creditors were paid in full.
Tyler Cowen argues that this may seem like a good bailout - no money upfront from the government, creditors paid, financial crisis put off...
However this ad hoc intervention by the government send a wrong signal to everyone. In Tyler's words
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.
And no guesses for who the creditors were : Bear Stearns, Merrill Lynch and Lehman Brothers, among others. They went on to continue business in the same fashion : recklessly investing leveraged money. And 10 years later, we know the consequences of the 3 firms.
The seeds of this financial crisis were sowed in the 1998 bailout of Long-Term Capital Management hedge fund.
Tyler Cowen, then wonders what would have happened if there had been no bailout. We would have experienced a 'milder version of the downturn in 1998 than the more severe version of 10 years later.' However, minus the collapsed housing bubble, government's large fiscal deficit, and the far-reaching extents of the derivative markets.
In his words "A financial crisis related to Long-Term Capital, however painful, probably would have been easier to handle than the perfect storm of recent months. "
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