Saturday, December 27, 2008

Long-Term's bailout: The roots of our present crisis

Everyone's heard of the Long Term Capital Management Fund. It was a regular hedge fund whose strengths were its 200 employees, many of them financial quants and quantitative analysts who took on highly leveraged, risky and unsound bets, and made huge billion dollar investments in interest rate derivatives. All was going well, but when Russia, in 1998, were unable to pay their debts, the fund's exotic investments brought their balance sheet in red, and their obligations multiplied.

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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1 comment:

  1. As i overhear continued discussions regarding TARP, bailouts, economic troubles and job losses, isn't it odd that simplicity is overlooked?

    If most agree that the housing debacle roots many problems, such as foreclosures, bad debt, loss of construction jobs-materials etc., and a defined stimulus program cannot be agreed upon and/or identified, why not implement the following:

    A 6 mo.deferment for all qualifying primary mortgages whereas, if the loan was issued within a predetermined "bubble time frame", primary homeowners could be eligible for a 6 month deferment.

    all prevailing rates and terms may be applied. 6 mos. would be added to the term of the loan.

    This would free up money, increase spending, create jobs, opportunities, and perhaps add hope to the struggling auto industry.

    hope and faith would be restored. Since the banks are getting $trillion or so, and aren't receiving monies from struggling homeowners, the "good paper" could be preserved while the bad debt could be relieved while we sort out this mess.


    Paying banks with tax holder money and throwing the American public out of there homes could prove to be disastrous.

    Stephen Berg
    West Palm beach, FL