The Bull Market part 6
4.Was there moral hazard?
The simple answer is yes, since the bailout of LTCM gave comfort that the Fed will come in and broker a solution, even if it doesn't commit funds. The Fed's intervention also arguably tempted Meriwether not to accept the offer from Buffett, AIG and Goldman. The offer, heavily conditional though it was, shows that the LTCM portfolio had a perceived market value. A price might have been reached in negotiations between Buffett and Meriwether. Meriwether's argument [and the Fed's] is that Buffett's deadline of 1230 didn't give Meriwether time to consult with LTCM's investors: he was legally unable to accept the offer.
It is possible to argue that a market solution was found. Fourteen banks put up their own money, regarding it as a medium-term investment from which they expected to make a profit. From a value-preservation point of view it was an enlightened solution, even if it did seem to reward those whose recklessness had created the problem.
Federal Reserve chairman Alan Greenspan defended the Fed's action at the October 1 hearing in the House Committee on Banking and Financial Services as follows: "This agreement [by the rescuing banks] was not a government bailout, in that Federal Reserve funds were neither provided nor ever even suggested. Agreements were not forced upon unwilling market participants. Credits and counterparties calculated that LTCM and, accordingly, their claims, would be worth more over time if the liquidation of LTCM's portfolio was orderly as opposed to being subject to a fire sale. And with markets currently volatile and investors skittish, putting a special premium on the timely resoluton of LTCM's problems seemed entirely appropriate as a matter of public policy."
The true test of moral hazard is whether the Fed would be expected to intervene in the same way next time. Greenspan pointed to a unique set of circumstances which made an LTCM solution particularly pressing. It seems questionable whether the Fed would act as broker for another fund bailout unless there were also such wide systemic uncertainties.
5. Was there truly a systemic risk?
Since there was no global meltdown it is difficult to prove that there was a real danger of such a thing last September. But if the officers at the US Federal Reserve had waited to see what happened no-one would have thanked them after the event. In the judgment of this writer, the world financial system owes a lot to the prompt action of Greenspan, McDonough, Fisher and others at the Fed for their willingness to meet the problem fair and square. One shudders to think what the Bank of England (FSA) might have done, given its "constructive ambiguity" during the Barings crisis.
But the counter-argument is also valid. Those Wall Street firms, once they knew the size of the problem, had only one sensible course of action, to bankroll a co-ordinated rescue. They had the resources to prevent a meltdown and it took only a night and a day to pool them. Mutual self-interest concentrates the mind wonderfully.
It seems that in the developed world, since the early 1990s, financial firms have built up enough capital to meet most disasters the world can throw at them. Their mistakes in emerging markets were costly both for them and for the countries concerned, but they haven't threatened the life of the world financial system. It seems the mechanisms for restructuring and acquisition are so swift that the demise of a financial firm simply means it will be stripped of the trash and carved up. In a down-cycle, however, the outcome could be very different. Moreover, the social costs of this financial overreach, followed by cannibalism, could be considerable.
Systemic, no; ripe for concerted private and public intervention, yes.
On September 29, 1999, six days after the LTCM bailout, US Federal Reserve chairman Alan Greenspan cut Fed fund rates by 25 basis points to 5.25%. On October 15, 1999 he cut them by another quarter. His critics associate these cuts directly with the bail-out of LTCM: it was an extra dose of medicine to make sure the recovery worked. Some sources attribute the cut to rumours that another hedge fund was in trouble.
The more generous view is that, if the financial markets were in disarray, we ain't seen nothing yet. Bruce Jacobs, who has followed the systemic implications of the 1929, 1987 and subsequent mini-crashes, fearful of the dangers of globally traded derivatives, writes in a new book: "Had LTC not been bailed out, the immediate liquidation of its highly leveraged bond, equity, and derivatives positions may have had effects, particularly on the bond market, rivaling the effects on the equity market of the forced liquidations of insured stocks in 1987 and margined stocks in 1929. Given the links between LTC and investment and commercial banks, and between its positions in different asset markets and different countries' markets, the systemic risk much talked about in connection with the growth of derivatives markets may have become a reality." [Capital ideas and market realities, Blackwell, 1999, page 293] |
