Tuesday, September 23, 2008

Happy 10th Birthday, Wall Street Bailouts!

Today is a very special day! Today is the 10th birthday of the Wall Street bailouts. It was ten years ago today, on September 23, 1998, that the Federal Reserve bailed out Long Term Capital Management. MarketWatch takes us on our joyful 1998 flashback:
LTCM was a hedge fund run by former Salomon Brothers bond whiz John Meriwether and a half dozen other traders. They raised $1.01 billion in 1994 and ended up with derivative positions of about $1.25 trillion, built on leverage, when the bets turned bad and lenders started asking for their money in the summer of 1998.

LTCM was strapped for cash. So, rather than unwind its positions and send the market into turmoil, the Federal Reserve Board of New York organized a $3.75 billion bailout paid for by Wall Street banks. The cash allowed LTCM to meet its obligations as it unwound its trades.

Maybe it's because the numbers seem small by today's standards, but LTCM caused a lot of anxiety at the time. The day after the bailout was announced, the Dow Jones Industrial Average fell 2%, mostly because investors feared the banks would lose their investment. The fall was followed by another 3% drop two trading days later when investors worried the Fed didn't do enough.

Flash forward to 2008. ... You can't blame Rick Wagoner at General Motors or Glenn Tilton at UAL Corp. for passing the hat to Uncle Sam. These CEOs have seen what a little government intervention can do, whether it be banning naked short selling for a few bank stocks or propping up the entire mortgage banking industry with billions in backing.

The taboo against bailouts has been broken. Now the problem is that everyone is rushing the government at the same time. Wall Street firms ran up risk for a decade after the LTCM bailout precisely because there was a bailout.

The unwritten message, what the bankers call moral hazard, was simple: come a crisis, the government will do everything it can to avoid a collapse.
It makes a nice bedtime story, doesn't it?

The Fed chose not to worry about moral hazard then, because it felt the immediate problem was far more important than any increased financial risk-taking it might encourage in the future. Such short-term thinking only causes greater problems in the long run. The Federal Reserve and the U.S. Treasury are again making short-term decisions without any regard to the long-term consequences.

1 comment:

  1. Well deja vu. Isn´t this the same thing they are doing right now? With releasing billions of Dollars to cover for the brutal financial loss? The banks did this to quickly stabilize the market, but they forgot the most important thing, to lower the interest rates so people can actually get to the money and do something with it. This is just a fast patch that will not last long. Now I am a Canadian, so it doesn´t concern me directly, but I do feel fo rhe citizens of The US and fear that this trouble will more significantly influence our own economy, mainly with the incoming recession. I just hope for the better.