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Too Big to Fail?
                      Long-Term Capital Management and the
                                Federal Reserve
                                                     by Kevin Dowd


No. 52                                                                                               September 23, 1999


             In September 1998 the Federal Reserve orga-               The intervention also is having more serious
         nized a rescue of Long-Term Capital Manage-               long-term consequences: it encourages more
         ment, a very large and prominent hedge fund on            calls for the regulation of hedge-fund activity,
         the brink of failure. The Fed intervened because          which may drive such activity further offshore;
         it was concerned about possible dire conse-               it implies a major open-ended extension of
         quences for world financial markets if it allowed         Federal Reserve responsibilities, without any
         the hedge fund to fail.                                   congressional authorization; it implies a return
             The Fed’s intervention was misguided and              to the discredited doctrine that the Fed should
         unnecessary because LTCM would not have                   prevent the failure of large financial firms,
         failed anyway, and the Fed’s concerns about the           which encourages irresponsible risk taking; and
         effects of LTCM’s failure on financial markets            it undermines the moral authority of Fed poli-
         were exaggerated. In the short run the interven-          cymakers in their efforts to encourage their
         tion helped the shareholders and managers of              counterparts in other countries to persevere
         LTCM to get a better deal for themselves                  with the difficult process of economic liberaliza-
         than they would otherwise have obtained.                  tion.




         Kevin Dowd is professor of economics at the University of Sheffield and an adjunct scholar at the Cato Institute.
The management                      Introduction                               that aim to make profits for their sharehold-
   of LTCM made                                                                ers by trading securities. Hedge funds vary
                           In September 1998 the Federal Reserve               enormously but fall into two main classes.
    the firm much      organized a rescue of Long-Term Capital                 The first is macro funds, which take specula-
     riskier, in the   Management, a very prominent U.S. hedge                 tive (i.e., unhedged) positions in financial
                       fund on the brink of failure. The Fed inter-            markets on the basis of their analyses of
  hope of bolster-     vened because it was concerned about the                financial and macroeconomic conditions.
ing the returns to     possibility of dire consequences for world              They bet on exchange-rate devaluations,
     shareholders.     financial markets if it allowed the firm to fail.       changes in macroeconomic policies, interest-
                           The Fed’s rescue of LTCM was misguided.             rate movements, and so on. Macro funds are
                       The intervention was not necessary to pre-              thus “hedge” funds in name only. They make
                       vent the failure of LTCM. The firm would not            their profits from speculation, and their
                       have failed, and even if it had, there would            portfolios are often highly risky. Most macro
                       not have been the dire consequences that                hedge funds are also highly leveraged—that
                       Federal Reserve officials feared. Indeed, let-          is, the amounts invested in their portfolios,
                       ting LTCM fail might well have had a salu-              the firms’ assets, are much greater than their
                       tary effect on financial markets: it would              share capital, with investments in excess of
                       have sent a strong and convincing signal that           capital being financed by borrowing.
                       no financial firm—however big—could expect              Leverage increases the potential profits of
                       to be bailed out from the consequences of its           shareholders, but it also increases their risks:
                       own mismanagement.                                      the greater the leverage, the bigger the profit
                           The rescue of LTCM also has a number of             to shareholders if investments are successful
                       detrimental consequences. It encourages                 and the bigger the loss to shareholders if they
                       more calls for the regulation of hedge-fund             are not. A highly leveraged fund can therefore
                       activities, which would be pointless at best            make very high profits but also runs a rela-
                       and counterproductive at worst. The rescue              tively high risk of going bankrupt. Macro
                       also implies a massive and open-ended exten-            funds are highly leveraged relative to most
                       sion of Federal Reserve responsibilities, with-         other institutional investors and typically
                       out any congressional mandate. In addition,             have asset bases five to nine times greater
                       the rescue implies a return by the Federal              than their capital.1
                       Reserve to the discredited doctrine of “too                 The other main class of hedge funds is rel-
                       big to fail”—the belief that the Fed will rescue        ative-value, or arbitrage, funds. Those funds
                       big financial firms in difficulty—for fear of           use sophisticated models to detect arbitrage
                       the possible effects on financial markets of            opportunities—differences in the prices of
                       letting big firms fail. Too big to fail encour-         nearly equivalent securities or portfolios—in
                       ages irresponsible risk taking by financial             financial markets. Having detected such
                       firms, which makes them weaker and finan-               opportunities, those funds construct arbi-
                       cial markets more fragile. Finally, the rescue          trage trading strategies to profit: they buy
                       of LTCM does a lot of damage to the credi-              securities that are underpriced and sell those
                       bility and moral authority of Federal Reserve           that are overpriced, while simultaneously
                       policymakers in their efforts to encourage              taking offsetting positions to hedge against
                       their counterparts in other countries to per-           any risks involved and lock in their arbitrage
                       severe with the necessary but difficult process         profits. Financial-market arbitrage is a rela-
                       of economic liberalization.                             tively low-risk activity, so relative-value funds
                                                                               often operate with much higher leverage
                                                                               than do macro funds.2
                         What Are Hedge Funds?                                     In the United States, hedge funds with
                                                                               fewer than 100 shareholders are exempt from
                          Hedge funds are private investment funds             regulation under the Securities Act of 1933,



                                                                           2
the Securities Exchange Act of 1934, and the          notably economists Robert Merton and
Investment Company Act of 1940. Most U.S.             Myron Scholes, who received the Nobel Prize
hedge funds therefore restrict the number of          in economics in 1997. The fund initially spe-
their shareholders to fewer than 100.                 cialized in high-volume arbitrage trades in
Overseas hedge funds are also usually subject         bond and bond-derivatives markets but grad-
to little or no regulation, particularly those        ually became more active in other markets
operating from offshore centers, such as the          and more willing to speculate. The fund thus
Bahamas and the Cayman Islands. The                   started as an arbitrage fund but gradually
hedge-fund industry is thus largely unregu-           became more like a macro fund. LTCM was
lated.                                                very successful: by the end of 1997 it had
    Despite its growth in recent years, the           achieved annual rates of return of around 40
industry still is only a very small part of the       percent and had nearly tripled its investors’
overall institutional investment sector. A            money. That track record and the prestige of
recent International Monetary Fund report             its associates made LTCM very popular with
estimated that the total amount of capital            investors, and the companies and individuals
invested in hedge funds in the third quarter          investing in LTCM “read like a who’s who list
of 1997 was about $100 billion. By compari-           of high finance.”5 LTCM was the darling of
son, other institutional investors—pension            Wall Street.
                                                                                                          As its losses
funds, mutual funds, insurance companies,                 By that stage, it appears that the fund’s       mounted, the
banks, and so on—had a combined capital of            assets had grown to about $120 billion and          fund had increas-
well over $20 trillion.3 Hedge funds therefore        its capital to about $7.3 billion.6 However,
account for less than 0.5 percent of the total        despite that high leverage—an assets-to-equi-       ing difficulty
capital of the institutional investment sector.       ty ratio of over 16 to 1—the management of          meeting margin
    Nonetheless, hedge funds have received            LTCM concluded that the capital base was
considerable attention during the last                too high to earn the rate of return on capital
                                                                                                          calls.
decade, most particularly because of their            for which they were aiming. They therefore
role in a number of recent exchange-rate              returned $2.7 billion of capital to sharehold-
crises. Perhaps the best-known example is             ers, thus cutting the fund’s capital to $4.8 bil-
George Soros’s Quantum Fund, a macro                  lion and increasing its leverage ratio to
fund reputed to have made more than $1 bil-           around 25 to 1. In effect, the management of
lion at the British government’s expense by           LTCM had taken a major gamble: they made
betting against the pound in the European             the firm much riskier, in the hope of bolster-
exchange-rate crisis of September 1992.               ing the returns to shareholders.
Hedge funds have also figured prominently
in more recent crises, including those in             LTCM Gets into Difficulties
Latin America, the Far East, and Russia in the           Unfortunately, LTCM’s luck ran out not
last couple of years. The activities of hedge         long afterwards. Most markets were edgy
funds have led to major controversy over              during the first part of 1998, but market con-
their impact on the world financial system            ditions deteriorated sharply in the summer
and to calls from some quarters that hedge            and led to major losses for LTCM in July.
funds be regulated.4                                  Disaster then struck the next month, when
                                                      the Russian government devalued the ruble
                                                      and declared a moratorium on future debt
       The Story of LTCM                              repayments. Those events led to a major dete-
                                                      rioration in the creditworthiness of many
   Long-Term Capital Management was                   emerging-market bonds and corresponding
founded in March 1994 by John Meriwether,             large increases in the spreads between the
a former Salomon Brothers trading star,               prices of Western government and emerging-
along with a small group of associates, most          market bonds. Those developments were very



                                                  3
bad for LTCM because the fund had bet mas-                 observed LTCM’s deterioration with mount-
                       sively on those spreads’ narrowing. To make                ing concern. Many Wall Street firms had
                       matters worse, the fund sustained major loss-              large stakes in LTCM, and there was also
                       es on other speculative positions as well. As a            widespread concern about the potential
                       result, by the end of August LTCM’s capital                impact on financial markets if LTCM were to
                       was down to $2.3 billion and the fund had                  fail. The Fed felt obliged to intervene, and a
                       lost over half of the equity capital it had had            delegation from the New York Federal
                       at the start of the year. By that time, its asset          Reserve and the U.S. Treasury visited the
                       base was about $107 billion, so its leverage               fund on Sunday, September 20, to assess the
                       ratio had climbed to over 45 to 1—a very high              situation.10 At that meeting fund partners
                       ratio by any standards, but especially in that             persuaded the delegation that LTCM’s situa-
                       volatile environment.7                                     tion was not only bad but potentially much
                           As its losses mounted, the fund had                    worse than market participants imagined.
                       increasing difficulty meeting margin calls                 The Fed concluded that some form of sup-
                       and needed more collateral to ensure that it               port operation should be prepared—and pre-
                       could meet its obligations to counterparties.              pared very rapidly—to prevent LTCM’s fail-
                       The fund was running short of high-quality                 ure and to forestall what the Fed feared
                       assets for collateral to maintain its positions,           might otherwise be disastrous effects on
                       and it also had great difficulty liquidating its           financial markets.
                       positions: many of its positions were relative-                Accordingly, the New York Federal
                       ly illiquid (i.e., difficult to sell) even in normal       Reserve invited a number of the creditor
                       times and hence still more difficult to                    firms most involved to discuss a rescue pack-
                       sell—especially in a hurry—in nervous and                  age, and it was soon agreed that this Federal
                       declining markets.                                         Reserve–led consortium would mount a res-
                           The fund was now in very serious difficul-             cue if no one else took over the fund in the
                       ties and, on September 2, 1998, the partners               meantime. However, when representatives of
                       sent a letter to investors acknowledging the               that group met on the early morning of
                       fund’s problems and seeking an injection of                Wednesday, September 23, they learned that
                       new capital to sustain it. Not surprisingly,               another group had just made an offer for the
                       that information soon leaked out and the                   fund and that that offer would expire at
                       fund’s problems became common knowl-                       lunchtime that day. It was therefore decided
                       edge.                                                      to wait and see how LTCM responded to that
                           LTCM’s situation continued to deterio-                 offer before proceeding any further.
There was consid-      rate in September, and the fund’s manage-                      A group consisting of Warren Buffett’s
                       ment spent the next three weeks looking for                firm, Berkshire Hathaway, along with
erable criticism of    assistance in an increasingly desperate effort             Goldman Sachs and American International
 the management        to keep the fund afloat. However, no immedi-               Group, a giant insurance holding company,
 of LTCM for get-      ate help was forthcoming, and by September                 offered to buy out the shareholders for $250
                       19 the fund’s capital was down to only $600                million and put $3.75 billion into the fund as
    ting into diffi-   million.8 The fund had an asset base of $80                new capital. That offer would have put the
 culites and of the    billion at that point,9 and its leverage ratio             fund on a much firmer financial basis and
                       was approaching stratospheric levels—a sure                staved off failure. However, the existing
  Federal Reserve      sign of impending doom. No one who knew                    shareholders would have lost everything
   for bailing out     LTCM’s situation really expected the fund to               except for the $250 million takeover pay-
          the fund.    make it through the next week without out-                 ment, and the fund’s managers would have
                       side assistance.                                           been fired. The motivation behind this offer
                                                                                  was strictly commercial; it had nothing to do
                       The Federal Reserve Intervenes                             with saving world financial markets. As one
                          Wall Street and the Federal Reserve had                 news report later put it:



                                                                              4
Buffett wasn’t offering public chari-              Was the Federal Reserve                           If the central
    ty. He was trying to do what he                          Justified?                                  bank merely
    preaches: buy something for much
    less than he thinks it’s worth. Ditto                 The immediate reaction of most observers       mimicked the pri-
    for Goldman Sachs, which made                     in the financial world was relief that the fail-   vate sector, then
    tons of money dealing in bankrupt-                ure of LTCM had been avoided, and the res-
    cies, salvaging financially distressed            cue package was generally well received on
                                                                                                         why did it need to
    real estate. . . . These folks weren’t out        Wall Street, although some financial               get involved at
    to save the world’s financial markets;            observers expressed concerns about its             all?
    they were out to make a buck out of               longer-term implications. Elsewhere, reac-
    Long-Term Capital’s barely breath-                tions were generally less favorable, and there
    ing body.11                                       was considerable criticism of the manage-
                                                      ment of LTCM for getting into difficulties
    Had it been accepted, that offer would            and of the Federal Reserve for bailing out the
have ended the crisis without any further             fund. Responding to those concerns, the
involvement of the Federal Reserve—a text-            House Committee on Banking and Financial
book example of how private-sector parties            Services called a hearing on the issue and
can resolve financial crises on their own,            invited some of the participants to give evi-
without Federal Reserve or other regulatory           dence. Among those called were the president
involvement.                                          of the New York Federal Reserve, William
    But that was not to be. The management            McDonough, and the chairman of the
of LTCM rejected the offer, and one can only          Federal Reserve Board, Alan Greenspan. Both
presume that they did so because they were            officials testified before the House commit-
confident of getting a better deal from the           tee on October 1. Their testimony focused on
Federal Reserve’s consortium.12 The Fed               three main issues:
therefore reconvened discussions to hammer
out a rescue package, which was agreed on by              • The rescue package itself,
the end of the day. The package was prompt-               • The necessity (or otherwise) of Federal
ly accepted by LTCM and immediately made                      Reserve intervention, and
public. Under the terms of the deal, 14 promi-            • The consequences for financial mar-
nent banks and brokerage houses—including                   kets if LTCM had failed.
UBS, Goldman Sachs, and Merrill Lynch but
not the Federal Reserve—agreed to invest              The Rescue: Private-Sector
$3.65 billion of equity capital in LTCM in            Solution or Federal Reserve
exchange for 90 percent of the firm’s equity.         Bailout?
Existing shareholders would therefore retain             In his testimony, McDonough defended
a 10 percent holding, valued at about $400            the rescue package as “a private sector solu-
million. This offer was clearly better for the        tion to a private-sector problem, involving an
existing shareholders than was Buffett’s offer.       investment of new equity by Long-Term
It was also better for the managers of LTCM,          Capital’s creditors and counterparties.” He
who would retain their jobs for the time              bristled at the claim that the Federal Reserve
being and earn management fees they would             had “bailed out” LTCM, pointing out that
have lost had Buffett taken over. Control of          control had passed to the 14-member credi-
the fund passed to a new steering committee           tor group and that “the original equity-hold-
made up of representatives from the consor-           ers [had] taken a severe hit.” He also stressed
tium, and the announcement of the rescue              that “no Federal Reserve official pressured
ended concerns about LTCM’s immediate                 anyone, and no promises were made. Not one
future. By the end of the year, the fund was          penny of public money was spent or commit-
making profits again.                                 ted.”13 Greenspan echoed that argument and



                                                  5
claimed that the LTCM episode was one of               out by the plain facts of the case itself.
                     those “rare occasions” when financial mar-
                     kets seize up and “temporary ad hoc respons-           Did the Federal Reserve Need to
                     es” are required. He also compared the LTCM            Intervene to Stop the Failure of
                     rescue to the famous occasion when J. P.               LTCM?
                     Morgan convened the leading bankers of his                Both officials also argued strongly that
                     day in his library to discuss how they were            the Federal Reserve was obliged to prevent
                     going to resolve the financial crisis of 1907.14       the failure of LTCM by fear of the adverse
                         There is a certain irony in central bankers’       effects that LTCM’s failure might have had
                     defending their resolution of the LTCM                 on financial markets. As Greenspan put it:
                     problem on the grounds that it was much the
                     same as a purely private-sector solution to                Financial market participants were
                     the same problem. If the central bank merely               already unsettled by recent global
                     mimicked the private sector, then why did it               events. Had the failure of LTCM trig-
                     need to get involved at all? Why couldn’t it               gered the seizing up of markets, sub-
                     have sat back and let Warren Buffett and his               stantial damage could have been
                     associates in the private sector do the job?               inflicted on many market partici-
 Greenspan over-     Indeed, what would be the point of having                  pants, including some not directly
  looks the point    the Federal Reserve regulate financial institu-            involved with the firm, and could
that the 1907 cri-   tions at all? The arguments put forward by                 have potentially impaired the
                     McDonough and Greenspan thus under-                        economies of many nations, includ-
 sis was resolved    mine the very actions they were trying to                  ing our own. . . . Moreover, our sense
by private-sector    defend.                                                    was that the consequences of a fire
                         McDonough’s testimony also invites the                 sale triggered by cross-default claus-
parties operating    response that an intervention led by a federal             es, should LTCM fail on some of its
    on their own.    body can hardly be described as a “private sec-            obligations, risked a severe drying up
                     tor solution to a private-sector problem.” The             of market liquidity. . . . In that envi-
                     Federal Reserve did intervene, and pointing                ronment, it was the FRBNY’s
                     out that it did not pressure institutions to               [Federal Reserve Bank of New York’s]
                     participate or spend or commit public money                judgment that it was to the advan-
                     does not alter that fact.                                  tage of all parties—including the
                         For his part, Greenspan overlooks the                  creditors and other market partici-
                     point that the 1907 crisis was resolved by pri-            pants—to engender if at all possible
                     vate-sector parties operating on their                     an orderly resolution rather than let
                     own—as they had to, because there was no                   the firm go into disorderly fire-sale
                     central bank at the time—while the LTCM                    liquidation.15
                     crisis was resolved by a rescue package put
                     together by the central bank. The lesson to            The Federal Reserve, therefore,
                     draw from a comparison of the two crises is
                     therefore not that the LTCM rescue was justi-              moved more quickly to provide their
                     fied because it was like the resolution of 1907.           good offices to help resolve the
                     Instead, the appropriate lesson is almost the              affairs of LTCM than would have
                     opposite: that if private-sector parties operat-           been the case in more normal times.
                     ing on their own could resolve the crisis of               In effect, the threshold of action was
                     1907, then there was no need for the Fed to                lowered by the knowledge that mar-
                     intervene in 1998. If 1907 tells us anything               kets had recently become fragile.16
                     about the LTCM episode, it suggests that the
                     private sector could have resolved the crisis             There is no denying that Federal Reserve
                     on its own—a conclusion that is also borne             officials were genuinely concerned about the



                                                                        6
impact that LTCM’s failure might have on              Reserve would have come together and made
financial markets. Nonetheless, Greenspan’s           an offer in the absence of the Fed’s involve-
argument begs the central question: it pre-           ment. If it had, the outcome would have pre-
supposes that LTCM would have failed if the           sumably been substantially the same as the
Fed had not intervened, and yet it is mani-           outcome that actually occurred, but without
festly the case that LTCM would not have              the Fed’s involvement. However, if there had
failed in the absence of the Fed’s interven-          been no other offers, the management of
tion.                                                 LTCM would probably have accepted the
    If the Federal Reserve had washed its             Buffett offer as the only way to avoid failure.
hands of LTCM early on the morning of                 In that case, the net effect of the Fed’s inter-
September 23, 1998—and made clear to                  vention would have been a better deal for
LTCM that it was doing so—the management              LTCM’s shareholders and managers, at the
of LTCM would have faced a set of alterna-            expense of Buffett and his associates who
tives very different from the one they actually       were thereby deprived of an opportunity to
faced at the time. Instead of choosing                make a profit from LTCM’s difficulties. That
between the Buffett offer and the likelihood          leads one to wonder whether Buffett has a
of a better offer later in the day, they would        case against the Federal Reserve for loss of
have had to choose between the Buffett offer          income.
and almost certain failure. The Buffett offer
was not a generous one: it would have cost            What If LTCM Had Failed?
the management of LTCM their remaining                    There still remains the hypothetical issue
equity, their jobs, and any future manage-            of what might have happened if LTCM had
ment fees they might have obtained from               failed. Were the Federal Reserve’s fears plau-
LTCM, but it would at least have left them            sible? I would suggest not. Central bankers
with a $250 million “exit” payment. The               are always worried about the impacts of the
alternative would have been to lose their             failures of large financial firms on market
equity, their jobs, and their management fees         “confidence,” and the argument that they
and get nothing in return—in short, to lose           had to intervene to prevent the knock-on
everything. They would therefore have been            effects of such failures has been used to justi-
crazy to turn Buffett down, and we must sup-          fy every bailout since time immemorial.
pose they would not have done so. There is            Nonetheless, no one can deny that financial
thus a very strong argument that the Fed              markets were in a particularly fragile state in
could have abandoned the rescue as late as            September 1998. Moreover, LTCM was a big
the morning of September 23 without letting           player that was heavily involved in derivatives       The Federal
LTCM fail. However, if that is the case, it           trading; it also had large exposures to many
could also have abandoned its rescue bid ear-         different counterparties, and many of its             Reserve could
lier without letting LTCM fail. Indeed, the           positions were difficult and costly to                have abstained
Federal Reserve could have abstained com-             unwind. One can therefore readily appreciate          completely from
pletely from intervening, and LTCM would              why the Fed was nervous about the prospect
still not have failed.                                of LTCM’s failing.                                    intervening, and
    So what did Federal Reserve intervention              There are, nevertheless, a number of rea-         LTCM would still
actually achieve? The answer depends on               sons to suggest that financial markets could
what offers would have been forthcoming for           have absorbed the shock of LTCM’s failing
                                                                                                            not have failed.
LTCM in the absence of Federal Reserve                without going into the financial meltdown
intervention. There would have clearly been           that Federal Reserve officials feared:
an offer from the Buffett consortium,
because that consortium was operating inde-               • Although many firms would have taken
pendent of the Fed. However, it is not clear                large hits, the amount of capital in the
whether the consortium led by the Federal                   markets is in the trillions of dollars. It is



                                                  7
Throwing LTCM        therefore difficult to see how the mar-                methodologies for stress testing and
     to the wolves     kets as a whole could not have absorbed                scenario analysis,19 and “credit enhance-
                       the shock, given their huge size relative              ment” techniques to keep down expo-
       would have      to LTCM. The markets might have                        sures to counterparties. Those tech-
     strengthened      sneezed, and perhaps even caught a                     niques include the use of netting agree-
                       cold, but they would hardly have caught                ments, periodic settlement provisions,
financial markets,     pneumonia.                                             credit triggers, third-party guarantees,
 rather than weak-   • When firms are forced to liquidate                     and credit derivatives.20 As a result,
        ened them.     positions in response to a major shock,                most firms’ “true” exposures are now
                       there are usually other firms willing to               only a small fraction of what they
                       buy at the right price. Sellers may have               might otherwise appear to be.
                       to take a loss to liquidate, but buyers
                       can usually be found, and competition            The Federal Reserve’s nightmare scenario—a
                       for good buys usually puts a floor               mass unwinding of positions with wide-
                       under sellers’ losses.                           spread freezing of markets—is thus far-
                     • Market experience suggests that the              fetched, even in the fragile market conditions
                       failure of even a big derivatives player         of the time.
                       usually has an impact only on the mar-               There is also another reason why the Fed
                       kets in which that player was very               was ill-advised to intervene, even if it was right
                       active. Worldwide market liquidity has           in its assessment that LTCM would otherwise
                       never been threatened by any such fail-          have failed. If the Federal Reserve is to pro-
                       ure. It follows, then, that the failure of       mote market stability, it needs to ensure that
                       LTCM might have had a major nega-                market participants have strong incentives to
                       tive impact on some of the derivatives           promote their own financial health—to avoid
                       markets in which the fund was active,            excessive risk taking, to keep their leverage
                       but it would not have caused a global            down to reasonable levels, to maintain their
                       liquidity crisis.                                liquidity, and so forth. However, the best
                     • In any case, even in those rather                incentive of all is the fear of dire consequences
                       extreme and unusual markets where                if they do not manage themselves properly
                       liquidity might be paralyzed in the              and, consequently, default on their obliga-
                       immediate aftermath of a major shock,            tions. If the Fed wishes to encourage institu-
                       participants have every reason to                tions to be strong, it should make an example
                       resume trading as soon as possible.              of those that fail. In that context, LTCM pro-
                       Time and time again in the 1990s,                vided the Federal Reserve with an ideal oppor-
                       derivatives markets have shown a                 tunity to make such an example and send out
                       remarkable ability to absorb major               the message that no firm, however promi-
                       shocks and quickly return to normal,             nent, could expect to be rescued from the con-
                       and there is no reason to suppose that           sequences of its own mistakes. Other firms
                       the market response would have been              would have taken note and strengthened
                       much different if LTCM had failed.               themselves accordingly, and financial markets
                     • Last, but by no means least, there have          would have been more stable as a result.
                       been major developments in derivatives           Throwing LTCM to the wolves would have
                       risk management over the last few                strengthened financial markets, rather than
                       years.17 Those developments include the          weakened them.
                       widespread adoption of value-at-risk
                       systems to measure and manage overall
                       risk exposures, the increasing accep-                 Consequences of the
                       tance of firm-wide risk management                          Bailout
                       guidelines,18 the rapid growth of



                                                                    8
Calls for More Regulation                                  diminish.23
    One of the most immediate consequences
of the LTCM affair was calls for more regula-             Greenspan went on to suggest that the
tion of hedge-fund activities. Among the peo-          primary defense against the problems posed
ple calling for more regulation was then–sec-          by the failures of hedge funds is for their
retary of the treasury Robert Rubin, who               counterparties to be careful in their dealings
called for an interagency study to look at             with them (e.g., not extend too much credit).
ways of making the activities of offshore              Greenspan’s assessment is surely correct.
hedge funds more transparent. Many others              Moreover, since it is also in the interests of
made similar suggestions. However, as one              those counterparties to be careful, there
observer wrote, “Many of these calls have              would appear to be no need for (and no point
been pure reflex actions rather than a care-           in) regulating those dealings. In an efficient
fully considered response to the issues—if             economy, parties should be free to make
any—which hedge funds pose for the world               whatever deals they want with hedge funds,
financial system.”21                                   and it is in their interest not to overexpose
    Those calls were met with widespread dis-          themselves to those or any other risky coun-
belief offshore. Many people familiar with             terparties.
offshore operations pointed out that there
                                                                                                          Attempts to regu-
was very little that U.S. regulators could actu-       Massive Extension of Federal                       late U.S. hedge
ally do about them. Some pointed out that              Reserve Responsibilities                           funds might drive
attempts to regulate U.S. hedge funds might                The LTCM rescue implies a very large and
drive more of them offshore where they                 problematic extension of the Federal               more of them off-
would be even further out of the reach of U.S.         Reserve’s responsibilities. The LTCM bailout       shore where they
regulators. The skeptics included Greenspan            indicates that the Fed now accepts responsi-
himself:                                               bility for the safety of U.S. hedge funds,
                                                                                                          would be further
                                                       despite the fact that it has no legislative man-   out of the reach
    It is questionable whether hedge                   date to do so. Moreover, the Fed accepts that      of U.S. regulators.
    funds can be effectively regulated in              responsibility even though it has no regula-
    the United States alone. While their               tory authority over hedge funds and even
    financial clout may be large, hedge                though the chairman of its board explicitly
    funds’ physical presence is small.                 argues that it should not have any such
    Given the amazing communication                    authority. The Federal Reserve thus main-
    capabilities available virtually around            tains the extraordinary position that it
    the globe, trades can be initiated                 should have responsibility for hedge funds
    from almost any location. Indeed,                  but no power over them. Even if it is legally
    most hedge funds are only a short                  sound, which is questionable, that position is
    step from cyberspace. Any direct U.S.              patently untenable, as it subjects the Fed to a
    regulations restricting their flexibili-           moral hazard problem over which it has no
    ty will doubtless induce the more                  control. That position allows large hedge
    aggressive funds to emigrate from                  funds to take risks that the Federal Reserve
    under our jurisdiction.22                          cannot control; yet the Fed picks up the tab if
                                                       the funds get themselves into difficulties.
He concluded:                                          Heads they win, tails the Federal Reserve
                                                       loses. Responsibility and power cannot be
    The best we can do . . . is what we do             separated indefinitely, however, and at some
    today: Regulate them indirectly                    point the Fed would have to abandon its
    through the regulation of the                      responsibility for hedge funds or, if its past
    sources of their funds. . . . If the funds         empire building is any guide,24 seek regulato-
    move abroad, our oversight will



                                                   9
ry authority to control them.                            to financial firms, and then the LTCM rescue
                          But there is also a deeper problem. Where             wiped out all that progress at a stroke. Not
                       does the Federal Reserve draw the line                   only did the Fed intervene to rescue a large
                       between U.S. hedge funds and overseas ones?              firm, but the reason given for the interven-
                       What is the difference between a U.S. hedge              tion—the Fed’s fears of the effects of LTCM’s
                       fund based in Greenwich, Connecticut,                    failure on world financial markets—was
                       which also operates in the Cayman Islands,               nothing less than an emphatic restatement
                       and a Caymans-based hedge fund, which also               of the doctrine. Too big to fail was back
                       operates in Greenwich? The two are indistin-             again, with a vengeance.
                       guishable for all practical purposes, and the                The return of too big to fail has serious
                       Fed cannot realistically support “American”              consequences for longer-term stability. If the
                       hedge funds without also supporting other                financial system is to be stable, individual
                       hedge funds as well. If the Fed supports large           institutions must be given incentives to make
                       “U.S.” hedge funds, it could easily find itself          themselves financially strong. Rescuing a
                       supporting all large hedge funds, regardless             firm in difficulties then sends out the worst
                       of their “real” nationality. To make matters             possible signal, as it leads others to think that
                       even worse, if the Fed becomes responsible               they, too, may be rescued if they get into dif-
                       for the hedge-fund industry, where and how               ficulties. That weakens their incentive to
                       will it draw the line between hedge funds and            maintain their own financial health and so
                       other investment firms, particularly those               makes it more likely that they will eventually
                       that might be similar to hedge funds? Where              get into difficulties. Bailing out a weak firm
                       would the Fed’s responsibility actually end?             may help to calm markets in the very short
                       Is the logical implication, as one industry              term, but it undermines financial stability in
                       commentator asked, that the Federal Reserve              the long run.
                       will “now try to shore up the Japanese bank-
                       ing system? After all, this is a lot more central        Damage to the Moral Authority of
                       to the fate of the world’s economy and mar-              the Federal Reserve
                       kets than one particular Greenwich,                          Perhaps the worst consequence of the
                       Connecticut hedge fund manager.” The                     LTCM affair was the damage done to the
                       LTCM bailout thus implies a very large and               credibility and, more important, moral
                       ultimately intolerable increase in Federal               authority of Federal Reserve policymakers as
                       Reserve responsibilities—without any legisla-            they encourage their counterparts in other
                       tive mandate whatsoever from Congress.                   countries to persevere with the necessary but
The LTCM rescue                                                                 difficult and painful process of economic lib-
                       The Return of Too Big to Fail                            eralization. Rep. Jim Leach (R-Iowa), chair-
marks a return to         The LTCM rescue marks a return to the                 man of the House Committee on Banking
   the discredited     discredited doctrine of too big to fail: the             and Financial Services, was absolutely correct
  doctrine of too      doctrine that the Federal Reserve cannot                 when he pointed out that “the LTCM saga is
                       allow very big institutions to fail, precisely           fraught with ironies related to moral author-
    big to fail: the   because they are big, out of fear of the conse-          ity as well as moral hazard. The Federal
 doctrine that the     quences of their failure for the financial sys-          Reserve’s intervention comes at a time when
                       tem. That doctrine is a direct inducement for            our government has been preaching to for-
  Federal Reserve      large institutions to act irresponsibly, and             eign governments, particularly Asian ones,
cannot allow very      ever since the bailout of Continental Illinois           that the way to modernize is to let weak insti-
  big institutions     in 1984, Federal Reserve officials have been             tutions fail and to rely on market mecha-
                       trying to convince large institutions that they          nisms, rather than insider bailouts.”26 Allan
            to fail.   cannot count on Federal Reserve support if               Sloan put the same argument more colorful-
                       they got themselves into difficulties. That              ly in Newsweek:
                       message seemed to be slowly getting through



                                                                           10
For 15 months, as financial markets                 doubts.                                                The most damag-
    in country after country collapsed                                                                         ing consequence
    like straw huts in a typhoon, the
    United States lectured the rest of the                                   Notes                             of the LTCM
    world about the evils of crony capital-                                                                    episode is the
    ism—of bailing out rich, connected                  The author would like to thank Dave Campbell,
    insiders while letting everyone else                James Dorn, and an anonymous referee for help-
                                                                                                               harm done by the
    suffer. U.S. officials and financiers               ful comments.                                          perception that
    talked about letting market forces
                                                        1. See International Monetary Fund, World              Federal Reserve
    allocate capital for maximum effi-                  Economic Outlook (Washington: International
    ciency. Thai peasants, Korean steel-                Monetary Fund, May 1998), chap. 1, p. 4.
                                                                                                               policymakers do
    workers and Moscow pensioners may                                                                          not really have
                                                        2. For more information on hedge funds, see, for
    suffer horribly as their local                      example, Stephen J. Brown, William N.                  the faith to take
    economies and currencies col-                       Goetzmann, and Roger G. Ibbotson, “Offshore
    lapse—but we solemnly told them                     Hedge Funds: Survival and Performance,                 their own medi-
    that was a cost they had to pay for the             1989–95,” Journal of Business 72, no. 1 (January       cine.
                                                        1999): 91–117; and Andrew Webb, “Hedge Fund
    greater good. . . . Cronyism bad.                   Fever,” Derivatives Strategy 3, no. 10 (October
    Capitalism good.                                    1998): 33–38.
        Then came the imminent collapse
    of Long-Term Capital . . . , the quin-              3. See International Monetary Fund, chap. 1, p. 4.
                                                        Further details can be found in Barry Eichengreen
    tessential member of The Club, with                 et al., “Hedge Funds and Financial Market
    rich fat-cat investors and rich hot-                Dynamics,” International Monetary Fund
    shot connected managers. Faster                     Occasional Paper 166, 1998.
    than you can say “bailout,” crony                   4. Malaysian prime minister Mahathir
    capitalism U.S. style raised its ugly               Mohammad has called repeatedly for greater con-
    head. . . . John Meriwether and the                 trols on the activities of international “specula-
    rest of the guys who ran the fund                   tors.” Indeed, Mahathir has blamed hedge funds
    onto the rocks got to keep their jobs.              for causing the recent economic meltdown in
                                                        South East Asia and has repeatedly singled out
    The fund’s investors, whose stakes                  George Soros, in particular, as being personally
    would have been wiped out in a col-                 responsible for many of the region’s problems.
    lapse, salvaged about seven cents on                See, for example, “Mahathir Blasts Speculators,”
    the dollar. . . . The rescuers even                 CNNfn, January 30, 1999, http://www.cnnfn.com/
                                                        worldbiz/europe/9901/30/davos_mahathir/.
    agreed to pay a management fee on                   Those claims cannot be taken seriously, and one
    their rescue fund.27                                suspects that Mahathir is seeking scapegoats for
                                                        his own policy failures.
   The most damaging consequence of the                 5. Amy Feldman, “Investment Titan’s Fall,” New
LTCM episode is therefore the harm done by              York Daily News, September 28, 1998, p. 2,
the perception that Federal Reserve policy-             http://www.nydailynews.com.
makers do not really have the faith to take
                                                        6. These figures are derived from those given on p.
their own medicine. How can they persuade               4 of the testimony of David Lindsey, director of
the Russians or the Japanese to let big insti-          the Securities and Exchange Commission’s
tutions fail, if they are afraid to do the same         Division of Market Regulation, before the House
themselves? At the end of the day, economic             Committee on Banking and Financial Services on
                                                        October 1, 1998, when the committee was hearing
liberalization is just as necessary as it always        evidence on the activities of hedge funds. This tes-
was, but in the wake of the LTCM rescue, one            timony is available at http://www.hedgefunds.
can understand why many of those who have               net /testimony.htm.
to pay the price for it might have their                7. Ibid., pp. 4–5.
                                                        8. Ibid., p. 5.



                                                   11
9. Allan Sloan, “What Goes Around,” Newsweek,                17. For more on developments in risk manage-
October 12, 1998.                                            ment, see, for example, Carol Alexander, ed.,
                                                             Measuring and Modelling Financial Risk, vol. 2 of Risk
10. A detailed account of the rescue is given in             Management and Analysis (New York: John Wiley,
William J. McDonough, president of the New                   1998); and Kevin Dowd, Beyond Value at Risk: The
York Federal Reserve, Statement before the House             New Science of Risk Management (New York: John
Committee on Banking and Financial Services,                 Wiley, 1998), pp. 3–37.
October 1, 1998, http://www.bog.frb.fed.us.
                                                             18. These include the Group of Thirty’s report of
11. See Sloan.                                               July 1993, Derivatives: Practices and Principles (New
                                                             York: Group of Thirty, 1994); and U.S. General
12. Since LTCM insiders have still to fully reveal           Accounting Office, “Financial Derivatives:
their side of the story, one can only speculate on           Actions Needed to Protect the Financial System,”
why the management of LTCM rejected the                      May 1994. Dowd, p. 16, provides a list of reports
Buffett offer. However, they would have been con-            by other interested parties.
fident at this point that another offer would be
forthcoming, and there are good reasons why                  19. See ibid., pp. 121–31.
they might have expected this second offer to be
more generous than the first. For one, Buffett had           20. These practices are explained in Lee Wakeman,
a fierce reputation for buying up firms at rock-             “Credit Enhancement,” in Alexander, pp. 255–75.
bottom prices and was clearly driving a very hard            For more on the use of credit derivatives, see Janet
bargain. In addition, they could reasonably infer            M. Tavakoli, Credit Derivatives: A Guide to
from its recent behavior and record in past crises           Instruments and Applications (New York: John Wiley,
that the Federal Reserve was determined to pre-              1998).
vent the firm’s failure, and if the Fed was to do so,
it needed to give the fund’s managers some incen-            21. Benedict Weller, “Betting with Hedges,”
tive to cooperate. In other words, they had some             Financial Regulator 3, no. 3 (December 1998): 21.
bargaining power with the Federal Reserve, which
was clearly desperate to prevent the failure of              22. Greenspan, p. 5.
LTCM, but they had no such bargaining power
                                                             23. Ibid.
with Buffett. If they turned Buffett down, the
management of LTCM could therefore be fairly                 24. See, for example, Richard H. Timberlake,
confident of getting a better deal shortly after-            Monetary Policy in the United States: An Intellectual
wards. From their point of view, rejecting the               and Institutional History (Chicago: University of
Buffett offer made good sense, but only because              Chicago Press, 1993), pp. 416–18.
they could expect a better offer later.
                                                             25. Patrick Young, “Lessons from LTCM,” Applied
13. McDonough, p. 4.                                         Derivatives Trading, October 1998, p. 1,
                                                             http://www.adtrading.com.
14. Alan Greenspan, chairman, Board of
Governors of the Federal Reserve System, “Private-           26. James A. Leach, “The Failure of Long-Term
Sector Refinancing of the Large Hedge Fund,                  Capital Management: A Preliminary Assess-
Long-Term Capital Management,” Testimony                     ment,” Statement to the House Banking and
before the House Committee on Banking and                    Financial Services Committee, October 12, 1998,
Financial Services, October 1, 1998, p. 5, http://           pp. 5–6, http://www. house.gov/banking/
www.bog.frb.fed.us.                                          101298le.htm.
15. Ibid., pp. 1, 3.                                         27. Sloan.
16. Ibid., p. 1.




Published by the Cato Institute, Cato Briefing Papers is a regular series evaluating government policies and
offering proposals for reform. Nothing in Cato Briefing Papers should be construed as necessarily reflecting
the views of the Cato Institute or as an attempt to aid or hinder the passage of any bill before Congress.
Additional copies of Cato Briefing Papers are $2.00 each ($1.00 in bulk). To order, or for a complete listing of
available studies, write the Cato Institute, 1000 Massachusetts Avenue, N.W., Washington, D.C. 20001, call
(202) 842-0200 or fax (202) 842-3490. Contact the Cato Institute for reprint permission.



                                                        12

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Ltcm

  • 1. Too Big to Fail? Long-Term Capital Management and the Federal Reserve by Kevin Dowd No. 52 September 23, 1999 In September 1998 the Federal Reserve orga- The intervention also is having more serious nized a rescue of Long-Term Capital Manage- long-term consequences: it encourages more ment, a very large and prominent hedge fund on calls for the regulation of hedge-fund activity, the brink of failure. The Fed intervened because which may drive such activity further offshore; it was concerned about possible dire conse- it implies a major open-ended extension of quences for world financial markets if it allowed Federal Reserve responsibilities, without any the hedge fund to fail. congressional authorization; it implies a return The Fed’s intervention was misguided and to the discredited doctrine that the Fed should unnecessary because LTCM would not have prevent the failure of large financial firms, failed anyway, and the Fed’s concerns about the which encourages irresponsible risk taking; and effects of LTCM’s failure on financial markets it undermines the moral authority of Fed poli- were exaggerated. In the short run the interven- cymakers in their efforts to encourage their tion helped the shareholders and managers of counterparts in other countries to persevere LTCM to get a better deal for themselves with the difficult process of economic liberaliza- than they would otherwise have obtained. tion. Kevin Dowd is professor of economics at the University of Sheffield and an adjunct scholar at the Cato Institute.
  • 2. The management Introduction that aim to make profits for their sharehold- of LTCM made ers by trading securities. Hedge funds vary In September 1998 the Federal Reserve enormously but fall into two main classes. the firm much organized a rescue of Long-Term Capital The first is macro funds, which take specula- riskier, in the Management, a very prominent U.S. hedge tive (i.e., unhedged) positions in financial fund on the brink of failure. The Fed inter- markets on the basis of their analyses of hope of bolster- vened because it was concerned about the financial and macroeconomic conditions. ing the returns to possibility of dire consequences for world They bet on exchange-rate devaluations, shareholders. financial markets if it allowed the firm to fail. changes in macroeconomic policies, interest- The Fed’s rescue of LTCM was misguided. rate movements, and so on. Macro funds are The intervention was not necessary to pre- thus “hedge” funds in name only. They make vent the failure of LTCM. The firm would not their profits from speculation, and their have failed, and even if it had, there would portfolios are often highly risky. Most macro not have been the dire consequences that hedge funds are also highly leveraged—that Federal Reserve officials feared. Indeed, let- is, the amounts invested in their portfolios, ting LTCM fail might well have had a salu- the firms’ assets, are much greater than their tary effect on financial markets: it would share capital, with investments in excess of have sent a strong and convincing signal that capital being financed by borrowing. no financial firm—however big—could expect Leverage increases the potential profits of to be bailed out from the consequences of its shareholders, but it also increases their risks: own mismanagement. the greater the leverage, the bigger the profit The rescue of LTCM also has a number of to shareholders if investments are successful detrimental consequences. It encourages and the bigger the loss to shareholders if they more calls for the regulation of hedge-fund are not. A highly leveraged fund can therefore activities, which would be pointless at best make very high profits but also runs a rela- and counterproductive at worst. The rescue tively high risk of going bankrupt. Macro also implies a massive and open-ended exten- funds are highly leveraged relative to most sion of Federal Reserve responsibilities, with- other institutional investors and typically out any congressional mandate. In addition, have asset bases five to nine times greater the rescue implies a return by the Federal than their capital.1 Reserve to the discredited doctrine of “too The other main class of hedge funds is rel- big to fail”—the belief that the Fed will rescue ative-value, or arbitrage, funds. Those funds big financial firms in difficulty—for fear of use sophisticated models to detect arbitrage the possible effects on financial markets of opportunities—differences in the prices of letting big firms fail. Too big to fail encour- nearly equivalent securities or portfolios—in ages irresponsible risk taking by financial financial markets. Having detected such firms, which makes them weaker and finan- opportunities, those funds construct arbi- cial markets more fragile. Finally, the rescue trage trading strategies to profit: they buy of LTCM does a lot of damage to the credi- securities that are underpriced and sell those bility and moral authority of Federal Reserve that are overpriced, while simultaneously policymakers in their efforts to encourage taking offsetting positions to hedge against their counterparts in other countries to per- any risks involved and lock in their arbitrage severe with the necessary but difficult process profits. Financial-market arbitrage is a rela- of economic liberalization. tively low-risk activity, so relative-value funds often operate with much higher leverage than do macro funds.2 What Are Hedge Funds? In the United States, hedge funds with fewer than 100 shareholders are exempt from Hedge funds are private investment funds regulation under the Securities Act of 1933, 2
  • 3. the Securities Exchange Act of 1934, and the notably economists Robert Merton and Investment Company Act of 1940. Most U.S. Myron Scholes, who received the Nobel Prize hedge funds therefore restrict the number of in economics in 1997. The fund initially spe- their shareholders to fewer than 100. cialized in high-volume arbitrage trades in Overseas hedge funds are also usually subject bond and bond-derivatives markets but grad- to little or no regulation, particularly those ually became more active in other markets operating from offshore centers, such as the and more willing to speculate. The fund thus Bahamas and the Cayman Islands. The started as an arbitrage fund but gradually hedge-fund industry is thus largely unregu- became more like a macro fund. LTCM was lated. very successful: by the end of 1997 it had Despite its growth in recent years, the achieved annual rates of return of around 40 industry still is only a very small part of the percent and had nearly tripled its investors’ overall institutional investment sector. A money. That track record and the prestige of recent International Monetary Fund report its associates made LTCM very popular with estimated that the total amount of capital investors, and the companies and individuals invested in hedge funds in the third quarter investing in LTCM “read like a who’s who list of 1997 was about $100 billion. By compari- of high finance.”5 LTCM was the darling of son, other institutional investors—pension Wall Street. As its losses funds, mutual funds, insurance companies, By that stage, it appears that the fund’s mounted, the banks, and so on—had a combined capital of assets had grown to about $120 billion and fund had increas- well over $20 trillion.3 Hedge funds therefore its capital to about $7.3 billion.6 However, account for less than 0.5 percent of the total despite that high leverage—an assets-to-equi- ing difficulty capital of the institutional investment sector. ty ratio of over 16 to 1—the management of meeting margin Nonetheless, hedge funds have received LTCM concluded that the capital base was considerable attention during the last too high to earn the rate of return on capital calls. decade, most particularly because of their for which they were aiming. They therefore role in a number of recent exchange-rate returned $2.7 billion of capital to sharehold- crises. Perhaps the best-known example is ers, thus cutting the fund’s capital to $4.8 bil- George Soros’s Quantum Fund, a macro lion and increasing its leverage ratio to fund reputed to have made more than $1 bil- around 25 to 1. In effect, the management of lion at the British government’s expense by LTCM had taken a major gamble: they made betting against the pound in the European the firm much riskier, in the hope of bolster- exchange-rate crisis of September 1992. ing the returns to shareholders. Hedge funds have also figured prominently in more recent crises, including those in LTCM Gets into Difficulties Latin America, the Far East, and Russia in the Unfortunately, LTCM’s luck ran out not last couple of years. The activities of hedge long afterwards. Most markets were edgy funds have led to major controversy over during the first part of 1998, but market con- their impact on the world financial system ditions deteriorated sharply in the summer and to calls from some quarters that hedge and led to major losses for LTCM in July. funds be regulated.4 Disaster then struck the next month, when the Russian government devalued the ruble and declared a moratorium on future debt The Story of LTCM repayments. Those events led to a major dete- rioration in the creditworthiness of many Long-Term Capital Management was emerging-market bonds and corresponding founded in March 1994 by John Meriwether, large increases in the spreads between the a former Salomon Brothers trading star, prices of Western government and emerging- along with a small group of associates, most market bonds. Those developments were very 3
  • 4. bad for LTCM because the fund had bet mas- observed LTCM’s deterioration with mount- sively on those spreads’ narrowing. To make ing concern. Many Wall Street firms had matters worse, the fund sustained major loss- large stakes in LTCM, and there was also es on other speculative positions as well. As a widespread concern about the potential result, by the end of August LTCM’s capital impact on financial markets if LTCM were to was down to $2.3 billion and the fund had fail. The Fed felt obliged to intervene, and a lost over half of the equity capital it had had delegation from the New York Federal at the start of the year. By that time, its asset Reserve and the U.S. Treasury visited the base was about $107 billion, so its leverage fund on Sunday, September 20, to assess the ratio had climbed to over 45 to 1—a very high situation.10 At that meeting fund partners ratio by any standards, but especially in that persuaded the delegation that LTCM’s situa- volatile environment.7 tion was not only bad but potentially much As its losses mounted, the fund had worse than market participants imagined. increasing difficulty meeting margin calls The Fed concluded that some form of sup- and needed more collateral to ensure that it port operation should be prepared—and pre- could meet its obligations to counterparties. pared very rapidly—to prevent LTCM’s fail- The fund was running short of high-quality ure and to forestall what the Fed feared assets for collateral to maintain its positions, might otherwise be disastrous effects on and it also had great difficulty liquidating its financial markets. positions: many of its positions were relative- Accordingly, the New York Federal ly illiquid (i.e., difficult to sell) even in normal Reserve invited a number of the creditor times and hence still more difficult to firms most involved to discuss a rescue pack- sell—especially in a hurry—in nervous and age, and it was soon agreed that this Federal declining markets. Reserve–led consortium would mount a res- The fund was now in very serious difficul- cue if no one else took over the fund in the ties and, on September 2, 1998, the partners meantime. However, when representatives of sent a letter to investors acknowledging the that group met on the early morning of fund’s problems and seeking an injection of Wednesday, September 23, they learned that new capital to sustain it. Not surprisingly, another group had just made an offer for the that information soon leaked out and the fund and that that offer would expire at fund’s problems became common knowl- lunchtime that day. It was therefore decided edge. to wait and see how LTCM responded to that LTCM’s situation continued to deterio- offer before proceeding any further. There was consid- rate in September, and the fund’s manage- A group consisting of Warren Buffett’s ment spent the next three weeks looking for firm, Berkshire Hathaway, along with erable criticism of assistance in an increasingly desperate effort Goldman Sachs and American International the management to keep the fund afloat. However, no immedi- Group, a giant insurance holding company, of LTCM for get- ate help was forthcoming, and by September offered to buy out the shareholders for $250 19 the fund’s capital was down to only $600 million and put $3.75 billion into the fund as ting into diffi- million.8 The fund had an asset base of $80 new capital. That offer would have put the culites and of the billion at that point,9 and its leverage ratio fund on a much firmer financial basis and was approaching stratospheric levels—a sure staved off failure. However, the existing Federal Reserve sign of impending doom. No one who knew shareholders would have lost everything for bailing out LTCM’s situation really expected the fund to except for the $250 million takeover pay- the fund. make it through the next week without out- ment, and the fund’s managers would have side assistance. been fired. The motivation behind this offer was strictly commercial; it had nothing to do The Federal Reserve Intervenes with saving world financial markets. As one Wall Street and the Federal Reserve had news report later put it: 4
  • 5. Buffett wasn’t offering public chari- Was the Federal Reserve If the central ty. He was trying to do what he Justified? bank merely preaches: buy something for much less than he thinks it’s worth. Ditto The immediate reaction of most observers mimicked the pri- for Goldman Sachs, which made in the financial world was relief that the fail- vate sector, then tons of money dealing in bankrupt- ure of LTCM had been avoided, and the res- cies, salvaging financially distressed cue package was generally well received on why did it need to real estate. . . . These folks weren’t out Wall Street, although some financial get involved at to save the world’s financial markets; observers expressed concerns about its all? they were out to make a buck out of longer-term implications. Elsewhere, reac- Long-Term Capital’s barely breath- tions were generally less favorable, and there ing body.11 was considerable criticism of the manage- ment of LTCM for getting into difficulties Had it been accepted, that offer would and of the Federal Reserve for bailing out the have ended the crisis without any further fund. Responding to those concerns, the involvement of the Federal Reserve—a text- House Committee on Banking and Financial book example of how private-sector parties Services called a hearing on the issue and can resolve financial crises on their own, invited some of the participants to give evi- without Federal Reserve or other regulatory dence. Among those called were the president involvement. of the New York Federal Reserve, William But that was not to be. The management McDonough, and the chairman of the of LTCM rejected the offer, and one can only Federal Reserve Board, Alan Greenspan. Both presume that they did so because they were officials testified before the House commit- confident of getting a better deal from the tee on October 1. Their testimony focused on Federal Reserve’s consortium.12 The Fed three main issues: therefore reconvened discussions to hammer out a rescue package, which was agreed on by • The rescue package itself, the end of the day. The package was prompt- • The necessity (or otherwise) of Federal ly accepted by LTCM and immediately made Reserve intervention, and public. Under the terms of the deal, 14 promi- • The consequences for financial mar- nent banks and brokerage houses—including kets if LTCM had failed. UBS, Goldman Sachs, and Merrill Lynch but not the Federal Reserve—agreed to invest The Rescue: Private-Sector $3.65 billion of equity capital in LTCM in Solution or Federal Reserve exchange for 90 percent of the firm’s equity. Bailout? Existing shareholders would therefore retain In his testimony, McDonough defended a 10 percent holding, valued at about $400 the rescue package as “a private sector solu- million. This offer was clearly better for the tion to a private-sector problem, involving an existing shareholders than was Buffett’s offer. investment of new equity by Long-Term It was also better for the managers of LTCM, Capital’s creditors and counterparties.” He who would retain their jobs for the time bristled at the claim that the Federal Reserve being and earn management fees they would had “bailed out” LTCM, pointing out that have lost had Buffett taken over. Control of control had passed to the 14-member credi- the fund passed to a new steering committee tor group and that “the original equity-hold- made up of representatives from the consor- ers [had] taken a severe hit.” He also stressed tium, and the announcement of the rescue that “no Federal Reserve official pressured ended concerns about LTCM’s immediate anyone, and no promises were made. Not one future. By the end of the year, the fund was penny of public money was spent or commit- making profits again. ted.”13 Greenspan echoed that argument and 5
  • 6. claimed that the LTCM episode was one of out by the plain facts of the case itself. those “rare occasions” when financial mar- kets seize up and “temporary ad hoc respons- Did the Federal Reserve Need to es” are required. He also compared the LTCM Intervene to Stop the Failure of rescue to the famous occasion when J. P. LTCM? Morgan convened the leading bankers of his Both officials also argued strongly that day in his library to discuss how they were the Federal Reserve was obliged to prevent going to resolve the financial crisis of 1907.14 the failure of LTCM by fear of the adverse There is a certain irony in central bankers’ effects that LTCM’s failure might have had defending their resolution of the LTCM on financial markets. As Greenspan put it: problem on the grounds that it was much the same as a purely private-sector solution to Financial market participants were the same problem. If the central bank merely already unsettled by recent global mimicked the private sector, then why did it events. Had the failure of LTCM trig- need to get involved at all? Why couldn’t it gered the seizing up of markets, sub- have sat back and let Warren Buffett and his stantial damage could have been associates in the private sector do the job? inflicted on many market partici- Greenspan over- Indeed, what would be the point of having pants, including some not directly looks the point the Federal Reserve regulate financial institu- involved with the firm, and could that the 1907 cri- tions at all? The arguments put forward by have potentially impaired the McDonough and Greenspan thus under- economies of many nations, includ- sis was resolved mine the very actions they were trying to ing our own. . . . Moreover, our sense by private-sector defend. was that the consequences of a fire McDonough’s testimony also invites the sale triggered by cross-default claus- parties operating response that an intervention led by a federal es, should LTCM fail on some of its on their own. body can hardly be described as a “private sec- obligations, risked a severe drying up tor solution to a private-sector problem.” The of market liquidity. . . . In that envi- Federal Reserve did intervene, and pointing ronment, it was the FRBNY’s out that it did not pressure institutions to [Federal Reserve Bank of New York’s] participate or spend or commit public money judgment that it was to the advan- does not alter that fact. tage of all parties—including the For his part, Greenspan overlooks the creditors and other market partici- point that the 1907 crisis was resolved by pri- pants—to engender if at all possible vate-sector parties operating on their an orderly resolution rather than let own—as they had to, because there was no the firm go into disorderly fire-sale central bank at the time—while the LTCM liquidation.15 crisis was resolved by a rescue package put together by the central bank. The lesson to The Federal Reserve, therefore, draw from a comparison of the two crises is therefore not that the LTCM rescue was justi- moved more quickly to provide their fied because it was like the resolution of 1907. good offices to help resolve the Instead, the appropriate lesson is almost the affairs of LTCM than would have opposite: that if private-sector parties operat- been the case in more normal times. ing on their own could resolve the crisis of In effect, the threshold of action was 1907, then there was no need for the Fed to lowered by the knowledge that mar- intervene in 1998. If 1907 tells us anything kets had recently become fragile.16 about the LTCM episode, it suggests that the private sector could have resolved the crisis There is no denying that Federal Reserve on its own—a conclusion that is also borne officials were genuinely concerned about the 6
  • 7. impact that LTCM’s failure might have on Reserve would have come together and made financial markets. Nonetheless, Greenspan’s an offer in the absence of the Fed’s involve- argument begs the central question: it pre- ment. If it had, the outcome would have pre- supposes that LTCM would have failed if the sumably been substantially the same as the Fed had not intervened, and yet it is mani- outcome that actually occurred, but without festly the case that LTCM would not have the Fed’s involvement. However, if there had failed in the absence of the Fed’s interven- been no other offers, the management of tion. LTCM would probably have accepted the If the Federal Reserve had washed its Buffett offer as the only way to avoid failure. hands of LTCM early on the morning of In that case, the net effect of the Fed’s inter- September 23, 1998—and made clear to vention would have been a better deal for LTCM that it was doing so—the management LTCM’s shareholders and managers, at the of LTCM would have faced a set of alterna- expense of Buffett and his associates who tives very different from the one they actually were thereby deprived of an opportunity to faced at the time. Instead of choosing make a profit from LTCM’s difficulties. That between the Buffett offer and the likelihood leads one to wonder whether Buffett has a of a better offer later in the day, they would case against the Federal Reserve for loss of have had to choose between the Buffett offer income. and almost certain failure. The Buffett offer was not a generous one: it would have cost What If LTCM Had Failed? the management of LTCM their remaining There still remains the hypothetical issue equity, their jobs, and any future manage- of what might have happened if LTCM had ment fees they might have obtained from failed. Were the Federal Reserve’s fears plau- LTCM, but it would at least have left them sible? I would suggest not. Central bankers with a $250 million “exit” payment. The are always worried about the impacts of the alternative would have been to lose their failures of large financial firms on market equity, their jobs, and their management fees “confidence,” and the argument that they and get nothing in return—in short, to lose had to intervene to prevent the knock-on everything. They would therefore have been effects of such failures has been used to justi- crazy to turn Buffett down, and we must sup- fy every bailout since time immemorial. pose they would not have done so. There is Nonetheless, no one can deny that financial thus a very strong argument that the Fed markets were in a particularly fragile state in could have abandoned the rescue as late as September 1998. Moreover, LTCM was a big the morning of September 23 without letting player that was heavily involved in derivatives The Federal LTCM fail. However, if that is the case, it trading; it also had large exposures to many could also have abandoned its rescue bid ear- different counterparties, and many of its Reserve could lier without letting LTCM fail. Indeed, the positions were difficult and costly to have abstained Federal Reserve could have abstained com- unwind. One can therefore readily appreciate completely from pletely from intervening, and LTCM would why the Fed was nervous about the prospect still not have failed. of LTCM’s failing. intervening, and So what did Federal Reserve intervention There are, nevertheless, a number of rea- LTCM would still actually achieve? The answer depends on sons to suggest that financial markets could what offers would have been forthcoming for have absorbed the shock of LTCM’s failing not have failed. LTCM in the absence of Federal Reserve without going into the financial meltdown intervention. There would have clearly been that Federal Reserve officials feared: an offer from the Buffett consortium, because that consortium was operating inde- • Although many firms would have taken pendent of the Fed. However, it is not clear large hits, the amount of capital in the whether the consortium led by the Federal markets is in the trillions of dollars. It is 7
  • 8. Throwing LTCM therefore difficult to see how the mar- methodologies for stress testing and to the wolves kets as a whole could not have absorbed scenario analysis,19 and “credit enhance- the shock, given their huge size relative ment” techniques to keep down expo- would have to LTCM. The markets might have sures to counterparties. Those tech- strengthened sneezed, and perhaps even caught a niques include the use of netting agree- cold, but they would hardly have caught ments, periodic settlement provisions, financial markets, pneumonia. credit triggers, third-party guarantees, rather than weak- • When firms are forced to liquidate and credit derivatives.20 As a result, ened them. positions in response to a major shock, most firms’ “true” exposures are now there are usually other firms willing to only a small fraction of what they buy at the right price. Sellers may have might otherwise appear to be. to take a loss to liquidate, but buyers can usually be found, and competition The Federal Reserve’s nightmare scenario—a for good buys usually puts a floor mass unwinding of positions with wide- under sellers’ losses. spread freezing of markets—is thus far- • Market experience suggests that the fetched, even in the fragile market conditions failure of even a big derivatives player of the time. usually has an impact only on the mar- There is also another reason why the Fed kets in which that player was very was ill-advised to intervene, even if it was right active. Worldwide market liquidity has in its assessment that LTCM would otherwise never been threatened by any such fail- have failed. If the Federal Reserve is to pro- ure. It follows, then, that the failure of mote market stability, it needs to ensure that LTCM might have had a major nega- market participants have strong incentives to tive impact on some of the derivatives promote their own financial health—to avoid markets in which the fund was active, excessive risk taking, to keep their leverage but it would not have caused a global down to reasonable levels, to maintain their liquidity crisis. liquidity, and so forth. However, the best • In any case, even in those rather incentive of all is the fear of dire consequences extreme and unusual markets where if they do not manage themselves properly liquidity might be paralyzed in the and, consequently, default on their obliga- immediate aftermath of a major shock, tions. If the Fed wishes to encourage institu- participants have every reason to tions to be strong, it should make an example resume trading as soon as possible. of those that fail. In that context, LTCM pro- Time and time again in the 1990s, vided the Federal Reserve with an ideal oppor- derivatives markets have shown a tunity to make such an example and send out remarkable ability to absorb major the message that no firm, however promi- shocks and quickly return to normal, nent, could expect to be rescued from the con- and there is no reason to suppose that sequences of its own mistakes. Other firms the market response would have been would have taken note and strengthened much different if LTCM had failed. themselves accordingly, and financial markets • Last, but by no means least, there have would have been more stable as a result. been major developments in derivatives Throwing LTCM to the wolves would have risk management over the last few strengthened financial markets, rather than years.17 Those developments include the weakened them. widespread adoption of value-at-risk systems to measure and manage overall risk exposures, the increasing accep- Consequences of the tance of firm-wide risk management Bailout guidelines,18 the rapid growth of 8
  • 9. Calls for More Regulation diminish.23 One of the most immediate consequences of the LTCM affair was calls for more regula- Greenspan went on to suggest that the tion of hedge-fund activities. Among the peo- primary defense against the problems posed ple calling for more regulation was then–sec- by the failures of hedge funds is for their retary of the treasury Robert Rubin, who counterparties to be careful in their dealings called for an interagency study to look at with them (e.g., not extend too much credit). ways of making the activities of offshore Greenspan’s assessment is surely correct. hedge funds more transparent. Many others Moreover, since it is also in the interests of made similar suggestions. However, as one those counterparties to be careful, there observer wrote, “Many of these calls have would appear to be no need for (and no point been pure reflex actions rather than a care- in) regulating those dealings. In an efficient fully considered response to the issues—if economy, parties should be free to make any—which hedge funds pose for the world whatever deals they want with hedge funds, financial system.”21 and it is in their interest not to overexpose Those calls were met with widespread dis- themselves to those or any other risky coun- belief offshore. Many people familiar with terparties. offshore operations pointed out that there Attempts to regu- was very little that U.S. regulators could actu- Massive Extension of Federal late U.S. hedge ally do about them. Some pointed out that Reserve Responsibilities funds might drive attempts to regulate U.S. hedge funds might The LTCM rescue implies a very large and drive more of them offshore where they problematic extension of the Federal more of them off- would be even further out of the reach of U.S. Reserve’s responsibilities. The LTCM bailout shore where they regulators. The skeptics included Greenspan indicates that the Fed now accepts responsi- himself: bility for the safety of U.S. hedge funds, would be further despite the fact that it has no legislative man- out of the reach It is questionable whether hedge date to do so. Moreover, the Fed accepts that of U.S. regulators. funds can be effectively regulated in responsibility even though it has no regula- the United States alone. While their tory authority over hedge funds and even financial clout may be large, hedge though the chairman of its board explicitly funds’ physical presence is small. argues that it should not have any such Given the amazing communication authority. The Federal Reserve thus main- capabilities available virtually around tains the extraordinary position that it the globe, trades can be initiated should have responsibility for hedge funds from almost any location. Indeed, but no power over them. Even if it is legally most hedge funds are only a short sound, which is questionable, that position is step from cyberspace. Any direct U.S. patently untenable, as it subjects the Fed to a regulations restricting their flexibili- moral hazard problem over which it has no ty will doubtless induce the more control. That position allows large hedge aggressive funds to emigrate from funds to take risks that the Federal Reserve under our jurisdiction.22 cannot control; yet the Fed picks up the tab if the funds get themselves into difficulties. He concluded: Heads they win, tails the Federal Reserve loses. Responsibility and power cannot be The best we can do . . . is what we do separated indefinitely, however, and at some today: Regulate them indirectly point the Fed would have to abandon its through the regulation of the responsibility for hedge funds or, if its past sources of their funds. . . . If the funds empire building is any guide,24 seek regulato- move abroad, our oversight will 9
  • 10. ry authority to control them. to financial firms, and then the LTCM rescue But there is also a deeper problem. Where wiped out all that progress at a stroke. Not does the Federal Reserve draw the line only did the Fed intervene to rescue a large between U.S. hedge funds and overseas ones? firm, but the reason given for the interven- What is the difference between a U.S. hedge tion—the Fed’s fears of the effects of LTCM’s fund based in Greenwich, Connecticut, failure on world financial markets—was which also operates in the Cayman Islands, nothing less than an emphatic restatement and a Caymans-based hedge fund, which also of the doctrine. Too big to fail was back operates in Greenwich? The two are indistin- again, with a vengeance. guishable for all practical purposes, and the The return of too big to fail has serious Fed cannot realistically support “American” consequences for longer-term stability. If the hedge funds without also supporting other financial system is to be stable, individual hedge funds as well. If the Fed supports large institutions must be given incentives to make “U.S.” hedge funds, it could easily find itself themselves financially strong. Rescuing a supporting all large hedge funds, regardless firm in difficulties then sends out the worst of their “real” nationality. To make matters possible signal, as it leads others to think that even worse, if the Fed becomes responsible they, too, may be rescued if they get into dif- for the hedge-fund industry, where and how ficulties. That weakens their incentive to will it draw the line between hedge funds and maintain their own financial health and so other investment firms, particularly those makes it more likely that they will eventually that might be similar to hedge funds? Where get into difficulties. Bailing out a weak firm would the Fed’s responsibility actually end? may help to calm markets in the very short Is the logical implication, as one industry term, but it undermines financial stability in commentator asked, that the Federal Reserve the long run. will “now try to shore up the Japanese bank- ing system? After all, this is a lot more central Damage to the Moral Authority of to the fate of the world’s economy and mar- the Federal Reserve kets than one particular Greenwich, Perhaps the worst consequence of the Connecticut hedge fund manager.” The LTCM affair was the damage done to the LTCM bailout thus implies a very large and credibility and, more important, moral ultimately intolerable increase in Federal authority of Federal Reserve policymakers as Reserve responsibilities—without any legisla- they encourage their counterparts in other tive mandate whatsoever from Congress. countries to persevere with the necessary but The LTCM rescue difficult and painful process of economic lib- The Return of Too Big to Fail eralization. Rep. Jim Leach (R-Iowa), chair- marks a return to The LTCM rescue marks a return to the man of the House Committee on Banking the discredited discredited doctrine of too big to fail: the and Financial Services, was absolutely correct doctrine of too doctrine that the Federal Reserve cannot when he pointed out that “the LTCM saga is allow very big institutions to fail, precisely fraught with ironies related to moral author- big to fail: the because they are big, out of fear of the conse- ity as well as moral hazard. The Federal doctrine that the quences of their failure for the financial sys- Reserve’s intervention comes at a time when tem. That doctrine is a direct inducement for our government has been preaching to for- Federal Reserve large institutions to act irresponsibly, and eign governments, particularly Asian ones, cannot allow very ever since the bailout of Continental Illinois that the way to modernize is to let weak insti- big institutions in 1984, Federal Reserve officials have been tutions fail and to rely on market mecha- trying to convince large institutions that they nisms, rather than insider bailouts.”26 Allan to fail. cannot count on Federal Reserve support if Sloan put the same argument more colorful- they got themselves into difficulties. That ly in Newsweek: message seemed to be slowly getting through 10
  • 11. For 15 months, as financial markets doubts. The most damag- in country after country collapsed ing consequence like straw huts in a typhoon, the United States lectured the rest of the Notes of the LTCM world about the evils of crony capital- episode is the ism—of bailing out rich, connected The author would like to thank Dave Campbell, insiders while letting everyone else James Dorn, and an anonymous referee for help- harm done by the suffer. U.S. officials and financiers ful comments. perception that talked about letting market forces 1. See International Monetary Fund, World Federal Reserve allocate capital for maximum effi- Economic Outlook (Washington: International ciency. Thai peasants, Korean steel- Monetary Fund, May 1998), chap. 1, p. 4. policymakers do workers and Moscow pensioners may not really have 2. For more information on hedge funds, see, for suffer horribly as their local example, Stephen J. Brown, William N. the faith to take economies and currencies col- Goetzmann, and Roger G. Ibbotson, “Offshore lapse—but we solemnly told them Hedge Funds: Survival and Performance, their own medi- that was a cost they had to pay for the 1989–95,” Journal of Business 72, no. 1 (January cine. 1999): 91–117; and Andrew Webb, “Hedge Fund greater good. . . . Cronyism bad. Fever,” Derivatives Strategy 3, no. 10 (October Capitalism good. 1998): 33–38. Then came the imminent collapse of Long-Term Capital . . . , the quin- 3. See International Monetary Fund, chap. 1, p. 4. Further details can be found in Barry Eichengreen tessential member of The Club, with et al., “Hedge Funds and Financial Market rich fat-cat investors and rich hot- Dynamics,” International Monetary Fund shot connected managers. Faster Occasional Paper 166, 1998. than you can say “bailout,” crony 4. Malaysian prime minister Mahathir capitalism U.S. style raised its ugly Mohammad has called repeatedly for greater con- head. . . . John Meriwether and the trols on the activities of international “specula- rest of the guys who ran the fund tors.” Indeed, Mahathir has blamed hedge funds onto the rocks got to keep their jobs. for causing the recent economic meltdown in South East Asia and has repeatedly singled out The fund’s investors, whose stakes George Soros, in particular, as being personally would have been wiped out in a col- responsible for many of the region’s problems. lapse, salvaged about seven cents on See, for example, “Mahathir Blasts Speculators,” the dollar. . . . The rescuers even CNNfn, January 30, 1999, http://www.cnnfn.com/ worldbiz/europe/9901/30/davos_mahathir/. agreed to pay a management fee on Those claims cannot be taken seriously, and one their rescue fund.27 suspects that Mahathir is seeking scapegoats for his own policy failures. The most damaging consequence of the 5. Amy Feldman, “Investment Titan’s Fall,” New LTCM episode is therefore the harm done by York Daily News, September 28, 1998, p. 2, the perception that Federal Reserve policy- http://www.nydailynews.com. makers do not really have the faith to take 6. These figures are derived from those given on p. their own medicine. How can they persuade 4 of the testimony of David Lindsey, director of the Russians or the Japanese to let big insti- the Securities and Exchange Commission’s tutions fail, if they are afraid to do the same Division of Market Regulation, before the House themselves? At the end of the day, economic Committee on Banking and Financial Services on October 1, 1998, when the committee was hearing liberalization is just as necessary as it always evidence on the activities of hedge funds. This tes- was, but in the wake of the LTCM rescue, one timony is available at http://www.hedgefunds. can understand why many of those who have net /testimony.htm. to pay the price for it might have their 7. Ibid., pp. 4–5. 8. Ibid., p. 5. 11
  • 12. 9. Allan Sloan, “What Goes Around,” Newsweek, 17. For more on developments in risk manage- October 12, 1998. ment, see, for example, Carol Alexander, ed., Measuring and Modelling Financial Risk, vol. 2 of Risk 10. A detailed account of the rescue is given in Management and Analysis (New York: John Wiley, William J. McDonough, president of the New 1998); and Kevin Dowd, Beyond Value at Risk: The York Federal Reserve, Statement before the House New Science of Risk Management (New York: John Committee on Banking and Financial Services, Wiley, 1998), pp. 3–37. October 1, 1998, http://www.bog.frb.fed.us. 18. These include the Group of Thirty’s report of 11. See Sloan. July 1993, Derivatives: Practices and Principles (New York: Group of Thirty, 1994); and U.S. General 12. Since LTCM insiders have still to fully reveal Accounting Office, “Financial Derivatives: their side of the story, one can only speculate on Actions Needed to Protect the Financial System,” why the management of LTCM rejected the May 1994. Dowd, p. 16, provides a list of reports Buffett offer. However, they would have been con- by other interested parties. fident at this point that another offer would be forthcoming, and there are good reasons why 19. See ibid., pp. 121–31. they might have expected this second offer to be more generous than the first. For one, Buffett had 20. These practices are explained in Lee Wakeman, a fierce reputation for buying up firms at rock- “Credit Enhancement,” in Alexander, pp. 255–75. bottom prices and was clearly driving a very hard For more on the use of credit derivatives, see Janet bargain. In addition, they could reasonably infer M. Tavakoli, Credit Derivatives: A Guide to from its recent behavior and record in past crises Instruments and Applications (New York: John Wiley, that the Federal Reserve was determined to pre- 1998). vent the firm’s failure, and if the Fed was to do so, it needed to give the fund’s managers some incen- 21. Benedict Weller, “Betting with Hedges,” tive to cooperate. In other words, they had some Financial Regulator 3, no. 3 (December 1998): 21. bargaining power with the Federal Reserve, which was clearly desperate to prevent the failure of 22. Greenspan, p. 5. LTCM, but they had no such bargaining power 23. Ibid. with Buffett. If they turned Buffett down, the management of LTCM could therefore be fairly 24. See, for example, Richard H. Timberlake, confident of getting a better deal shortly after- Monetary Policy in the United States: An Intellectual wards. From their point of view, rejecting the and Institutional History (Chicago: University of Buffett offer made good sense, but only because Chicago Press, 1993), pp. 416–18. they could expect a better offer later. 25. Patrick Young, “Lessons from LTCM,” Applied 13. McDonough, p. 4. Derivatives Trading, October 1998, p. 1, http://www.adtrading.com. 14. Alan Greenspan, chairman, Board of Governors of the Federal Reserve System, “Private- 26. James A. Leach, “The Failure of Long-Term Sector Refinancing of the Large Hedge Fund, Capital Management: A Preliminary Assess- Long-Term Capital Management,” Testimony ment,” Statement to the House Banking and before the House Committee on Banking and Financial Services Committee, October 12, 1998, Financial Services, October 1, 1998, p. 5, http:// pp. 5–6, http://www. house.gov/banking/ www.bog.frb.fed.us. 101298le.htm. 15. Ibid., pp. 1, 3. 27. Sloan. 16. Ibid., p. 1. Published by the Cato Institute, Cato Briefing Papers is a regular series evaluating government policies and offering proposals for reform. Nothing in Cato Briefing Papers should be construed as necessarily reflecting the views of the Cato Institute or as an attempt to aid or hinder the passage of any bill before Congress. Additional copies of Cato Briefing Papers are $2.00 each ($1.00 in bulk). To order, or for a complete listing of available studies, write the Cato Institute, 1000 Massachusetts Avenue, N.W., Washington, D.C. 20001, call (202) 842-0200 or fax (202) 842-3490. Contact the Cato Institute for reprint permission. 12