In September 1998, the Federal Reserve of New York intervened to rescue Long-Term Capital Management (LTCM), a very prominent hedge fund on the brink of collapse. The Fed followed this course of action because it wanted to prevent any dire consequences that would affect world financial markets should the hedge fund be allowed to fail. The incident induced an open-ended extension of the Fed’s responsibilities without congressional authorization. Furthermore, the benefits gained through the U.S. Federal Reserve’s intervention in the rescue of LTCM may have been lower than anticipated. Although it did not provide any public money for the salvation operation, the costs, in terms of ‘moral hazard’ as well as the indirect implication of Crony Capitalism, are perhaps greater than those initially perceived.
Long-Term Capital Management was a hedge fund company founded by John Meriwether in 1994, in cooperation with Nobel Prize in economics winners Myron Scholes and Robert Merton who resided on its board. Hedge funds are essentially large, unregulated, private investment pools for wealthy individuals and institutions. They are not limited by the portfolio composition and leverage (how much they borrow compared with their capital) restrictions put on other types of investment vehicles. This company had developed a sophisticated computer model to take advantage of arbitrage deals usually with U.S., Japanese, and European sovereign bonds.
The basic concept behind LTCM was that the value of these bonds would gradually become identical, and, by a series of financial transactions, it would be possible to make a profit as the difference in the value of the bonds narrowed. Since these differences in value were very small, the fund needed to take highly leveraged positions in order to turn a significant profit. At the beginning of 1998, the firm had equity of $5 billion and had borrowed over $125 billion. When Russia defaulted on its national debt in August and September 1998, Long Term Capital Management suffered great losses. Since all the global markets were moving in the same direction, the diversification necessary for LTCM to function, no longer existed. Panicked investors sold Japanese and European bonds to buy U.S. treasuries. In direct contradiction of the predicted trend, the values of the bonds diverged, and hence the investors experienced huge losses. As a result of the “flight to liquidity” (flight to the most liquid assets, i.e. the most heavily traded American Treasuries) the company lost up to $100 billion and presumably required the $3.5 billion engineered by the rescue initiated by the Federal Reserve in order to avoid the spread of a wider collapse, which would encompass other financial markets. However, it is questionable if the involvement of the Fed was truly necessary.
The Federal Reserve’s decision to intervene was undoubtedly due to its conviction that the large-scale failure of LTCM would have a grave impact on the financial market. If LTCM had been allowed to collapse completely, financial panic would have been expressed in several ways. Banks that had lent money to LTCM could have become targets for bank runs. Moreover, a sudden sale of LTCM’s relatively illiquid investments would have driven their prices down steeply, thereby pushing global interest rates up and calling into question the solvency of the many other financial institutions with similar portfolios to LTCM’s. However, the Fed presupposed that LTCM was going to fail. This was not necessarily the case. When it became official that the Fed was going to negotiate an offer for the acquisition of LTCM, another possibility was presented. A group consisting of Warren Buffett’s firm, Berkshire Hathaway, along with Goldman Sachs and American International Group, a giant insurance holding company, offered to buy out the shareholders for $250 million and put $3.75 billion into the fund as new capital. However, the existing shareholders would have lost everything except for the $250 million takeover payment, and the fund’s managers would have been fired. Had it been accepted, that offer would have ended the crisis without any involvement of the Federal Reserve. Moreover, such a solution would prove the ability of the private sector to resolve financial crises independent of regulatory involvement. Nevertheless, the offer was rejected, ostensibly because it was anticipated that the Fed would offer a better deal. Consequently, the Fed came up with a rescue package that was immediately accepted by LTCM. Fourteen prominent banks and brokerage houses agreed to invest $3.65 billion of equity capital in LTCM in exchange for 90 percent of the firm’s equity. Existing shareholders would therefore retain a 10 percent holding, valued at approximately $400 million. Dissimilar to Buffett’s deal, the managers were able to retain their positions and therefore earn management fees.
The Fed’s involvement in the LTCM rescue implies a problematic expansion of its responsibilities. After 1998, it appears that the Fed accepted responsibility for the safety of large U.S. hedge funds, despite the fact that it did not have, and still does not have a legislative mandate permitting it to do so, or giving it authority over hedge funds. Therefore, these funds are prone to undertake risks for which the Fed would take responsibility, in case of failure, although it lacks any control over such actions. Furthermore, if the Fed became responsible for the hedge fund industry, then the line between hedge funds and other investment firms, especially those that might be similar to hedge funds, would be difficult to draw. Such action becomes even more questionable when viewed in a large context, in which it is clear that other factors, such as the Japanese banking system, have a considerably higher impact on financial markets. It is increasingly difficult to judge what the Fed presumes to be within the boundaries of its responsibilities.
Critics of the strategy adopted by the Fed, draw attention to the fact that it created moral hazard. Moral hazard is defined as the fear that financial institutions will take excessive risks if they believe that the government will save them from their own imprudence. This idea has also been coined the ‘too big to fail’ notion. More specifically, this doctrine states that the Federal Reserve cannot allow large institutions to fail, precisely because of their size, out of fear of the consequences that would be borne out on the financial system should the Fed decide against such action. This is perceived to be a direct encouragement for such institutions to act irresponsibly, and, ever since the bailout of Continental Illinois in 1984, Federal Reserve officials have been trying to convince these institutions that they cannot count on Fed support should they come into financial trouble. All progress that had been made in the direction of conveying this message was reversed with the rescue of LTCM. The return of this phenomenon has had serious consequences for long-term stability, which can only be ensured by giving institutions the incentive to be strong and efficient. Saving a weak firm from failure may help to calm markets in the short term, but it weakens financial stability in the long run.
 Kilander, Peter, LTCM – Hubris (or, Moral Hazard), LBO-Talk, 1999
 Dowd, Kevin, Too Big to Fail? Long-Term Capital Management and the Federal Reserve, CATO Institute, 1999
In addition, there was a highly visible conflict of interests. The close association between the heads of the LTCM and the Fed gave the salvation effort the appearance of crony capitalism. This had been once cited as the underlying cause of the 1997 crisis in Asia, where a closed and secretive elite held absolute control over politics, the economy and finance. The banks of those countries would often lend to countries. The State would then miraculously insure that the books would be balanced. Throughout 1997, governments in Asia and elsewhere have been politely told to put their economies in order, by, for example, making their systems more transparent and subject to the laws of the market. Above all, they were asked to stop funding failing banks or enterprises based on personal connections. Hypocritically, the Federal Reserve intervened simultaneously with the U.S. government’s attempt to convince foreign governments, especially Asian ones, that they should allow weak institutions to fail and to rely on market mechanisms, in order to modernize and achieve a healthy and stable economy. As a consequence, the LTCM bailout brought about significant damage to the credibility and moral authority of Federal Reserve Policymakers who do not really have the faith to take their own medicine.
There is little doubt that the Fed, by organizing and hosting meetings between LTCM and private banking and financial institutions, avoided an imminent crisis in the financial market. However, there is little evidence that a rescue operation could not have been orchestrated by the private sector, and hence, avoided the long-term difficulties characterized by moral hazard, and the loss in moral authority of Fed policymakers to guide other countries into healthy and productive economic practices.
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Kilander, Peter, LTCM – Hubris (or, Moral Hazard), LBO-Talk, 1999