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December 28, 2008

Lessons of LTCM

When Genius Failed Marginal Revolution's Tyler Cowen makes a similar point in this NY Times op-ed about the 1998 federal bailout of the Long-Term Capital Management hedge fund that this earlier post made about Enron and the current Treasury bailout:

At the time, it may have seemed that regulators did the right thing [in bailing out LTM]. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed. [ .  .  .}

The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good.

Absent allocation of risk consequences to the parties who entered into transactions with financially-troubled companies, markets have a difficult time accurately pricing risk in regard to future investment and transactions. Such indecision plays a big part in delaying recovery in financial markets.

Similarly, without cleaning up the balance sheets of troubled companies (and putting the hopelessly insolvent ones out of their misery), extending additional credit to financially-strapped companies only makes them an even poorer risk for investment. That doesn't facilitate recovery in the financial markets, either.

Amidst many blunders, the Bush Administration's failure to tap corporate reorganization experts in connection with its policy-making regarding the financial crisis was one of the worst. Hopefully, Obama's advisors note the mistake and correct it in the next Administration.

Update: Barry Ritholtz agrees with Tyler and me.

Posted by Tom at December 28, 2008 12:01 AM |

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