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Authors for macroblog are Dave Altig and other Atlanta Fed economists.

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May 07, 2007

Long-Term Capital Management And The Fed

My colleague Joe Haubrich writes about "Some Lessons on the Rescue of Long-Term Capital Management":

... the LTCM episode raises many key issues about the resolution of financial crises: How far should the involvement of the central bank extend, what is the scope of action each of the various players should be responsible for, and what are the costs and benefits of the differing options? ...

Joe starts with two distinct views of the event and the Federal Reserve's involvement.  First, from Myron Scholes:

Although the Federal Reserve Bank (FRB) facilitated the takeover, it did not bail out LTCM. Many debtor entities found it in their self-interest not to post the collateral that was owed to LTCM, and other creditor entities claimed to be ahead of others to secure earlier payoffs. Without the FRB acting quickly to mitigate these holdup activities, LTCM would have had to file for bankruptcy—for some, a more efficient outcome, but a far more costly outcome for society. If there was a bailout, it failed: LTCM has been effectively liquidated.

On the other side of the fence is Kevin Dowd:

The Fed’s intervention was misguided and unnecessary because LTCM would not have failed anyway, and the Fed’s concerns about the effects of LTCM’s failure on financial markets were exaggerated. In the short run the intervention helped the shareholders and managers of LTCM to get a better deal for themselves than they would otherwise have obtained.

After more discussion of arguments pro and con, Dr. Haubrich concludes with his own take on the lessons learned:

Lesson 1: Context matters. Large losses at a financial firm do not by themselves create a need for Federal Reserve action: there must be a systemic component...

... Federal Reserve Board Chairman Alan Greenspan explained:

The scale and scope of LTCM's operations, which encompassed many markets, maturities, and currencies and often relied on instruments that were thinly traded and had prices that were not continuously quoted, made it exceptionally difficult to predict the broader ramifications of attempting to close out its positions precipitately.

In that passage, Mr. Greenspan continued:

It was the judgment of officials at the Federal Reserve Bank of New York, who were monitoring the situation on an ongoing basis, that the act of unwinding LTCM's portfolio in a forced liqudiation would not only have a significant distorting impact on market prices but also in the process could produce large losses, or worse, for a number of creditors and counterparties, and for other market participants who were not directly involved with LTCM. In that environment, it was the FRBNY's judgment that it was to the advantage of all parties--including the creditors and other market participants--to engender if at all possible an orderly resolution rather than let the firm go into disorderly fire-sale liquidation following a set of cascading cross defaults.

Joe goes on:

Lesson 2: Details matter.

That the problem was resolved successfully depended, in a large part, on “the orderly continuation in the risk arbitrage business of the newly recapitalized LTCM” (Bank for International Settlements, 1999, p. 9) which in turn depended on getting the details of the recapitalization right. In the LTCM case it meant retaining the management, giving enough stake in the firm to provide an incentive for efficient liquidation, and bringing in outside oversight.

Even after taking the intermediate step of “providing good offices,” the amount and type of moral suasion had to be decided on. Each choice in turn faced trade-offs...

Which brings us to:

Lesson 3: Look for the minimum effective intervention; or work with the market not against it.

... there is some evidence that even more reliance could have been placed on the market in the LTCM case. Stock prices and federal funds rates incorporated substantially correct information about exposures to LTCM. Fed intervention, despite its limited character, may have indeed increased moral hazard by increasing the perception of too-big-to-fail.


May 7, 2007 in Federal Reserve and Monetary Policy, This, That, and the Other | Permalink


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I asked then Senator Phil Gramm this very question in 1997 after Glass-Stegall was repealed and financial firms began combining. At what point do we have an event where someone is deemed too big to fail? I was referencing Citibank. I did not dream that one hedge fund could cause so much havoc.

Gerry Corrigan was a member of the CME BOD. He told me that in his investigation of LCTM, it was the closest to financial disaster that he would want to see. Obviously, there was a lot of systemic risk to the system.

Was it right to bail them out? At the time, I think McDonough made the right decision. If you read the book, " When Genius Failed", I have a sour taste in my mouth over how the boys from LTCM traded, and the easy lines of credit that they received. However, Goldman is the man in the black hat to me. Before they extended credit to LCTM, they downloaded their positions, pressed them, extended the credit knowing that LCTM would blow out. Goldman made a bushel basket full of money, and they did it at very little risk.

The question is not if the next bailout will need to happen, but when. Will it be prudent to bail out the financial entity that needs it? Or will it be better to let them fail?

Posted by: jeff | May 07, 2007 at 07:12 PM

Jeff's point is well taken. Some agrue that Greenspan's intervention into the LTCM mess set a stage upon which has subsequently been built an very large superstructure.

Some Black Swan event may yet let us know how well we've perceived systemic risk. At that time, should it happen, we'll find out how big such a bailout might need to be, else how troubled will be the times.

Posted by: Dave Iverson | May 08, 2007 at 12:24 PM

Noteworthy, Haubrich concludes with this from NY FRB President Geithner: "...[C]hanges since LTCM have improved the stability and resilience of the financial system, reducing the 'probability of systemic events.' Those same changes, though, 'may amplify the damage casued by and complicate the management of very severe financial shocks.'"

Are we in for a wild ride sometime relatively soon? Who knows? Why so little focus on Nassim Taleb's Black Swan events?

I contnue to wonder just how we get out of this without a Roubini-esq "hard landing". Perchance some years hence I and others will be eating up large portions of "crow." On the other hand, there are many, many cheerleaders and steadfast adherents to narrow-focus models who may have to do so.

Posted by: Dave Iverson | May 08, 2007 at 01:25 PM

Good work Dave... I linked back to this because it ties in to Systemic Risk & Group Behaviour.

Posted by: The Nattering Naybob | May 14, 2007 at 04:29 PM

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