The long-term impact of Long Term Capital: limitless moral hazard

Twenty years ago, I was a trader in the Tokyo office of Long-Term Capital Management when exposures from our American and European offices lost 92 percent of our fund’s capital. Within a month, we had to be bailed out by a meeting organized by the New York Federal Reserve.

The Fed intervention seemed mild: No government funds were used and no sanctions were imposed. But it was clear that the Fed needed the deal to happen. Its reason? “Systemic risk.” The Fed was worried that a fire sale of LTCM’s highly leveraged assets would lead to widespread financial harm.

{mosads}To my knowledge, this was the first corporate death panel convened by a government entity in America on a single private financial firm since the creation of the Federal Reserve a century ago. They should have just let us die.

Ten years ago, almost to the day, the financial crisis hit America, and the corporate death panel reared its ugly head once more. AIG, Bear Stearns and many others were saved. Lehman Brothers was not.

The federal government had bailed out entire financial industries before, such as the savings and loan crisis of the late 1980s. But after wading in with LTCM, and diving in with the 2008 crisis, the government established the dangerous precedent that it can examine any financial entity and decide whether to funnel taxpayer money to it.

This is a stupid policy that is drowning us with moral hazard, crony capitalism and systemic fragility.

Moral hazard incites firms to take too many risks. With LTCM, the Fed exposed the possibility of bailouts to financial firms. Over the next decade, the firms therefore rationally and steadily increased the risks they took. While it worked, they reaped outsized profits. When it ultimately failed, as it always will, the taxpayers suffered.

Crony capitalism is the difference between being bailed out or not. When discretion is involved, who do you think on average will get bailed out more, firms that are cozier to the officials or ones that are more distant? What size firms are likely to be tighter cronies, small independent companies or large multinational conglomerates? Who will the law favor?

Systematic fragility follows inevitably whenever risks are artificially repressed. Like the subprime mortgage crisis or Japan’s lost decade or any vulnerable currency peg, hiding potential problems is the equivalent of covering your eyes and pretending there’s nothing wrong. For a while, things appear calm, but the true risk is hiding, and when it reveals itself, it will cause far more damage.

All these consequences are aspects of selection bias. This is the bias most overlooked by regulators, politicians, pundits and anyone who has ever uttered the phrase, “They ought to do something about that.”

When “they” do something, they distort the incentives of private firms, causing moral hazard. They corrupt public officials by giving them discretion, and they exacerbate the very problem they were trying to solve by hiding risks that could have otherwise been dealt with.

“They” selected LTCM to live, 20 years ago. They should have done nothing. Unfortunately, the situation is asymmetrical: We have no direct way of letting failing government entities die. Failing firms should fail. At least we can see their failure. But we don’t even know if some of our largest government entities are failing or how badly. 

Two decades since LTCM, and a century since it spawned, it is time to start this conversation. As a first step, it is
time to audit the Fed.

Philip Z. Maymin, is an associate professor of analytics and finance at the University of Bridgeport Trefz School of Business. He ran as a Libertarian for Connecticut’s 4th congressional district election in 2006. He holds a Ph.D. in finance from the University of Chicago.