Case Study The Day the World Almost Ended Formed in 1994, Long Term Capital Management (LTCM) was a well-known and successful investment fund numbering two winners of the economics Nobel Prize among its partners. Readers of the financial press therefore were shocked to learn on September 23, 1998, that LTCM was at the brink of failure and had been taken over by a consortium of major financial institutions. The reasons LTCM ran into problems, and the fears that led the Federal Reserve Bank of New York to organize its takeover, illustrate how the activities of unregulated nonbank financial institutions can make the entire international financial system more fragile, and even vulnerable to collapse.
Long Term Capital Management specialized in trades involving similar securities that differ slightly in yields due to their liquidity or risk characteristics. In a typical trade, LTCM would obtain money by promising to repay with newly issued 30-year United States Treasury bonds. The fund then would invest those funds in previously issued 30-year Treasury bonds, which have a smaller market than the newly issued ones, are harder to sell (less liquid), and therefore must offer a slightly higher yield. Long Term Capital Management would make this trade when the liquidity yield spread between the old and new bonds was unusually high; but since even unusually high spreads generally amount to only a small fraction of a percentage point, the trade would have to be very, very large to generate much profit. Where did the necessary money come from?
LTCM’s reputation for financial wizardry and its initially favorable track record gave it access to many big lenders willing to provide huge sums for such trades. Given the resources available to it and a desire to diversify, LTCM traded across countries and currencies. The firm amassed a huge global portfolio of assets and liabilities, the difference between the two representing capital invested by the firm’s partners and customers. LTCM’s capital at the start of 1998 was $4.8 billion; but at the same time, it was involved in financial contracts totaling almost $1.3 trillion, roughly 15 percent of a year’s United States GNP! (Such magnitudes are not uncommon for major financial institutions.) Although its massive positions generated high profits when things went right for LTCM, the possibility of correspondingly huge losses was also there, provided that enough of LTCM’s assets fell in value while the assets they had promised to deliver rose. An analysis of historical data by LTCM suggested that such an event was extremely improbable.
In August and September 1998, however, the extremely improbable event happened. A debt default by Russia in August (to be discussed in Chapter 22) sparked what the International Monetary Fund has called “a period of turmoil in mature markets that is virtually without precedent in the absence of a major inflationary or economic shock.”* The assets of LTCM plummeted in value and the value of its liabilities soared as frightened financial market participants around the world scrambled for safety and liquidity. Since LTCM now appeared very risky, its funding sources dried up and it had to dig into its capital to repay loans and provide additional collateral to its creditors.
With LTCM’s capital down to a “paltry” $600 million, the Federal Reserve Bank of New York organized a rescue. Fourteen major American and European financial institutions, most of them creditors, agreed to provide the firm with $3.6 billion in new capital in return for a claim to 90 percent of LTCM ’s profits and control over all its important decisions. Most of the institutions participating in the consortium would have made large immediate losses if LTCM had failed, as it certainly would have in the absence of a coordinated rescue effort. Even the news that LTCM had been saved from disaster, however, was enough to spook markets further. Only much later did a semblance of calm return to world asset markets.
Why did the New York Fed step in to organize a rescue for LTCM, rather than simply letting the troubled fund fail? The Fed feared that an LTCM failure could provoke financial panic on a global scale, leading to a cascade of bank failures around the world at a time when Asia and Latin America were already facing a steep economic slowdown. If LTCM had failed, financial panic could have arisen through several channels. Banks that had lent money to LTCM could have become targets for bank runs. Moreover, a rapid move by LTCM to sell its relatively illiquid investments (to meet creditors’ demands for repayment) would have driven their prices down steeply, pushing global interest rates up and calling into question the solvency of the many other financial institutions with portfolios similar to LTCM’s. In contrast, the strategy adopted by the Fed gave LTCM time to unwind its positions gradually without creating a selling panic.
Was the Fed’s action necessary or advisable? Critics claim that international investors will take excessive risks if they believe that the government will always save them from the results of their own imprudence. The possibility that you will take less care to prevent an accident if you are insured against it is called moral hazard. (Domestic bank supervision is necessary to limit the moral hazard resulting from deposit insurance and access to the lender of last resort, which otherwise would lead banks to make excessively risky loans.)
The Fed’s reply to its critics is that it did not use its LLR abilities to bail out LTCM. No public funds were injected into the ailing fund. Instead, major creditors were “bailed in” by being asked to put more of their money at risk to keep LTCM afloat. The additional risks they were forced to take—as well as the costs to the LTCM partners, who lost their wealth and their control over the fund—should be adequate deterrents to moral hazard, in the Fed’s view. Nonetheless, in the wake of the incident there were numerous calls for the official regulation of large global funds such as LTCM.
Not surprisingly, the debate rages on because the tradeoff between financial stability and moral hazard is inevitable. Any action by government to reduce the systemic risk inherent in financial markets will also reduce the risks that private operators perceive, and thereby encourage excessive gambling. In the LTCM case, the Fed clearly judged that the risk of a global financial meltdown was too serious to allow. ------------------------- *See “World Economic Outlook and International Capital Markets: Interim Assessment." Washington, D.C.: International Monetary Fund, December 1998, p.36.