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BIS assessment of costs and benefits of 1998 LTCM rescue

by Chakravarthi Raghavan

Geneva, 13 Sep 2001 - At least in retrospect, the benefits of intervention by the US Federal Reserve (in September 1998) in organising the rescue of the Long-Term Capital Management (LTCM) may have been lower than was made out and, even though the Fed did not provide any public money for the rescue, the costs (in terms of ‘moral hazard’) may be higher than perceived at that time, according to a Bank for International Settlements Working Paper.

The paper, “The costs and benefits of moral suasion: Evidence from the rescue of long-term capital management,” is by Mr. Craig Furfine, ( BIS Monetary and Economic Department, Working Paper No. 103 of August 1991).

After examining the level of unsecured borrowing done by the firms that ultimately rescued the LTCM in the days leading to the rescue, the BIS paper suggests that the market never believed that the troubles at LTCM would have “solvency-threatening” repercussions for the fund’s major creditors - which implies that the reasons advanced by Greenspan, New York Federal Reserve’s William McDonough and others, who must have had direct access to ‘market information’ (used subsequently by the BIS for this analysis), were not really sound.

The LTCM, which was run as a highly leveraged hedge fund operation, using some theories of two US economic Nobel laureates, who were applying their theories to the actualities of the LTCM operation in whose management they were involved or associated with - Myron Scholes and Robert Merton. Also associated or involved in the LTCM was a former Fed personality.

In September 1998, when the problems at LTCM began to surface in the media, the US Federal Reserve Chairman, Mr. Alan Greenspan, played a key role in organising the rescue of the LTCM by organising and hosting meetings between LTCM and the private banking and financial institutions that ultimately rescued the troubled hedge fund.

At that time, a somewhat orchestrated, majority view was that there were systemic consequences (if the LTCM had failed) that would have posed a serious threat to the health of the US economy, and that the intervention of the US Fed averted this threat, both to the US and perhaps abroad too.

A minority of critics, not only questioned the rescue at that time, but even suggested, perhaps a little uncharitably, that those rescued and those rescuing had close associations, and this was an instance of ‘crony capitalism’ on which the Asian financial crisis was blamed.

The BIS paper notes that at the time of the rescue, and as it was happening, the events surrounding the troubles at the LTCM were portrayed as a serious threat to the health of the US economy.

In justifying the Fed’s involvement in the rescue, the President of the New York Federal Reserve Bank, Mr. William J McDonough said, “The abrupt and disorderly closeout of Long-Term Capital’s positions would pose unacceptable risks to the US economy”. This emphasised that much of what was driving the Fed’s involvement with LTCM was the uncertainty regarding the consequences of letting the fund collapse and having its financial contracts unwound in a forced liquidation.

And since it was difficult to know what might have happened in the absence of Fed involvement, policymakers chose to facilitate a resolution that allowed the hedge fund’s financial contracts to be closed out in an orderly fashion. One important consequence was that it avoided potentially excessive financial hardship or possibly the failure of major commercial and investment banks.

In looking at the evidence on the magnitude of the benefits and costs, the BIS looks at the operations in the market of the ‘creditors’, the nine international commercial banks (part of a group of 14 institutions) that jointly rescued the LTCM.

While these institutions would have experienced significant losses had the LTCM crisis not been resolved in an orderly manner, the study notes that the potential losses need not have arisen from direct credit exposures to the LTCM, but rather from the ‘proprietary trading positions’ of these banks, similar to those of the LTCM, thereby making the ‘creditor’ banks similarly exposed to market movements that would have followed a forced liquidation of the LTCM.

The study looks at the potential costs in terms of evidence of a possible expansion of the ‘safety net’ by the US Fed as a result of the rescue, and by looking at the data (now published) of the unsecured, overnight federal funds market.

This data, according to the BIS, shows that the nine large commercial banks, counter-parties to LTCM, had reduced their borrowings of overnight, unsecured funds during the last days of the crisis period. However, this reduction was accompanied by an increase in the gross level of overnight lending done by these same institutions.

These two findings, says BIS, jointly suggest that the nine banks were voluntarily reducing their net borrowing of overnight funds rather than being rationed from the market. The lack of rationing, in turn, implies that market participants were not overly worried about the solvency of these institutions.  The paper also finds that large and complex US commercial banks that were not exposed to LTCM paid lower interest rates to borrow overnight unsecured money after the hedge fund’s rescue than they did before the crisis began to unfold.

“One interpretation of this finding is that the market has viewed the Fed’s action as an enhancement of the ‘Too-Big-To-Fail’ (TBTF), an implicit safety net provided by the Fed, leading to ‘moral hazard’ of market participants being assured they could not be punished by the market for wrong and unsound decisions.

The BIS notes that the possible benefits of Fed intervention had at least two dimensions. First, such policymaker action would limit the market disruption arising from a forced liquidation of LTCM. Second, Fed intervention would prevent the failure of any major commercial or investment bank, thereby avoiding the disruptions to economic activity that such a failure might cause.

Analysing and interpreting evidence of the data of overnight bank borrowings by the creditor banks as well as others not involved, whether by counter-part repurchase agreements or Fed fund wire operations for repayments in cash, and also the data available of the situation of the Russian bond failures around that time (in which German banks were involved, but without any rescue by the German Central Bank), the BIS finds that in the days before the resolution of the LTCM crisis, the creditor banks, relative to other larger banks, had lower levels of borrowing, but “this represented a voluntary action” by the creditor banks.

“Thus, the market did not perceive that the LTCM banks were in imminent danger of failing. Nevertheless, the behaviour of these nine institutions was atypical.  In particular, in the days immediately preceding the resolution, these banks chose to increase the level of funds sold at a cost of nearly 5 basis points. In conjunction with their borrowing activity, this action noticeably reduced the banks’ net level of overnight borrowing that would be able to fund other investment activities.

“One interpretation of this is that after the Fed became involved, the LTCM creditors sought to reduce their investments in risky short-term activities (eg trading positions), and instead, placed more in the relatively safe investment of lending in the funds market (to non-LTCM-exposed counter-parties). An alternative and possibly complementary interpretation of the reduction in net borrowing by the LTCM banks was a desire to temporarily hold more liquid assets.  Given the unrest in securities markets during this time period, a shift from holding securities in a trading book to lending more in the funds market may have been a logical way to achieve this goal.”

However, regardless of whether the LTCM banks’ actions were an attempt to reduce risks, increase liquidity, or both, the results indicate that the change in behaviour occurred only during the period after the Fed became involved.

One explanation of this timing is that Fed involvement might have conveyed new information to the nine creditors that the problems at LTCM were more serious and could cause greater losses than previously thought. A natural response to this new information might have been for the banks to reduce risk-taking and increase the liquidity of their short-term investments. The Fed’s involvement also conveyed the fact that the Fed would not use public money to assist in any creditor bailout of LTCM. This, too, might have led institutions that had expected public support to act in this way.

Analysing the evidence of the data after the resolution of the LTCM, the BIS sums up the empirical results in its conclusions thus:

“First, participants in the federal funds market did not restrict their borrowing to the nine major creditors of LTCM. The observed decrease in borrowing done by these nine banks was accompanied by an increase in their interbank lending, suggesting that the resulting decline in net borrowing was by choice. Further, there was no apparent shift towards borrowing from less knowledgeable institutions. Numerical estimates suggest that a perception of ‘too-big-to-fail’ also seems unlikely to be the driving force behind this result.

“These findings suggest that the market never believed that these major institutions had a significant probability of default.

“The second major result of the paper is that large, complex banking organisations began paying lower interest rates for unsecured overnight money following the resolution of the LTCM crisis.

“One possibility is that markets viewed these institutions as safer because they avoided the difficulties related to the troubled hedge fund. Alternatively, this result suggests that the Fed’s action, even though it provided no public money, may have been perceived in the market as an implicit extension of a too-big-to-fail policy.

“Ultimately, these findings cannot lead one to conclude whether the Fed should have intervened in the way in which it did because the benefits and costs of Fed action are neither measured in their entirety nor weighted by an appropriate social welfare function.

“Nevertheless, the results suggest that the benefits of Fed intervention may have been lower and the costs higher than perceived at the time.”  - SUNS4966

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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