"it is safe to lend to them at low rates … no matter how leveraged they are or how many risky bets they are making"

From Brad Setser:

"By bsetser

Tyler Cowen argues that the “Committee to Save the World” made a mistake in 1998 by, well, saving the financial world. They thus missed an opportunity to teach the banks a lesson in sound risk-management.

He specifically argues that the Fed (actually the New York Fed) shouldn’t have called the big banks together to recapitalize LTCM. The recapitalization didn’t require any Treasury funds or draw on the Fed as a lender of last resort, so calling it a bailout obscured the meaning of the term bailout – the fed catalyzed a private bailout of LTCM but it didn’t do a true government bailout. You might even say that the Fed catalyzed a bail-in of LTCM’s creditors. But by acting, Cowen argues that the Fed set a precedent that creditors of big financial institutions don’t take losses, and thus encouraged bad bets.( I AGREE WITH COWEN THAT IT SET A PRECEDENT, IN THAT THIS IS IN FACT GOVERNMENT INTERVENTION. WHO KNOWS WHAT THE GOVERNMENT WOULD HAVE BEEN WILLING TO DO? HOWEVER, IT'S CLEAR THAT THEY WOULDN'T COUNTENANCE A CALLING RUN. I DON'T AGREE THAT THE NY FED SHOULDN'T HAVE INTERVENED.)

I am not totally sure. The big banks called to the New York Fed were the creditors of LTCM and they were in some sense “bailed-in.” To avoid taking losses on the credit that they had extended to LTCM, they had to pony up and recapitalize LTCM.*( WERE ANY GOVERNMENT GUARANTEES OR INDUCEMENTS USED? )

It just so happened that the market recovered and it was possible for LTCM to exit many of its positions without taking large losses, or in some cases any losses. The banks that took control of LTCM when LTCM was on the ropes were able to unwind LTCM’s portfolio in a way that didn’t result in additional losses. But the result Cowen desired — large losses for the banks and broker-dealers who provided credit to LTCM – was quite possible if LTCM’s assets weren’t sufficient to cover all its liabilities. No creditor of LTCM was able to get rid of its exposure as a result of the Fed’s actions.

Lehman’s creditors didn’t get a chance to do a similar deal. There were too many of them — and there was too little time. I suspect, though, that Lehman’s creditors and counter-parties would be far better off if they had all agreed to pony up say 10% of the money they had lent to Lehman and in the process had provided Lehman with enough equity to allow it to be unwound in a more orderly way( I AGREE ).** They still would have taken losses, but those losses might well have been smaller – even counting the new money they put in – than the losses that Lehman’s creditors will incur as a result of Lehman’s bankruptcy filing( I TEND TO AGREE ).

Moreover, it seems a bit strange to look at LTCM in isolation( WE SHOULDN'T ).

LTCM, remember, came just after Russia defaulted.

And Russia was at the time considered the quintessential moral hazard play.

A host of financial institutions thought it was too nuclear to fail, and thus concluded that that they could safely pocket the high coupon on Russia’s GKOs (short-term Ruble denominated Russian securities) …

Bad bet. Then Treasury Secretary Robert Rubin concluded that it wasn’t possible to save Russia without effectively turning Russian credit into US credit. He wasn’t willing to do that. He wasn’t willing to support the disbursement of the second tranche of Russia’s IMF program after Russian burned through the first tranche really quickly.

Not providing Russia more money then was a risky call. Kind of like letting Lehman fail. Russia, remember, had nukes. Lots of them. The national security types weren’t thrilled by the prospect of a bankrupt nuclear power.

Russia’s creditors (including Lehman) took large losses at the time( A CALLING RUN WAS AVERTED. ). That presumably should have taught them a lesson or two about managing risk – it was more or less what I suspect Dr. Cowen would have prescribed.

It also implies that LTCM wasn’t the Lehman of 1998.

It was more like one of the institutions that was found to be swimming naked after Lehman defaulted.

LTCM was bailed out by its creditors (you might even say its creditors were bailed in … ). Today, the big financial institutions are truly getting bailed out. Most would be bust if not for Treasury capital injections and Fed liquidity support( TRUE ).

Nor was LTCM the only big borrower that got a bit of help after Russia didn’t get bailed out.

Brazil, like Russia, had a lot of short-term debt that had to be rolled over. Now it so happens that most of Brazil’s domestic debt was owed to domestic banks not foreign investors – and that really helped. The analogy isn’t perfect. Brazil also had a pegged exchange rate. It, like Russia, had pegged to the dollar at too high a rate to be sustained after Asia’s crisis cut into global demand for commodities and reduced private capital flows.

Brazil not surprising came under a lot of pressure. But it also got a decent sum of money from the IMF. That loan supplemented Brazil’s reserves and allowed for a more orderly exit from its fixed exchange rate than otherwise would have been the case. They delay made possible by the IMF (and the government’s heavy intervention) in the foreign exchange market allowed a lot of Brazilian firms to hedge their dollar exposure, so they didn’t go bust when the real eventually was devalued. And Brazil didn’t default. Not in 98. Not in 99. And not in 2002, when it also had to draw on the IMF after Argentina’s default.

Ending moral hazard consequently would have implied letting Brazil go – not just letting LTCM go. The odds are that a Brazilian default soon after Russia’s default would have brought done a major financial institution or two, and brought about a major systemic crisis.( NOT GOOD )

I am personally though glad that this wasn’t what happened. Brazil actually was suffering from a liquidity crisis as much as a solvency crisis. Or rather the IMF provided it with a cushion that allowed it to make the fiscal adjustment needed to assure its long-term solvency — and that was something it was willing to do. That kept its liquidity crisis from morphing into a solvency crisis. The line between the two often isn’t as clean in practice as in theory (apologies for all the detail; I wrote an equation-free book on this with Dr. Doom before he was Dr. Doom).

I doubt Brazil would be better off today if it had defaulted in 98 or early 99. Defaulting on domestic government debt does bad things to the long-term health of any country’s domestic banking system. It creates a really bad hangover – and leaves a country permanently more vulnerable to a run( I AGREE ).

Nor am I convinced that Dr. Cowen’s solution – standing aside as LTCM failed – would have ended moral hazard.( NOT BY ITSELF )

LTCM after all was an unregulated hedge fund. It wasn’t a regulated bank. Or a big – and sorta-regulated- broker-dealer. If LTCM had failed, I suspect that policy makers would have stepped in to prevent any major regulated financial institutions from failing as a result of its exposure to LTCM, or its own LTCM-style bets. Rather than ending the expectation that big banks and big broker-dealers were too big-to-fail, the failure of LTCM might have reinforced that sense( I AGREE ).

The real moral hazard in the financial system – in my view – comes not from expectations that if a firm like Goldman (or Lehman) makes a bad bet on a country like Russia (or a bad bet on US commercial real estate) the government will come in and protect the firm from losses on those investments. Rather it comes from the expectation on the part of those lending to places like Lehman and Goldman that these institutions are too important to fail, and thus it is safe to lend to them at low rates … no matter how leveraged they are or how many risky bets they are making.( THAT'S IT EXACTLY )

If that is right, ending moral hazard in 1998 would have required allowing an institution like Lehman to fail in a way that imposed large losses on Lehman’s creditors. Not just allowing LTCM to fail in a way that imposed large losses on firms like Lehman. ( IN A WAY THAT SHOWED THE GOVERNMENT WOULD NEVER INTERVENE )

And, well, right now a lot of people seem to think allowing an institution like Lehman to go bankrupt in 2008 was a mistake.( IT WAS )

To me the real failure during the last crisis was the failure of regulators to clamp down more seriously on leveraged institutions once the markets calmed.( IF THIS MEANS BAGEHOT'S PRINCIPLES, I AGREE. IF IT JUST MEANS TINKERING WITH THE REGULATIONS, THEN I DON'T AGREE. )

Losses in Russia – and a close call with LTCM did lead to a bit more prudence for a while. Regulators did start to pay more attention to the financial firms that were providing a lot of credit to big hedge funds. But that started to seem a bit superfluous in a context where (for a period) the banks actually were lending less to hedge funds, in part because the big hedge funds were shrinking. Not just LTCM. Tiger too … even Soros.

Most macro funds got burnt on the yen carry trade in 98.

And when the party got going again this decade — and hedge funds and private equity firms and the broker-dealers and the banks (through off balance sheet vehicles) all started to gear up — there was a team at the Treasury that wasn’t at all interested in regulating the financial sector. And the Fed – Greenspan especially – was never very keen on tight regulation.

Given all the scale of this year’s crisis, I certainly cannot rule out the possibility that Dr. Cowen is right and we would all be better off now if we had had a deeper crisis in 1998. A crisis that scarred the banks as deeply as it scarred most emerging markets might have produced a world where the banks wanted to increase their capital as badly as most emerging markets wanted to increase their reserves.( MAYBE )

But I doubt that that outcome would have been possible without standing by and watching a lot more institutions than just LTCM fail( I AGREE. IT COULD HAVE LED TO A RUN ). One big borrower — Russia — did fail rather spectacularly in 1998. Its failure created large losses for a lot of banks (far more than most were expecting, as some banks’ risk models at the time didn’t allow for a default on ruble denominated debt … ). The yen carry trade also unwound in ways that led to big losses at a lot of hedge funds. And that wasn’t enough.

My bottom line: getting rid of all moral hazard – and forcing creditors to evaluate the real risk of lending to a large, highly leveraged financial institution rather than bet that some large institutions were too big and too complex to fail – would have required a lot more that letting the market sort out LTCM with a gentle nudge from the Fed. It would have required allowing the set of institutions that were lending to LTCM to have failed …( AND EVEN THEN... )

And I suspect it would ultimately have meant allowing solvent but illiquid institutions (and countries) to fail. That is a bit further than I would be willing to go( I AGREE ).

*Bear Stearns excepted. Bear didn’t participate in the equity injection.
** Lending here should be read as shorthand for all credit exposure, even if it isn’t structured as a loan. And no doubt one complication of a plan based on “recapitalization from Lehman’s creditors” was that a lot of Lehman’s creditors had lent on a secured basis, and thus had little direct exposure to Lehman (though lots of exposure to a firesale of Lehman’s assets in the secondary market).
Relitigating 1998 …"

I agree with Setser, but I also agree that LTCM did add to the belief about implicit and explicit government guarantees. Whatever happened in Russia or Brazil or Mexico, our government was not going to let a Calling Run occur here. They were probably wise with LTCM.

I've concluded that we need a LOLR or final guarantor in order to prevent a Calling Run. Like the FDIC, its terms should be clear from the outset. The hope would be that it would allow the time for deals to unwind without inducing a panic. Implementation of Bagehot's Principles would help solve this problem, and possibly even rid us of it.

"The cost of living in the U.S. probably fell in October by the most in almost sixty years"

Well, Bloomberg says this:

"The cost of living in the U.S. probably fell in October by the most in almost sixty years, while manufacturing and homebuilding sank deeper into a recession, economists said before reports this week.

Consumer prices probably dropped 0.8 percent last month, the most since 1949, according to the median estimate in a Bloomberg News survey. Builders broke ground on the fewest houses in at least a half century and factory output weakened further, other reports may show.

Commodity costs plunged in October when the economy, which descended last quarter, went into freefall as credit and financial markets collapsed. Slumping sales are forcing retailers to lower prices, giving the Federal Reserve scope to keep cutting interest rates to limit the damage.

``Tumbling energy and commodity prices have altered the inflation landscape,'' said Ryan Sweet, a senior economist at Moody's Economy.com in West Chester, Pennsylvania. ``More rate cuts are needed as the economy is sinking deeper into recession.''

The Labor Department's consumer-price report is due Nov. 19. Fuel, clothing and auto costs probably dropped last month as sales at U.S. retailers fell 2.8 percent, the most since records began in 1992, economists said.

The slump in crude oil is feeding through to prices at the pump. The average cost of a gallon of regular gasoline plunged 17 percent last month to $3.08, according to AAA."

Here's the thing: Shouldn't the drop in the price of gas and other commodities act as a stimulus?

"Commodity Deflation

``We are seeing the fallout of global recession on inflation,'' said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts. ``In commodity prices, it's leading to deflation.''

Core prices, which exclude food and energy, rose 0.2 percent last month after a 0.1 percent gain the prior month, according to the survey median.

A report from the Labor Department on Nov. 18 may foreshadow the drop in retail costs. Wholesale prices fell 1.8 percent last month, the most since records began in 1947, according to economists surveyed.

As sales fall, manufacturers are cutting output and firing workers. Ford Motor Co. plans temporary shutdowns at nine North American plants this quarter after an 18 percent drop in U.S. sales this year, Angie Kozleski, a spokeswoman for the Dearborn, Michigan-based automaker, said last week.

Auto cutbacks probably pushed down manufacturing output last month, economists said a report from the Fed tomorrow may show. Overall industrial production, which includes factories, mines and utilities, rose 0.2 percent in October, led by a resumption of work at Gulf Coast refineries after Hurricane Ike shut down oil rigs the prior month, economists forecast."

I'm going to post about Yves Smith's post on this.

"Hurricane Rebound

A report from the New York Fed the same day may show manufacturing in the state contracted this month at the fastest pace since at least 2001. A similar report from the Philadelphia Fed on Nov. 20 may show regional activity shrank for an 11th time in 12 months.

The economic slump will intensify this quarter and persist into the first three months of 2009, making it the longest downturn since 1974-75, according to economists surveyed this month.

The housing recession at the heart of the economic downturn shows no signs of letting up. New-home starts in October dropped to a 780,000 annual pace, the lowest level since records began in 1959, the Commerce Department is forecast to report Nov. 19."

Here's a case where a weather word can be used both literally and metaphorically.

"Outlook Dims

A gauge of the economy's course will point to continued weakness, economists project a private report on Nov. 20 will show. The New York-based Conference Board's index of leading economic indicators probably fell 0.6 percent after increasing 0.3 percent in September.

Central bankers are battling to cushion the economy from the worst financial crisis in seven decades.

``Policy makers will remain in close contact, monitor developments closely and stand ready to take additional steps should conditions warrant,'' Fed Chairman Ben S. Bernanke said Nov. 14 at a panel discussion in Frankfurt hosted by the European Central Bank.

Heads of state of the Group of 20, which represents almost 90 percent of world output, met in Washington Saturday to lay the framework for coordinated actions to stem the global recession."

They must be reading Roubini.

``Perception trumping reality once more.'': A Philosphical Treatment By Richard Fuld

We just heard Liddy, now, from Bloomberg, let's listen to Fuld:

``Here we go again,'' Fuld erupted at one point, the person recalled. ``Perception trumping reality once more.''

It was vintage Fuld, a man so physically imposing, so volcanically explosive that, even at age 62, he scared underlings and competitors alike. He was raging on the captain's bridge, while a storm engulfed the company he had willed into becoming one of Wall Street's finest. Couldn't the short-sellers see how much he had done to shed bad assets? Couldn't they understand what a great franchise it still was?

Fuld was grounded enough in reality to know one thing: ``We've got to act fast,'' he said, ``so this financial tsunami doesn't wash us away.''

Fuld's an epistemologist. Who knew? Oh dear, weather words. It's bad.

"Then, on the morning of Sept. 14, after a series of weekend meetings at the New York Fed, a private deal to save the firm from bankruptcy was hatched. The government persuaded a syndicate of banks to backstop a new entity that would take over $55 billion to $60 billion of Lehman's troubled assets, and London-based Barclays Plc agreed to acquire the rest of the firm, according to people familiar with the negotiations.

When the U.K.'s Financial Services Authority refused to sign off on the Barclays purchase late that morning, U.S. officials refused to take any steps to save the deal. At about 2 a.m. on Monday, Sept. 15, Lehman filed the biggest bankruptcy in U.S. history."

Why?

"The Dow Jones Industrial Average fell 504 points on the day Lehman collapsed, triggering an increase in bank borrowing costs and a run on money-market funds and financial institutions around the world. By Tuesday, Paulson and Bernanke had reversed course, agreeing to an $85 billion bailout of foundering American International Group Inc., at the time the world's largest insurer. The government has since decided to make $250 billion of capital infusions to bolster major U.S. banks. Only Lehman has paid the ultimate price of the financial meltdown to date -- obliteration by bankruptcy."

Still, some claim it wasn't a mistake. Go figure.

"As cut off from information as Fuld may have been, it wasn't as if he didn't recognize the firm's problems. In November 2004, more than two years before the bull market reached its peak, Fuld was telling people around him that low interest rates and cheap credit would create a bubble that could one day pop.

``It's paving the road with cheap tar,'' he told colleagues in a meeting at the time. ``When the weather changes, the potholes that were there will be deeper and uglier.''

Weather again. Here's my point: An actual human agent saw the problem and did nothing.

"Fuld also warned against taking on too much risk, such as leveraged loans, which are used to finance buyouts of firms, as Lehman tried to compete with commercial banks that used their bigger balance sheets to support investment banking operations. ``We're vulnerable if we throw our balance sheet around,'' Fuld said, according to a person at the meeting. "

He's a kind of Cassandra apparently, not the head of a business.

"Lehman used its balance sheet to finance leveraged buyouts anyway. So did other Wall Street firms forced to compete with commercial banks, which were allowed to practice investment banking after the 1999 repeal of the Glass-Steagall Act.

Leveraged loans weren't Lehman's undoing, though. Fuld saw the dangers they posed and rid the firm of the riskiest ones in the fourth quarter of 2007, according to company filings.

What Fuld failed to do is take advantage of a rebound in the prices of fixed-income assets at the time to sell some of Lehman's $84 billion mortgage portfolio. He took false comfort in having hedged the firm's mortgage positions at the end of 2006. Because of the hedges, insiders say, Lehman executives were sanguine after the July 2007 implosion of two Bear Stearns hedge funds that had invested in subprime securities. Fuld even loaded up on mortgage-backed securities at the beginning of 2008, not seeing how vulnerable the firm would be when the subprime cancer metastasized to other asset classes."

I thought that he'd predicted a bubble?

"To Fuld, the idea was outrageous. The hit was a matter of wrong perceptions, not weak fundamentals. So he got on the phone with the firm's biggest clients to tell them Lehman was no Bear Stearns, and he ordered other executives to do the same."

Objects in the mirror are bigger than they appear.

"Why Fuld was unable to find a buyer for all or part of Lehman remains a matter of dispute. It was not for want of trying, although some people familiar with those efforts throughout the spring and summer say he was unwilling to accept the rapidly falling valuation of his firm.

``Dick was so proud of Lehman that he was slow to recognize that others didn't share that belief,'' said George L. Ball, chairman of Houston-based investment firm Sanders Morris Harris Group Inc. and a friend of Fuld's."

Sounds here like Fuld couldn't differentiate between perception and reality. It's Proustian, frankly. The problem you project onto others is actually your own.

"Even interested parties figured the price would keep coming down, as real estate valuations fell and Lehman got more desperate for cash. The Bear Stearns precedent, in which the government stepped in to facilitate a deal, also gave prospective buyers a reason to wait."

Absolute gold. I've been waiting for it. Waiting for government intervention. Got it!

"Meanwhile, worried that his lieutenants wouldn't be able to fetch a fair price from an investor, Fuld was pursuing another strategy. The plan his associates devised would offload Lehman's toxic commercial-mortgage portfolio to an independent company, codenamed Spinco. The new company's stock would be owned by Lehman shareholders, and its startup capital would be provided by the firm. While Lehman would have to raise fresh capital to replace what it transferred to Spinco, investors would be buying into an investment bank with a scrubbed balance sheet. "

I might work this into a novel.

"The cost of insuring Lehman's debt surged by almost 200 basis points after the KDB news, rising to 500, still not as high as where Bear Stearns's credit-default swaps were trading before its collapse. (A basis point equals one-hundredth of a percentage point.)

That caused Lehman's hedge fund clients to pull out, and short-term creditors cut lending lines. New York-based JPMorgan, Lehman's clearing agent for trades, demanded additional powers to seize cash and collateral in the firm's accounts."

It does appear that he's sitting on a weaker and weaker hand. Perhaps he playing a game none of us understand.

"The next day, Sept. 10, Fuld pre-announced quarterly results -- a $3.9 billion loss, after $5.6 billion of writedowns. He also said Lehman would auction off a majority stake in its asset-management division, and he revealed his Spinco plan. He was still talking defiantly.

``We have a long track record of pulling together when times are tough,'' Fuld said on a conference call with investors. ``We are on track to put these last two quarters behind us.''

Once again, Fuld was a step behind events. Before the day was out, Moody's Investors Service said it was reviewing Lehman's credit ratings and that it would downgrade the firm unless it made a deal with a strategic partner. Lehman's shares fell another 42 percent the next day to $4.22."

Perception and reality again. This article is making him sound like King Lear.

"As things were spinning out of control, Fuld turned to the federal regulators with whom he had been talking since the demise of Bear Stearns.

He had approached Timothy F. Geithner, 47, president of the Federal Reserve Bank of New York, in July to see whether Lehman might become a bank-holding company, which would allow it to widen its funding base."

Now he's an alchemist.

"Meanwhile, Paulson was putting out the word there would be no more federal bailouts, that the government couldn't rescue every failing investment bank. "

Note to Paulson. Moral hazard only works when you enforce it from the beginning. If you don't, then your actions seem fickle and arbitary.

"When asked why AIG was saved and Lehman wasn't, he leaned into a microphone, scowled and slowly replied: ``Until the day they put me in the ground, I will wonder.''

I told you we'd learn a lot if we'd just listen. Fuld was right, and is just saying what I said people would say once you've ignored moral hazard. Actions are as important as words.

"At that point, the only way to save the deal would have been for U.S. regulators to make the temporary debt guarantee. They didn't. Paulson, who told the New York Times he didn't have the authority to rescue Lehman, didn't answer questions about Sunday's events submitted by Bloomberg. Nor did Geithner. "

What's he going to say? I'm an ass. He's too rich to admit that to himself.

"Fuld thought Paulson was in his corner, he told a person familiar with events, even as the Treasury secretary publicly resisted spending taxpayer money to help Lehman. Fuld was stunned, the person says, when Paulson didn't throw him a lifeline at the end.

It was McDade who called Fuld from the Fed meeting on Sunday afternoon, not Paulson. Far from helping Lehman, Paulson, Geithner and other officials, including SEC Chairman Christopher Cox, began pressing Lehman to declare bankruptcy. McDade told them that would have serious repercussions for other firms. Wall Street executives gathered at the Fed said a bankruptcy wouldn't be the end of the world. Goldman Sachs and Morgan Stanley both had war rooms with charts detailing Lehman's subsidiaries and their exposure to each one, and they thought their potential losses would be limited.

No one, not even Lehman, knew what furies the firm's failure was about to unleash."

He misheard Paulson, who told him to go sit in the corner. Mythology talk. That's bad as well.

"The end came at about 2 a.m. Sept. 15, when Fuld, out of running room, filed for bankruptcy. That day the Standard & Poor's 500 Index had its biggest daily drop since the September 2001 terrorist attacks, and bank-lending rates soared. Paulson, who was poised to let AIG fail, quickly re-thought the wisdom of that decision and approved an $85 billion bailout. He and Bernanke also went to Congress to push for a $700 billion federal bailout to buy bad assets from troubled banks.

Only Lehman ended up in the wrong place at the wrong time.

Fuld was hard-pressed to explain his fate when he appeared in front of Waxman's committee on Oct. 6. To many of the congressmen's hostile questions and accusations, he had no answers. ``I wake up every single night,'' Fuld said, ``thinking, `What could I have done differently?'''

It might have ended differently had Fuld not risked so much on mortgage-backed securities. It might have ended differently had Fuld been willing to acknowledge Lehman's falling valuations. It might have ended differently if Fuld had made a deal in June, or July, or August.

That would have required acknowledging that time had run out on Wall Street's over-leveraged, overpaid gilded age. Instead, in his stubbornness and isolation, Dick Fuld failed to save the firm he lived for."

He walked out into cold evening air, bumped into a man carrying a bag of groceries, and quickly apologized. The cars and buses roared past him, ignoring the dimensions of the harm his failings would cause to the world's financial system. A beautiful middle aged woman smiled at him, something that would usually cheer him up, but not today.

"Why did I risk so much on mortgage-backed securities?", he asked aloud to passing pedestrians, none of whom responded, either because they didn't know or didn't care. "Was is simply a matter of using the name 'Spinco'?", he mused. "Could it all boil down to choosing a laughable name sounding like one of the Marx Brothers?"

Time for me to end this narrative before I actually start writing a novel based on it.