Tuesday, September 24, 2013

How the concept of Too Big To Fail began

While the commemoration of the 5 year anniversary of the start of the Great Financial Crisis is slowing but surely fading, another just as important anniversary is revealed when one goes back not 5 but 15 years into the past, specifically to September 23, 1998. On that day, the policy that came to define the New Normal more than any other, namely the bailout of those deemed Too Big To Fail, a/k/a throwing good (private or taxpayer) money after bad was enshrined by Wall Street as the official canon when faced with a situation where capitalism, namely failure, is seen as Too Dangerous To Succeed. This was first known as the Greenspan Put, subsequently the Bernanke Put, and its current iteration is best known as the Global Central Banker All-In Systemic Put. We sow the seeds of bailing out insolvent financial corporations to this day, when instead of making them smaller and breaking them up, they are rewarded by becoming even bigger, even more systemics, and even Too Bigger To Fail, and their employees are paid ever greater record bonuses.

Enter, or rather exit, Long-Term Capital Management.

While we could republish Roger Lowenstein's wonderful When Genius Failed in its entirety, for those who are unfamiliar with what transpired that day, Wiki has a good and succinct summary:

On September 23, 1998, Goldman Sachs, AIG, and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $3.75 billion and to operate LTCM within Goldman's own trading division. The offer was stunningly low to LTCM's partners because at the start of the year their firm had been worth $4.7 billion. Warren Buffett gave Meriwether less than one hour to accept the deal; the time period lapsed before a deal could be worked out.

Seeing no options left the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. The principal negotiator for LTCM was general counsel James G. Rickards. The contributions from the various institutions were as follows:
  • $300 million: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P.Morgan, Morgan Stanley, Salomon Smith Barney, UBS
  • $125 million: Société Générale
  • $100 million: Lehman Brothers, Paribas
  • Bear Stearns declined to participate.

In return, the participating banks got a 90% share in the fund and a promise that a supervisory board would be established. LTCM's partners received a 10% stake, still worth about $400 million, but this money was completely consumed by their debts. The partners once had $1.9 billion of their own money invested in LTCM, all of which was wiped out.

The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices, which would force other companies to liquidate their own debt creating a vicious cycle.

While LTCM was structurally bailed out to avoid counterparty risk to other Wall Street firms, any equity invested in it was not, and the result was one of those sharp and sudden repricings that Stan Druckenmiller discussed in his interview last week. This can be seen in the following chart showing the value of $1,000 invested in LTCM, the Dow Jones Industrial Average and invested monthly in U.S. Treasuries at constant maturity.

Fifteen years later, virtually all deposit-taking institutions are considered systematic and too big to fail. However, the biggest to fail institution of them all is not a bank, symmetrically perhaps, once again a hedge fund: the biggest one, according to Warren Buffet, in the world.

The Federal Reserve.

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