In a post earlier today, Justin ruminated about how financial crisis might be just what the economy needs from time to time to keep everybody’s appetite for risk in check. Quoting Justin, paraphrasing Tyler Cowen: “If the Federal Reserve had just let the hedge fund Long-Term Capital Management fail in 1998—preferably in a messy and disorderly fashion—we’d be much better off today.”
Failure I’m okay with, but I wonder about that disorderly bit—especially in the current climate.
Quoting the Wall Street Journal, paraphrasing Alvarez & Marsal, the firm that has spent the past three months inside Lehman Brothers trying to figure out what went wrong: “A less-hurried Chapter 11 bankruptcy filing likely would have preserved tens of billions of dollars of value.”
The question is, are those tens of billions of dollars we’d have wanted to preserve, or were they part of the lesson-teaching? Let’s take a look:
Much of the destruction of value came from the bankruptcy filing of the parent guarantor, Lehman Holdings. The filing triggered a cascade of defaults at subsidiaries that held trading contracts. That created what is known as an “event of default” for Lehman’s derivatives. This resulted in a termination of more than 80% of the transactions with counterparties—typically major European and U.S. banks such as J.P. Morgan Chase & Co… In all, the bankruptcy canceled 900,000 separate derivatives contracts.
The problem for creditors is that this also terminated contracts in which Lehman was owed money. Mr. Marsal said a few extra weeks would have allowed Lehman to transfer or unwind most of its 1.1 million derivatives trades, preserving more cash for creditors.
What did happen—the whole overnight-bankruptcy thing—seems to be the exact sort of wipe-out Cowen would have liked to see with Long-Term Capital Management.
But then there’s this other part of the story:
The unplanned bankruptcy pushed down prices for Lehman assets in an already depressed market. An example is Lehman’s trading and investment-banking businesses, which before the filing made about $4 billion in annual profits and were sold for less than $500 million. Experts say such businesses —once separated from Lehman’s real-estate portfolio—could have garnered a higher price in a more orderly wind-down.
Are we also okay with that? Seems we’re moving from lesson-teaching into some other realm. Not sure if it counts as the “collateral damage” Justin refers to, but battering businesses that provide economic value [insert your own snarky comments about investment banking here] does seem to go beyond punishing excessive risk taking.
I get the argument about Long-Term, but my question is how does that apply to today? Should we have let AIG go under? Citi? As Cowen points out, Long-Term was just a hedge fund with 200 employees. It’s interesting history to revisit, but I’m not sure what the take-away should be for current policymaking.