The Bailout Culture Turns 10

In light of the government bailout of failed institutions, it is only fitting that these current efforts are happening around the 10-year anniversary of the rescue of Long Term Capital Management (LTCM), which I detailed in a book review last year titled “When Genius Failed.”

MarketWatch had a follow up story to that historic bailout. Here are some snippets:

In less than two weeks, Wall Street will pass a milestone that on the surface probably doesn’t seem to have much relevance today: the 10th anniversary of the bailout of Long-Term Capital Management.

But the LTCM near-collapse and rescue set in motion Wall Street’s unchecked rush to risk during the decade by signaling to the market that the government would ultimately come to the rescue.

Wall Street is a kids’ game, so let’s refresh our memories. Everyone born before 1990 can skip ahead a couple of paragraphs.

LTCM was a hedge fund run by former Salomon Brothers bond whiz John Meriwether and a half dozen other traders. They raised $1.01 billion in 1994 and ended up with derivative positions of about $1.25 trillion, built on leverage, when the bets turned bad and lenders started asking for their money in the summer of 1998.

LTCM was strapped for cash. So, rather than unwind its positions and send the market into turmoil, the Federal Reserve Board of New York organized a $3.75 billion bailout paid for by Wall Street banks. The cash allowed LTCM to meet its obligations as it unwound its trades.

Maybe it’s because the numbers seem small by today’s standards, but LTCM caused a lot of anxiety at the time. The day after the bailout was announced, the Dow Jones Industrial Average fell 2%, mostly because investors feared the banks would lose their investment. The fall was followed by another 3% drop two trading days later when investors worried the Fed didn’t do enough.

Flash forward to 2008. On Monday the government pledged $200 billion to prop up Fannie/Freddie, two companies whose main investments were considered among the safest on Wall Street: American home mortgages.

The Treasury Department’s move followed one by the Fed in March. In a desperate attempt to help Bear Stearns Cos. avoid bankruptcy, New York Fed Chairman Timothy Geithner brokered a buyout with J.P. Morgan Chase & Co. The Fed backed $30 billion in assets with taxpayer money as part of the deal.

Since the start of the year, 11 U.S. commercial banks have failed. In July, regulators shut down IndyMac Bank, a move that will cost the Federal Deposit Insurance Corp. — and, by extension, anyone who keeps his or her money in a bank — $10 billion.

That’s reasonable, at least compared to what the auto industry wants: a $50 billion bailout in the form of loans to help the companies retool lines and become competitive. The airlines will be next, of course.

You can’t blame Rick Wagoner at General Motors for passing the hat to Uncle Sam. These CEOs have seen what a little government intervention can do, whether it be banning naked short selling for a few bank stocks or propping up the entire mortgage banking industry with billions in backing.

The taboo against bailouts has been broken. Now the problem is that everyone is rushing the government at the same time. Wall Street firms ran up risk for a decade after the LTCM bailout precisely because there was a bailout.

The unwritten message, what the bankers call moral hazard, was simple: come a crisis, the government will do everything it can to avoid a collapse. The leverage at Wall Street banks remains high. At Lehman, the ratio of debt to equity is 10.6, and this is after the bank spent nine months reducing its leverage. At the time of the LTCM meltdown the ratio at Lehman was 6.2.

Rising leverage is a familiar story across Wall Street. That these firms are all imploding at the same time should not come as any surprise to the government. Brokerages, banks, mortgage banks, airlines and automakers at the door in a classic run on the bank, but this time it’s the Central Bank.

The good news is that there was a happy ending to the LTCM scandal. The bailout banks eventually made a profit on the investment by the time the fund actually was closed in 1994.

Do you think taxpayers will have the same success when we look back on this in 10 years? Even Meriwether and his LTCM buddies could get that one right.

The last paragraph sums it up. LTCM was one entity to deal with. Now we have entire industries in dire straits and, to my way of thinking, this bailout will not end up making a profit no matter how long you wait. It’s like poring money into a bottomless sink hole with the taxpayers getting stuck footing the bill.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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