Bailouts Seminar Karen Bradshaw, Molly Grovak, Drew Navikas, Asha

Spencer

Long-Term Capital Management

Gross value of $1 invested March 1994 - October 1998 in LTCMWhen Genius Failed pp. xiv

3/1994 1/1995 1/1996 1/1997 1/1998

$4.50

4.00

3.00

2.00

1.00

0.00

***

Agenda

• Background• Framework for analysis• Was LTCM a bailout?• Was LTCM successful (as a bailout)?

• Relevance to Current Crisis• Conclusions• Questions

LTCM

BAILOUT = $3.6BLOANS

LOANS

INVESTMENTSMerton

Meriwether

Scholes

Mullins

Black

PRESSURE

PRES

SURE

Bond trading experience

$1.25 billion up to $7B down to $555M

Up to 40%

returns

Up to $1 trillion in derivatives

Background

Background

3/1994 1/1995 1/1996 1/1997 1/1998

$4.50

4.00

3.00

2.00

1.00

0.00

Gross value of $1 invested March 1994 - October 1998 in LTCMWhen Genius Failed pp. xiv

Background

80% loss over 5 weeksRussia defaults

BackgroundBank Amount

ContributedBankers Trust $300MBarclays 300MChase 300MCSFB 300MDeutsche Bank 300MGoldman Sachs 300MMerrill Lynch 300MJP Morgan 300MMorgan Stanley 300MSalomon 300MUBS 300MSociété Générale 125MLehman Bros 100MParibas 100MBear Stearns $0. (Karma)

Total: $3.625B

Background

Wall Street’s Rocket Scientists thought they had a surefire way to bear the markets. Boy, were they wrong!

-Business Week, Sept 21, 1998

MISFIRE

Framework for Analysis

1. Use case studies from class to define the criteria for determining a bailout/success

2. Consider whether LTCM qualifies as a bailout/success against the criteria

3. Determine whether LTCM was a bailout/success and how LTCM might impact the criteria

Was LTCM a bailout?

Was LTCM successful (as a bailout)?

FRAMEWORK

ASK

Was LTCM a bailout?

Was LTCM a Bailout?What makes something a bailout?Input of private parties

Government interventionMore like a bailout

WHOPrincipals of the firm

Existing creditors and stakeholders

Market Players The Fed Treasury Congress

Was LTCM a Bailout?What makes something a bailout?

WHAT/WHY

Marketfacilitation

Government interventionMore like a bailout

Input of private parties

Government interventionMore like a bailout

WHOPrincipals of the firm

Existing creditors and stakeholders

Market Players The Fed Treasury Congress

Jumpstart private

negotiations

Stopping a downward spiral

Propping up firmsduring economicturbulence

Emulating private market

when dysfunctional

Gov’t intervention to pursue normative vision

Was LTCM a Bailout?

WHAT/WHY

Marketfacilitation

Government interventionMore like a bailout

Input of private parties

Government interventionMore like a bailout

WHOPrincipals of the firm

Existing creditors and stakeholders

Chapter 11GE Immelt bonusLaw firm partners

Market Players

Buffet & GS

The Fed Treasury

Detroit Today

Congress

TARPHOLC

Chrysler 1979

Jumpstart private

negotiations

Chrysler 1979

Stopping a downward spiral

S&LHousing

Propping up firmsduring economicturbulence Detroit TodayChrysler 1979

Emulating private market

when dysfunctional

TARP

Gov’t intervention to pursue normative vision

Detroit TodayAmerican Dream:

F&F

What makes something a bailout?

Discount windowBOA & Merrill

Was LTCM a Bailout?Yes yes yes! ~ NO

WHAT/WHY

Marketfacilitation

Government interventionMore like a bailout

Input of private parties

Government interventionMore like a bailout

WHOPrincipals of the firm

Existing creditors and stakeholders

Market Players The Fed Treasury Congress

Jumpstart private

negotiations

Stopping a downward spiral

Propping up firmsduring economicturbulence

Emulating private market

when dysfunctional

Gov’t intervention to pursue normative vision

LTCM LTCM LTCM

LTCMLTCM

Why does it matter?

• Distributes the perception of responsibility– Bailout = needed rescuing/failure by managers

– Not a Bailout = this was a function of regulatory choices and global markets

• Sets criteria by which we measure success

Was LTCM successful

(as a bailout)?

t

people impacted

short-term long-term

first party

third party

Short-term impact on third parties

Short-term impact on first parties

Long-term impact on third parties

Long-term impact on first parties

t

people impacted

short-term long-term

first party

third party

Short-term impact on third parties

Short-term impact on first parties

Long-term impact on third parties

Long-term impact on first parties

Reputational Harm

Shielding Stakeholder

s Autos, S&L, Banks

Saving JobsChrysler, Detroit

Keeping HomesHOLC, F&F, S&L

t

people impacted

short-term long-term

first party

third party

Short-term impact on third parties

Short-term impact on first parties

Long-term impact on third parties

Long-term impact on first parties

Public Policy

Economic Growth Panic/

Confidence

Reputational Harm

Shielding Stakeholder

s

Home OwnershipS&L, F&F

American AutosChrysler, Detroit

Easy CreditTARP

TARP

Autos, S&L, Banks

Saving JobsChrysler, Detroit

Keeping HomesHOLC, F&F, S&L

t

people impacted

short-term long-term

first party

third party

Short-term impact on third parties

Short-term impact on first parties

Long-term impact on third parties

Long-term impact on first parties

Public Policy

Economic Growth Panic/

Confidence

Preserving Jobs

Moral Hazard

Reputational Harm

Shielding Stakeholder

s

Home OwnershipS&L, F&F

American AutosChrysler, Detroit

Easy CreditTARP

TARP

Autos, S&L, Banks

Saving JobsChrysler, Detroit

Keeping HomesHOLC, F&F, S&L

Chrysler, Detroit

Autos, S&L, Banks

t

people impacted

short-term long-term

first party

third party

Short-term impact on third parties

Short-term impact on first parties

Long-term impact on third parties

Long-term impact on first parties

Public Policy

Economic Growth Panic/

Confidence

Opportunity Cost

Preserving Networks

Moral Hazard

Preserving Jobs

Moral Hazard

Reputational Harm

Shielding Stakeholder

s

Home OwnershipS&L, F&F

American AutosChrysler, Detroit

Easy CreditTARP

TARPChrysler, Detroit

Market LearningS&L, Chrysler

Barrier to Entry, Alternative Investment

TARP, Chrysler, F&F

Autos, S&L, Banks

Saving JobsChrysler, Detroit

Keeping HomesHOLC, F&F, S&L

Chrysler, Detroit

Autos, S&L, Banks

t

people impacted

short-term long-term

first party

third party

Short-term impact on third parties

Short-term impact on first parties

Long-term impact on third parties

Long-term impact on first parties

Public Policy

Economic Growth Panic/

Confidence

Opportunity Cost

Preserving Networks

Moral Hazard

Preserving Jobs

Muting Economic Turbulence

Moral Hazard

Stopping Downward Spiral

Reputational Harm

Shielding Stakeholder

s

Home OwnershipS&L, F&F

American AutosChrysler, Detroit

Easy CreditTARP

TARPChrysler, Detroit

Market LearningS&L, Chrysler

Barrier to Entry, Alternative Investment

TARP, Chrysler, F&F

Autos, S&L, Banks

Saving JobsChrysler, Detroit

Keeping HomesHOLC, F&F, S&L

Chrysler, S&L

Chrysler, Detroit

Autos, S&L, Banks

t

people impacted

short-term long-term

first party

third party

Short-term impact on third parties

Short-term impact on first parties

Long-term impact on third parties

Long-term impact on first parties

Public Policy

Economic Growth Panic/

Confidence

Opportunity Cost

Preserving Networks

Moral Hazard

Preserving Jobs

Muting Economic Turbulence

Moral Hazard

Stopping Downward Spiral

Reputational Harm

Shielding Stakeholder

s

t

people impacted

short-term long-term

first party

third party

Short-term impact on third parties

Short-term impact on first parties

Long-term impact on third parties

Long-term impact on first parties

Public Policy

Economic Growth Panic/

Confidence

Opportunity Cost

Preserving Networks

Moral Hazard

Preserving Jobs

Muting Economic Turbulence

Moral Hazard

Stopping Downward Spiral

Reputational Harm

Shielding Stakeholder

s

+ no huge costs in human capital+ unwound at a profit+ internalized losses+ investors who got out early

+ prevented credit meltdown+/- precedent for Fed involvement+/- avoided regulation

+ mitigated moral hazard

t

people impacted

short-term long-term

first party

third party

Short-term impact on third parties

Short-term impact on first parties

Long-term impact on third parties

Long-term impact on first parties

Public Policy

Economic Growth Panic/

Confidence

Opportunity Cost

Preserving Networks

Moral Hazard

Preserving Jobs

Muting Economic Turbulence

Moral Hazard

Stopping Downward Spiral

Reputational Harm

Shielding Stakeholder

s

- benefit financial gaming- made quantitative investment less risky- “how to” rather than a ghost story

+ no huge costs in human capital+ unwound at a profit+ internalized losses+ investors who got out early- reputational decline

+ prevented credit meltdown+/- precedent for Fed involvement+/- avoided regulation

+ mitigated moral hazard- didn’t continue as a going concern

Relevance to Current Crisis

• Investment strategies

• Market dynamics

• Moral hazards

Conclusions

• How do we put a stop to the learning gap without knee-jerk regulation?

• What should LTCM have led the Fed and Treasury to ask about Bear and Lehman?

• Why shotgun weddings without equity?

Questions?

LTCM

BAILOUT = $3.6BLOANS

LOANS

INVESTMENTSMerton

Meriwether

Scholes

Mullins

Black

PRESSURE

PRES

SURE

Bond trading experience

$1.25 billion up to $7B down to $555M

Up to 40%

returns

Up to $1 trillion in derivatives