I recently finished reading When Genius Failed by Roger Lowenstein.   The book details the glorious rise and ignoble fall of Long Term Capital Management, a fund that boasted not one Nobel laureate but two.   I had been meaning to read the book for the last 4 years, but recently came to it indirectly.   The previous week, I had finished reading the Warren Buffet biography Snowball by Alice Schroeder.  The characters of LTCM, especially Jon Meriweather, play a prominent role during Buffet’s days at Salomon Brothers.  My curiosity was ignited to hear another tale of high finance.

Roger Lowenstein is great writer, and an even better financial writer.  He doesn’t just thrown down good prose, but understands the basic financial issues at hand.  I write here not the review the book, but dwell on one issue that epilogue raised - did the bailout of LTCM set the stage for the recent financial collapse and subsequent bailout?

Lowenstein writes prophetically, “If one looks at the Long-Term episode in isolation, one would tend to agree that the Fed was right to intervene, just as, if confronted with a suddenly mentally unstable patient, most doctors would willingly subscribe a tranquilizer.  The risks of breakdown are immediate; those of addiction are long term.”  In the case of LTCM, the Fed did not risk any public money - it merely orchestrated the meeting of the heads of the various Wall Street banks so they could privately fund a bailout.  In 2008 we had the Fed and the government take unprecedented steps to prevent a financial collapse, and this time the public did foot the bill.

I for one think it worked, but the spectre of long term addiction that already loomed since the days of LTCM rides much higher in the horizon.   Moral hazard is easy to recognize; if the government is willing to bailout financial firms that are “too large to fail”, the government is implicitly encouraging financial institutions to take on too much risk.  Moral hazard is easy to recognize and hard to avoid.   Purists will argue that we should have let AIG and brethren banks fail, and dealt with the consequences even if those consequences were another Great Depression.

I’m not a purist, but have to admit the precedent that we’ve set is a dangerous one.   Ultimately, it’s not just about  making sure that those who do misdeeds are punished.  At some point, as the stakes become greater and greater, there will be no recourse and the consequences even greater.   There are failures which cannot be bailed out.

The question is, can we pursue a course of action that is “correct” for the here and now while still setting the right precedent?  I like to believe there is.   Commonly, we make no distinction between Banks and Bankers, but there is a distinction to be made.   Institutions devoid of people should not susceptible to moral hazard.  So how can we bail out banks and not send the message to bankers to engage in ever riskier activity?

I think the “bailout” of LTCM spoke spades about how badly we deal with the guilty right now.  The managers/partners of LTCM received 250k salaries and 500k bonuses.  Yes, these amounts were trivial in comparison to the compensation these partners made in the good years, and admittedly many of the partners saw a majority own net worth vanish with that of their fund.  A few lost even more than they had as they borrowed money into invest in the fund.   Still why were they paid anything?  The twisted irony of failing in the financial world is that one is most needed when one has screwed up the most badly.  As a result financial sinners are able to hold their saviors hostage.  The worst part is that the same partners at LTCM took in more money from investors a little more than a year later in a new fund.   Should not there be repercussions?

Should we not hold some of those in the finance industry who nearly brought us brink of armageddon criminally liable?   I like to think there is some way, but here in lies the rub.   The banking crisis of the past year was widespread with no one party truly at the heart of the crisis.  The financial risks were truly institutional.   There was no one activity that was in itself too risky, but sets on interconnected activities that amplified risk.   How do you reform Wall Street?  It’s not arbitrary limits on pay going forward.   It’s a combination of good regulation that prevents systemic risk, and it’s also policies that let’s bankers know that they will not get away with risking the entire financial sector without repercussion.   Do you punish everyone who had a hand at all in the crisis which would be most of Wall Street, real estate agents, appraisers, home buyers, sellers, etc?  Individually each can claim their innocence, but collectively we are all guilty.