This is an abridged version of an article originally published in the latest The Price Report newsletter
There have been times in the past when central banks have let big firms fail, but concurrently supplied bridging liquidity in order to prevent needless collateral damage to credit markets. A classic – and successful – example was the Fed flooding credit markets in 1970 in the wake of the Penn Central Railroad failure. Penn had sought a federally guaranteed loan bailout to mitigate the effects of, mainly, poor management decisions. They argued they should be saved because bankruptcy would threaten the entire commercial paper market in which they had borrowed heavily.
The specific risk they claimed was that the railroad’s creditors would find their own funding cut off due to their exposure to Penn and a domino effect would be triggered down the commercial paper market line. The Fed did not buy this. It let them fail but provided temporary liquidity to the other actors in the commercial paper market.
An elegant approach and one that gave no reward to the company for its poor stewardship.
In contrast, during the US savings and loans (S&Ls) crisis of the 1980s, all sorts of panic measures were taken to avoid the bankruptcy of thrifts – including the poorly run ones – and thus to preserve political fiefs at state and national levels that it was thought out-of-pocket ex-depositors would otherwise have stormed. The term “insolvent”, for example, was re-defined; bills were passed granting S&Ls retrospective tax-relief on mortgage losses; federal deposit insurance limits were raised; and S&L net worth requirements were debased by broadening qualifying capital criteria.
Some of the results were unintended. Frauds came to light including that of Michael Milken’s linked financing schemes (“I’ll send deposits your way if you buy these worthless junk bonds”); and numerous S&Ls took greater moral hazard related risks than they should have and consequently failed. By the end, estimates of the total cost to the US taxpayer fell in the $200bn range – and that is 1990 money.
Nevertheless, by the time the Long Term Capital Management (LTCM) crisis broke the temptation to intervene prompted by a tendency to overweight and understudy the political considerations was again visible. Or perhaps ingrained. The US central bank took the view – with persuasion from the macro fund itself – that this was one firm too big to fail and stepped in. Or, to be fair, Mr Greenspan’s view was not that LTCM was too big to fail, but that it was too big to liquidate quickly. What the worth of that distinction is in practical terms is debatable.
By intervening the Fed appeared to have discouraged a credible and timely private sector rescue of LTCM by Warren Buffett. This is a disputed point; but it is clear that such an offer was made, rejected and withdrawn whilst the Fed and LTCM were talking. Intervention also amounted to a rejection of the idea that a global capital market valued in trillions of dollars is well able to absorb crises, demonstrate swift refractory snap-back times and make rapid order from chaos. Further, it glossed over the moral hazard dangers the Fed’s actions would engender. The Fed still went ahead and brokered a deal they later labelled a private-sector solution – but one with far better terms for LTCM managers and shareholders than they would have got from Mr Buffett.
It is hard to escape the depressing conclusion that regulators had come to believe only they can save, and know when to save, the market from itself. Is it a surprise, therefore, that when we look at the Northern Rock debacle we can hear distant echoes of all these events?
In today’s credit crisis, of which Northern Rock is a small, visible symptom, regulators are conditioned to believe, partly by precedent and partly by lobbying from the ranks of the distressed, that the potential fallout is of catastrophic scale and warrants major intervention. But there is a new twist: the source of this crisis is too much easy money for too long, a problem that permeates the entire system. Stepping in this time with a strategy of feeding credit markets liquidity does not look an apt policy stance.
There is thus not only the risk that regulators have become too trigger-happy in general saving those who do not merit it and penalising the prudent. There is also the further concern that they are lighting a match in the arsenal. When recession, re-balancing, and regeneration do come – and they cannot be legislated or re-inflated away into perpetuity – the price of such good but distortive intentions may well be that the final denouement is more protracted, painful and expensive than it otherwise could have been. That is the lesson of previous inelegant interventions that have tried to work against the market dynamic.
A light-touch interventionist philosophy that delineates clearly between market order and laissez-faire is what financial overseers ought to be striving for. That does not exclude safety nets: but these should not overly mitigate the downside of risk-taking – however great the political need to be seen to be doing something to smooth that jagged but necessary cornerstone of the market economy.