The participation of several private-sector financial companies in the ongoing Yes Bank reconstruction is reminiscent of a similar ‘consortium bailout’ of a large floundering financial firm.
In September 1998, 14 banks and financial institutions were shepherded by the Federal Reserve Bank of New York to step in to bail out a hedge fund called Long-Term Capital Management. LTCM was established in early 1994 by John Meriwether, a former vice chairman at Salomon Brothers, the 1980s bond-market investment bank caricatured in Michael Lewis’ bestseller ‘Liar’s Poker’.
LTCM had a dream team with partners such as Professors Robert Merton and Myron Scholes. The duo, along with Fischer Black, were the key brains behind the equation which helped price financial derivatives. Later in 1997, Merton and Scholes shared the Nobel Memorial Prize in Economic Sciences, adding even more aura to LTCM. Even today, one can see the mention of LTCM in their Nobel Prize lectures.
A Rapid Start, Then Missteps
The field of finance had already emerged as a new big stream in economics with the 1990 Nobel Prize given to three scholars for work in financial economics. Apart from Merton-Scholes, the fund also managed to rope in David Mullins who was the vice-chair of Federal Reserve from 1990 to 1994. With this so-called dream team and its experience, LTCM was seen as the next big thing in finance. It began well, generating heavy returns through its arbitrage strategies leading to enormous interest among the financial community.
However, like all good stories, this one too came to an end, just four years into the journey. By 1998, LTCM was running up losses thanks to a convergence of troubles, from the July 1997 Asian financial crisis, culminating in the August 1998 Russian sovereign debt default and devaluation of the Ruble. The latter, in particular, created a serious problem for LTCM as the firm was not positioned anticipating the Russian government to default on sovereign debt. While LTCM had a diversified portfolio, losses spread across asset classes. The fund was highly leveraged and did not have adequate capital. The New York Fed’s financial surveillance brought LTCM’s troubles to its attention in early-September, 1998. Much like the global financial crisis that was to occur in 2008, and the Yes Bank situation in 2020 in India, events moved at a breakneck pace hereafter.
LTCM’s management told the New York Fed it would raise capital. But on Sept. 18, 1998, it expressed inability to do so.
Consequently, the New York Fed team visited LTCM on Sept. 20 and the large positions held by the firm came to light. However, the Federal Reserve lacked the powers to be the lender of last resort to a hedge fund, like LTCM. On Sept. 23, Warren Buffett’s Berkshire Hathaway, Goldman Sachs, and insurance giant AIG offered proposed a deal, that did not go through.
Other Financial Firms Step Up
With no other solution in sight, the New York Fed coordinated a 14-firm consortium bailout on the same day. These 14 firms were: Chase Manhattan Corporation; Goldman Sachs Group; Merrill Lynch & Co.; J.P. Morgan & Co.; Morgan Stanley Dean Witter & Co.; Salomon Smith Barney (Travelers Group); Credit Suisse First Boston Company; Barclays; Deutsche Bank; UBS; Bankers Trust Corporation; Société Generale; Paribas; and Lehman Brothers Holdings.
On Sept. 28, 1998, the consortium infused capital worth $3.6 billion for 90 percent ownership of the fund. In a press release, the consortium stated the objective was “to provide sufficient capital to permit Long-Term Capital to continue active management of its positions and over time, to reduce excessive risk exposures and leverage, return capital to the participants and ultimately realize the potential of the portfolio.”
The infusion saved LTCM from failure and prevented the system from going into a meltdown.
Balancing The Moral Hazard
By 1999, LTCM sold most of its remaining positions and paid back the consortium’s $3.6 billion investment. In a way, these firms didn’t just bail out LTCM but themselves too.
That did not stop this coordinated bailout from being criticised sharply. In a testimony to the U.S. House Committee on Banking and Financial Services on Oct. 1, 1998, then New York Fed President William McDonough outlined the reasons for LTCM’s downfall and the need for the Fed’s intervention. He said financial stability was one of the objectives of the Federal Reserve was and there was a widespread feeling that there would have been widespread instability if LTCM was allowed to fail.
The consortium approach was seen not only as a last resort, but also a private-sector solution to a private-sector problem.
In the same hearing, Federal Reserve Chair Alan Greenspan said, “no Federal Reserve funds were put at risk, no promises were made by the Federal Reserve, and no individual firms were pressured to participate.”
However, markets did not quite buy Greenspan’s testimony and the reaction was just the opposite. The market internalised that no financial firm would be allowed to fail, leading to what soon came to be known as ‘too big to fail’. Firms took on even larger risks and along came the 2008 crisis, forcing the Federal Reserve and the U.S. government to step in.
Who would have imagined that similar concerns would play out in India, nearly twenty-two years after LTCM? Over the history of private bank failures in India, RBI has juggled with two priorities: prevent failure to protect depositor interests, and also avoid the use of public funds. The use of the moratorium tool has been to do the first; and the practice of merging an ailing bank with a large bank to ensure the second.
In the case of Yes Bank, RBI chose a different path. It instead first allowed SBI to take 49 percent stake and then encourage other investors to buy into an expanded capital base.
The consortium of private banks and other investors realise that if Yes Bank fails, the outcome will impact them as well.
This is what’s likely to have made them inclined to be part of the bailout.
Financial crises transpire in cycles despite the ample history of past mistakes, and moral hazards are created despite the best efforts for avoiding them. Last week, this columnist pointed out how RBI governor Shaktikanta Das’ interview with BloombergQuint seemed to channel the thoughts of his predecessor HVR Iyengar following the failure of Palai Central Bank in 1960, on the delicate balancing required in the extent and manner of RBI’s intervention. Now, in having a consortium rescue Yes Bank, Governor Das has drawn a page from the playbook of Alan Greenspan, with the hope that it ends well.
p.s. For more on the rise and fall of LTCM, read ‘When Genius Failed’ by Roger Lowenstein, and ‘Inventing Money’ by Nicholas Dunbar.
Amol Agrawal is a faculty member at Ahmedabad University. He has a PhD in Indian Banking History and writes the Mostly Economics blog.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.
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