Too Big to Fail. Really?

How the Fall of LTCM in 1998 Can Help Guide Us Today

The too big to fail gospel has an aura of conventional wisdom and self evident truth that makes it very hard to debate. It is, however, one of the key assumptions behind the massive government intervention we have been seeing since last year. If these financial institutions were not saved, or so goes the gospel, the entire worldwide financial system would have collapsed and all hell would have broken loose.

Really? The Long Term Capital Management (LTCM) case tells us another story.

LTCM was a gem among hedge funds in the late nineties. It gathered probably the best of the best in financial engineers (including many MIT graduates, by the way): two Nobel Prize winners in economics, top Wall Street traders, and quants. All applied the latest mathematical and economic models to markets. But when the Asian and Russian crisis broke up, LTCM found itself overly exposed and on the verge of insolvency.

When that happened, LTCM apparently had nearly $120 billion in assets. It was almost as big as AIG at that time, which had approximately $150 billion in assets, and it was bigger than Bear Stearns, which had around $100 billion in assets. But what is more important is that LTCM had exposure to 1.4 trillion dollars in financial derivatives. This represented a significant portion of the derivatives market at that time, and most of the counterparts in these derivatives contracts were big financial institutions. In many ways, it was a situation very similar to today’s crisis.

Despite the size of LTCM’s failure, the market left alone was able to solve the problem. A group of firms led by Warren Buffet, Goldman Sachs, and AIG offered to buy LTCM and infuse it with new capital. Simultaneously, a consortium of LTCM’s creditors organized by the Fed also placed a bid and ended up taking over LTCM. After a year, LTCM was profitable again and there was no Fed or taxpayer money at risk. The problem was solved by private players left to their own self interests and there was no need for federal bailouts.

An analogy to today’s crisis would not be completely wrong. Just like in today’s crisis, the players that defaulted were very big. Just like in today’s crisis, the financial sector then was under huge stress as a result of the Asian crisis and the default of Russia. So could the market have survived today’s crisis without government bailout just like it did in 1998?

David Viniar, Goldman Sachs’ chief financial officer said during a conference call last Friday that “Goldman would have been unaffected by the failure of AIG,” and that “We would have had no credit losses if they failed.” As Ben Bernanke PhD ’79 said on Friday, it is time to “fix the too big to fail problem.” Indeed, it may be time to bring down the too big to fail myth and let the markets do their job.

Alejandro Rogers is an MBA student in the Sloan School of Management.