Ltcm Case Financial Institutions and Markets-Received A

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4. Compare and contrast the Fed’s response to the LTCM blowup vis-à-vis the Bear Stearns collapse.

Investment banks determined that LTCM would have enough in assets to receive a bailout and that their assets would increase in value over time and there was a high amount of backing by investment banks. Investors began pulling money out of the Bear Stearns which caused the bankers to call their loans, which required Bear Stearns to start selling assets. Bear Stearns were basically determined to be worthless and without intervention from the Fed, the failure of Bear Stearns could spread to other over-leveraged banks at the time such as Citigroup, and Merrill Lynch. While they were both saved to prevent systemic risk, the impact of the potential of Lehman failing seemed to play a bigger role on the finance world than LTCM’s near collapse did. Banks became unwilling to lend to one another after realizing nobody knew where the bad debt was within some of the largest institutions. The main difference between these two then really was that with Bear Stearns, the Fed had relied on the Federal Reserve Act to make the loan. These were considered to be “unusual and exigent circumstances,” and it was deemed that the collateral would be good enough to pay back the loan. Ben Bernanke had tried to stir up a similar collection of investment and backing by investment banks as had occurred in LTCM’s bailout but because Bear Stearns was so lowly valued, this solution did not work out and the Fed had to provide the capital.

5. What is Section 13 (3) of the Federal Reserve Act and what does it have to do with this case, if anything?

Section 13(3) of the Federal Reserve Act stated that in unusual and exigent circumstances, the Fed could essentially loan to any institution if the loan was secured to the satisfaction of the Federal Reserve Bank. What this meant is that the firm must be solvent and have a necessary amount of collateral which it can lend against. This was directly related to the case because in regard to all firms, solvency and collateral were evidently looked at to determine whether they would be bailed out or not. When looking at Lehman, it was determined there was a “$66 billion hole” in its balance sheet and though specific numbers were not placed on its valuation, it was deemed insolvent, backed also by Ben Bernanke. The reason this raises questions is because there was never basis provided for this conclusion and that there was no time for a written analysis which caused members to not prepare any written or formal reports. LTCM and Bear Stearns had evidently lived up to the Fed’s requirements and were bailed out, one through private investors and the latter with capital from the Federal Reserve. Ben Bernanke stated that they could not help Lehman legally; the act states that they can lend to an institution, any-one that they want, and that the governor’s must vote whether their collateral is good enough; in the case of Lehman, they determined that it was not.

6. Unlike Bear Stearns and LTCM, Lehman was allowed to fail. Why do you think that Lehman was treated different than LTCM? In your opinion, should Lehman have been bailed out? Why or Why not?

I believe that Lehman was treated differently than Bear Stearns and LTCM for a variety of reasons. First of all, LTCM was far before this and seemed to be viewed as a catalyst for a financial downfall if it was to collapse. For this reason, there was a lot of systemic risk surrounding the situation and the Fed did not know if the economy would be able to recover if they did not set-up a bailout. This would have been a global disaster; since LTCM was in so many global markets, liquidating all their assets would have caused many other developing economies to fall as well.

In one of the lectures Ben Bernanke stated that if a company was labeled “too big to fail” and knew it would be bailed out, then this would not be fair to other companies. They will have a large incentive to take big risks because if they pay off, they make tons of money, and if not; the government will save them. He expressed that this is a situation that the Fed could not tolerate, which begs one to question whether they were allowed to fail to make a point. He also stressed the point that there were not any legal or policy tools that would allow Lehman and AIG and other firms to go bankrupt without causing incredible damage, “… and therefore, we chose the lesser of two evils and prevented AIG from failing.” I believe that Lehman was a firm that was actually “too big to recover” rather than “too big to fail” due to having so much leverage in the markets. If all of a sudden the markets took a turn for worse/opposite, as occurred here; then they are the among the firms which would be adversely impacted first.

In my opinion, I do not think that Lehman should have been bailed out. First of all, it would have been unfair to other firms if they were bailed out because they were too big. Lehman was considered an insolvent firm by the Fed, which and they cannot put capital into a firm which is insolvent. Since there was no legal way to rescue them, there does not seem to be any reason to further view the topic. Maybe it would have curbed the destruction of the financial crises to some extent, but it may also have created managers whose mindsets in the future were, “if we are too big to fail, we can take on massive risk, and not be worried because the government will save us no matter what.” The Fed has to think about financial decisions with foresight and hindsight, even when approving a merger, it is attempting to evaluate whether the merger would create a more systematically dangerous situation.

7. In your opinion, would Dodd-Frank have prevented the LTCM debacle? Bear Stearns?

The Dodd-Frank Act expanded the financial stability duties of financial regulators including the Fed. It had created the FSOC to help regulators, and gave them all the responsibility to track and respond to risks to the financial system as a whole. The FSOC can also designate systemically important nonbank institutions to supervision by the Fed and gave them enhanced supervision. Higher capital requirements were established for most systemic firms and bank affiliates would no longer be able to trade on their own account. Regular stress tests would be conducted to make sure firms have adequate capitals in all types of scenarios, ensuring tougher supervision and created new orderly liquidation authority which would provide a less damaging way to close failing systemic firms.

I believe that the Dodd-Frank act would have helped the LTCM debacle because it required more transparency and