Monday, September 10, 2007

Bailouts for Profit

When a market is under stress, prices come untethered from value, driven instead by the liquidity demand of those who have to get out – for example, funds that are leveraged and have the banks breathing down their necks – and those who simply cannot face the mounting losses and find it prudent to cut and run. But if the breakdown is coming from the liquidity needs of the leveraged fund, cut-and-run may not be the right strategy; profits can come to those who are willing to provide the other side of the trade for those who must liquidate.

This is a role we have seen Citadel take in the past couple of years, once with Amaranth and once with Sowood. They provided liquidity to the market when it was needed, and in providing this service they scooped up the assets that were going begging for pennies on the dollar. Good for them. I think this can be a great business for a fund to be in.

No one seems to begrudge Citadel, no one is chastising them for providing a bailout. The reason, of course, is that while they did bail out the markets – that is, while they helped stem a problem from getting worse or propagating out further to affect other firms – they are the ones who put up the capital, took the risk, and ultimately will earn the profits from their action. And Sowood and Amaranth are still out of business.

The point is that there are two types of bailouts. There are bailouts that keep the offending fund on it feet and in business. Arguably these sorts of bailouts create a moral hazard problem. But there is another sort of bailout that does not stand in the way of failure, but that still reduces the collateral damage. What I have described above are bailouts of the latter type. And the government should start to think of financial bailouts in these terms.

To be specific, what if the government maintained a pool of capital on the ready to buy up assets of firms that are failing, much as Citadel did for Amaranth and Sowood? Of course, if a private entity is willing to step up to the plate, all the better. But as a last resort, what if the government took on the role that Citadel did in these instances. There would be no moral hazard problems, since the firm still fails. But the collateral damage would be contained; the market would be kept from going into crisis, the dominos would be kept from falling. And the taxpayer would have good odds of pocketing some profits.

We have seen other cases that were ripe for this type of bailout. Take the Bear Stearns hedge funds; in their case a bailout of sorts occurred through the banks, which in an exercise of price suppression (as opposed to the usual function of the market, which is price discovery) agreed not to push their collateral into the market. Or take LTCM, where the Fed in effect used the banks as a surrogate for performing the second type of bailout.


  1. Rick,

    Excellent post - you have hit the nail on the head. The only point worth adding is that various governments and monetary authorities today have so much 'excess' FX reserves that they also now have the financial means to set up such a safety net.

    In my line of work, I advise central banks and sovereign wealth funds on various issues pertaining to reserve management. One of my 'hobby horses' is hedge fund investment by these institutions. I have long suggested that a small allocation of reserves to a broadly diversified portfolio of hedge funds could go a long way towards getting the official sector up to speed on hedge funds and potential systemic risks they present (for example, see a reprint of my article from the Wall Street Journal last December: )

    For your suggestion to work in practice, monetary authorities need to adopt a 'two-pronged' approach: keep a small allocation to a broadly diversified portfolio of hedge funds on an ongoing basis, and maintain a large liquid reserve ready for deployment along the lines of the 'second type of bailout' you describe...

    Andrew Rozanov, CFA FRM CAIA
    State Street

  2. The market will adjust to this, and the end result will be that it's easier for risky funds to raise money. If I'm going to get into the business of trading illiquid CDSs, or OTC stocks, or distressed debt, I'll have a portfolio vulnerable to massive shocks.

    Essentially, what you're suggesting is a subsidy for massive failure. If you're paying people to be Amaranth, you're going to get another Amaranth.

  3. Byrne,
    I think you are missing the distinction between the two types of bailouts. No one is being paid to be an Amaranth if the second type of bailout is done -- the Amaranth-type fund will fail. But what this second type of bailout will do is reduce the effect that failure has on the markets. So there is not the sort of moral hazard problems you allude to -- i.e. there is not the risk that funds will be less prudent because someone will bail them out if they get into trouble.

  4. "... the taxpayer would have good odds of pocketing some profits." ?????

    In theory, perhaps, since it is technically our money they'd be playing with. But the idea that we would actually see any real benefits is rather laughable in my opinion.

  5. Yes, I am speaking figuratively. Let's just say that the odds are the assets will be acquired at a low enough price that this bailout approach will be a net money-maker.

  6. I'm having a hard time imagining a scenario in which no financial agent other than the government (backed by its taxpayers) could step in with liquidity to contain a liquidity crisis.

    I'm also having a hard time believing that a government bailout could avoid precisely the sort of moral hazard with which we are concerned. If the government were in the bidding for Sowood's assets, using taxpayer money as collateral, do you not think some politician or bureaucrat would step up on behalf of a special interest (say, Sowood investors) and offer a price higher than private investors like Citadel are willing to pay?

    Even absent such political hazard, one thing I would wager is that the government is among the agents least capable of determining a fair value for distressed assets.

  7. Worth considering. Our govt tends to do this after the fact - eg., RTC. One example when they did this contemporaneously was the Chrysler guaranty in 1980, when they took back warrants that were worth something like 1/3 of the company and sold them back to the co at a profit, Iacocca kicking and screaming all the time.
    And in the past decade, there was the Emergency Steel Loan Guaranty board program and the post 9/11 investment in America West.

    But I think a lot of people would hesitate to create a blind pool run by the government to do vulture investing. It's unlikely the govt would be as sharp as Citadel - how could the govt hire Citadel-quality personnel or keep them around or move quickly enough to do a trade like that? I guess the govt could coinvest with hedge funds theoretically, but why would the funds let the govt in? And so many political loudmouths would go ballistic if the govt did that. I'm pessimistic.

  8. Chris G said...

    I like Ricks idea. How about you get the government to do this in concert with some Fed action to really manipulate the market? Wait for the market to really get skittish, bid for the assets at a discount... have the Fed ease the next day and liquidate into the short squeeze. Inside information on behalf of the taxpayer.

  9. The market might be a right place for 'bail out' to happen. Anyone who have courage and capital to buy those cheap assets that are dumped by trouble funds in asset markets, such as stock and commodity market, can supply liquidation and make profits.

  10. Bailouts should NOT be allowed, especially bailouts by the Fed.

    I find it very bizarre when Cramer and Kudlow are telling the Fed what to do with the Fed Funds rate. There were reports that Rubin spoke to Bernanke to make the September rate cut happen. This is not how the free markets are supposed to work.

    Let those who mismanage their funds go under and allow others with better trading strategies to get access to capital. Unfortunately, that is not happening these days because we live in a land of CRONY CAPITALISM where Rubin can infuence the decision of the FED and where Goldman Sachs has direct access to the US Treasury.

    This CRONY CAPITALISM is what we criticized in Indonesia and Malaysia but we practice the same terrible practices.