This Is the End


Markets, Risk and Human Interaction

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.