Losses are an integral part of the capitalist process. But you wouldn't know it from the way some big boys are treated by the Federal Reserve. It seems that if your losses are big enough, and your connections good enough, you can rely on a permanent line of credit to shield you from the consequences of your mistakes.
The new rule is gleaned from the treatment afforded to Long-Term Capital Management, a hedge fund that seemed to be consistently beating the odds. It specialized in investing borrowed money in a complex array of very risky financial instruments around the world. Because the firm was also run by two Nobel Prize winning economists, its activities enjoyed the aura of science.
There was also a record of accomplishment. In 1995, the fund returned 43 percent after fees, 40 percent in 1996, and 17 percent last year. By early 1998, it managed $4.8 billion, but by the end of summer, the value of its positions shot up to $125 billion. It accomplished this astounding feat by borrowing to the hilt. It all turned sour in September, when bad bets in the bond market led to an avalanche of margin calls that threatened to plow the firm under.
There's a valuable lesson to be learned here. It is that the market economy gives high returns only to those who are willing to take high risks on the downside as well. The art of entrepreneurial investing consists, not only of taking risks, but also of tempering one's enthusiasm for high returns with an awareness that the future is always uncertain, even to the experts.
But thanks to intervention by the Federal Reserve Bank of New York, this lesson will go unlearned. The Fed worked with Merrill Lynch, J.P. Morgan, Travelers, and others to put together a collection of investment houses that ponied up $3.5 billion to keep Long-Term Capital from going under. It's not being called a "bailout" because the Fed' s arm-twisting did not involve committing its own resources.
Plain language is out of fashion, but there's still good reason to call this a bailout in the way regular Americans would use the term. For the weeks prior, the firm had sought an infusion of credit by approaching anyone who would listen. But it found no takers. George Soros, for example, told the firm to take its margin calls and dunning letters and hit the road.
You can't blame the firm for trying. When the bank is coming for your house, you're glad to stand on the roof crying out for last-minute assistance. But when help doesn't arrive, it suggests that the community of lenders has decided that your judgment cannot be trusted. Similarly, the market decided not to take on Long-Term Capital's risks as its own. People decided that loanable funds have better uses.
Finally, an offer came in the form of a fax to Long-Term Capital, from Goldman Sachs, AIG, and Berkshire Hathaway (Warren Buffett). They offered to run the firm's portfolio and pay $250 million for the assets (conditioned on the firing of LTC's board). The offer, not a bailout but a free-market purchase, was set to expire at noon.
The Fed intervened to stop this "fire sale" (Greenspan's word for a market price) by assembling buyers on its own terms. It should be clear: the Federal Reserve is no ordinary market player. It possesses the singular power of buying and selling debt with new paper money it can create out of thin air. By cobbling together a host of reluctant bailers, it was implicitly committing its own resources, and saying, in effect, "This hedge fund is too big and too important to fail. By helping it, you help yourself."
What lesson does that impart? Not the capitalist one. Instead, it says to other shaky firms that if they take big enough risks with their capital, and their services are regarded as indispensable to the market, they too stand the chance of having their bills paid with other people's money. They win on the upside; others lose on the downside.
It just so happens that one of the partners at Long-Term Capital is David Mullins, Jr., former vice chairman of the Fed. Might that fact have something to do with the manner in which the failing firm garnered unprecedented access to the Fed's good offices? This is no way to run a financial system. It smacks of the crony capitalism the U.S. denounces in Asia, whereby bad bets are protected from exposure to market forces simply because they were made by well-connected gamblers.
Two other partners of the firm are Robert Merton and Myron Scholes, who nabbed the Nobel Prize for their work in financial instruments. Some of us were happy about that prize because it suggested the committee was being attentive to the nuts and bolts of finance rather than high-flown schemes for central management of economies. Their formulas made it possible for traders to more efficiently calculate prices for complex financial instruments.
But did someone actually think that Merton and Scholes were involved in real science rather than art by statistics? That the quantitative patterns they found in history made it possible to anticipate the future without having to resort to judgment and instinct? A fortune-teller with a high IQ, a prestigious prize, and a fast computer is still a fortune-teller.
The beauty of the free market is its built-in sorting mechanism: good judgment is rewarded and bad judgment is punished. That's why the system tends toward efficiency. Bailouts dramatically change the character of the system, exalting losers over winners and turning high risks into sure bets that we all pay for in the long run.
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Addendum: This letter is making the rounds among less fortunate investment houses:
Open Letter to the Fed
September 24, 1998
Messrs. Alan Greenspan and William McDonough
Board of Governors Federal Reserve System
Washington, DC 20551
It was with great pleasure that we read in this morning's Wall Street Journal of your decision to help alleviate the unfortunate and unnecessary loss incurred by the investors and creditors of Long Term Capital Management LP. The rapid and unforeseen decline in global markets has made it hard for all of us to master this universe. Your decision to intervene yesterday will certainly help Long Term Capital raise the funds necessary to buy into this unusually large dip. Americans everywhere are thankful for having such a thoughtful and forward-looking Federal Reserve System.
We are writing you to inform you of our own investment losses of late (though, most unfairly, our losses have not been on the cover of BusinessWeek). The following is a list of reasons for this loss, which, we think, is not unlike that of Long Term's:
We owned a large sum of derivatives, fully convinced of the smooth and continuous pricing of the markets. Our blind faith in Black Scholes models remains intact. Our models are perfect. It is the market's fault for not following them, not ours.
We were clueless regarding the nature of gamma risk. We are still a little fuzzy on this.
We have never lived through a bear market, nor do we think we need one now.
We have never read anything written by Nicolai Kondratieff, Sidney Homer, Benjamin Graham, Alexander Dana Noyes, Robert Rhea, Ralph Elliott, or anyone else with a sense of history. History is a waste of time.
We invested heavily in junk bonds, especially those issued by countries which cannot be located on a map by our crack research department. We never understood why people called them junk to begin with.
We think you're doing a great job, and we think you'll cut rates (wink, wink, nudge, nudge). We think this will be pure gravy for all of us, and we can't wait to buy more junk bonds on margin.
Enclosed you will find a more detailed list of our losses since mid-summer. Please enclose your check (payable to TheGreaterFool.com LLC) in the self-addressed stamped envelope provided.
P.S. Do you have the IMF's address?
Cc: Mr. David Komansky, chairman, Merrill Lynch & Co.
Mr. Sanford I. Weill, chairman, Travelers Group
Mr. Jon Corzine, senior partner, Goldman Sachs & Co.
Mr. Douglas Warner, chairman, J. P. Morgan & Co.
Mr. John Merriwether, general partner, Long Term Capital Management LP