Financial Follies

One consoling feature of most of the derivatives-related financial fiascoes of the past decade is that they were object lessons in what can happen when incompetents play with large amounts of other people’s money. Robert L. Citron, the former treasurer of Orange County, who lost almost $2 billion of the public’s money in 1994, could plausibly plead that he didn’t know Merrill Lynch was stuffing his portfolio with all that high-risk paper. One can almost sympathize with Nicholas W. Leeson, the rogue trader who single-handedly brought down the British investment bank Baring Brothers in 1995. Picture Leeson, still just a kid, sweating bullets in front of his computer screen, as week after week all his positions turned sour, until he finally took off on a wild global flight that ended in a German prison.

The obvious response is to keep dangerous weapons out of the hands of children and incompetents. But what do you do when the smartest financial people in the world lose yet-uncounted billions and come close to causing a global financial thrombosis when their trading strategies go bad?

The scene of the latest financial debacle was a Greenwich, Conn., “hedge fund,” Long-Term Capital Management, whose senior partners include John W. Meriwether, once a near-legendary trader at Salomon Bros., and Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel prize in economics for co-inventing the fundamental mathematical techniques of modern risk management. On any league table of the savviest financiers, they’d rank near the top.

Hedge funds are investment pools for the rich. As long as they have fewer than 100 investors, who must be either wealthy individuals or institutions, they are allowed to operate virtually without regulation. Long-Term Capital specialized in bonds, though it wandered far afield into takeover stocks and other risky instruments. Like most hedge funds, it earned big returns for its investors--in the range of 40% annually--by leveraging up its positions with borrowed money. Assume you have $1,000 and know how to make a 1% profit on an overnight bond trade. Instead of just investing your $1,000, borrow $19,000, so you’ll make $200 on the trade. Pay back the $19,000 and book a 20% profit on your $1,000. That works both ways, of course. If you guess wrong and lose 1%, you still have to pay back the $19,000 and are left with a 20% loss.

The investors in Long-Term Capital put up about $5 billion in capital, which the fund managers leveraged into positions in the $100-billion to $150-billion range, and occasionally far higher, but not “$1.25 trillion,” as many papers reported. When world markets had a collective heart attack in August, almost all of Long-Term Capital’s investments went south at the same time, and lenders started calling in their loans. But the falling markets had eaten up all of Long-Term Capital’s equity, so the securities it owned were worth less than outstanding loans, which is when the Federal Reserve stepped in.

Press reports to the contrary, there was no bailout.

A consortium of financial houses, all lenders or investors in the fund, took over its positions and put up the $3 billion in additional cash needed to finance an orderly unwinding of the portfolio. No public money was involved. In effect, the fund’s creditors seized its assets, much as in bankruptcy, but without the legal delays. Fund investors will be lucky to recover 10 cents on the dollar, and several partners may be facing personal bankruptcy. Unlike what’s been happening in Japan, there’s no cover-up of the losses. All of Long-Term Capital’s losses will be fully recognized on its own books and those of its investors and creditors.

At the end of the day, the story of Long-Term Capital is a fairly simple one. Some very smart investors used borrowed money to make a series of stock and bond bets, which, eyes wide open, they guessed had maybe a 90% chance to make a lot of money. They were probably right, but when all the 10%-probability outcomes came up at the same time, they were wiped out. The bigger question is: What are the implications for the stability of markets?

Superficially, the system worked. Wall Street got early warnings that Long-Term Capital was in trouble. The Fed was alerted, the big boys got together and divvied up the losses, the portfolio is being sold off in a way that will minimize any market impact. No fuss, no muss.

But there is a bigger question. None of the top financial firms that were investing in, and lending huge amounts of money to, Long-Term Capital had the slightest idea of how risky their positions were. These were stars, so nobody asked as long as the profits rolled in.

Star systems and secrecy are the essential ingredients of financial fiascoes. Citron and Leeson were each stars in their own little world, so nobody paid attention to what they were doing. The mortgage-backed crisis of 1994, which raised consumer mortgage costs by a full percentage point, was triggered by the collapse of Askin Capital, another black-magic fund run by a star; and Michael R. Milken’s star power blew up the 1980s leveraged-buyout bubble beyond the bounds of economic common sense.

Asian politicians are accustomed to blaming hedge funds for their currency troubles, instead of cleaning up their own financial systems. But they’re not entirely wrong. George Soros became famous, and made a $1-billion profit, by triggering a run on the British pound in 1992. The hedge funds that speculate in currencies are notable for their herd behavior and have been a big factor in the rapid spread of currency instability in the last few years. Volatile and easily spooked investors, secretly disposing of hundreds of billions in equity and trillions in leveraged positions, hold the potential for massive disruptions.

Bringing hedge funds under better regulatory control will be a subtle and difficult problem. The U.S. regulatory system is designed to protect the public from scams, and sensibly assumes that rich people and institutions can look after themselves. If the government tried to regulate hedge-fund investments, they would just domicile themselves overseas, as many, including Soros’ flagship fund, the Quantum Group, already do.

An important first step would be to pierce the veil of hedge-fund secrecy. The government has no power to make hedge funds open their books, but it could forbid regulated financial institutions from investing in, or lending money to, funds, such as Long-Term Capital, that don’t open their books to investors and lenders. If the big players putting money into Long-Term Capital had known what the partners were doing with it, they might have pulled the plug far sooner. Hedge-fund managers will plead that even confidential information will leak and limit their trading strategies, but maybe that is all to the good.

Rich individuals should be allowed to lose their money however they like. But there’s no reason why regulated institutions should be lending or investing without knowing what their customers are doing with the money.