Long Term Capital Mismanagement
Henry Paulson, the Secretary of the U.S. Department of Treasury, recently announced a plan to purchase equity stakes in large public financial institutions to stem the tide of bankruptcies and failures brought on by the credit crisis. By buying shares in big banks, the government is essentially providing much needed cash to stabilize the companies and provide for some liquidity and credit stimulus. This is just one of many actions announced in an attempt to diffuse the credit crisis. Equally busy are Ben Bernanke and the Federal Reserve. Paulson swears up and down that this equity program is aimed at regulated banks so unregulated hedge funds will not be able to participate. “The program right now is for banks and thrifts.”
That qualifier, “right now,” is what has me worried that our well-intentioned public servants will find it difficult to ignore the inevitable cries for mercy and help from their hedge fund brethren. Paulson is leaving himself the option of opening the program up to hedgies sometime in the future, when the most leveraged hedge funds with an intricate web of derivatives trades come calling for help are “too big to fail.” The average American taxpayer, while deemed unsophisticated enough to make direct investments in hedge funds will finally be able to own some of these exotic bad boys through our government proxies.
In the 1990s, a hedge fund called Long Term Capital Management promised to generate excess returns with minimal risk through the use of sophisticated financial models and formulae devised by a team full of PhDs and Nobel Prize laureates. Sounds seductive doesn’t it? It certainly was seductive enough that investors put in over $1 billion before the fund started trading in 1994, a huge starting coffer even by today’s standards. The short story of LTCM is that it made extremely leveraged trades with an intricate web of trading partners that, while highly profitable in the beginning, turned out horribly wrong. The fund suffered tremendous losses and teetered on the edge of outright failure. The Federal Reserve orchestrated a bailout in 1998 of over $3.5 billion. LTCM’s highly leveraged derivatives trades were made with so many counter-parties in the financial world that a Darwinian approach would have had much wider repercussions. The risk of a more widespread collapse of the financial markets loomed as a distinct possibility. LTCM was simply too big to ignore and not bail out.
So the precedent was set exactly 10 years ago. Today, the scary prospect of hedge fund failures acting as catalyst for another leg of decline in the markets is very real. We are collectively hyper-focused on the credit crunch, falling real estate prices, and Main Street’s inability to pay the mortgage. Few can see around the corner when imminent hedge fund failures will send shock waves through the system and drive us deeper into this bear market. There are now at least a dozen LTCMs out there, all crossing their fingers that their limited partners won’t request withdrawals. If the LPs bail en masse, Mr. Paulson as the taxpayer’s agent will bail out his hedge fund buddies.
Interestingly, Warren Buffett’s Berkshire Hathaway (BRK-A) teamed with Goldman Sachs (GS) to offer an alternative plan to the principals of LTCM. Ultimately, LTCM went with the government sponsored rescue. I wish it went down differently. If we’re going to spend taxpayer money to bail out hedge funds, and I’m betting we will, we should find private partners who can share the risk with the public taxpayer. We could give incentives for large private players like Buffett, who have the talent and financial heft to collaborate on a bailout, to help us carry the load. So what if a few fat cats get a little wealthier, I’d like to see the public taxpayer not have to foot the entire bill.
I think I have come up with the perfect business plan. Start a company and do anything with a high degree of risk that is very profitable in the short term. Make sure to get as many other players involved heavily. Then, when things turn south, get the government to bale us out.
The most important concern in all of this is the moral hazzard. You simply teach people that irresponsible behaviour is ok. When it works you keep the upside. When things do not work, the Feds will bale your out.
Of course, the people who actually pay are those who did not take unreasonable risks, accepted their more modest gains, and now have the money the government can appropriate to cover the loses.
The government will soon pass a law requiring all ants to share their stored food with the grasshoppers.
I’d never heard of that 1998 bailout. Thanks for the great info.
Hi Allan, I fully agree with you: hedge fund are going to go bust and actually they are already going bust behind closed doors (terms renegotiated, etc) but it’s not yet on the front pages. There is already been more than USD 200 bn withdrawal from hedge funds (roughly 10% of AuM). And yes, the big ones will be bailed out.
Rand, I agree that it is moral hazard but is there really an alternative? Let’s not forget the consequences of having let Lehman fall. I think it’s the lesser evil. There is already progress. At least in Europe, when govt intervened in the past there was no upside for the governement and shareholders got minimal (if at all) dilution. If there is no suitable buyer, the govt needs to ensure that existing shareholders get massive dilution, CEO gets fired, and keep the upside for the taxpayer.
Nov 24th, 2008 at 1:14 pm
[…] late October, I wrote about Paulson’s statement, “The program right now is for banks and thrifts.” I was alarmed to see his qualifier “right now.” It indicated to me that he was […]