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  1. 1. Too Big to Fail? Long-Term Capital Management and the Federal Reserve by Kevin Dowd No. 52 September 23, 1999 In September 1998 the Federal Reserve orga- The intervention also is having more serious nized a rescue of Long-Term Capital Manage- long-term consequences: it encourages more ment, a very large and prominent hedge fund on calls for the regulation of hedge-fund activity, the brink of failure. The Fed intervened because which may drive such activity further offshore; it was concerned about possible dire conse- it implies a major open-ended extension of quences for world financial markets if it allowed Federal Reserve responsibilities, without any the hedge fund to fail. congressional authorization; it implies a return The Fed’s intervention was misguided and to the discredited doctrine that the Fed should unnecessary because LTCM would not have prevent the failure of large financial firms, failed anyway, and the Fed’s concerns about the which encourages irresponsible risk taking; and effects of LTCM’s failure on financial markets it undermines the moral authority of Fed poli- were exaggerated. In the short run the interven- cymakers in their efforts to encourage their tion helped the shareholders and managers of counterparts in other countries to persevere LTCM to get a better deal for themselves with the difficult process of economic liberaliza- than they would otherwise have obtained. tion. Kevin Dowd is professor of economics at the University of Sheffield and an adjunct scholar at the Cato Institute.
  2. 2. The management Introduction that aim to make profits for their sharehold- of LTCM made ers by trading securities. Hedge funds vary In September 1998 the Federal Reserve enormously but fall into two main classes. the firm much organized a rescue of Long-Term Capital The first is macro funds, which take specula- riskier, in the Management, a very prominent U.S. hedge tive (i.e., unhedged) positions in financial fund on the brink of failure. The Fed inter- markets on the basis of their analyses of hope of bolster- vened because it was concerned about the financial and macroeconomic conditions. ing the returns to possibility of dire consequences for world They bet on exchange-rate devaluations, shareholders. financial markets if it allowed the firm to fail. changes in macroeconomic policies, interest- The Fed’s rescue of LTCM was misguided. rate movements, and so on. Macro funds are The intervention was not necessary to pre- thus “hedge” funds in name only. They make vent the failure of LTCM. The firm would not their profits from speculation, and their have failed, and even if it had, there would portfolios are often highly risky. Most macro not have been the dire consequences that hedge funds are also highly leveraged—that Federal Reserve officials feared. Indeed, let- is, the amounts invested in their portfolios, ting LTCM fail might well have had a salu- the firms’ assets, are much greater than their tary effect on financial markets: it would share capital, with investments in excess of have sent a strong and convincing signal that capital being financed by borrowing. no financial firm—however big—could expect Leverage increases the potential profits of to be bailed out from the consequences of its shareholders, but it also increases their risks: own mismanagement. the greater the leverage, the bigger the profit The rescue of LTCM also has a number of to shareholders if investments are successful detrimental consequences. It encourages and the bigger the loss to shareholders if they more calls for the regulation of hedge-fund are not. A highly leveraged fund can therefore activities, which would be pointless at best make very high profits but also runs a rela- and counterproductive at worst. The rescue tively high risk of going bankrupt. Macro also implies a massive and open-ended exten- funds are highly leveraged relative to most sion of Federal Reserve responsibilities, with- other institutional investors and typically out any congressional mandate. In addition, have asset bases five to nine times greater the rescue implies a return by the Federal than their capital.1 Reserve to the discredited doctrine of “too The other main class of hedge funds is rel- big to fail”—the belief that the Fed will rescue ative-value, or arbitrage, funds. Those funds big financial firms in difficulty—for fear of use sophisticated models to detect arbitrage the possible effects on financial markets of opportunities—differences in the prices of letting big firms fail. Too big to fail encour- nearly equivalent securities or portfolios—in ages irresponsible risk taking by financial financial markets. Having detected such firms, which makes them weaker and finan- opportunities, those funds construct arbi- cial markets more fragile. Finally, the rescue trage trading strategies to profit: they buy of LTCM does a lot of damage to the credi- securities that are underpriced and sell those bility and moral authority of Federal Reserve that are overpriced, while simultaneously policymakers in their efforts to encourage taking offsetting positions to hedge against their counterparts in other countries to per- any risks involved and lock in their arbitrage severe with the necessary but difficult process profits. Financial-market arbitrage is a rela- of economic liberalization. tively low-risk activity, so relative-value funds often operate with much higher leverage than do macro funds.2 What Are Hedge Funds? In the United States, hedge funds with fewer than 100 shareholders are exempt from Hedge funds are private investment funds regulation under the Securities Act of 1933, 2
  3. 3. the Securities Exchange Act of 1934, and the notably economists Robert Merton and Investment Company Act of 1940. Most U.S. Myron Scholes, who received the Nobel Prize hedge funds therefore restrict the number of in economics in 1997. The fund initially spe- their shareholders to fewer than 100. cialized in high-volume arbitrage trades in Overseas hedge funds are also usually subject bond and bond-derivatives markets but grad- to little or no regulation, particularly those ually became more active in other markets operating from offshore centers, such as the and more willing to speculate. The fund thus Bahamas and the Cayman Islands. The started as an arbitrage fund but gradually hedge-fund industry is thus largely unregu- became more like a macro fund. LTCM was lated. very successful: by the end of 1997 it had Despite its growth in recent years, the achieved annual rates of return of around 40 industry still is only a very small part of the percent and had nearly tripled its investors’ overall institutional investment sector. A money. That track record and the prestige of recent International Monetary Fund report its associates made LTCM very popular with estimated that the total amount of capital investors, and the companies and individuals invested in hedge funds in the third quarter investing in LTCM “read like a who’s who list of 1997 was about $100 billion. By compari- of high finance.”5 LTCM was the darling of son, other institutional investors—pension Wall Street. As its losses funds, mutual funds, insurance companies, By that stage, it appears that the fund’s mounted, the banks, and so on—had a combined capital of assets had grown to about $120 billion and fund had increas- well over $20 trillion.3 Hedge funds therefore its capital to about $7.3 billion.6 However, account for less than 0.5 percent of the total despite that high leverage—an assets-to-equi- ing difficulty capital of the institutional investment sector. ty ratio of over 16 to 1—the management of meeting margin Nonetheless, hedge funds have received LTCM concluded that the capital base was considerable attention during the last too high to earn the rate of return on capital calls. decade, most particularly because of their for which they were aiming. They therefore role in a number of recent exchange-rate returned $2.7 billion of capital to sharehold- crises. Perhaps the best-known example is ers, thus cutting the fund’s capital to $4.8 bil- George Soros’s Quantum Fund, a macro lion and increasing its leverage ratio to fund reputed to have made more than $1 bil- around 25 to 1. In effect, the management of lion at the British government’s expense by LTCM had taken a major gamble: they made betting against the pound in the European the firm much riskier, in the hope of bolster- exchange-rate crisis of September 1992. ing the returns to shareholders. Hedge funds have also figured prominently in more recent crises, including those in LTCM Gets into Difficulties Latin America, the Far East, and Russia in the Unfortunately, LTCM’s luck ran out not last couple of years. The activities of hedge long afterwards. Most markets were edgy funds have led to major controversy over during the first part of 1998, but market con- their impact on the world financial system ditions deteriorated sharply in the summer and to calls from some quarters that hedge and led to major losses for LTCM in July. funds be regulated.4 Disaster then struck the next month, when the Russian government devalued the ruble and declared a moratorium on future debt The Story of LTCM repayments. Those events led to a major dete- rioration in the creditworthiness of many Long-Term Capital Management was emerging-market bonds and corresponding founded in March 1994 by John Meriwether, large increases in the spreads between the a former Salomon Brothers trading star, prices of Western government and emerging- along with a small group of associates, most market bonds. Those developments were very 3
  4. 4. bad for LTCM because the fund had bet mas- observed LTCM’s deterioration with mount- sively on those spreads’ narrowing. To make ing concern. Many Wall Street firms had matters worse, the fund sustained major loss- large stakes in LTCM, and there was also es on other speculative positions as well. As a widespread concern about the potential result, by the end of August LTCM’s capital impact on financial markets if LTCM were to was down to $2.3 billion and the fund had fail. The Fed felt obliged to intervene, and a lost over half of the equity capital it had had delegation from the New York Federal at the start of the year. By that time, its asset Reserve and the U.S. Treasury visited the base was about $107 billion, so its leverage fund on Sunday, September 20, to assess the ratio had climbed to over 45 to 1—a very high situation.10 At that meeting fund partners ratio by any standards, but especially in that persuaded the delegation that LTCM’s situa- volatile environment.7 tion was not only bad but potentially much As its losses mounted, the fund had worse than market participants imagined. increasing difficulty meeting margin calls The Fed concluded that some form of sup- and needed more collateral to ensure that it port operation should be prepared—and pre- could meet its obligations to counterparties. pared very rapidly—to prevent LTCM’s fail- The fund was running short of high-quality ure and to forestall what the Fed feared assets for collateral to maintain its positions, might otherwise be disastrous effects on and it also had great difficulty liquidating its financial markets. positions: many of its positions were relative- Accordingly, the New York Federal ly illiquid (i.e., difficult to sell) even in normal Reserve invited a number of the creditor times and hence still more difficult to firms most involved to discuss a rescue pack- sell—especially in a hurry—in nervous and age, and it was soon agreed that this Federal declining markets. Reserve–led consortium would mount a res- The fund was now in very serious difficul- cue if no one else took over the fund in the ties and, on September 2, 1998, the partners meantime. However, when representatives of sent a letter to investors acknowledging the that group met on the early morning of fund’s problems and seeking an injection of Wednesday, September 23, they learned that new capital to sustain it. Not surprisingly, another group had just made an offer for the that information soon leaked out and the fund and that that offer would expire at fund’s problems became common knowl- lunchtime that day. It was therefore decided edge. to wait and see how LTCM responded to that LTCM’s situation continued to deterio- offer before proceeding any further. There was consid- rate in September, and the fund’s manage- A group consisting of Warren Buffett’s ment spent the next three weeks looking for firm, Berkshire Hathaway, along with erable criticism of assistance in an increasingly desperate effort Goldman Sachs and American International the management to keep the fund afloat. However, no immedi- Group, a giant insurance holding company, of LTCM for get- ate help was forthcoming, and by September offered to buy out the shareholders for $250 19 the fund’s capital was down to only $600 million and put $3.75 billion into the fund as ting into diffi- million.8 The fund had an asset base of $80 new capital. That offer would have put the culites and of the billion at that point,9 and its leverage ratio fund on a much firmer financial basis and was approaching stratospheric levels—a sure staved off failure. However, the existing Federal Reserve sign of impending doom. No one who knew shareholders would have lost everything for bailing out LTCM’s situation really expected the fund to except for the $250 million takeover pay- the fund. make it through the next week without out- ment, and the fund’s managers would have side assistance. been fired. The motivation behind this offer was strictly commercial; it had nothing to do The Federal Reserve Intervenes with saving world financial markets. As one Wall Street and the Federal Reserve had news report later put it: 4
  5. 5. Buffett wasn’t offering public chari- Was the Federal Reserve If the central ty. He was trying to do what he Justified? bank merely preaches: buy something for much less than he thinks it’s worth. Ditto The immediate reaction of most observers mimicked the pri- for Goldman Sachs, which made in the financial world was relief that the fail- vate sector, then tons of money dealing in bankrupt- ure of LTCM had been avoided, and the res- cies, salvaging financially distressed cue package was generally well received on why did it need to real estate. . . . These folks weren’t out Wall Street, although some financial get involved at to save the world’s financial markets; observers expressed concerns about its all? they were out to make a buck out of longer-term implications. Elsewhere, reac- Long-Term Capital’s barely breath- tions were generally less favorable, and there ing body.11 was considerable criticism of the manage- ment of LTCM for getting into difficulties Had it been accepted, that offer would and of the Federal Reserve for bailing out the have ended the crisis without any further fund. Responding to those concerns, the involvement of the Federal Reserve—a text- House Committee on Banking and Financial book example of how private-sector parties Services called a hearing on the issue and can resolve financial crises on their own, invited some of the participants to give evi- without Federal Reserve or other regulatory dence. Among those called were the president involvement. of the New York Federal Reserve, William But that was not to be. The management McDonough, and the chairman of the of LTCM rejected the offer, and one can only Federal Reserve Board, Alan Greenspan. Both presume that they did so because they were officials testified before the House commit- confident of getting a better deal from the tee on October 1. Their testimony focused on Federal Reserve’s consortium.12 The Fed three main issues: therefore reconvened discussions to hammer out a rescue package, which was agreed on by • The rescue package itself, the end of the day. The package was prompt- • The necessity (or otherwise) of Federal ly accepted by LTCM and immediately made Reserve intervention, and public. Under the terms of the deal, 14 promi- • The consequences for financial mar- nent banks and brokerage houses—including kets if LTCM had failed. UBS, Goldman Sachs, and Merrill Lynch but not the Federal Reserve—agreed to invest The Rescue: Private-Sector $3.65 billion of equity capital in LTCM in Solution or Federal Reserve exchange for 90 percent of the firm’s equity. Bailout? Existing shareholders would therefore retain In his testimony, McDonough defended a 10 percent holding, valued at about $400 the rescue package as “a private sector solu- million. This offer was clearly better for the tion to a private-sector problem, involving an existing shareholders than was Buffett’s offer. investment of new equity by Long-Term It was also better for the managers of LTCM, Capital’s creditors and counterparties.” He who would retain their jobs for the time bristled at the claim that the Federal Reserve being and earn management fees they would had “bailed out” LTCM, pointing out that have lost had Buffett taken over. Control of control had passed to the 14-member credi- the fund passed to a new steering committee tor group and that “the original equity-hold- made up of representatives from the consor- ers [had] taken a severe hit.” He also stressed tium, and the announcement of the rescue that “no Federal Reserve official pressured ended concerns about LTCM’s immediate anyone, and no promises were made. Not one future. By the end of the year, the fund was penny of public money was spent or commit- making profits again. ted.”13 Greenspan echoed that argument and 5
  6. 6. claimed that the LTCM episode was one of out by the plain facts of the case itself. those “rare occasions” when financial mar- kets seize up and “temporary ad hoc respons- Did the Federal Reserve Need to es” are required. He also compared the LTCM Intervene to Stop the Failure of rescue to the famous occasion when J. P. LTCM? Morgan convened the leading bankers of his Both officials also argued strongly that day in his library to discuss how they were the Federal Reserve was obliged to prevent going to resolve the financial crisis of 1907.14 the failure of LTCM by fear of the adverse There is a certain irony in central bankers’ effects that LTCM’s failure might have had defending their resolution of the LTCM on financial markets. As Greenspan put it: problem on the grounds that it was much the same as a purely private-sector solution to Financial market participants were the same problem. If the central bank merely already unsettled by recent global mimicked the private sector, then why did it events. Had the failure of LTCM trig- need to get involved at all? Why couldn’t it gered the seizing up of markets, sub- have sat back and let Warren Buffett and his stantial damage could have been associates in the private sector do the job? inflicted on many market partici- Greenspan over- Indeed, what would be the point of having pants, including some not directly looks the point the Federal Reserve regulate financial institu- involved with the firm, and could that the 1907 cri- tions at all? The arguments put forward by have potentially impaired the McDonough and Greenspan thus under- economies of many nations, includ- sis was resolved mine the very actions they were trying to ing our own. . . . Moreover, our sense by private-sector defend. was that the consequences of a fire McDonough’s testimony also invites the sale triggered by cross-default claus- parties operating response that an intervention led by a federal es, should LTCM fail on some of its on their own. body can hardly be described as a “private sec- obligations, risked a severe drying up tor solution to a private-sector problem.” The of market liquidity. . . . In that envi- Federal Reserve did intervene, and pointing ronment, it was the FRBNY’s out that it did not pressure institutions to [Federal Reserve Bank of New York’s] participate or spend or commit public money judgment that it was to the advan- does not alter that fact. tage of all parties—including the For his part, Greenspan overlooks the creditors and other market partici- point that the 1907 crisis was resolved by pri- pants—to engender if at all possible vate-sector parties operating on their an orderly resolution rather than let own—as they had to, because there was no the firm go into disorderly fire-sale central bank at the time—while the LTCM liquidation.15 crisis was resolved by a rescue package put together by the central bank. The lesson to The Federal Reserve, therefore, draw from a comparison of the two crises is therefore not that the LTCM rescue was justi- moved more quickly to provide their fied because it was like the resolution of 1907. good offices to help resolve the Instead, the appropriate lesson is almost the affairs of LTCM than would have opposite: that if private-sector parties operat- been the case in more normal times. ing on their own could resolve the crisis of In effect, the threshold of action was 1907, then there was no need for the Fed to lowered by the knowledge that mar- intervene in 1998. If 1907 tells us anything kets had recently become fragile.16 about the LTCM episode, it suggests that the private sector could have resolved the crisis There is no denying that Federal Reserve on its own—a conclusion that is also borne officials were genuinely concerned about the 6
  7. 7. impact that LTCM’s failure might have on Reserve would have come together and made financial markets. Nonetheless, Greenspan’s an offer in the absence of the Fed’s involve- argument begs the central question: it pre- ment. If it had, the outcome would have pre- supposes that LTCM would have failed if the sumably been substantially the same as the Fed had not intervened, and yet it is mani- outcome that actually occurred, but without festly the case that LTCM would not have the Fed’s involvement. However, if there had failed in the absence of the Fed’s interven- been no other offers, the management of tion. LTCM would probably have accepted the If the Federal Reserve had washed its Buffett offer as the only way to avoid failure. hands of LTCM early on the morning of In that case, the net effect of the Fed’s inter- September 23, 1998—and made clear to vention would have been a better deal for LTCM that it was doing so—the management LTCM’s shareholders and managers, at the of LTCM would have faced a set of alterna- expense of Buffett and his associates who tives very different from the one they actually were thereby deprived of an opportunity to faced at the time. Instead of choosing make a profit from LTCM’s difficulties. That between the Buffett offer and the likelihood leads one to wonder whether Buffett has a of a better offer later in the day, they would case against the Federal Reserve for loss of have had to choose between the Buffett offer income. and almost certain failure. The Buffett offer was not a generous one: it would have cost What If LTCM Had Failed? the management of LTCM their remaining There still remains the hypothetical issue equity, their jobs, and any future manage- of what might have happened if LTCM had ment fees they might have obtained from failed. Were the Federal Reserve’s fears plau- LTCM, but it would at least have left them sible? I would suggest not. Central bankers with a $250 million “exit” payment. The are always worried about the impacts of the alternative would have been to lose their failures of large financial firms on market equity, their jobs, and their management fees “confidence,” and the argument that they and get nothing in return—in short, to lose had to intervene to prevent the knock-on everything. They would therefore have been effects of such failures has been used to justi- crazy to turn Buffett down, and we must sup- fy every bailout since time immemorial. pose they would not have done so. There is Nonetheless, no one can deny that financial thus a very strong argument that the Fed markets were in a particularly fragile state in could have abandoned the rescue as late as September 1998. Moreover, LTCM was a big the morning of September 23 without letting player that was heavily involved in derivatives The Federal LTCM fail. However, if that is the case, it trading; it also had large exposures to many could also have abandoned its rescue bid ear- different counterparties, and many of its Reserve could lier without letting LTCM fail. Indeed, the positions were difficult and costly to have abstained Federal Reserve could have abstained com- unwind. One can therefore readily appreciate completely from pletely from intervening, and LTCM would why the Fed was nervous about the prospect still not have failed. of LTCM’s failing. intervening, and So what did Federal Reserve intervention There are, nevertheless, a number of rea- LTCM would still actually achieve? The answer depends on sons to suggest that financial markets could what offers would have been forthcoming for have absorbed the shock of LTCM’s failing not have failed. LTCM in the absence of Federal Reserve without going into the financial meltdown intervention. There would have clearly been that Federal Reserve officials feared: an offer from the Buffett consortium, because that consortium was operating inde- • Although many firms would have taken pendent of the Fed. However, it is not clear large hits, the amount of capital in the whether the consortium led by the Federal markets is in the trillions of dollars. It is 7
  8. 8. Throwing LTCM therefore difficult to see how the mar- methodologies for stress testing and to the wolves kets as a whole could not have absorbed scenario analysis,19 and “credit enhance- the shock, given their huge size relative ment” techniques to keep down expo- would have to LTCM. The markets might have sures to counterparties. Those tech- strengthened sneezed, and perhaps even caught a niques include the use of netting agree- cold, but they would hardly have caught ments, periodic settlement provisions, financial markets, pneumonia. credit triggers, third-party guarantees, rather than weak- • When firms are forced to liquidate and credit derivatives.20 As a result, ened them. positions in response to a major shock, most firms’ “true” exposures are now there are usually other firms willing to only a small fraction of what they buy at the right price. Sellers may have might otherwise appear to be. to take a loss to liquidate, but buyers can usually be found, and competition The Federal Reserve’s nightmare scenario—a for good buys usually puts a floor mass unwinding of positions with wide- under sellers’ losses. spread freezing of markets—is thus far- • Market experience suggests that the fetched, even in the fragile market conditions failure of even a big derivatives player of the time. usually has an impact only on the mar- There is also another reason why the Fed kets in which that player was very was ill-advised to intervene, even if it was right active. Worldwide market liquidity has in its assessment that LTCM would otherwise never been threatened by any such fail- have failed. If the Federal Reserve is to pro- ure. It follows, then, that the failure of mote market stability, it needs to ensure that LTCM might have had a major nega- market participants have strong incentives to tive impact on some of the derivatives promote their own financial health—to avoid markets in which the fund was active, excessive risk taking, to keep their leverage but it would not have caused a global down to reasonable levels, to maintain their liquidity crisis. liquidity, and so forth. However, the best • In any case, even in those rather incentive of all is the fear of dire consequences extreme and unusual markets where if they do not manage themselves properly liquidity might be paralyzed in the and, consequently, default on their obliga- immediate aftermath of a major shock, tions. If the Fed wishes to encourage institu- participants have every reason to tions to be strong, it should make an example resume trading as soon as possible. of those that fail. In that context, LTCM pro- Time and time again in the 1990s, vided the Federal Reserve with an ideal oppor- derivatives markets have shown a tunity to make such an example and send out remarkable ability to absorb major the message that no firm, however promi- shocks and quickly return to normal, nent, could expect to be rescued from the con- and there is no reason to suppose that sequences of its own mistakes. Other firms the market response would have been would have taken note and strengthened much different if LTCM had failed. themselves accordingly, and financial markets • Last, but by no means least, there have would have been more stable as a result. been major developments in derivatives Throwing LTCM to the wolves would have risk management over the last few strengthened financial markets, rather than years.17 Those developments include the weakened them. widespread adoption of value-at-risk systems to measure and manage overall risk exposures, the increasing accep- Consequences of the tance of firm-wide risk management Bailout guidelines,18 the rapid growth of 8
  9. 9. Calls for More Regulation diminish.23 One of the most immediate consequences of the LTCM affair was calls for more regula- Greenspan went on to suggest that the tion of hedge-fund activities. Among the peo- primary defense against the problems posed ple calling for more regulation was then–sec- by the failures of hedge funds is for their retary of the treasury Robert Rubin, who counterparties to be careful in their dealings called for an interagency study to look at with them (e.g., not extend too much credit). ways of making the activities of offshore Greenspan’s assessment is surely correct. hedge funds more transparent. Many others Moreover, since it is also in the interests of made similar suggestions. However, as one those counterparties to be careful, there observer wrote, “Many of these calls have would appear to be no need for (and no point been pure reflex actions rather than a care- in) regulating those dealings. In an efficient fully considered response to the issues—if economy, parties should be free to make any—which hedge funds pose for the world whatever deals they want with hedge funds, financial system.”21 and it is in their interest not to overexpose Those calls were met with widespread dis- themselves to those or any other risky coun- belief offshore. Many people familiar with terparties. offshore operations pointed out that there Attempts to regu- was very little that U.S. regulators could actu- Massive Extension of Federal late U.S. hedge ally do about them. Some pointed out that Reserve Responsibilities funds might drive attempts to regulate U.S. hedge funds might The LTCM rescue implies a very large and drive more of them offshore where they problematic extension of the Federal more of them off- would be even further out of the reach of U.S. Reserve’s responsibilities. The LTCM bailout shore where they regulators. The skeptics included Greenspan indicates that the Fed now accepts responsi- himself: bility for the safety of U.S. hedge funds, would be further despite the fact that it has no legislative man- out of the reach It is questionable whether hedge date to do so. Moreover, the Fed accepts that of U.S. regulators. funds can be effectively regulated in responsibility even though it has no regula- the United States alone. While their tory authority over hedge funds and even financial clout may be large, hedge though the chairman of its board explicitly funds’ physical presence is small. argues that it should not have any such Given the amazing communication authority. The Federal Reserve thus main- capabilities available virtually around tains the extraordinary position that it the globe, trades can be initiated should have responsibility for hedge funds from almost any location. Indeed, but no power over them. Even if it is legally most hedge funds are only a short sound, which is questionable, that position is step from cyberspace. Any direct U.S. patently untenable, as it subjects the Fed to a regulations restricting their flexibili- moral hazard problem over which it has no ty will doubtless induce the more control. That position allows large hedge aggressive funds to emigrate from funds to take risks that the Federal Reserve under our jurisdiction.22 cannot control; yet the Fed picks up the tab if the funds get themselves into difficulties. He concluded: Heads they win, tails the Federal Reserve loses. Responsibility and power cannot be The best we can do . . . is what we do separated indefinitely, however, and at some today: Regulate them indirectly point the Fed would have to abandon its through the regulation of the responsibility for hedge funds or, if its past sources of their funds. . . . If the funds empire building is any guide,24 seek regulato- move abroad, our oversight will 9
  10. 10. ry authority to control them. to financial firms, and then the LTCM rescue But there is also a deeper problem. Where wiped out all that progress at a stroke. Not does the Federal Reserve draw the line only did the Fed intervene to rescue a large between U.S. hedge funds and overseas ones? firm, but the reason given for the interven- What is the difference between a U.S. hedge tion—the Fed’s fears of the effects of LTCM’s fund based in Greenwich, Connecticut, failure on world financial markets—was which also operates in the Cayman Islands, nothing less than an emphatic restatement and a Caymans-based hedge fund, which also of the doctrine. Too big to fail was back operates in Greenwich? The two are indistin- again, with a vengeance. guishable for all practical purposes, and the The return of too big to fail has serious Fed cannot realistically support “American” consequences for longer-term stability. If the hedge funds without also supporting other financial system is to be stable, individual hedge funds as well. If the Fed supports large institutions must be given incentives to make “U.S.” hedge funds, it could easily find itself themselves financially strong. Rescuing a supporting all large hedge funds, regardless firm in difficulties then sends out the worst of their “real” nationality. To make matters possible signal, as it leads others to think that even worse, if the Fed becomes responsible they, too, may be rescued if they get into dif- for the hedge-fund industry, where and how ficulties. That weakens their incentive to will it draw the line between hedge funds and maintain their own financial health and so other investment firms, particularly those makes it more likely that they will eventually that might be similar to hedge funds? Where get into difficulties. Bailing out a weak firm would the Fed’s responsibility actually end? may help to calm markets in the very short Is the logical implication, as one industry term, but it undermines financial stability in commentator asked, that the Federal Reserve the long run. will “now try to shore up the Japanese bank- ing system? After all, this is a lot more central Damage to the Moral Authority of to the fate of the world’s economy and mar- the Federal Reserve kets than one particular Greenwich, Perhaps the worst consequence of the Connecticut hedge fund manager.” The LTCM affair was the damage done to the LTCM bailout thus implies a very large and credibility and, more important, moral ultimately intolerable increase in Federal authority of Federal Reserve policymakers as Reserve responsibilities—without any legisla- they encourage their counterparts in other tive mandate whatsoever from Congress. countries to persevere with the necessary but The LTCM rescue difficult and painful process of economic lib- The Return of Too Big to Fail eralization. Rep. Jim Leach (R-Iowa), chair- marks a return to The LTCM rescue marks a return to the man of the House Committee on Banking the discredited discredited doctrine of too big to fail: the and Financial Services, was absolutely correct doctrine of too doctrine that the Federal Reserve cannot when he pointed out that “the LTCM saga is allow very big institutions to fail, precisely fraught with ironies related to moral author- big to fail: the because they are big, out of fear of the conse- ity as well as moral hazard. The Federal doctrine that the quences of their failure for the financial sys- Reserve’s intervention comes at a time when tem. That doctrine is a direct inducement for our government has been preaching to for- Federal Reserve large institutions to act irresponsibly, and eign governments, particularly Asian ones, cannot allow very ever since the bailout of Continental Illinois that the way to modernize is to let weak insti- big institutions in 1984, Federal Reserve officials have been tutions fail and to rely on market mecha- trying to convince large institutions that they nisms, rather than insider bailouts.”26 Allan to fail. cannot count on Federal Reserve support if Sloan put the same argument more colorful- they got themselves into difficulties. That ly in Newsweek: message seemed to be slowly getting through 10
  11. 11. For 15 months, as financial markets doubts. The most damag- in country after country collapsed ing consequence like straw huts in a typhoon, the United States lectured the rest of the Notes of the LTCM world about the evils of crony capital- episode is the ism—of bailing out rich, connected The author would like to thank Dave Campbell, insiders while letting everyone else James Dorn, and an anonymous referee for help- harm done by the suffer. U.S. officials and financiers ful comments. perception that talked about letting market forces 1. See International Monetary Fund, World Federal Reserve allocate capital for maximum effi- Economic Outlook (Washington: International ciency. Thai peasants, Korean steel- Monetary Fund, May 1998), chap. 1, p. 4. policymakers do workers and Moscow pensioners may not really have 2. For more information on hedge funds, see, for suffer horribly as their local example, Stephen J. Brown, William N. the faith to take economies and currencies col- Goetzmann, and Roger G. Ibbotson, “Offshore lapse—but we solemnly told them Hedge Funds: Survival and Performance, their own medi- that was a cost they had to pay for the 1989–95,” Journal of Business 72, no. 1 (January cine. 1999): 91–117; and Andrew Webb, “Hedge Fund greater good. . . . Cronyism bad. Fever,” Derivatives Strategy 3, no. 10 (October Capitalism good. 1998): 33–38. Then came the imminent collapse of Long-Term Capital . . . , the quin- 3. See International Monetary Fund, chap. 1, p. 4. Further details can be found in Barry Eichengreen tessential member of The Club, with et al., “Hedge Funds and Financial Market rich fat-cat investors and rich hot- Dynamics,” International Monetary Fund shot connected managers. Faster Occasional Paper 166, 1998. than you can say “bailout,” crony 4. Malaysian prime minister Mahathir capitalism U.S. style raised its ugly Mohammad has called repeatedly for greater con- head. . . . John Meriwether and the trols on the activities of international “specula- rest of the guys who ran the fund tors.” Indeed, Mahathir has blamed hedge funds onto the rocks got to keep their jobs. for causing the recent economic meltdown in South East Asia and has repeatedly singled out The fund’s investors, whose stakes George Soros, in particular, as being personally would have been wiped out in a col- responsible for many of the region’s problems. lapse, salvaged about seven cents on See, for example, “Mahathir Blasts Speculators,” the dollar. . . . The rescuers even CNNfn, January 30, 1999, worldbiz/europe/9901/30/davos_mahathir/. agreed to pay a management fee on Those claims cannot be taken seriously, and one their rescue fund.27 suspects that Mahathir is seeking scapegoats for his own policy failures. The most damaging consequence of the 5. Amy Feldman, “Investment Titan’s Fall,” New LTCM episode is therefore the harm done by York Daily News, September 28, 1998, p. 2, the perception that Federal Reserve policy- makers do not really have the faith to take 6. These figures are derived from those given on p. their own medicine. How can they persuade 4 of the testimony of David Lindsey, director of the Russians or the Japanese to let big insti- the Securities and Exchange Commission’s tutions fail, if they are afraid to do the same Division of Market Regulation, before the House themselves? At the end of the day, economic Committee on Banking and Financial Services on October 1, 1998, when the committee was hearing liberalization is just as necessary as it always evidence on the activities of hedge funds. This tes- was, but in the wake of the LTCM rescue, one timony is available at http://www.hedgefunds. can understand why many of those who have net /testimony.htm. to pay the price for it might have their 7. Ibid., pp. 4–5. 8. Ibid., p. 5. 11
  12. 12. 9. Allan Sloan, “What Goes Around,” Newsweek, 17. For more on developments in risk manage- October 12, 1998. ment, see, for example, Carol Alexander, ed., Measuring and Modelling Financial Risk, vol. 2 of Risk 10. A detailed account of the rescue is given in Management and Analysis (New York: John Wiley, William J. McDonough, president of the New 1998); and Kevin Dowd, Beyond Value at Risk: The York Federal Reserve, Statement before the House New Science of Risk Management (New York: John Committee on Banking and Financial Services, Wiley, 1998), pp. 3–37. October 1, 1998, 18. These include the Group of Thirty’s report of 11. See Sloan. July 1993, Derivatives: Practices and Principles (New York: Group of Thirty, 1994); and U.S. General 12. Since LTCM insiders have still to fully reveal Accounting Office, “Financial Derivatives: their side of the story, one can only speculate on Actions Needed to Protect the Financial System,” why the management of LTCM rejected the May 1994. Dowd, p. 16, provides a list of reports Buffett offer. However, they would have been con- by other interested parties. fident at this point that another offer would be forthcoming, and there are good reasons why 19. See ibid., pp. 121–31. they might have expected this second offer to be more generous than the first. For one, Buffett had 20. These practices are explained in Lee Wakeman, a fierce reputation for buying up firms at rock- “Credit Enhancement,” in Alexander, pp. 255–75. bottom prices and was clearly driving a very hard For more on the use of credit derivatives, see Janet bargain. In addition, they could reasonably infer M. Tavakoli, Credit Derivatives: A Guide to from its recent behavior and record in past crises Instruments and Applications (New York: John Wiley, that the Federal Reserve was determined to pre- 1998). vent the firm’s failure, and if the Fed was to do so, it needed to give the fund’s managers some incen- 21. Benedict Weller, “Betting with Hedges,” tive to cooperate. In other words, they had some Financial Regulator 3, no. 3 (December 1998): 21. bargaining power with the Federal Reserve, which was clearly desperate to prevent the failure of 22. Greenspan, p. 5. LTCM, but they had no such bargaining power 23. Ibid. with Buffett. If they turned Buffett down, the management of LTCM could therefore be fairly 24. See, for example, Richard H. Timberlake, confident of getting a better deal shortly after- Monetary Policy in the United States: An Intellectual wards. From their point of view, rejecting the and Institutional History (Chicago: University of Buffett offer made good sense, but only because Chicago Press, 1993), pp. 416–18. they could expect a better offer later. 25. Patrick Young, “Lessons from LTCM,” Applied 13. McDonough, p. 4. Derivatives Trading, October 1998, p. 1, 14. Alan Greenspan, chairman, Board of Governors of the Federal Reserve System, “Private- 26. James A. Leach, “The Failure of Long-Term Sector Refinancing of the Large Hedge Fund, Capital Management: A Preliminary Assess- Long-Term Capital Management,” Testimony ment,” Statement to the House Banking and before the House Committee on Banking and Financial Services Committee, October 12, 1998, Financial Services, October 1, 1998, p. 5, http:// pp. 5–6, http://www. 101298le.htm. 15. Ibid., pp. 1, 3. 27. Sloan. 16. Ibid., p. 1. Published by the Cato Institute, Cato Briefing Papers is a regular series evaluating government policies and offering proposals for reform. Nothing in Cato Briefing Papers should be construed as necessarily reflecting the views of the Cato Institute or as an attempt to aid or hinder the passage of any bill before Congress. Additional copies of Cato Briefing Papers are $2.00 each ($1.00 in bulk). To order, or for a complete listing of available studies, write the Cato Institute, 1000 Massachusetts Avenue, N.W., Washington, D.C. 20001, call (202) 842-0200 or fax (202) 842-3490. Contact the Cato Institute for reprint permission. 12