Losses are an integral part of the capitalist process. But you
wouldn’t
know it from the way some big boys are treated on Wall Street. 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,
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 overtly
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. Both Warren Buffet and
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.
But 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.
