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Issue 34, January 1999

The West's crony capitalists

THE INSOLVENCY and near collapse of Long Term Capital Management (LTCM), formerly the premier hedge fund, brought the world financial system to the very edge of meltdown. Only the rapid $3.6bn rescue organised by the Federal Reserve averted catastrophe.

While LTCM has been bailed out, however, a string of major US, European and Japanese banks and finance houses are being hit by huge losses: a chain reaction of linked failures certainly cannot be ruled out in the coming months.

Only when the New York Federal Reserve Bank (Manhattan arm of the US central bank) announced a rescue package on 23 September did news emerge of the LTCM crisis. As a result of miscalculating its bets on international bonds, together with losses in Russia and other 'emerging markets' in August, LTCM was facing a 90% loss. In return for near-complete control of the firm, 15 US and European banks and finance houses - lassoed by the Federal Reserve - injected $3.6bn to prevent total collapse.

For the big financiers, LTCM was 'too big to fail'. At the beginning of 1998 it had capital of $4.8bn, but in September its 'exposure' (debts) amounted to over $200bn - an incredible borrowing ratio of over 1:40. LTCM was holding derivatives with a nominal value of $1,250bn.

Had LTCM been forced to sell its portfolio in order to cover its losses, that would have flooded markets with bonds, shares, etc, and precipitated a massive fall in asset prices. The supervising board appointed by the rescuing banks will attempt to sell off LTCM assets over a longer period, though this may still depress prices.

As it was, the LTCM crisis was widely blamed for provoking an unprecedented 20% fall in the value of the dollar against the yen (as LTCM and possibly other institutions sold dollar assets to repay yen loans to Japanese banks). A string of major banks and finance houses announced massive losses which were party due to LTCM (together with huge losses after Russia defaulted on its foreign loans). Burned LTCM investors include the world's second-largest bank, UBS of Switzerland (which lost around $700m), Merrill Lynch (which stands to lose $1.4bn), the Central Bank of Italy (which has lost $100m), and the Dresdner Bank of Germany ($142m).

  Financial strategists and economic commentators were painfully aware that this episode had been a very narrow escape for global capitalism. The sums involved point to the scale of the crisis. The $3.6bn rescue package contrasts, for instance, to the mere $200m offered by the Western powers on 7 November to alleviate the vast human disaster in Central America.

Commentators, moreover, began to ask some obvious questions, which had never been asked before. Why had the financial institutions lent so much money to this hedge fund, a highly secretive organisation which engaged in highly speculative investment on the basis of largely unsecured loans 20 to 40 times greater than its capital assets? In any case, what is the role of hedge funds - apart from making huge profits for those who invest in them?

Hedge funds were originally supposed to be funds to cover various contingencies, to provide security, but in reality they have become funds for speculation. A variety of enterprises are referred to as hedge funds. There are estimated to be around 4,000 funds with investments of around $400bn.

Essentially, the hedge funds are investment companies which operate on the basis of relatively small groups of wealthy investors or financial institutions, usually requiring a minimum stake of at least $10m. If, in the US, they confine themselves to under 99 big investors they are not subject to any regulatory control and are not required to disclose accounts. While operating from US or European financial centres, most of the hedge funds - like LTCM, which is based in Connecticut - are legally incorporated in tax havens like the Cayman Islands.

Hedge funds took off in the 1990s, using their enormous (mainly borrowed) funds to cream off super-profits from the avalanche of profit arising from globalisation. They have been prominent in trading derivatives - a term which covers a variety of financial instruments, such as futures, options, swaps, etc, whose value is derived from the assets (property, commodities, or financial assets, such as shares, government or company bonds, loans, etc) underlying them. The theory was that derivatives, through a complex spreading of risks, virtually eliminated risk for fund managers, reduced the cost of loans to borrowers, and increased investors' returns. Hedge funds also specialised in buying and selling bonds, shares and currency between different financial markets, relying on a huge volume of business to exploit fractional differences between prices (this is known as arbitrage).

  This speculative strategy was largely successful during the mid-1990s (though some speculators came to grief). Even after charging 2% for 'administrative expenses' and collecting 25% of the profits, LTCM handed its shareholders returns of 42.8% in 1995, 40.8% in 1996 and, due to the Asian crisis, 'only' 17.1% in 1997. But in September this year, after mistakenly gambling on the convergence of G7 government bond rates, LTCM made massive losses.

While the going was good, LTCM had no problem finding wealthy investors. There was a long queue of US and European finance houses, with some of their directors (eg from Merrill Lynch) putting in huge amounts of their own money. They had no qualms, at that time, with the absolute secrecy of LTCM's operations. There were no balance sheets, no details of even major investments. Success, it was believed, was guaranteed by the illustrious pedigree of the shareholders.

The fund was set up in 1993 by John Meriwether who, despite being forced to leave Soloman Brothers after a bonds trading scandal, was regarded as the supreme virtuoso of global speculation. Another shareholder had previously been vice-president of the Federal Reserve Bank. Two others had won the Nobel Prize in mathematics for their sophisticated investment formulas. They were regarded as pre-eminent 'rocket scientists', as the theoretical speculators are known. Unfortunately, they forgot the old axiom that what goes up must come down.

When the Asian crisis broke out, Western capitalists began to blame it on the 'crony capitalism' of the East, demanding greater 'transparency' as a condition of rescue loans. But no outfit could have been more opaque than LTCM, which operated through a closed, secretive and incestuous clique of profit-mad speculators. Analysing the fiasco later, the New York Times (23 October) summed it up: 'Fund stars didn't tell, savvy financiers didn't ask'. What is this if not crony capitalism? Yet when LTCM crashed, 15 of the biggest banks, orchestrated by the Federal Reserve, immediately stepped in to bail them out.

  LTCM, however, is not out of the woods yet. And other hedge funds, including the Soros Group, have made massive losses. They surfed on the wave of globalised financial speculation of the last three or four years, but with the worldwide fall in markets, accompanied by a sharp decline of production and trade, hedge funds and finance houses have inevitably sustained huge losses. Already, there is an international banking crisis as banks register more and more losses from Asia, Russia, Latin America, and from their own speculative investments turning bad.

So far, the central banks, especially those of the US and Japan, have managed to prevent - or at least, postpone - a systemic crisis, through organising bail-outs or effective nationalisation of insolvent institutions. The partial recovery of the US and European stock exchanges since September has temporarily eased the pressure. The deepening recession in the US, however, will bring further falls. Justifying the rescue of LTCM, Alan Greenspan, Chairman of the Federal Reserve, said: "Substantial damage could have been inflicted on many market participants - (which) could have potentially impaired the economies of many nations". True. And the worst is yet to come.

Lynn Walsh

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