I would not cast this episode in the forces-of-darkness-are-out-to-get -us style of rhetoric some commentators favor, because, however true that might be, it still doesn't advance my understanding, in any scientific sense, of what is going on.
That said, there is still a serious problem here. Say you lend me money to operate a business. When it's time to repay the loan, I hand you a deed for a bankrupt business. The money you loaned me is no longer available to lend to a healthy business -- hence, a loss to the economy. Further, you may have a problem now repaying the people you borrowed the money from -- with possible domino effect consequences.
Once or twice a decade this may be okay. But, Japan got addicted to it -- now all of their potential risk capital is instead tied up rolling over loans for wealth destroying businesses -- and therefore, the overall economy is destroying more wealth than it's creating. Hence, output is plunging, demand is plunging, and the rest of East Asia has no hope of recovering until somebody actually goes bankrupt -- thereby freeing the capital that's proping them up to be used for more profitable purpose.
But, this type of rescue, even only once or twice a decade in the beginning, has what some call a "moral hazard". Some say the Mexican bailout only encouraged profligacy in lending to East Asia. If the lenders to LTCM really did get equal equity in exchange for the defaulted loans, why not keep making loans to people doing things that no one really understands the risk of? If shareholders of the lenders are still whole, why should they scrutinize the lender more closely? Eventually, there's a fiasco that's "too big to rescue".
Adding insult to injury, the principals of LTCM will be left in charge (two of them Nobel laureates -- including half of the team credited with the Black-Scholes options pricing formula). This is because the lenders admit that, even now, no one really understands what the principals were doing -- so only they can continue doing it! If you were a shareholder in the lender, how would this strike you? |
