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Strategies & Market Trends : Graham and Doddsville -- Value Investing In The New Era -- Ignore unavailable to you. Want to Upgrade?

To: porcupine --''''> who wrote (840)	10/1/1998 1:32:00 AM
From: porcupine --''''>	Respond to of 1722

LTCM workout creates no moral hazard -- NYTimes ECONOMIC SCENE Long-Term Capital Didn't Get, or Warrant, a Bailout By MICHAEL M. WEINSTEIN -- October 1, 1998 NEW YORK -- Judging from the volume of criticism, William McDonough, president of the New York Federal Reserve Bank, made a dreadful mistake when he orchestrated a "bailout" of Long-Term Capital Management, the multibillion-dollar investment fund that bought most of its assets with borrowed money. Paul Volcker, the former Federal Reserve Board chairman, wonders out loud why the government needed to rescue private investors. Jeff Faux, an economist at the Economic Policy Institute, spoke for many on the political left when he questioned the fairness of rescuing millionaire speculators when the government turns its back on bankrupt companies that employ low-paid workers. Other critics ask whether the Fed's action creates a destructive incentive, known as a moral hazard, for banks and securities firms to lend recklessly to investment funds, assured by last week's action that the government would not let their investments go belly up. Good questions all. But the Fed has even better answers. The truth is that it orchestrated no bailout, created no moral hazard and set no bad precedent. First, let's clean up some language. There was no bailout, because the Fed turned over no taxpayer money to the fund. Long-Term Capital is a hedge fund, a type of investment fund that caters only to investors who are rich and sophisticated. The investors raised a few billion dollars of their own and borrowed tens of billions more from banks and securities firms like Merrill Lynch. For three years its investment strategy worked brilliantly, but its investments soured this year. Because the firm had borrowed to the hilt, losses turned to disaster when creditors demanded their money. That, says professor George Benston of Emory University, "sets up a classic free-rider problem." Each creditor grabs for its money while there is still money to grab. But if all the creditors grab at once, the fund will be forced to sell assets hastily, guaranteeing stupendous losses. A fire sale of securities would put the fund in about the same position as a family forced to sell its suburban mansion in 24 hours. "What McDonough appears to have done," Benston suggests, "is to use the credibility of the Fed to bring the creditors together for their mutual benefit." Working together, they can keep the fund alive at least long enough to sell off its assets in an orderly, patient and perhaps even profitable manner. A bailout for the rich? For all the prattle, the fact is that the partners come away nearly empty-handed. The creditors, a consortium of banks and securities firms, have pledged to put up $3.6 billion in exchange for 90 percent ownership. Moral hazard? The deal nearly wipes out the misbehaving speculators and forces inattentive creditors to fork over money and take over the wreckage they indirectly sponsored. This deal hardly offers comfort for repeat offenders. There has also been talk that the deal smacks of hypocrisy. The United States lectures the Japanese to let the market weed out bankrupt banks and companies. But it is a stretch to connect the dots between last week's deal and Japan's neglectful bank regulators or its "convoy" system, under which strong companies prop up the weak. Last week's deal puts creditors in charge of a mop-up exercise. There is nothing to suggest they will keep the fund in business longer than it takes them to get back the best value for its assets -- unless they decide it can generate long-term profit. The Fed-brokered deal raises the larger question of when the government should rescue bankrupt companies. Bailing out nonfinancial companies rarely makes sense, because a government that protects losers will attract losers galore. But politicians sometimes cannot resist bailing out the likes of Chrysler and Lockheed -- huge corporations whose demise threatens thousands of workers -- even though research shows that few if any jobs are truly saved. Banks, however, are special. Burton Malkiel, an economics professor at Princeton University, argues that bailing out banks makes sense "because taxpayers are already on the hook for the federally insured deposits." And the government needs to protect the nation's money supply. Most economists are unwilling to extend the safety blanket beyond banks even though the failure of hedge funds, securities firms and other financial concerns could in theory touch off cascading defaults that could infect banks because their loans would go unpaid or the value of their other assets would plummet. But it is easy to exaggerate the threat, and besides, the Fed can pump up an economy temporarily dragged down by sluggish credit markets. So where does that leave the debate over Long-Term Capital? It is not a bank, nor does its collapse appear to threaten the solvency of banks. It does not, then, warrant a bailout. It didn't get one. McDonough merely helped creditors take over the firm and spare themselves needless losses. Score one for McDonough's good sense. Copyright 1998 The New York Times Company