Western crony capitalism
You thought cronyism was a feature of Asian economies?
John Plender investigates the web of ties around LTCM
3 october 98/ financial times
Many Western policymakers regard the flood of private capital out of Asia, Russia and Latin America as a just penalty for flawed policies and corrupt crony capitalism. In the light of the collapse and rescue of John Meriwether's Long-Term Capital Management, this view looks unforgivable.
The LTCM hedge fund fiasco has exposed not only inept banking practice from Wall Street via Switzerland to the Italian central bank, but a surprising degree of cronyism in the West; a cronyism less corrupt than in Indonesia, Malaysia or Russia, but with more dangerous consequences, given the scale of the financial risks involved.
No one would suggest that high office in Washington has become the chief means of acquiring material wealth in the US, as in the worst of the emerging markets. But the rescue of LTCM has revealed relationships that smack of cronyism and potential conflicts of interest.
One concerns the involvement of the Federal Reserve in brokering the fund's controversial rescue."Why," asked former Fed chairman Paul Volcker this week, "should the weight of the federal government be brought to bear to help out a private investor? It's not a bank."
The only respectable answer is that the Fed believed the collapse of LTCM would have posed a threat to the whole US banking system. This is not implausible. LTCM was allowed by its bankers to run up a peak exposure on its balance sheet of $200bn (against an equity capital of $4.8bn). The off-balance sheet exposures arising from derivatives trading were on a similarly impressive scale.
Yet in making a judgement on whether the fund was too big to fail, Mr Volcker's successor Alan Greenspan was sanctioning the rescue of an outfit whose board included David Mullins, his former vice chairman at the Fed, and still a friend.
Equally striking, Mr Mullins had been responsible for the Fed's input into a government investigation into the Salomon Brothers' market rigging scandal in 1991. As a result of his involvement in the illegal rigging of the US Treasury bond market, John Meriwether was forced to resign as vice chairman of Salomon, and then went on to found LTCM.
There is constant traffic between the Fed and the Treasury to and from Wall Street. But Mr Mullins' official role in the Salomon affair makes his choice of destination in the private sector all the more surprising, to put it mildly. So is the extraordinary deal whereby the Bank of Italy invested some of its foreign exchange reserves in a hedge fund (LTCM) known for its arbitrage dealings in the Italian bond market.
The potential conflicts did not stop there. Among those who agreed to participate in the rescue was David Komansky, chairman of Merrill Lynch. He had a personal investment of $800,000 in the hedge fund; his fellow Merrill executives had more than $20m in the pot. Donald Marron, chairman of PaineWebber, was another Wall Street investment banker with a personal stake in the fund.
Many of the top commercial banks supervised by Mr Greenspan's Fed had lent money to LTCM, offering 100 cents for every dollar of collateral, without imposing any overall borrowing limit. The big investment banks had made similarly imprudent loans to a firm that generated huge volumes of business in securities and derivatives trading for them.
A striking feature of the globalisation of capital markets is the extraordinary large volumes that can be generated by a small number of institutions. Relatively few are capable of the derivative- based trading strategies that produce such quirky outcomes as a sudden rise in the yen in response to a default on Russian bonds.
Hedge funds are among them. Despite scepticism among staff at the International Monetary Fund about the importance of the hedge funds, the IMF's annual report reveals that some directors now dissent. They argue that "hedge funds at times had a strong effect on asset prices, particularly in light of the relative size of their positions in specific markets."
Certainly market practitioners have no doubt that the larger funds have been the dominant force in emerging markets, high-yielding debt and mortgage derivatives. And while the hedge funds have not been at the forefront in South Korea, Malaysia or Brazil, decisions by Malaysia and others to devalue were prompted partly by fear of hedge fund speculative attack.
The derivatives world, which overlaps with that of the big hedge funds, is similarly concentrated. Nobel laureates Robert Merton and Myron Scholes, who provided the theoretical underpinning for much derivatives trading, sat on LTCM's board.
Many of Merrill Lynch's derivatives experts learned their trade at Bankers Trust under Alan Wheat, who has now moved to Credit Suisse First Boston, which also does business with hedge funds. Bankers Trust's role as a big lender to the hedgers has heavily dented its stock price.
Meanwhile, UBS, which was both an equity investor and a lender to LTCM, owed its involvement in the first instance to Ron Tannenbaum, a former colleague of John Meriwether at Salomon Brothers. This was the deal that led to the resignation of Mathis Cabiallavetta as UBS's chairman.
Most of the big hedge fund managers know each other, talk to each other and share the same lawyer. The Hong Kong authorities are convinced that four or five of them colluded in a recent attempt to smash the Hong Kong currency peg.
This is not the first allegation of collusion. The US Department of Justice and the Securities and Exchange Commission accused Steinhardt Management and Caxton Corporation of involvement in the same market rigging scandal that forced John Meriwether out of Salomon. The two hedge funds paid $70m in fines without admitting wrongdoing.
In the close-knit global financial community herding comes naturally. As one Wall Streeter puts it, "there is hardly a hedge fund this week that is not short of the Australian dollar - collusion isn't necessary". A commodity producer facing an election is a sitting duck for the hedge funds.
They even have a uniquely paradoxical private language. Their "market neutral" positions, for example, refer to trading strategies that can bankrupt them. "Long term" capital means a slender wedge of short term capital leveraged to an unlimited degree. And, of course, there is that brilliantly propagandist misnomer: "hedge" fund.
By way of assistance the investment bankers act as free publicists for them. A prime example was the report earlier this year from Goldman Sachs which asserted that hedge funds were safer than other forms of collective investment - a cheery prognosis that now commands as much respect as Goldman's perennially bullish stock market forecasts.
The propaganda also emphasises differences between hedge funds. Yet they are notably similar in offering minimal disclosure to investors and regulators. Most are leveraged; and when they outperform, the high return often owes more to leverage than investment judgement. Despite claims to the contrary, many usually turn out to have taken wildly risky punts when markets move against them.
The hedge funds do incorporate some genuinely novel features: the phenomenon of the ineffectual Nobel laureate on the board is unprecedented in high finance. Yet the academics who lent lustre to the LTCM board were merely a modern incarnation of the aristocrats who until recently lent a veneer of respectability to shaky British boards. Brilliance in mathematical modelling is no better qualification for the board, it seems, than brain-dead lineage.
As for the banks, they have been behaving no differently with the hedge funds than in other speculative ventures. The collapse of the Reichmann brothers' property empire provides a parallel. The Reichmanns were able to raise money from the banks for specific projects without ever showing a group balance sheet. It is the old story of lending on collateral without understanding the underlying business.
If there is something genuinely unusual in the present crisis, it is that the doyen of the hedge fund managers, George Soros himself, is arguing for draconian re-regulation. In effect, his message is: "Stop me before I kill again." As one seasoned analyst remarks, while Mr Soros worries upstairs about the world, his manager Stanley Druckenmiller asks all comers below, "what should I be shorting today?" Do the policymakers in Washington have the will to rise to Mr Soros's challenge? |
