Absence of prudence on hedge funds Bailout: These funds are really nothing more than high-risk gambling vehicles.

October 10, 1998

THE Federal Reserve had little choice when it organized the bailout of the insolvent hedge fund, Long-Term Capital Management. Thefund's collapse would have further unsettled the already jittery world financial markets and could have precipitated a global panic. Maintaining confidence in financial institutions is in everyone's interest.

Although the U.S. economy continues to perform magnificently -- producing more jobs and higher incomes with a low rate of inflation -- the economies of Asia, Russia and Latin America are in very weak shape.

U.S. and European banks, investment houses and insurance companies are now writing down investments and loans they made to these countries. Had LTCM collapsed, its billion-dollar derivative holdings -- financial instruments that "derive" from price movements of bonds, currencies or other financial instruments -- would have been dumped on the world markets. A global financial meltdown would have followed.

The bailout did not involve public money. The Federal Reserve, this nation's central bank, simply organized a group of LTCM's largest creditors to take over the insolvent fund. The action was similar to a group of banks foreclosing on a failed business.

The financial institutions that were owed money have taken control to salvage whatever assets remain. These institutions can now gradually liquate the hedge fund's derivative positions without roiling world financial markets.

Nonetheless, it is appropriate to criticize the behavior of the banks, investment houses, insurance companies and pension funds thatlent this hedge fund large amounts of money. These normally prudent financial organizations were seemingly oblivious to the high degree of risk inherent in LTCM's highly-leveraged investments.

They also may have been mesmerized by the reputation of LTCM's founder, Wall Street bond whiz John Meriweather; by the presence of two Nobel Prize laureates for economics on the fund's advisory board; and by the supposedly sophisticated computer models LTCM used.

Yes, the fund produced extraordinary returns for two years, but at a high level of risk. The fund was not investing, but gambling.

Just as the cards can turn against the best poker player, conditions turned against LTCM. This summer it became clear that all their bets were wrong.

Outlawing hedge funds would be a futile exercise. They would just move offshore. Rather than regulate these investment vehicles, the federal government can impose restrictions on banks that loan to hedge funds. It can require higher reserves on these loans or that banks obtain loan guarantees. Theoretically, the high cost of guaranteeing risky loans should discourage them.

As long as banks, pension funds and others are lending other people's money, prudence should be the byword. Loaning money to LTCM was anything but prudent.

Pub Date: 10/10/98

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