CAMBRIDGE: There was a clear mood of schadenfreude around the world last week when the U.S. hedge fund Long Term Capital Management (LTCM) collapsed. There were several reasons for the hidden pleasure among many international critics of U.S. economic smugness over the past year. First, of course, was the irony that the firm's management included the very pinnacle of the finance industry - two brilliant Nobel prize winners and one of the most envied hot-shot traders from the investment banking world. Second, after a year in which the U.S. and IMF had lectured Asia to avoid government meddling in closure of failed financial institutions, the New York Federal Reserve stepped in, very Asian style, to coordinate a rescue of the failing LTCM. It turns out, not surprisingly, that the world is more complicated than the U.S. and IMF had acknowledged.
Actually, there is much to learn about the rise and fall of LTCM. First, it was yet another case of an under-regulated financial firm placing unacceptable bets with other people's money. The firm leveraged millions of dollars of its owners' money into hundreds of billions of dollars of financial claims. Commercial banks lent freely to LTCM on the basis of the fund's early record of high profitability, and on the names of its principal partners. It is clear that the banks did not really know what LTCM was doing with the loans until it was too late.
One major truth about the past year is that financial market problems lie not just with hedge funds - which are the biggest and least regulated gamblers - but with good old commercial banks, which display an uncanny ability to create trouble by excessively risky gambling, whether in loans to emerging markets or to the likes of LTCM. The banks that lent huge sums, mostly unsecured, to LTCM, are the same ones that put in around $175 billion of short-term loans to five East Asian developing countries (Indonesia, Korea, Malaysia, the Philippines, Thailand), and then abruptly reversed gear, and yanked out tens of billions of loans in 1997 and 1998. Amazingly, Chase Manhattan reports that it had exposure of some $32 billion in loans and derivatives at LTCM, roughly 2% of the bank's total loan and credit exposure to just the one hedge fund!
LTCM also illustrates some truths about financial market crises, and how to manage them. When push came to shove, with LTCM on the brink of collapse, the Federal Reserve didn't simply let "market forces" take their course. Rather, it coordinated a takeover of ownership of the firm by its major creditors, mainly the banks that had lent LTCM the billions of dollars which were converted into hundred of billions of dollars of speculative investments. The operation was rather like a bankruptcy procedure, but it was done informally, in the "shadow" of the bankruptcy courts. The original owners of LTCM may have kept some equity, for now, and this might not be appropriate, but most of the value of the firm - or whatever remains, appropriately was transferred to the creditors.