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December 17, 1998
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When the investment fund called Long-Term Capital Management almost
collapsed last August, the event sent tremors throughout the financial world.
Many feared that Long-Term Capital's problems would spread to other
institutions as the prices of financial assets generally fell. Suddenly
attention was concentrated on the arcane and mostly unregulated investments
known as hedge funds; they apparently have much more influence over global
financial markets, and indeed the economic lives of most people, than was
generally realized.
A hedge fund is a limited partnership which, unlike a traditional
mutual fund, has no restrictions on the types of investments it can buy and
sell other than those its managers impose on themselves. It can also borrow
several times its capital to make these investments. Long-Term Capital
Management was one of the nation's largest hedge funds. Headed by John
Meriwether, formerly of Salomon Brothers, and with two Nobel Prize winners in
economics among its partners, it was also one of the most respected. After it
lost most of its $4.8 billion in capital last summer—at the time when
worldwide markets were falling in reaction to financial turmoil in East Asia
and Russia—the Federal Reserve decided that it had to mobilize private
resources to save the firm. More than a dozen banks and other institutions
were asked to invest in it and take over its operations, and they put up some
$3.6 billion to do so.
Because Long-Term Capital had borrowed extensively, its actual
investments may have amounted to as much as several hundred billion dollars,
if not more. With the value of financial assets in general falling, the
turmoil could have spread well beyond the investors directly involved with
Long-Term Capital to many other domestic and international institutions. In
fact, major commercial and investment-banking firms in Europe and the United
States reported losses of hundreds of millions of dollars that were related to
hedge fund activity. Several major hedge funds, including two of the largest,
Julian Robertson's Tiger Fund and George Soros's Quantum Fund, also reported
substantial losses of billions of dollars.
There are probably about fifty hedge funds today with capital of more
than $100 million and some three hundred with $50 million or more. There may
well be several thousand funds in all, many and perhaps most with capital of
no more than $1 or $2 million. Precise data are not available because hedge
funds are generally unregulated. According to federal law, if the funds have
fewer than five hundred investors, each with a minimum net worth of $5
million, the disclosure and other regulatory requirements the Securities and
Exchange Commission (SEC) imposes on mutual funds do not apply. For any
individual, the minimum investment in one of these funds is $500,000. The
government has concluded that investors with sufficiently high net worth are
sophisticated enough or rich enough to afford expert advice, making basic
protective measures unnecessary.
Many American firms also run off-shore funds, also unregulated, which
are generally closed to American taxpayers, in which the minimum for
investments is much lower. In general, small investors cannot invest in hedge
funds, notwithstanding the frequent claim that they are the most profitable
way to invest over the long run.
In the last twenty years, hedge funds have become increasingly popular
because many of them have produced significantly higher returns than stock
market indices, such as the Standard and Poor's 500 Stock Index, or most
mutual funds. The best-known of these funds, George Soros's Quantum Fund, an
offshore fund, has produced gains that average 30 percent a year, as have some
other funds. Only in the last three years of an exuberant stock market has the
average mutual fund been able to equal or exceed this performance; in fact,
during these years, many mutual funds have done so well that even the best
hedge funds have generally not matched their returns. Still, the services that
tabulate fund results find that for the
last ten years or so hedge funds have performed better than the
average mutual fund and have been less volatile.1
During the late 1960s there was no more than $2 billion invested in
hedge funds. Today, hedge funds have between $200 billion and $300 billion in
capital. This remains a small percentage of the more than $3 trillion under
management in mutual funds. But because hedge funds can invest a great deal
more than their capital by borrowing—that is, they can
"leverage" their capital—they can effectively buy far more in
securities than they could pay for in cash. They can also trade in options and
futures contracts, which are known as "derivatives." These contracts
enable them to buy or sell securities in the future at a fraction of the cost
of the securities themselves. (The contracts are called derivatives because
they fluctuate in value with the price of the underlying security.)
In fact, most hedge funds borrow very little, if at all, to make
investments. But many of the biggest hedge funds have investment positions of
five times their capital and sometimes more. Perhaps no other hedge fund
borrowed as aggressively as did Long-Term Capital, whose investment position
was many times that. Hedge funds are not entirely free of reporting
requirements. For example, every calendar quarter they must report the amount
of equities they own to the Securities and Exchange Commission. But they need
not report how much they have borrowed or most of the trading they undertake
in the many exotic derivatives and other investment instruments now available
to them.2
As a senior partner of Oppenheimer & Co., Leon Levy started the
first mutual fund that could adopt several of the same practices used by hedge
funds in the 1960s. Levy and his partner Jack Nash sold Oppenheimer in 1982
and founded the hedge fund Odyssey Partners, which was one of the most
successful of such funds until its recent liquidation. Leon Levy remains
chairman of the board of trustees of Oppenheimer Funds based in New York. He
is also president of the Institute for Advanced Study in Princeton and
vice-chairman of the Jerome Levy Institute for Economic Research at Bard
College.
In late October and early November, I talked to Levy about hedge
funds, their investment strategies, and their influence over the financial
markets and, ultimately, the world economy.
—J. M.
Jeff Madrick: So many hedge funds have been able to produce
above-average returns for investors that they became enormously popular as
investment vehicles for the wealthy over the last ten or fifteen years. But
these funds were originally designed to control the size of potential losses
in several ways, especially by using sophisticated financial instruments to
their advantage. Recently some of them seem to be taking inordinate risks, and
they may have put the world financial system in jeopardy.
Leon Levy: It is important to realize that, as a limited
partnership, a hedge fund has virtually no investment restrictions, except
those that the people who create the hedge funds choose to impose on
themselves. A hedge fund can buy stocks, bonds, commodities such as gold or
oil, international currencies, and so on. It can also borrow to invest. It can
invest in futures and options—which people now call
derivatives—which allow a manager to put up a small fraction of a
security's value in order to buy or sell it. And it can also sell short, that
is, sell stocks and other investments that it doesn't own if the manager
believes they will go down. (To sell short you borrow a stock and sell it at
today's price. Then later you buy it back at a lower price, return it to
whomever you borrowed it from, and keep the profit.)
Such possibilities can reduce as well as increase risk. By selling
short—or using other hedging techniques to accomplish the same
thing—you can concentrate on picking individual stocks without having to
worry as much about which way the overall market is going. No matter how good
you are at picking stocks, a sudden downturn in the market can undo all your good
analysis.
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1 See "The
U.S. Offshore Funds Directory," Antoine Bernheim, New York, New York.
Also, LJH Global Investments, Naples, Florida. (back)
2 Hedge funds must
report their transactions in futures contracts on formal exchanges to the
Commodity Futures Trading Commission, a government agency. Much and perhaps
most such trading is not done on exchanges but in over-the-counter markets,
for which there is no reporting requirement. (back)
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How better to protect yourself in a falling market than to be able
to sell short? For example, the hedge fund manager might think most stocks are
going up. Or he might own a lot of individual stocks that he thinks are
undervalued. But in case he is wrong, or if the entire market suddenly falls,
he might also sell short certain kinds of stocks that seem to him particularly
overvalued at the time. Even in the same industry. For example, the manager
may own some drug company stocks he thinks are cheap and sell other drug
stocks short that he thinks are overpriced. If he turns out to be wrong, and
stocks in general go down, he will still make some money on the short sale to
offset some of the losses on his portfolio. He is hedging. Of course this is
not fool-proof. We have seen managers who have occasionally both owned the
wrong stocks and shorted the wrong stocks. And they lost money on both sides
of the transaction.
So hedge funds have many more ways to make money than mutual funds,
and perhaps the most important thing about hedge funds is that they take the
responsibility away from the investor for choosing what market to put money in
and place it entirely in the hands of the money manager. He or she can be in
any market at any time.
J.M.: But if the stock you sold short keeps going up in
price, and does not go down as you expected, the risk can be enormous. You
never know how high it can go.
L.L.: That's right. If you don't cover your short—that
is, buy the stock back—and the price keeps rising, losses can be quite
grand. So it depends on how you use these investments. The same with
borrowing. Most hedge funds do not borrow very much, do not use much leverage
at all. But if you borrow wisely, it can improve your profits. You can hedge
with derivatives, also. In fact, fund managers now largely hedge in derivative
markets. For example, by using futures, you can sell the entire S&P 500
index or the Dow Jones average short while putting up very little money.
J.M.: Such derivatives are seemingly mysterious vehicles
because we don't know who has invested in them, and to what extent, at any
given time. But don't they also incur great risk?
L.L.: Yes, they are risky because you are putting up much
less money for the securities than if you had to buy or sell the same
portfolio of stocks. But they are also effective methods for protecting
against down markets. You can buy a "put" option, a contract that
gives you the right to sell a stock at a certain price within a specified
amount of time. For $5, for example, you can pay for a contract by which
another investor will buy a stock from you for $50 at any time over the next
three months, even if it goes down to $30. He keeps the $5, but you may be
able to buy the stock for $30 and sell it to him for $50. So you've made $15
on your $5 investment. You've tripled your money. A "call" is the
opposite. You can buy a security for a fraction of the price.
But that may not be the main reason you would do it. The chances are
that some stocks you own outright, "own long" as we say, are going
down at the same time. Stocks do have the habit of moving together. So,
because you've hedged, at least you'll have profits on the stocks you don't
like.
Of course, if stocks go up, you'll make money on those you own, but
only lose the $5 that your put option cost. These days you can buy or sell a
put or call on most active stocks and many futures contracts. There are now
futures indexes in all kinds of stock, bond, and even commodities indexes,
from the Dow industrials and the Russell 2000 index of stocks to a municipal
bond index and a commodities index for precious metals or grains. And there
are also contracts for most of the major foreign currencies.
J.M.: These derivative markets have taken on a life of
their own. Just to take an example, people make a good living simply trading
on the difference between the put option to expire tomorrow compared to
the one to ex-pire in a month if they think the price is even slightly
out of line with expectations.
L.L.: Yes. But hedge fund managers don't usually do this.
It's more likely that traders at commercial and investment banks will do so.
J.M.: Some would argue that's not a very productive use of
capital.
L.L.: I've had some doubts about the value of these markets
in the past, but I've probably lost the argument. If you think the stock
market is a valuable mechanism, then the derivatives market is also valuable.
But maybe for a different reason. And this is an important point that is often
lost. These instruments can make the markets more liquid because there are
today dramatically more investors buying and selling securities and they are
doing so with a lot more capital. So in these days of large agglomerations of
capital, this greater availability of choices and a larger pool of investment
allow such large investors to buy or sell enormous quantities of stocks or
other securities without disturbing prices. They have less fear that, if they
buy, they will drive the price way up, and if they sell, they will drive it
way down.
J.M.: But in times of crisis, this liquidity can suddenly
evaporate.
L.L.: In all markets, there are times when it is hard to
find buyers. On the way up and vice versa. There is always a door which might
close—or close enough so that everyone cannot fit through at the same
time. Remember, in 1987, there was a purportedly marvelous system where large
Wall Street firms would insure a portfolio by taking a short position in
derivatives. If you had a portfolio of $100,000, you could buy so-called
insurance for a very small price against a major downturn in its value. People
felt they could buy more stocks as a result because the experts told them
their portfolios could only lose a limited amount of money even if stocks in
general fell. But when the market crashed that year, the system was strained;
more people kept trying to sell, and that led to the debacle. The insurance
based on derivatives didn't work. Today, the strategies to protect investments
are more sophisticated and the system can handle more capacity. And I myself
use derivatives. But if you are looking for one simple answer about whether
derivative markets are good or bad, there is none. They are often very useful,
and sometimes they can be dangerous.
J.M.: Another complaint that is made about the riskiness of
hedge funds is that the managers usually get 20 percent of profits and are
still paid a salary even when there are losses. So it encourages risk-taking.
L.L.: I like that structure. The people who run hedge funds
can make an awful lot of money, and so I think there's some tendency for the
most able money managers to manage hedge funds. But I usually insist that the
hedge fund managers have a lot of their own money in the fund as well. That
way they will have an incentive to avoid losses as well as to make profits.
Those are good incentives for doing the best job. I feel safer on an airplane
because the pilot is riding with me. The same with hedge funds.
J.M.: When did you gravitate to this kind of investing?
L.L.: You know, when we started Oppenheimer Mutual Fund in
1968, I was fearful that the world might revert to a depression like the
1930s, and so we devised a mutual fund that could sell short, buy whole
companies or enough of one to control it, and purchase commodities. These were
merely protective measures that I thought might be useful if everything went
bad at some future time.
J.M.: Was this the first such mutual fund?
L.L.: Yes, I think so. Certainly, the SEC never gave its
approval to such a mutual fund before. But I know that you should never think
you're the first of anything—there is almost always someone ahead of you.
My lawyer and I had to go down to Washington and argue with the Securities and
Exchange Commission for a year to get it approved. They thought selling short
was a highly speculative device. We
had to convince them it could be conservative, that it was the only
effective way to protect your money if the market is going down. But the
public also thought the fund was speculative. And it was hard to find a money
manager in those days who was good at buying stocks as well as selling short.
Now, there are a number of mutual funds that can sell a certain percentage of
their portfolio short.
I do think that hedge funds represent a legitimate theory of
investing. The only thing about investing that's certain is that you don't
know for sure what the future is going to hold. Therefore, you want in your
arsenal every possible kind of weapon to make money, which should include the
ability to hedge against being wrong.
J.M.: Some experts insist that investors should just invest
in stocks and almost nothing else for the long run. They will invariably go up
if the time horizon is sufficiently long.
L.L.: That's true if you are young enough and healthy
enough. But look, the broad averages of stocks will usually outperform most
money managers over time because the averages don't have transactions costs
and don't have to worry about the marketability of their investments, and so
forth. But the real problem with the traditional point of view you are
describing is that it overlooks the only real rule of investing, which is to
measure risk against reward. This is what hedge fund managers do. They make
controlled bets, or at least they think they are controlled. There will be
moments when some kinds of securities or commodities or currencies seem to be
way out of line, priced too high or too low. George Soros wrote that markets
inevitably overshoot, which means that the trends go too far in one direction
or the other. And he's right, prices overshoot, both on the upside and the
downside. Bank stocks were way too low in the early 1990s, for example. I
think interest rates have generally been too high for a long time. Making a
controlled bet that interest rates would fall has been very profitable. I
think stocks have overshot on the upside recently.
J.M.: I think it would give us a clearer picture if you
provide a few examples of the kind of hedge funds you invest in.
L.L.: I own several risk arbitrage funds, which invest in
mergers. They essentially buy the stocks of the company that's going to be
taken over after assessing the risks, and sell the stock of the acquiring
company. If the merger is consummated, which is what they try to determine,
there's usually going to be a fair profit. Other funds I own specialize in
bankruptcies. These are usually very complex, and there are relatively few
people who can analyze the bankrupt situation. They involve difficult legal
issues. But the prices of these securities are very low, and if the company
comes out of bankruptcy successfully, it can be profitable. I also own some
hedge funds that specialize in bank stocks. After 1990-1991, when real estate
fell and the banks got in trouble, there were a lot of bank stocks that
appeared very cheap. I also believed there was an unstated desire on the part
of the government to see savings and loan associations and banks merge. The US
has more banks and more S&Ls than virtually any other country. I believe
regulators thought we'd be better off with fewer of them. The values of the
companies taken over would go up.
J.M.: How are they doing at the moment, however?
L.L.: Well, over five years, the bank stocks did very well.
But since the collapse of Russia and the troubles with Long-Term Capital, it's
been a rougher ride. I should also say that I own drug stocks and a couple of
funds that specialize in health care. I think there is going to be a great
deal of growth in these areas.
J.M.: What about the kind of investing that seems to
attract the most publicity these days: investing in international currencies
and bonds?
L.L.: Ulysses, which is the successor to the Odyssey hedge
fund, does some of that, particularly investing in banks (under Josh Nash). It
has had a very good year. They thought interest rates would go down, and that
has worked out. Ulysses bought calls on short-term fixed-income securities
because they thought rates on these maturities would fall faster than those on
long-term Treasury bonds. When rates fell, the price of these securities went
up, and the value of the calls went up much faster.
J.M.: That brings us to the current situation. Over the
past twenty years or so, some prominent hedge funds returned, according to
various reports, as much as 25 or 30 percent a year to investors. Well above
the returns on stocks.
L.L.: I think that's about right.
J.M.: Now, this didn't merely reflect the ability of these
managers, did it? Didn't other factors contribute to this performance, such as
aggressive borrowing?
L.L.: Well, I would like to believe that it has something
to do with the ability of the managers and it also had to do with the
flexibility which they had that allowed them to go into anything. We were
going through a period in the last twenty years, in a very broad sense, where
inflationary expectations were coming down and that made common stocks more
attractive, and it made some fixed-income securities attractive also. Hedge
fund managers by nature are pretty competitive, and so they want the most bang
for the buck. At the same time, they are trying to be conservative, and if
that sounds like a conflict, well I guess it is.
J.M.: So how does that work? Do they borrow so they can buy
much more of a conservative investment?
L.L.: That's one possibility.
J.M.: Or do they borrow to make an investment where they
think the odds are very favorable?
L.L.: First of all, they want the odds to be favorable.
That's first. They have to believe that. That's part of what makes the
investment strategy conservative. But, second, once they believe the odds are
in their favor, there's a tendency for many to want the most volatile
investment vehicle out of a particular group. That's the one likely to make
the biggest move. And if you have enough conviction, you might borrow to make
the investment.
J.M.: An example?
L.L.: Let's say that we think the copper industry is going
to make much more profit next year. There are some companies whose profit
margins in the copper industry are relatively high. But there are some
companies whose profit margins are very low. If there is an improvement in
margins for one company of two or three percentage points from 2 percent of
sales to 4 or 5 percent of sales, it's going to make proportionately a heck of
a lot more money than it did in the past compared to the company that begins
with high profit margins of maybe 4 percent and moves to 5 percent. The
profits might go up by 100 percent compared to only 20 percent at the other
company. So the stock price should rise more rapidly as well. Or take the oil
industry. If you buy Standard Oil of New Jersey and they make a strike, it's
not going to be spectacular for the stock because the company is so big. If
you find a little oil company in a small exotic country and it makes a strike,
that stock will attract an enormous amount of speculative interest.
J.M.: Is this how hedge funds essentially outperformed the
market?
L.L.: In some cases. In rising markets, many hedge funds
will simply get, as I said, more
potential gain for every dollar of investment. I hate to generalize
too much. But if you strongly believe in something like the price of oil going
up, then you would certainly want the oil company whose stock price is likely
to move most on the good news. In a rising stock market, many of these
situations worked out well. And then many of these hedge funds borrowed a lot
against their capital, as we've been saying. So a typical investor with $100
might earn 20 percent on capital in a good year. If a hedge fund borrows
another $100, it would earn 40 percent a year on its $100 capital before
interest, expenses, and dividends. Of course, if you're wrong, you would lose
more than the investor who did not borrow.
J.M.: What are other examples of the sorts of investments
hedge funds made that the traditional mutual funds did not?
L.L.: There were good investments other than traditional
stocks in the 1990s that hedge funds were able to exploit. Some bought
emerging-market debt—the debt of developing nations. Buying Mexican
securities when everyone was scared of them looked very good for a while.
Investing in Russian securities when they were first available for purchase
was attractive for some investors. You did not know whether they would work
out, but they were so cheap initially that the odds were highly in your favor.
Some hedge fund managers obviously stayed in too long and recently lost money.
Falling interest rates provided opportunities in bond markets. Now there are
many mutual funds that invest in bonds. But hedge funds can again make
leveraged bets, and they can usually invest all over the world. They can also
hedge some kinds of fixed-income securities against others.
But if you want another example of an investment in stocks which hedge
fund managers like because it has greater potential to move up if interest
rates are falling, you could buy the stocks of finance companies because the
rates they receive on their loans don't fall as fast as the rates on what they
borrow. The rates on credit cards, for example, haven't fallen as fast. The
stocks of finance companies will probably do better when interest rates fall
in general than investments in traditional banks. This is how hedge fund
managers usually think.
J.M.: As the market did well in recent years, did some
hedge funds borrow more boldly?
L.L.: I think some did. There is often a tendency to follow
the pack. And there is another risk that is not talked about very much. As
some of these funds get very large, they can only invest in enormous liquid
markets, such as those for currencies or fixed-income securities. These
markets are so large that they can invest a lot of money without driving the
price up, and they can sell out without causing prices to fall too much. The
size of the funds, then, limits their choices to big markets, and such
restrictions were exactly what hedge funds were designed to avoid. Some of
these large funds could not easily invest in small-company stocks in America,
for example, which have been undervalued, because a purchase of a couple of
hundred million dollars or more would run up the price of these stocks quickly
and they'd have to pay too much. The same is true for the sale. It would drive
down the price and eat away their profits. Perhaps this situation enticed some
to take too many risks by investing in markets that were not sufficiently
liquid.
J.M.: You believe, in general, that a lot of borrowing can
be a serious danger.
L.L.: Very much so. I think the consequences of leverage
are not well understood sometimes even by the brightest people.
J.M.: Is this what got Long-Term Capital in trouble?
L.L.: To a large degree. The key problem is that when you
borrow too much, you can put the rest of your portfolio at risk. After all,
you've promised a bank to pay it back even if your investment goes
bad. So everything else you own becomes collateral for that loan. If
you are not leveraged, each and every investment would not be at risk if
another investment does poorly.
J.M.: What seems clear is that if you borrow a lot, even if
you are right about your investments most of the time, one or two mistakes can
result in a great deal of damage. Even if you're right 99 out of 100
times—I'm only taking the most extreme example—when you borrow
aggressively, the one time out of 99 you are not right can do you in.
L.L.: There are some fellows at Long-Term Capital who found
that to be true. Look at it this way. If you're running a fund with many
different investments, and you haven't borrowed, each stands on its own
bottom. When unexpected disaster takes place, you've lost one investment
that's, let's say, 3 percent of your capital, but that's all. If, however,
you're heavily borrowing to invest a lot more in this transaction, the loss
would require you to sell off other investments to pay the lenders when the
unexpected event occurs.
J.M.: Is that what happened at Long-Term?
L.L.: That's certainly one of the things. They were
borrowing at 20-to-1 leverage on some holdings, and sometimes probably more.
That is, they invested $20 for every dollar of their own capital. In my
opinion, that's ridiculous. They had bets all over the place. And remember
they were also going by the statistical experience of the past. Many of them
are essentially mathematicians. They search for statistical relationships from
the past, build models, and trade based on those models. They'd say, "In
the last fifteen or twenty years, nothing bad happened if we took such and
such a position." That position might be buying corporate bonds and
selling Treasury bonds short. Then, they'd say, "Furthermore, going back
as far as our figures go back, odds are enormously in our favor, so we can
borrow $20 for each of our own dollars that we put up."
What's wrong with that is that in a mathematical world conditions are
always the same and the relationships might work. In markets, something is
different every time. After all, we're dealing with people. Then these
historical relationships can be thrown off.
J.M.: What's an example of such a statistical relationship
that Long-Term Capital exploited?
L.L.: Let's take a general case, that of low-grade bonds,
so-called junk bonds. I am told that they invested in these. These are riskier
bonds so they may pay three or four percentage points more in interest, say,
than do Treasury bonds. Now, over time, if you hold a portfolio of these
bonds, they will usually do better than Treasury bonds even if some of the
companies in the portfolio do poorly. Or so history tells us.
J.M.: Because usually investors think these companies on
average are riskier than they turn out to be? And therefore the discount to
Treasuries they are selling at is too great?
L.L.: Yes. So the portfolio of junk bonds goes up in price,
at least compared to Treasury securities, and you're locking in a higher rate.
The problem for the investor in junk bonds is that if interest rates rise in
general, the value of all bonds will go down, so he won't make any money even
if the companies issuing junk bonds prosper. In other words, an investor won't
pay as much for a bond paying 6 percent if he sees that all rates are moving
up and that he can suddenly buy an equivalent bond with a coupon of 6.5
percent. The price of the 6 percent bond must go down or no one will buy it.
So the hedge fund manager who owns junk bonds tries to hedge against that
possibility of shifting interest rates by selling Treasury securities short.
That way, if rates go up and bond prices down, you've made some money on your
short position to offset the losses on your portfolio of junk bonds. You've
taken the movement of interest rates in general out of the equation—more
or less.
J.M.: But, as we know, these historical relationships
shifted.
L.L.: Yes. Long-Term did not anticipate that. Alas, the
time came when everybody felt that because we may be going into a recession,
and that the financial crisis could become even more severe, they didn't want
to own junk bonds and they wanted to own only Treasuries. So prices of
Treasuries went up and their yields came down. Meantime, prices went way down
on junk bonds, exactly the opposite of what Long-Term expected. They had a lot
of these bets on relationships between different fixed-income securities, in
the US and around the world. The rush to Treasury securities threw off all
these historical relationships to a degree.
J.M.: And the amount of leverage made it all the worse?
L.L.: Yes. I think the leverage is what made the position
uncontrollable because the potential loss was so large that every investment
then became collateral for the others. But when everyone else is trying to
sell, you have an additional problem. As we said before, there's never perfect
marketability, even in a giant market like government securities. There is no
assurance on any particular day that you're going to be able to sell as many
of anything as you would like to within a certain range of prices. You just
may not be able to sell all those junk bonds unless you are willing to take a
price a couple of points or more less than you think they are worth. Long-Term
Capital had positions which were so large that they couldn't sell them without
bringing prices way down. And what frightened the Federal Reserve is that as
Long-Term Capital drove down prices for securities, other hedge funds and more
traditional investors, including banks, had to sell their own bonds and other
investments to raise cash to cover the losses on those securities which they
owned. That's how a financial contagion occurs. And it has helped to bring on
a credit crunch today. Businesses are having trouble borrowing while banks,
with all those losses, are hesitating to lend as freely as they had.
J.M.: As has been widely noted, these were bright people at
Long-Term Capital. Why didn't they realize that such relationships could
someday break down?
L.L.: I think some people have a problem with time. Some
concentrate very well on the near term, like a month or two or out to six
months. Other people are better at longer sweeps of time, a couple of years.
Others, say, American historians, a few hundred years of time. And
archaeologists think in far longer periods of time. I think it is very hard
for one person to have a highly developed sense of time beyond his own
particular fields of interest, and these reflect his own personality. This is
partly why nobody consistently makes money in the market, including myself.
J.M.: There is also the case of the banks, of course.
Long-Term Capital invested unusually aggressively. The banks were willing to
lend them the money.
L.L.: In defense of the banks, but not a very great defense
I admit, they usually did not know who else Long-Term Capital was borrowing
from, as I understand it.
J.M.: Shouldn't they have asked?
L.L.: Yes.
J.M.: It seems to me that the relationships between the
bankers and some of the hedge fund managers may have been quite comfortable.
Maybe too comfortable—a form of crony capitalism that we criticize when
it takes place in countries like Thailand or Korea.
L.L.: Perhaps. Clearly they should have gotten more
information. But banks can fail, too.
J.M.: I think there should be more government requirements
on these activities.3 What's your view?
3 In November it
was reported that US regulators are investigating the transactions of hedge
funds with several large Wall Street banks earlier this year. (back)
|
L.L.: I'd be very careful about that. You don't want to
inhibit people from making profitable investments. But I think it is important
that we know how much the hedge funds are borrowing. I certainly think that
the bankers who deal with them should know that.
J.M.: So you would favor more of what is now termed
"transparency."
L.L.: I think there should be more requirements that hedge
funds file information with the SEC, specifically about the extent of their
borrowing. You know, whenever a disaster takes place, people always think
there should be tighter scrutiny. The question is at what point more reporting
becomes a nuisance and serious hindrance to business. On the other hand, the
history of the American securities industries, which I'm most familiar with,
has been increased reporting requirements. In the 1920s, nobody reported short
positions, I believe. Now short positions must be reported to the SEC, which
seems very desirable, because investors and lenders need that kind of
information to make the best business decisions.
J.M.: The banks also do not fully report their positions,
including their own trading in derivatives. Their losses have been enormous
recently. According to some reports in the press, Bankers Trust Co. looks as
if it might have to find someone to take it over. There is talk of other
mergers.
L.L.: Again, I think we should look more closely at
reporting requirements for banks as well. But I know less about that than I do
about securities firms. Probably there should be more disclosure.
J.M.: It still strikes people as odd that a few successful
men could have jeopardized the world's financial system.
L.L.: I don't think they could have brought the system
down. But they damaged it a lot.
J.M.: And that affects the real economy, our jobs, our
incomes, the security of our lives.
L.L.: It certainly can. In my view a declining market
affects the real economy because I strongly believe falling stock prices make
people who own stock spend less money. I think losses at the banks make them
reduce the amount they are willing to lend. This also impedes the economy.
When investors are afraid to buy corporate bonds, it makes it harder for
businesses to borrow. When investors don't want to make risky investments,
that's bad for business. And in the end all this can be bad for jobs. This is
how all of us can be affected. Less consumer spending and investment means
lower profits. As a consequence businesses may stop raising wages and may
start letting workers go. There is still less consumption and investment.
These factors can bring on a recession.
J.M.: Doesn't this suggest that regulation to require more
reporting is a pressing necessity?
L.L.: I favor more disclosure, as I said, because investors
have to have the facts. So do lenders.
J.M.: What I think frightens investors most is that there
may be another Long-Term Capital Management out there. Do you think there is?
L.L.: Unfortunately, as things stand, we won't know until
we read it on the front page of The New York Times.
<poemright>—November 18, 1998
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Original Text at http://www.nybooks.com/nyrev/WWWarchdisplay.cgi?1998121773F