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How to Avert A US Economic Crisis
Save the Hedge Funds!
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Ellington Capital Management is the latest American hedge fun to face financial problems, forcing it to liquidate substantial amounts of its mortgaged-backed securities portfolio to meet demands by its lenders for more collateral. The question being asked is: Will the US Federal Reserves (Feds) also sponsor a concerted bail-out action for Ellington, as it sponsored Long Term Capital Management (LTCM)?

First the history. Business Week reported in August 1997 that in the first half of 1997, hedge funds performed poorly posting a meagre 10.3% net profit (after fees), but their performance rebounded strongly in July 1997 enabling the hedge funds to post a 19.1% average net profit for the 7 months period. This translates to a net profit of 71.9% in July 1997 alone. We will recall that July 1997 was that auspicious month when the Thai Bhat took a major battering, precipitating in the Asian Crisis.

The footnote: International Monetary Fund (IMF) in its April 1998 study of hedge funds concluded squarely that the hedge funds were late entrants to the speculative attacks, and other financial institutions had a more significant contributing role in precipitating the financial panic that lead to the Asian Crisis.

So how did LTCM suffer financial problems? Nobody wants to say how. The fact remains that LTCM took heavy bets on derivatives. It lost USD 1.8 billion or 44% of its value when its bets on world interest rates faltered. Some 10% of the loss is attributed to the Russian financial crisis. (Webmaster's note: Russia blew an estimated USD 4 billion in a matter of weeks before it devalued the rouble and defaulted on its debts to international banks).

Next, why is LTCM problem a problem? LTCM is one of the biggest hedge funds in America. Hedge funds are also great borrowers, leveraging some 20 to 40 times their equity capital. The funds borrow against their equity capital, invest in derivatives, use these financial assets as collateral to borrow, and use the further borrowings to further invest. The Times reported that LTCM's equity capital of USD 4 billion enabled it to borrow some USD 1 trillion. LTCM's bets: some USD 200 billion. All figures are best estimates, as hedge funds are not regulated by the Feds. If LTCM files for bankruptcy, the creditor (principally Wall Street) banks will be severely affected. The credit tightening will ripple across the US financial system, precipitating a financial panic and crisis. As Fed Chairman Alan Greenspan succinctly put it: the bankruptcy of LTCM could have posed "severe risk" to global fiancial markets. So the Feds sponsored a bailout package, and managed to avert the panic, temporarily.

Should the Feds now sponsor a bailout of Ellington? Ellington, run by former Kidder Peabody and Co-star bond trader Micheal Vranos, is smaller than LTCM with a equity capital base of some USD 1 billion. The financial leverage will be lower than LTCM's and quite likely Ellington will be able to pull through. If a bailout is required, the quantum will be less. So the Feds need not fret too much as yet.

The pressing concern now is the level of risky investments collectively made by the hedge funds. LTCM was saved by a USD 3.6 billion bailout package, but the figure will be substantial if there occurs a systemic failure of hedge funds collectively consequent to credit tightening by lenders. Fed's William McDonough notes that the biggest US banks have already started to restrict credit in the face of hightened risk perception, though the trend is not apparent in regional and community banks. The lenders need assurance that their prudence in lending to highly leveraged hedge funds is not being questioned, rather that calm is required to avert a financial panic. After all, it was a financial panic by global financial intermediaries that deflated the stock markets and currencies in Asia and precipitated the Asian Crisis.

The LTCM debacle is really not a bailout, since it is designed to avert a financial panic. What about bailouts for Asia? Well, IMF states that crony capitalism and nepotism first needs to be structurally removed, the weaker financial institutions must be allowed to fold, so that a more transparent open and competitive market place is established. Anyway, the Asian Crisis has already occurred. The rationale for the LTCM bailout is to avoid a financial crisis in US at all cost. There are enought lessons in the US panics/crisis of 1873, 1893, 1907, 1920 and 1931. If the world's largest economy panics, global recession cannot be averted.

So, the final question: Does the bailout of hedge funds amount to double standards? Not really, if you are altruistic by nature.

Webmaster's note: This editorial review is written by Ali Salim, and does not necessarily reflect the views of Sadec.

We welcome your comments and views on the article.

Related Reading:
Apec's Kuala Lumpur Declaration. More Info Malaysian Government gored!
For More Transparency of Hedge Funds
Regulate the Hedge Funds!
The Hunter is Down!
The Wise Goose Chase
Letter to the Prime Minister of Malaysia
Just Fix the Economy
The IMF's Response to the Asian Crisis - IMF Website.

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