The real clowns are the bankers
Every time a boom ends, bankers come out looking like plonkers. How could they have been so stupid?
Saturday 26 September 1998
Generally, it is the financial excess itself which brings these periods of prosperity to an end. That was certainly so in the 1980s and it seems to be true of the 1990s, too.
Each time the excess takes different forms, which is why bankers and others have such difficulty in seeing or correcting the position until it is too late. But the unifying feature is nearly always an explosion in credit. It is therefore reasonable to see bankers and financial markets as invariably instrumental in the boom and the bust of the business cycle.
Bankers nearly always come out of the process looking like plonkers. How could they have been so stupid, is the common refrain every time a boom ends in a bust of bad debts. What clowns, what idiots!
Last time it was dodgy financiers and entrepreneurs who stung the banks - Robert Maxwell, Michael Milken and the like. This time the fault seems to have been in an over-expansion of credit within financial markets themselves. The chief beneficiaries were the hedge fund operators and the proprietary trading operations of big investment banks.
Armed with Nobel Prize-winning economists, state-of-the-art computer modelling and mathematical equations that only they understood, they came guaranteeing 30 per cent-plus returns a year. We've found the secret, they said - just turn on, tune in and drop out.
Hedge funds are just the latest manifestation of that old, deluded belief that money doesn't need to be earned, but can be conjured up out of nothing. Only now is it becoming clear how close to the edge it brought us. Martin Taylor, chief executive of Barclays, likens the near-collapse of John Meriwether's Long-Term Credit Management to a mile-wide meteorite heading towards the earth. For a long time, everybody ticked along blissfully unaware of the cataclysmic threat coming at us from outer space.
Thanks to the efforts of the US Federal Reserve in hurriedly organising a rescue, disaster has been averted, but, boy, how appalling it could have been. For the time being, the crisis is over, but we are still seeing some of its after-effects in the markets, with both the FTSE and Dow sharply off. To extend Mr Taylor's metaphor, the meteorite has in the end missed us, but the shock of discovering how close to Armageddon we were has left a severe state of the jitters.
To understand the enormity of what's happened, it is worth revisiting some of the detail. LTCM is one of the largest hedge funds around, and it applies a much higher degree of leverage than other, smaller funds. Those who ran the fund were people of high reputation in financial markets. Also, LTCM confined itself to apparently "safe" trading strategies in G7 bonds. As a result, bankers were more than happy to lend on favourable terms. In any event, by the end LTCM, a fund with capital of just $4bn, was playing these markets to the tune of anything up to $100bn.
One of LTCM's strategies was the so called "convergence play" - the assumption that Italian bonds would converge ahead of monetary union with lower yielding German bonds. Unfortunately nobody bargained for the crisis in emerging markets. The Russian meltdown caused a general flight to safety in financial markets and the spread in this and other positions widened, rather than narrowing as it should have done. This took place at a time when bankers and investors were reigning in everywhere. The cost of credit was rising and its availability was shrinking. As always in such events, bankers began to foreclose.
What made the situation much more serious than a normal bankruptcy was the size of the sums involved. The hedge fund industry as a whole is said to total some $300bn, but the use of bank borrowings, or leverage, means its exposure to markets is much greater. To have allowed the enforced liquidation of such a large fund's positions might have had a disastrous effect on markets. The losses would have caused a domino effect through the banking system, resulting in multiple bankruptcies among hedge funds and other proprietary trading operations.
In the end, then, this was less a case of the crisis in emerging markets striking at the heart of the Western financial system, which is how it has been widely portrayed, than a necessary piece of emergency surgery by the Fed to stop US markets causing a global financial meltdown. The only link with the turmoil in emerging markets was that this had caused Western bankers to become more risk-averse. The difference is an important one, for the lessons we are learning from all this are more to do with the West than the East.
The most important of these is quite how fragile and reckless Western financial markets had become. John Meriwether and other hedge fund operators are only able to run the trading strategies they do, most of which rely on massive positions for wafer thin margins, because credit is available to them at very limited cost. This in turn is because at the top of every banking cycle there is always a huge excess of capital desperately searching for a home. In other cycles the money has gone into property, small business, and sometimes to crooked financiers. This time round it went to hedge funds.
The hope has to be that the worst is now over. Obviously there are other hedge funds and investment banks in a perilous condition, but none of them appear to be as large as LTCM. A debacle of this sort must prompt regulatory action, and the rules are bound to be tightened. But actually the position may be self correcting. Banks have presumably learned their lesson, and the cost of credit to hedge funds will now rise, curtailing their ability to run the sort of positions in markets they have.
In the meantime, we are all going to have to live with the fallout. Some huge losses have been sustained in the banking system and elsewhere as a result of the turmoil in financial markets. For the real economy - our pockets and our jobs, that is - the effect cannot be anything other than negative in the extreme.
PETER MANDELSON, President of the board of trade, is feeling more than a little fed up with our Outlook item yesterday in which we said he had been lobbied by PowerGen over its bid for East Midlands Electricity before taking up his present post - and justifiably so.
I'm happy to make clear on his behalf that he was not lobbied, and indeed could not have taken the decision giving PowerGen conditional clearance if he had been. The rules are clear on these issues - Trade Secretaries are required to stand aside and let someone else take the decision if there is a connection of this sort.
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