World economic crisis begins to hit US
By Barry Sheppard
The stock market was sent reeling by the news that Long Term Capital (LTC), a highly speculative investment firm, was bankrupt and had to be bailed out by a group of banks as a result of the turmoil in world financial markets.
The meeting of bankers was called by Alan Greenspan, head of the US Federal Reserve, who feared the collapse of the firm would destabilise the whole financial system.
On September 23, the consortium of banks put up $3.5 billion to cover loans LTC owed. In return, the banks took control of the company.
A columnist in the New York Times wrote: "Wall Streeters not involved in the fund's $3.5 billion bailout ... are agog not only at the size of the losses but also at the idea that so speculative a firm would be saved from a demise of its own making. Cries of crony capitalism, Wall Street-style, are growing louder. And with some justification.
"For starters, the deal ... goes against the advice that American policy makers have been dispensing to tattered economies around the world. If a financial institution is bankrupt, Washington has scolded, it should be allowed to fail. The United States has been especially vocal on this score to Japan."
The Wall Street Journal explained, "Almost every major Wall Street securities firm and many large commercial banks have extended credit lines to Long Term Capital. Although the fund managed just $4.8 billion at the start of the year, it borrowed heavily to boost its returns".
By August, LTC "was supporting $125 billion of assets, about 54 times its capital base", which had shrunk to $2.3 billion. Even now it has assets of $80 billion, mostly loans, supported by only $600 million of real capital, a drop of over $4 billion from the beginning of the year.
LTC is one of an estimated 4500 "hedge funds" in the US. They are completely unregulated and allowed to do business in complete secrecy. Not even the Federal Reserve knew of the dire situation the fund was in until soon before it would have collapsed.
The rationale for this lack of regulation is that investments in such funds are made only by rich firms and rich individuals, who supposedly "know better" and can regulate the funds themselves. Institutions usually have to put up at least $25 million to join such funds, and individuals $5 million. LTC demanded $10 million from individuals.
LTC was formed a few years ago by supposed "geniuses", including two Nobel laureates in economics. They developed computer models of how to bet billions of dollars, mostly borrowed, on how the markets would move.
Their basic assumption was that interest rates, for example, would fluctuate about a certain point. Those that were above this point would tend to go back down towards it, while those that were below would go up. The bets the fund made that high interest rates would go back down were "hedged" by bets that the lower interest rates would go up.
The fund returned 42.8% after fees in 1995 and 40.9% in 1996, before slipping to 17.1% in 1997. With these huge returns, no wonder big capitalist institutions thought the "geniuses" would churn out money for them forever.
The bets that LTC made were purely speculative — not a penny went towards productive investment in plants, equipment and jobs.
LTC invested all over the world, but especially in the US, Japan and Europe. The Wall Street Journal points out, "While Long Term Capital won't comment, bankers who were present at the meeting to craft the bailout say that the firm's models failed to take into account what might happen in the event of a worldwide financial crisis that caused unusual reactions in markets.
"That was precisely what happened in mid-August when Russia suddenly devalued its rouble and defaulted on some of its debt. Those actions touched off a worldwide flight to safety that resulted in heavy purchases of US treasury bonds and widespread sales of riskier debt instruments. Both moves flew in the face of Long Term Capital's leveraged bets and set up conditions that quickly pared the value of its assets."
The banks that came up with the short-term bailout were themselves big investors in LTC. They have taken on the huge risks of the wobbly fund because not to do so would have been worse.
"Over the weekend [of September 20-21] the situation became critical", says the Wall Street Journal. "Before the Fed [Federal Reserve] intervened on Sunday to coordinate the rescue, several banks discussed unwinding their exposures [cutting their losses and running from LTC], a process that would have cost most banks only a few million dollars in fees, so long as all the banks didn't do it at once. But when the Fed entered the picture, any such notions were set aside in the interest of preventing a rush to unwind.
"Most bankers were aware that LTC's market exposure was large enough and cut across enough markets that if the fund were forced into sudden liquidation, markets around the world would be disrupted yet again. Many illiquid securities held by LTC would have to be dumped at well below face value."
It is highly dubious that the bailout will work in the long run. For LTC to recover, world financial markets would have to settle down, which is by no means assured.
There has been a ripple effect around the world from the LTC crisis (see article on page 23).
As the world economic crisis has developed, the International Monetary Fund and the governments of the major capitalist countries have tried to paint a rosy picture.
First, we were told that the IMF would contain the crisis to Thailand. When it spread to the rest of south-east Asia, the line was that Japan had to avoid at all costs the swelling wave. After Japan succumbed, Russia was hit by a crisis which shows no signs of abating. Today, the IMF is trying to figure out what to do about Brazil, which is tottering on the brink.
The IMF recently predicted that the Russian economy would contract by 6% this year and next, and that Japan would sink into its worse recession since the end of World War II.
While in the past the IMF has repeatedly said the world crisis was abating, today it warns, "Chances of any significant improvement in 1999 have also diminished and the risks of a deeper, wider and more prolonged downturn have escalated".
Now we have the first indication that the developing worldwide tsunami may hit the world's most powerful capitalist economy.