The Straits Times OCT 2 1998New bandits of finance
By NEIL BEHRMANN
BUSINESS TIMES
WHO are they, what are they and where are they? Thanks to Long-Term Capital Management's (LTCM) problems, questions are at last being asked about today's financial highwaymen, the hedge funds.
It is difficult to gauge their number, but such has been the growth of this speculative industry that there are over 2,000 hedge funds managing more than US$200 billion (S$340 billion) worldwide.
LTCM, the hedge fund which received a US$3.5 billion capital injection from 14 US and European banks and financial institutions, is believed to have bought and sold derivatives representing US$1.25 trillion of underlying securities.
Bankers say the company's losses amount to at least US$4 billion. It had an exposure to markets of US$200 billion at various times this year. It was betting that spreads would narrow between inferior and top quality bonds. Instead, there was a flight to quality.
Its near collapse as well as failures and losses among several other hedge funds illustrate the scale of gambling across global markets. With capital of around US$4.6 billion, LTCM controlled liquid and illiquid derivatives and assets worth US$200 billion, or more than 40 times its capital reserves.
Deposits or margin on the positions thus amounted to only 2.5 per cent of the capital value. This meant that capital invested in the speculation could double or be lost on a move of a mere 2.5 per cent or less.
In today's markets, despite all the sophisticated computer programs which LTCM used, this is tantamount to throwing dice.
And of course, the great and powerful did it again! Global banks which encouraged the South-east Asian borrowing spree during the 1990s, the property bubble of the 1980s, the apartheid regime in South Africa and economic basket cases in South America in the 1970s just had to get involved. They financed this speculation by each lending hundreds of millions to LTCM and other hedge funds.
In a global derivatives market of about US$30 trillion, hedge funds have been in control of US$2 trillion to US$3 trillion of financial assets, about half the size of the US economy.
Moreover, according to Mr David Hale, chief economist of Zurich Group in Chicago, at least another US$100 billion of speculative funds are being traded by the proprietary trade departments of banks and corporate treasury operations.
These trading desks have betted alongside hedge funds and have dumped currencies and securities from Asia to South America.
The Federal Reserve Bank of New York by supporting this bail-out (at least indirectly) has created incentives for other financial institutions to continue to place similar bets.
Because US law, like British law, does not require much disclosure from these funds, such bets are concealed in the underbelly of investment portfolios. So, true to form, finance ministers, central bankers and regulators are reacting to, rather than anticipating, events: Banking regulators in Britain, the US and Switzerland intend to tighten rules to control bank loans to hedge funds.
The Financial Services Authority, Britain's financial watchdog, for example, is asking questions that should have been put well over a year ago. Banks and other financial institutions are hastily filling in the forms.
At the International Monetary Fund annual meeting, a task force of the Group of 22 countries will put forward recommendations to the IMF's policy-making interim committee on the problem of hedge funds. But unless there are a few more failures soon, these are bound to languish.
Markets are hoping that interest rate cuts by the US Federal Reserve are enough to keep the ball rolling and risks will be limited.
But Mr Hale points out: "This decade is the first time in history that there has been such a great pool of highly speculative capital using leverage on a large scale to pursue profits through aggressive buying and selling of securities (and derivatives) in practically all the world's financial markets."
As has been proved in Asia, these "financial bandits", as a psychiatrist calls them, have managed to cause havoc in developing countries, causing poverty and untold misery. All so that a large new class of wealthy Americans and Europeans will get even richer.
Among the wealthy investment bankers and businessmen who invested their own money in LTCM, for example, were the heads of Merrill Lynch and Paine Webber. Both banks are involved in the rescue, but this is, presumably, not a case of crony capitalism.
Can hedge funds and the speculative trading desks of banks cause a global financial and economic crisis? Some economists, such as Mr Hale, doubt whether they can. Others disagree. Massachusetts Institute of Technology's Paul Krugman, for example, has suggested that crisis-ridden Asian economies place barriers around their capital markets.
Let us examine the dangers of this hedge fund and bank speculation in the markets. For a start, there is the experience of East Asia. Nations in the region are already in or sliding into recession, all as the result of attacks on their currencies. Interest rates have been raised to protect depleted foreign exchange reserves.
The result has been widespread corporate bankruptcies, general economic and political instability and a huge increase in the number of people impoverished. Asia is beginning to learn the meaning of "downsizing".
Banks which are rescuing LTCM hope to get out of its "investments" now worth an estimated US$80 billion, but there are rumours in London that prices are sliding. So it will be an exceedingly difficult task to get their investments out intact.
While LTCM does not appear to be involved directly in Asia, other hedge funds that are have their backs to the wall. Firstly, fearful investors are redeeming units in the funds on a large scale.
Secondly, banks, with or without regulators' prompting, are beginning to cut loans.
There is thus the risk that other hedge funds will fail and will be forced to dump their holdings, causing new dislocations.
Even if other vulnerable funds survive miraculously, banks would have once again wasted their capital. With less capital, they will cut lending to worthwhile businesses that would have gone into investment in job-creating factories and other such projects.
[The writer is The Business Times' London correspondent]