Moral Hazard Revisited
EDITORIALS
Wall Street Journal
In our first reaction to the bailout of Long Term Capital, we mistated matters
in saying that while principals in the fund might lose a lot, investors were enjoying a one-way
bet. In fact, the bailout, and its overtones of moral hazard, did not principally concern
investors in the fund but lenders to it.
We now have a better idea of the leverage Long-Term's John Meriwehter had generated,
with the fund supporting market positions worth some 100 times its capital base. A collapse
with this kind of leverage wipes out investors as well as principals. Yesterday Liechtenstein
Global Trust announced it was writing off "almost all" of its $30 million investment in the
fund, joining Credit Suisse and others in specifying losses.
Still, the Fed-blessed rescue did indeed benefit both investors and principals, we
now see from revelation of the purchase offer from a partnership led by Warren Buffet. With
American International Group and Goldman Sachs, Mr. Buffett was ready to put up $4 billion, with
$3.75 billion going to run the portfolio and $250 million for title to the assets. The deal
ultimately struck was for $3.65 billion for 90% of the fund, leaving principals and investors with
a 10% stake valued at some $405 million. In other words, the plan left Mr. Meriwether and crew
with almost twice as much as the truly private bid they turned down. Fed Chairman Alan Greenspan
agreed in testimony yesterday that this represents moral hazard.
The principal beneficiaries of the rescue, however, were the lenders who advanced the
money that built the 100 to 1 leverage. Lenders as well as investors are susceptible to moral
hazard, the temptation to make resky loans and investments on the assumption they will be bailed
out if they go wrong. Some of the lenders no doubt had real collateral; the point of bankruptcy
proceedings is to separate those who did from those who didn't. Having a work-out for all of
them scarcely encourages a more careful look when you loan funds.
It may be that lenders were so exposed that a collapse would have been systemic risk,
with the possibility of a spiral of bankruptcies through an intrinsically leveraged financial
system. Someone needs to ask how that could have happened, and in particular, what were
deposit-insured banks doing lending to a fund leveraged at 100 to 1. This is a much more
fruitful field for Congressional inquiry than attempts to regulate hedge funds or derivative
trading that would simply move offshore.
Speakng of which, another huge dollop of moral hazard emerged on the horizon recently
with the report that the IMF is weighing new policies that would allow official loans to nations
in default to commercial lenders. The object of this exercise seems to be Russia, which has not
only been a bottomless pit for international money, but also has defaulted on ruble-denominated
debt at home and abroad. But this policy change by the IMF, and the U.S. Treasury behind it,
further undermine what remains of the rule of law in the international private markets.
The problem with morla hazard is that it comes back to bite. The IMF proposals, for
example, risk drying up international financial flows, an ominous prospect last seen in the 1930s.
And the Long-Term Capital debacle looks a lot like the Savings and Loan crisis. That produced the
ill-timed if not mindless FIRREA legislation, clogging credit arteries and producing our last
recession. Lenders tempted by moral hazard to overextend themselves with the likes of Long-
Term Capital will now be puling in their horns. A Fed survey concluded this trend is already
under way. Even without overreaction in Congress, the danger is a spontaneous credit crunch, with
possibility of recession in the U.S. to accompany crisis in Asia.
Email: livetrade@cwixmail.com
