Long-Term Capital’s Bad Bet

What the $3.5 billion bailout of hedge fund Long-Term Capital makes clear is that for all the press attention that’s been focused on hedge funds and their role in the global economy, few people really understand just how important they’ve become. Take emerging-market economies, where the global economic crisis started.

Contrary to what you might think, the amount of foreign money invested in emerging-market economies remains quite small, at least compared to the U.S. stock and bond markets. But most of that foreign capital is controlled by a small group of hedge funds, including Long-Term Capital. And since hedge funds are incredibly leveraged–Long-Term is holding something like $90 billion worth of positions on a capital base of just $2.3 billion–the impact of every market tremor is magnified. More importantly, since hedge funds often also hold large positions in the U.S. currency and bond markets, losses in one part of the world can have massive ripple effects, as funds liquidate their positions in order to raise capital. The Fed’s bailout, then, is designed both to save emerging-market economies from what would be a devastating liquidation and to soften the blow to our own markets as well.

The problem, of course, is that stepping in to save Long-Term from the consequences of its own bad bets probably increases the chances of future debacles. This point can be overstated, since Meriwether and his principals had to give up more than 90 percent of the equity in the hedge fund, and the bailout did not make Long-Term’s investors whole. (It just gave Long-Term more time to improve its results.) But there is something offensive about the Fed orchestrating a rescue operation designed to save wealthy investors from the consequences of their mistakes. Still, as with so much of what’s happened in the past year, we find ourselves having to do things we don’t want to do because it really does seem as if the alternative would be worse. The idea that having one hedge fund, even one as large as Long-Term, go under might actually shake the global economy seems, well, nuts. But the scary thing is that it may be true.

The name “hedge fund” now appears, of course, almost laughably inaccurate. In fact, what we’ve seen since May is that it simply is not possible to diversify away all risk in a world economy where speculative frenzies and the rapid movement of capital make history a poor guide to the future. Long-Term built itself around the strategy of taking advantage of divergences in the traditional relationship between the prices of related assets. In other words, it expected the dramatic price spreads between emerging-market assets and U.S. assets to narrow, as people realized what a value emerging markets were offering. And it expected the spread between the price of corporate bonds and of U.S. treasuries to narrow. But instead the spreads just got wider, wider than anyone had ever imagined they could become. Everything moved in the wrong direction at once, and kept moving.

What’s really interesting about what happened to Long-Term is that the fund’s entire approach was based on the idea that history teaches us the appropriate relationship between risk and return. Long-Term assumed that you could make money in the future based on what’s happened in the past. But the past was not a world where capital was as liquid as it is today, nor was it a world where hedge funds were as powerful as they are today. And so when it comes to the world in which hedge funds now operate, history may just be bunk.

CORRECTION: eBay, the online auctioneer that saw its stock price jump sharply on its first day of trading, is in fact profitable, contrary to my cavalier dismissal in Friday’s Cocktail Chatter. Its profits are slim–a couple of cents a quarter–but for an Internet firm that’s impressive. Apologies.