Hedge Funds and Nobel Laureates
Oct 13, 1998

When I met my friend Dan, an Accounting professor, the other day, he had a wicked gleam in his eye. "Aha," he cried triumphantly, "you economists have done it again!"

I feigned ignorance. "What do you mean, Dan?" I said innocently.

"You know damn well what I mean," Dan replied heatedly. "The Long-Term Capital Management fiasco!"

"Oh that," I said nonchalantly, "the hedge fund that failed. I believe it was headed by a former Salomon bond trader. Quite a well-known fellow in investment circles. Goes to show how even highly-regarded Wall Street professionals can make stupendous mistakes."

But Dan was made of sterner stuff. "Oh no, you don't get off that easily. I am talking about the two economists who ran the fund." He added meaningly, "The two Nobel Laureates."

"Ah," I said weakly. I had to think fast. "They are not real economists. Scholes and Merton, you see, are professors of finance, not economics."

But even as I said this, I realized how disingenuous it sounded. Scholes and Merton were, after all, winners of the Nobel Prize in Economics. They had done path-breaking work in options, and Scholes is part of the Black-Scholes options pricing formula that graces every textbook on investments.

For long the economics profession had regarded finance with suspicion - its closeness to the world of trading rendered it incapable, in the eyes of some, of being sufficiently theoretical and rigorous to be considered a sub-discipline in economics. The awarding of the Nobel Prize for finance-related work had finally conferred a stamp of academic legitimacy to the field. (Not that most finance practitioners had been overly worried by the economics profession's half-hearted acceptance; and in any case, to paraphrase Colin Powell's famous rejoinder to the allegation that affirmative-action beneficiaries suffered from low self-esteem, they could use their substantial earnings to undergo whatever therapy was needed to restore their equanimity.)

And now comes this Long-Term Capital debacle. A hedge fund that took enormous risks with its investors' money, Long-Term Capital had posted spectacular gains in previous years. But in 1998 its luck ran out. The fund's losses in August alone amounted to $ 1.8 billion. The hedge fund's emphasis on emerging-market operations made it vulnerable to an unanticipated financial meltdown in developing countries: when the Russian debt market collapsed a few weeks ago, the fate of Long-Term Capital was all but sealed.

What followed was even more striking. Unlike most financial institutions, hedge funds, which typically manage money for small groups of very wealthy investors, are unregulated. The government - and market analysts - are largely ignorant of the investments carried out by such funds and the returns they generate. When such a fund becomes bankrupt, the normal response from the government is silence, and perhaps a nod of sympathy for the private investors who have lost their capital (although it should be noted that the folks who invest in hedge funds are hardly the sort to find themselves in penury after the failure of a hedge fund.)

But the failure of Long-Term Capital did not go unnoticed by the Federal Reserve. In a curious move, it cobbled together a consortium of financial institutions to bail out the troubled fund. The Fed's rationale: If Long-Term Capital was forced to liquidate its assets, already-unsettled financial markets would tumble still further, leading to a financial crisis in the United States and the rest of the world. At the Fed's urging, the consortium injected $3.6 billion into the troubled hedge fund. Long-Term Capital's survival, at least for the present, was assured.

What is troubling here is the government-initiated bailout of an unregulated hedge fund and the practice of the "too-big-to-fail" doctrine. In the future, hedge funds will become even bigger - and indulge in even riskier activities - noting that in the event of failure, they may be able to count on the Fed's intervention.

The collapse of Long-Term Capital has also pointed out the eagerness with which commercial banks such as Chase Manhattan made risky loans to the hedge fund. Perhaps the fact that the fund was run by noted Wall Street traders and Nobel Laureates served to loosen the purse-strings.

In the wake of the fiasco, critics of hedge funds have called for government regulation. Such a course of action, however, is unlikely to be effective: Regulation would simply serve to drive the funds offshore. (Actually, some of them are already offshore; the threat of regulation would hasten the departure of the remaining ones.)

So what is to be done? Better regulation of banks - a view recently voiced by Alan Greenspan, Chairman of the Federal Reserve. Since the deposits at commercial banks are insured by the government, government supervision is necessary to ensure that banks do not undertake unduly risky ventures. Loans made to hedge funds in particular would need to be scrutinised more carefully.

In the meantime, some famous hedge funds continue to be in turmoil. In one day alone, on October 8, Tiger Management reportedly lost almost $2 billion. Due, the report stated, to unfavorable currency movements in the dollar-yen market.

I fervently hope no Nobel Laureates were involved this time.

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