Living in Michigan means the yearly
spectacle of watching the Detroit Lions consistently perform as one of
the worst teams in the National Football League. But even, though theyve
only won a single game this year, this should not stop you from betting
your life savings on the Lions to win the Super Bowl. Sure, its
a long shot, but if you win the returns will be huge and if you lose,
you can always count on the Federal Reserve arranging a bailout to prevent
you from going under.
Not likely to happen? Tell that
to the investors of Long-Term Capital Management who got the Feds to help
them organize a bailout simply because its managers made such horribly
stupid decisions with is $80 billion portfolio that the Fed insisted LTCM
couldn’t be allowed to fail.
LTCM is a hedge fund — banks and
brokerage firms, along with some rich individuals, gave LTCM’s managers
$80 billion to invest in extremely risky arbitrage schemes — the hedge
fund, in effect, bet billions of dollars by buying extremely risky lots
of Russian bonds. When the Russian economy tanked and Russia defaulted
on the bonds, LTCM was on the verge of collapsing.
The Federal Reserve stepped in to
arrange a bailout of the banks and investors who potentially faced write-offs
of $10 billion and upwards. Although all of the funding for the bailout
was put up by private institutions, the Federal Reserve was instrumental
in brokering the deal. Dont count on similar help if you get into
trouble gambling your money this sort of intervention is reserved
for the ultra-rich.
The whole series of events that put
LTCM on the verge of failure only to be rescued by the Federal Reserve
reveals the perverse effects of moral hazard, when government encourages
people and institutions to take on enormous risks with the belief that
if they fail the government will come to their rescue. LTCM bought Russian
bonds in part because its managers believed the IMF would save Russia
from its own economic mismanagement after all, the IMF has repeatedly
bailed out nations who created their own economic hell.
In turn, many of the banks investing
in LTCM have federally guaranteed deposit insurance, meaning even should
they fail due to their risky investments, the taxpayers would ultimately
bail them out just as the taxpayers had to bail out the Savings and Loans
industry for its mistakes.
Of course the usual suspects immediately
discerned what the real problem was — not enough government regulation
of hedge funds. Hedge fund managers, of course, oppose any new regulations,
but they’ll gleefully take the government-brokered bailout, thank you
very much. Hey, if rich people, banks and others want to place their bets
on the economic equivalent of the Detroit Lions to win it all, more power
to them; but the government should get out of the business of riding to
the rescue of those who voluntarily agree to accept such risks.
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