The Brightest and the Brokest

Washington and Wall Street buzzed last week with outraged talk of "moral hazard," and for once it had nothing to do with Bill Clinton's sex life. Instead people were talking about the danger created when government backing for private lenders encourages them to take bigger risks--in search of bigger rewards. That danger was demonstrated in dramatic fashion when the Federal Reserve had to engineer the rescue of Long Term Capital Management, a high-flying hedge fund that as recently as August controlled high-risk, global investments worth more than $120 billion--enough to buy all of AT&T.

Though the partners and investors in Long Term Capital are sophisticated and wealthy (the minimum price of admission was $10 million), Federal Reserve officials feared letting them go bankrupt. So many of the nation's biggest banks and brokerages had loaned so much money to Long Term Capital that its collapse could have severely damaged those lenders, forced a spiral of securities sales and shaken confidence in the already wobbly world financial system. Long Term Capital, if not exactly too big to fail, loomed too large on the balance sheets of institutions like J.P. Morgan and Merrill Lynch.

Supporters of the bailout stressed that the Federal Reserve only facilitated the deal, and that the $3.5 billion in rescue capital came from 16 large banks and brokerages, rather than from taxpayers. Yet the critics pointed out that the rescuing banks are backed by taxpayers through federal deposit insurance. Moreover, they enjoyed that federal backing while throwing the money at Long Term Capital that enabled it to pursue its exotic--and, for three years, very profitable--speculations. "Why should the weight of the Federal Government be brought to bear to help out a private investor?" demanded former Fed Chairman Paul Volcker. "It's not a bank."

Last week's bailout raised twin fears in Washington and on Wall Street as tall as Manhattan's Twin Towers. The first: that Long Term Capital's financial troubles are shared by many of the country's 4,000 hedge funds--lightly regulated and often secretive, high-risk vehicles for sophisticated investors. The banks and brokerages that have loaned them money could be carrying big and undisclosed potential liabilities. If those lenders get caught in a cash squeeze, they could respond by cutting back on lending, even to low-risk borrowers.

The second fear is that the Long Term Capital bailout could encourage banks to make still more risky loans, confident that the government won't let them get into trouble. In this regard, the rescue was rich in irony: it came as the Senate passed a bill that would make it harder for ordinary citizens to seek bankruptcy-court protection from banks and other creditors.

John Hsu, whose investment company manages some $500 million in assets, observes that "given all the losses that U.S. banks suffered in the late 1980s and early 1990s, you would think they would remember what went wrong." Concurs Ken Guenther, executive vice president of the Independent Bankers Association of America: "Why wasn't the Fed blowing the whistle on these totally inappropriate, crapshoot investments by some of the biggest banks in the country?"