[PEN-L:296] BY THE END OF 1999, A RECESSION IN NORTH AMERICA?; Too Big To Fail?

[Michael Eisenscher <meisenscher@xxxxxxxxxxx>]

THE GLOBE AND MAIL 			MONDAY, SEPTEMBER 28, 1998

BY THE END OF 1999, A RECESSION IN NORTH AMERICA?

	The chief economist of RBC Dominion Securities
	blames flawed global financial markets

	Taken from a speech delivered on Sept 24 at the annual
	dinner of the Toronto Society of Financial Analysts.

Paul Summerville

	Not since 1929 has the world's financial system, and by implication the
global economy, been at such risk. In the last 12 months the risk premium
in the shares of financial institutions around the world has risen
dramatically. For example, the financial sector sub indice in Hong Kong is
down 52 per cent, in Tokyo 44 per cent, Toronto 42 per cent, Frankfurt 38,
London 36 and New York 32 per cent. Companies like Citicorp are down 52 per
cent, CIBC 50 per cent, Commerz [Germany] Bank 38, Barclays 35 and Royal
Bank 30 per cent.
	I believe that the reason for this rout of I global financial sector
shares is that July, 1997, marked the end of an extraordinary eight year
period that began with the fall of the Berlin Wall. The devaluation of the
[Thai] baht [on July 2, 1997] marked the death knell of the widely held
view that American financial capitalism had won a permanent victory.
	The belief that openness, transparency and the rule of law would be the
ongoing principles of global financial markets was obliterated with the
recognition that corruption, opaqueness and lawlessness are fundamentally a
part of how many countries, big and small, rich and poor, organize their
capital markets and their civil societies.
	The new period we have entered is thus fraught with danger because there
is no overarching agreement on the best way to organize financial markets.
Witness Malaysia's capital controls, Hong Kong's and Japan's use of public
money to buy distressed stocks, and the emerging thesis that it was simply
the availability of global capital that has caused all the recent distress
instead of the existence of corrupt financial markets and regulators. The
new period is also fraught with danger because it necessarily implies a
brutal adjustment in the pricing of financial assets, with a punishing
impact on world economic growth.
	I expect that the financial market excess and deteriorating credit quality
which has already caused so much economic pain in the world of late will
also have a pernicious impact on North America. I expect that by the end of
1999, the risk is that America will be in recession, accompanied by Canada,
because North American consumers are levered into a falling stock market
and companies have hired and invested for an economy that does not exist.
	This is reflected in our exceptation that short term interest rates will
be slashed in the United States by 100 basis points and in Canada by at
least 175 basis points by December, 1999, and that long rates will follow.
The Canadian dollar will likely retrace its summer weakness against the
U.S. dollar as the economic consequences for Canada of a U.S. recession
become clear.
	We can only hope that the obvious crisis in leadership in the world and
the narrow domestic agendas of scared politicians do not turn an almost
certain recession into a global depression.	
	


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Bailout of a Big Failure Raises Big
Questions About Too-Big-to-Fail Policy

By Allan Sloan

Tuesday, September 29, 1998; Page E03

For the past year, as markets from Thailand to Russia to
South Korea to Central America have taken it in the chops,
the United States has talked a good game about the evils
of crony capitalism. Our officials and financiers talk about
how letting impersonal market forces allocate capital is all
for the greater good. Thai peasants, Korean steelworkers
and Russian urbanites are suffering as financial crises
sweep their countries, but that's the price someone has to
pay to keep capital flowing.

Then, what happens? Thanks to stupid investment
decisions, bad luck and dumb lenders, an enormous U.S.
hedge fund called Long-Term Capital Management L.P. is
about to croak. But instead of letting it die and wipe out
its investors and managers, the Federal Reserve Board
orchestrates a rescue, and leading lights of the brokerage
and banking businesses kick in $3.5 billion to $3.6 billion to
keep the fund in operation.

The argument, as you doubtless know by now, is that
letting Long-Term Capital go under could have led to a
financial panic, paralyzed bond markets all over the world,
and set off a domino effect as failing institutions dragged
one another into insolvency. That could well be right, and it
may well have made sense for the Fed to put the rescue
together. Certainly, the 14 institutions putting up those
billions to bail out Long-Term thought it was in their
interest to do so.

But even if you think it was right to keep Long-Term
Capital from collapsing, there are aspects of the rescue
that should bother even ardent capitalists, whose ranks
include me. For one thing, the investors in Long-Term
Capital should have been wiped out, or virtually wiped out.
That's the way capitalism is supposed to work. Instead, the
investors get to salvage about $400 million of their
investment. How so? Because the 14 new investors are
paying $3.5 billion to $3.6 billion for a 90 percent stake,
and it follows that the old investors' 10 percent stake is
worth $390 million to $400 million. Granted, $400 million
is a lot less than the $4.7 billion the old investors' stake
was worth at the beginning of the year. But it's $400
million more than they deserve to have.

My favorite part is that the new investors are paying
Long-Term a management fee on the $3.5 billion or so
they're investing. The fee is 1 percent of assets a year plus
12.5 percent of any profits. That's half of Long-Term's
regular fee, but it's still a ton of money. Even though the
investors in effect can get half the fee back, that's a lot of
money for a failed management team. The explanation,
which no one wants to give publicly, is that the new
investors want to make sure that Long-Term can afford to
pay fat salaries to keep good people on the job. Isn't
capitalism fun? Sure beats being an unemployed Korean
steelworker.

Call me cynical, but I think that leaving investors with
hundreds of millions of dollars and paying fat fees to failed
managers is Wall Street's clubbiness at work. Long-Term's
chief executive, John Meriwether, forced out of Salomon
Brothers Inc. in 1991 for not properly supervising
subordinates who were rigging government bond auctions,
is one of The Boys. Everyone knows everyone, everyone
trades with everyone, and everyone invests with everyone.
Executives of some of the rescuing firms have their own
money invested in Long-Term Capital? Good thing that's
not crony capitalism. Or conflict of interest.

The reason Long-Term Capital is not Long-Gone Capital is
that it was too big to fail, thanks to $80 billion or so of
borrowed money. It also had so many deals with other
institutions -- call it $1 trillion worth -- that its sudden
demise could have crippled some of those
"counterparties."

But there's a policy question here. Laurence Tisch, whose
family controls the Loews insurance-tobacco
conglomerate, rightly points out that it seems inconsistent
to bail out institutions that are to big to fail at the same
time regulators are allowing bank and bank-insurance
mergers that create institutions too big to ever be allowed
to fail. "If you're accepting the doctrine that we're putting
together combinations too big to fail, let's have that
stated up front," Tisch argues. "Maybe you should make
their capital requirements higher [than other institutions'],
so they don't become a drain on the American taxpayer."

Congress will soon hold hearings on Long-Term Capital's
collapse and the role of hedge funds. Weeping and wailing
and posturing is doubtless on tap. But the problem posed
by Long-Term Capital is larger than lack of regulation. It's
that foolish lenders gave the fund far too many loans too
cheap, and regulators didn't realize what was going on
until it was too late.

And members of Congress might ask whether letting giant
financial institutions combine is really such a good idea.
Ironically, the same day that the Fed brokered a deal
because Long-Term Capital was too big to fail, it approved
the merger of Citicorp and Travelers Group Inc. Citicorp
alone was deemed too big to fail when it got in big trouble
a decade ago. The new $750 billion Citigroup will be so
gigantic that it will put "too big to fail" into a whole new
dimension.

Sloan is Newsweek's Wall Street editor. His e-mail address
is sloan@xxxxxxxxx

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