[PEN-L:305] World financial calamity -- a narrow miss, for now; Noam Chomsky Speech on Web

[Michael Eisenscher <meisenscher@xxxxxxxxxxx>]

The Globe and Mail				Wednesday, September 30, 1998

Column One

THE SMART MONEY GOT STUPID

	How John Meriwether and his whiz kids
	blundered badly and almost caused a
	world financial calamity.

	Andrew Willis
	With a report from Susanne Craig.

Toronto -- A charismatic chief executive charms and intimidates the world's
financial elite, borrows billions without ever disclosing the state of his
affairs, then causes enormous grief when it becomes clear that the house of
cards built with borrowed money is crashing down.
	In the early 1990s, the Reichmann family starred in this riches-to-rags
tale as their real-estate empire crumbled.
	Last week, a money manager named John Meriwether and a supporting cast of
math whiz kids, all virtually unknown outside Wall Street, took the world
to the brink of financial disaster.
	Pulling back from the edge required a $3.5-billion (U.S.) rescue package
stitched together after a frantic scramble by U.S. regulators and 14
investment banks.
	Who is Mr. Meriwether, and how did he get into all this trouble?
	The answer goes to the heart of how financial markets have evolved over
the past two decades as technology and brain power have mixed with
unprecedented amounts of money to create a potent cocktail.
	With hindsight, it is clear that the 51-year-old money manager and those
around him were intoxicated by their power. For the bankers who backed Mr.
Meriwether with up to $120-billion in loans, bailing him out was a
terrifying experience made necessary because his so-called hedge fund,
Long-Term Capital Management LP, was perceived as just too big and
important on the world financial stage to fail.
	Still, the rescue has led to sobering reflection about the practices of
the market's most sophisticated players and about the alarming degree to
which the largest institutions are linked.
	"The problem we are worried about is the domino effect," said John Palmer,
who keeps an eye on Canada's banks as the country's Superintendent of
Financial Institutions. (In the wake of Mr. Meriwether's problems, the
Canadian regulator canvassed the country's banks on their direct exposure
and found no immediate cause for concern.)  But Mr. Palmer said the drama
played out in recent weeks demonstrates that financial troubles in one part
of the world now have a nasty habit of spilling over borders.
	"As a bank, I may have a perfectly solid counterparty in country X, but
that counterparty has a very big exposure to someone in Russia. As a
result, my solid exposure to the intermediate begins to look problematic. .
.. ."
	"We don't have a good handle on that exposure," Mr. Palmer added. "It is
making the whole regulatory community a bit nervous."
	Nerves are raw in part because Mr. Meriwether and his colleagues
represented the best and the brightest.
	Mr. Meriwether founded Long-Term Capital, a fund for super-rich investors,
in 1994. Two of his staff members, economists Robert Merton and Myron
Scholes of Timmins, Ont., are Nobel Prize winners. The 190-member troop
used sophisticated computer programs to make massive wagers on the markets.
	But last week, all that education and software was found wanting as a
series of bets went against them.
	Those who have dealt with Mr. Meriwether talk about an engaging, fiercely
loyal fellow who rose from the Irish neighbourhoods of Chicago to the
pinnacle of financial success. Mom was a teacher, Dad was an accountant and
their son arrived on Wall Street in 1974 hungry and ambitious.
	During a storied career as a bond trader with Salomon Brothers, Mr.
Meriwether's idea of a power lunch was bologna on white bread, no mayo --
at his desk. He was among the first to integrate computers with bond trading.
	In the great bull markets of the 1980s and early 1990s, Salomon Brothers'
traders got rich. Mr. Meriwether's passions became horse racing and golf.
He has memberships in three top U.S. clubs and co-owns a course in Ireland.
	A scandal in Salomon Brothers led to Mr. Meriwether's resignation in 1991.
Three years later, he had recruited many of his former staff to a quiet,
well-treed suburb of Greenwich, Conn., where they put their talents to work
on a fund that was sold to the world's financial elite.
	"What you have to understand is Long-Term Capital had an incredible lineup
of heavy hitters, not just at the fund, but among its friends on Wall
Street," said John Van, a principal in Van Hedge Fund Advisors Inc. in
Nashville, Tenn. "It operated at the highest level."
	Long-Term Capital's minimum price was $10-million for entry in the hedge
fund -- a benign-sounding name for a style of money management that is
actually designed to control the risks inherent in investing.
	Hedge funds combine relatively simple principles with devilishly
complicated math in an attempt to capitalize on market anomalies.
	Mr. Meriwether made millions with bets based on the idea that securities
that have historically sported a certain price would eventually drift back
to those prices.
	If Long-Term Capital's computers said Italian government bonds were too
cheap and German bonds too dear, Mr. Meriwether would sell German debt and
buy the Italian, making money as the gap between the two narrowed.
	The challenge facing any hedge fund is to profit on very small price
movements. The solution is to make very large bets. No one put more on the
line than Long-Term Capital.
	To put the hedge fund's wagers in perspective, consider that no bank in
Canada will provide a home mortgage unless the potential buyer puts down 25
per cent of the purchase price. On Wall Street or Bay Street, this
borrowing ability is known as leverage, and homeowners can lever only three
times their own capital.
	Long-Term Capital could get that $100,000 home for $3,300 down -- its
leverage was often 30 times its capital. In its first four years, the hedge
fund posted annual returns of more than 40 per cent.
	Just where the hedge fund made its money was kept a mystery; Mr.
Meriwether's monthly letters to investors described the fund's strategies
in the broadest possible terms. And it is now clear he was just as
secretive with its lenders.
	The risk to Long-term Capital was the same as that shouldered by a
homeowner -- if the neighbourhood turns ugly, prices fall. But with this
much leverage, a hedge fund has very little cushion against bad news. A
firm's capital can be wiped out if its holdings move even marginally in the
wrong direction.
	"There was nothing abnormal about Long-Term Capital's investments," Mr.
Van said. "But the amount of leverage and the players involved, that was
abnormal."
	Heading into August, Long-Term Capital had $5-billion of its own money
riding on the market. The rest of the hedge fund's estimated $120-billion
investment portfolio either was bought with borrowed money or was obtained
through the use of derivatives -- sophisticated financial instruments with
a value derived from another asset, such as a currency, commodity or stock.
	The wheels came off when Asian and Russian economic woes hammered the
world's markets last month, driving up the price of high-quality securities
such as German and U.S. government bonds while knocking down securities
perceived as weak.
	A Canadian partner at the Wall Street securities firm Goldman Sachs who
deals with Long-Term Capital said: "Their computer models told them there
was a very low probability of this series of events taking place. The model
was wrong."
	The market's gyrations left Long-Term Capital with huge losses on holdings
of Scandinavian and Italian bonds, along with some lower-quality U.S. debt.
	On Sept. 2, Mr. Meriwether wrote investors, saying the hedge fund had lost
44 per cent of its value in the previous month.
	By last week, further losses left the fund teetering near collapse, its
capital almost gone. Bankruptcy seemed imminent, an event that could have
forced liquidation of the entire fund. Such a fire sale would have created
chaos in the market and damaged the entire U.S. financial system.
	To head off a crisis, the New York Federal Reserve, an arm of the U.S.
central bank, called the world's most powerful investment bankers in for a
meeting.
	"That [leverage] is why the Fed intervened in Long-Term Capital," said Mr.
Palmer, the Financial Institutions Superintendent. "You had banks who were
exposed not only as bank lenders but as people on the other side of
derivative contracts and if that whole thing unravelled, who knows where it
would have led."
	In the Fed's 10th-floor boardroom, the heads of investment dealers that
included Goldman Sachs, Merrill Lynch and Salomon Smith Barney put together
the plan that saw them contribute up to $300-million each to keep Long-term
Capital afloat.
	It was a chilling meeting -- each knew their survival was on the line.
	In return, the dealers took a 90-per-cent interest in the hedge fund, and
are likely to wind it down in coming years.
	For now, Mr. Meriwether remains at Long-Term Capital. But he is no longer
calling the shots and his reputation is forever tarnished. Likewise, the
largely unregulated hedge-fund community will now face all kinds of new
scrutiny.
	Central banks and bank regulators such as Mr. Palmer's office are likely
to take the first whack -- they have the power to tear down the walls of
secrecy around a hedge fund's holdings. The U.S. Congress will hold
hearings, and a new set of rules are likely.
	But the easiest sanity check may be tighter lending policies at the banks.
Like easy-going bartenders feeding drinks to a drunk, they fuelled
Long-Term Capital's speculative spree by allowing the hedge fund to borrow
freely.
	Mr. Van said: "If anyone should get involved in regulating these funds, it
should be the banks, since they helped create this problem with their
lending."

HIGH STAKES

	            Number of       Assets
	             hedge funds     ($U.S. billions)
	 1989        1,648            58
	 1991        2,373            94
	 1993        3,417           172
	 1995        4,700           217
	 1997        5,500           295
	Source: Van Hedge Fund Advisors Inc.

WHAT WENT WRONG

	Given that these are "hedge funds," you would think the folk running
Long-Term Capital Management LP would protect themselves by hedging their
bets. In fact, fund managers speculated wrongly on several scenarios last
month:
	Long-Term Capital bet that the spread between prices of German bonds and
those sold by Italy and Scandinavian countries would narrow as European
monetary union grew closer. But when Russia's financial system tanked, the
gap widened.
	The hedge fund wagered that the spread between seldom-traded U.S.
government bonds -- known as "off-the-run" bonds -- and frequently traded
issues would narrow. But the Russian crisis also widened spreads between
highly liquid U.S. bond issues and the rest of the market. That led to
losses in Long-Term Capital's holdings of corporate bonds and
mortgage-backed securities.
	Fund managers bet on a proposed $3.1-billion (U.S.) merger between Cendant
Corp. and American Bankers Insurance Inc., then watched in horror as
accounting problems knocked Cendant stock back by 75 per cent and put the
deal in jeopardy.


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 Forwarded message........

Date: Wed, 30 Sep 1998 00:17:30 -0700
From: Sandra Taylor-Owen <sandrato@xxxxxxxxxxxxxxx>
To: bobolsen@xxxxxxxxxxx
Subject: Noam Chomsky's speech

======================>>>

  Subject:        crln: [Fwd: Noam's Calgary Speech]
       Date:           Tue, 29 Sep 1998 08:40:35 -0600
       From:           Michael Stec <41500390@xxxxxxxx>
   Reply-To:           crln-l@xxxxxx

    Subject:          Noam's Calgary Speech
       Date:          Mon, 28 Sep 1998 20:29:02 +0000
       From:          Greg Harris <gharris@xxxxxxxxxxx>

Noam Chomsky recently delivered a speech at the University of
Calgary inCanada, which I have transcribed and placed on the
Web. "Whose World Order: Conflicting Visions" is available at:

              http://www.ucalgary.ca/~gharris