Another Behind-the-Scenes Wall Street Bailout

Most people don't know it, but the financial world almost stopped turning in 1998 when a huge hedge fund called LTCM (Long-Term Capital Management) "lost $4.6 billion in less than four months and became the most prominent example of the risk potential in the hedge fund industry," according to Wikipedia. ($4.6 billion in 1998 is the equivalent of $5.79 billion in today's dollars. Source)

Fearing devastating repercussions at the time, the Central Bank of New York got involved, and a "bail out" arrangement ensued whereby several large financial houses agreed to back the bad loans.

Where have I heard before that history always repeats itself? We now have a similar situation happening today, only the present-day LTCM is Bear Stearns. This time, we're talking about $3.2 billion at risk, guaranteed by Bear Stearns itself. The quasi-authoritarian intermediary this time is Blackstone, whose two principals are a former classmate of Bush at Yale and a former US secretary of commerce, the same Blackstone in which China just invested mucho dollars. (Aside: Has anyone investigated the potential conflict of interest with this kind of mixed-bedfellow deal? But I digress.)

So far, this is well within Bear Stearn's means, so panic hasn't started yet. But the jitters have begun in earnest, as players watch the other hedge funds that have highly leveraged portfolios as well. There may be a steady flow of money coming into the country even as the big players unwind their unbalanced dollar portfolios, but panic is a funny thing: it doesn't always listen to reason and won't always wait for a level-headed solution to an immediate sticky problem.


[Thanks to number-10.gov.uk for the image.]

The problem irking everyone is that the global financial markets now flow so easily from one country to another, and from one sector to another, and the sums are so huge, that any sign of instability could create a panic environment. The US deficit is supported by billions of investment from foreigners, and these investors have already begun to diversify away from the US dollar as it loses value on the international market. (It has gone from $1 = euro 1.20 to $1.00 = euro 0.74 over the last 6.5 years.)

Whether or not this situation is actually going to threaten America's financial stability is not a sure bet. There are those who deny that the LTCM matter was life-threatening, ironically among them the former chief of Bear Stearns himself. But there is a consensus that there exists an unsavory level of leveraged risk-taking at the present time.

I'm all for risk taking, assuming that it will be the risk-takers who pay the piper, and not the rest of us. Unfortunately, as I have explained in previous posts like this one, I believe the central banks are responsible for this situation and that we are all paying for it through diversion of real wealth to such lottery games, due to the uncertainty of the financial times we live in.

For more on these events, read this article at The Economist, this one by Michael Panzner at SeekingAlpha.com, and this one by Jody Shenn and Bradley Keoun at Bloomberg.

This is definitely something we all should be following closely.