Portfolio manager’s Letter June 2008
I just finished rereading “When Genius Failed” Roger Lowenstein’s excellent book about the fall of Long Term Capital Management (LTCM). I thought it would be interesting to compare this earlier blow up with the current pyrotechnics in the bond market; and the fall of Bear Sterns. Indeed the parallels are surprising, surprising that is, if you assume, like I do, that large financial institutions should be able to learn from their mistakes.
All of the actors from the 1998 adventure (with the exception of the deceased Long Term Capital Management of course) have reassembled for the sequel. Merrill Lynch is here, only without Kamansky, Goldman Sachs is back (this time without Corsine or John Thain), but the Wall Street gang was all there, Lehman Bros, Chase, JP Morgan, UBS, Barclays, Morgan Stanley, etc, and of course Bear Sterns with James Caine (who was the only one who refused to participate in the Long Term Capital Management bail-out).
There is one big difference this time, in that the cast has been expanded to include many more large banks and other institutions from all over the World. Even though the scale of the present crisis is much larger, the similarities are striking (except for the fact that the institutions do not have Long Term Capital Management around to blame).
Yes, Long Term Capital Management was guilty of egregious over – leveraging, but they could not have done this without the help of the people passing out the credit. All the big commercial and investments banks were competing to get John Meriwether’s and his partner’s Merton and Scholes business. Wall Street was shoveling money to Long Term Capital Management in 1998 in a mad rush to pump up their bottom lines.
If you are a bank you cannot make a profit if you are not making loans, and if the bank is not making money the people that work there do not get bonuses. Many of the biggest losers in the current crisis were big lenders to Long Term Capital Management and they could have established internal controls that would have prevented the recurrence of stupid lending, but they chose not to.
Perhaps we gain some understanding of the term “moral hazard” by the study of the Long Term Capital Management bailout. The subsequent ability of the banks to recover all the money they contributed to the bailout did nothing to encourage them to institute safeguards to prevent sloppy lending. Indeed, some will say that the main lesson the banks learned in 1998 was that if your stupidity gets the best of you, the FED will bail you out.
The Cato Institute in a Briefing Paper published in 1999 has called the Fed’s intervention “misguided and unnecessary”. It was unnecessary because Buffett had an offer on the table.
“A group consisting of Warren Buffett’s firm, Berkshire Hathaway, along with Goldman Sachs and American International Group, a giant insurance holding company, offered to buy out the shareholders for $250 million and put $3.75 billion into the fund as new capital. That offer would have put the fund on a much firmer financial basis and staved off failure.
However, the existing shareholders would have lost everything except for the $250 million takeover payment, and the investment’s managers would have been fired. The motivation behind this offer was strictly commercial; it had nothing to do with saving world financial markets. As one news report later put it.
“Buffett wasn’t offering public charity. He was trying to do what he preaches: buy something for much less than he thinks its worth. Ditto for Goldman Sachs, which made tons of money dealing in bankruptcies, salvaging financially distressed real estate … These folks weren’t out to save the world’s financial markets; they were out to make a buck out of Long-Term Capital’s barely breathing body.”
There were technical problems with the offer Buffett had faxed (the stated offer was to buy the management Company when what Buffett wanted to buy were the assets of the partnership. Since Buffett was temporarily out of touch, Long Term Capital Management Partners were able to get the FED to move ahead with bailout, a deal which was better for them.
Buffett had added the condition that his offer had to be accepted within one hour Lowenstein says this indicated that Buffett was not enthusiastic about the prospects of the deal, but I think it more likely that the one hour limit was there to prevent Meriwether from shopping his bid. I think Buffett’s bid was serious, and that he assumed that the technicalities could be worked out after his bid was accepted.
The CATO study goes on to say:
“Had it been accepted, that offer would have ended the crisis without any further involvement of the Federal Reserve — a textbook example of how private-sector parties can resolve financial crises on their own, without Federal Reserve or other regulatory involvement.”
Today the collapse of Long Term Capital Management seems very small potatoes. The creditors chipped in 3.65 billion and all eventually got their money back when the markets returned to normal. The bond markets suffered a few weeks of panic, but the only serious long term damage was the approximately $3 billion in losses suffered by a few investors and the Long Term Capital Management partners. Few have questioned the extent and the nature of the FED’s intervention in 1998, but the fact is that here we are today with a problem that is many times the magnitude 1998, but the underlying cause is pretty much the same.
How much responsibility for the current crisis stems from the Long Term Capital Management bailout is an open question, but in general the FED has fostered an environment that has encouraged bad lending practice. Whether it was the “Greenspan put” or just too much liquidity, banks were ignoring risk and focusing only on the bottom line, big checks at bonus time; and endlessly ascending stock prices. One thing is obvious, banks whether commercial or Investment will do whatever they can to maximize profits, and as long as there exists am implied FED bail out when loans go bad it increases the incentive to make bad loans.
Fortunately I think we can say that things are different this time. Major Banks and other financial institutions have already written off almost $400 billion and there are predictions of much more to come. Beyond the sheer magnitude of the loss this time is the fact that in 1998 the loss was suffered by a few dozen individual investors, and the Long Term Capital Management Partners.
In contrast this time the financial institutions are suffering real damage to their balance sheets. The pain is real and widespread, and because pain is the mother of wisdom it is more likely to provide a valuable long term learning experience for the survivors. For the world economy the education is likely to spread well beyond the financial sector. The sucking sound you hear today is capital being drained from the world’s largest financial institutions. These Institutions leverage this capital 20 or 30 times.
The FED has proven in the past that they can provide whatever liquidity our national economy requires, and probably they can again, but now this an international problem we have never been faced with crisis of this scope before. There are so many complexities and imponderables in the present situation that I do not believe that anyone knows where the next two years will lead us.
The 1998 Crisis left few scares on the economy, but I think it would be a big mistake to take any comfort from that. In 1998 the bond markets froze up for a week or two but with FED intervention the bond markets where back to normal within a few weeks and the stock market was off and running headlong toward the great 2000 Tech bubble.
I think it gets more obvious as we go forward that excess liquidity and central bank bail-outs are a two edged sword and that they really do carry with them a large moral hazard. For the bankers its heads I win, tails the tax payer losses.
But, who knows maybe today’s educational experience with extent all the way up to the level of some central banks. Clearly, bankers should not be allowed to continue to expand their risk profile at the expense of the taxpayers. One thing is certain, politicians with try to cure the moral hazard that grew from pervious regulation by inventing new regulations. Personally I remain skeptical, our economic system advances because it learns from its mistakes, but the education comes from pain and to the extent that you try to regulate away the pain you institutionalize stupidity.
Ignoring the damage to today’s financial markets from the moral hazard that was Long Term Capital Management, there is one group of investors that we know for sure are poorer today because of the bailout. That group is Berkshire Hathaway Shareholders. Since the 1998 financial markets returned to normal within a few months, the $250 million that Buffett offered to invest would have yielded a nice profit.
If the Long Term Capital Management positions had just returned to the prices prior to the crisis this profit could have amounted to as much as $4 billion. Deducting taxes and the partners’ share Berkshire Hathaway would have netted something like $2 billion and increased Berkshire Hathaway’s income in 1999 from $1.5 billion to $3.5 billion. Shareholder equity would have increased from $38,000 per A share to $39,300 an increase of 3.4%, and would have increased the intrinsic value of an A share today by $4700.