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History Lessons

October 9, 2007

Mark on the markets

History lessons

In September of 1999, Kevin Dowd, a professor of economics wrote an executive summary titled; Too Big to Fail: Long-Term Capital Management and the Federal Reserve.
In September 1998 the Federal Reserve organized a rescue of Long-Term Capital Management, a very prominent hedge fund on the brink of failure. The Fed intervened because it was concerned about possible dire consequences for world financial markets if it allowed the hedge fund to fail.
The Fed’s intervention was misguided and unnecessary because LTCM would have not failed anyway, and the Fed’s concerns about the effects of LTCM’s failure on the financial markets were exaggerated. In the short run the intervention helped the shareholders and managers of LTCM to get a better deal for themselves than they would otherwise have obtained.
The intervention also is having more serious long-term consequences: it encourages more calls for regulation of hedge-fund activity, which may drive such further activity futher offshore; it implies a major open-ended extension of Federal Reserve responsibilities, without any congressional authorization; it implies a return to the discredited doctrine that the Fed should prevent failure of large financial firms, which encourages irresponsible risk taking; and it undermines the moral authority of Fed policymakers in their efforts to encourage their counterparts in other countries to persevere with the difficult process of economic liberalization.
Kevin Dowd wrote this in 1999, but could have added in 2001 that the liquidity added to the markets by the Fed in, 1998, fueled the stock market bubble which exploded in 2000, causing more pain to more people than if the Fed had not bailed out LTCM.
We are supposed to learn things from history that will help us make better decisions in the future. The sub-prime bailout looks to me like the Fed is following the same path it did in 98, not allowing markets to fix themselves, encouraging irresponsible lending and borrowing, and fueling yet another potential stock market bubble.

Mark Patterson is a registered investment advisor with MHP Asset Management LLC, and can be reached at 447-1978, or Mark@MHP-Asset.com