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January 1999
Volume 17, Number 1

"Transparency" and Other Sugar Pills
by Jeff Scott

The most talked-about financial failure of the year is Long-Term Capital Management, an investment partnership (loosely termed a hedge fund) run by Wall Street darling John Meriwether. The fund is known for its esoteric financial models and complex securities transactions, many involving derivatives. Its partners include Nobel Prize winners and a former Federal Reserve vice-chairman. The principals of the firm represent the fusion of MIT and Salomon Brothers, top names respectively, in the theory and practice of investment management.

The simple version of LTCM's plight is that the firm simply doubled its bets to get out of losing positions. Hence the high level of borrowing: a $100 billion portfolio with a $4.8 billion equity capital base. In another version, the firm was involved in highly technical investments based on sound techniques, but which turned out to be mistaken. Both versions could be right.

No one in LTCM is accused of criminal conduct or negligence, as in the case of Barings a few years ago. There was clearly a lapse in judgment somewhere no matter how crude or complex the underlying logic of their strategy.

Nevertheless they were surprised, which is one thing a fiduciary does not want to be, and it is the one thing that quantitative investors should fear the most. Bad news, or "exogenous" events, as conventional economists might put it, tend not to fit into investment models. Implicit in a model drawn from past behavior is the proposition that all positive trends never really come to an end in the long run. They are simply upset by random events, sharp deviations from overall trends.

In LTCM's case, they invested in a bond market that assumed governments pay their debts. In August, Russia blew that assumption out of the water. In the stock market, they indulged their fund money on merger arbitrage anticipating the completion of several high-profile mergers. When the broad market started sliding, that assumption was also blown. They borrowed a lot of money to pursue these strategies. But the only thing they didn't and couldn't hedge against was the loss of confidence. There is no protection you can buy against governments like Russia and falling stock prices of ambitious merger partners. When investments turned sour, they tried to raise more capital. They did not succeed. Hedge fund king George Soros turned down an offer to participate, and Warren Buffet's offer to inject new capital was rebuffed as lowball.

Nevertheless, the fund's creditors, about fourteen banks and brokerages in the U.S. and Europe, met at the offices of the Fed and were nudged into forming an ad hoc partnership to oversee the fund's operation, leaving Meriwether at the helm. They injected $3.6 billion of new capital to support the fund.

Controversy erupted immediately. Clearly, the average investor's sense of fair play is not to be taken lightly. When connected investors get a chance that is not available to other investors, capital is harder to attract. There is also the charge of hypocrisy leveled at financial policy- makers in the U.S. and Europe. We bash the Asians for "crony" capitalism and when the going gets tough, we are no better at leaving the cronies to topple.

The Federal Reserve has come under special scrutiny. Though no taxpayer funds were put to use, the Fed's action signals that the socialization of risk is still the operative principle of the central banking policy. The LTCM case is an expression of the coziness of public-private partnerships that is revealed whenever crises occur in allegedly competitive financial markets. The biggest loss is not in John Meriwether's portfolio, but in our collective memory of financial crises.

Even leaving aside the Fed's intervention, the firm's failure has given the anticapitalist crowd a new lease on life. The message, which hasn't changed since the first resistance to the Industrial Revolution, is, once again, that capitalism isn't delivering on its promises. Because this and that market is down, the market as such is a failure.

William Greider, the voice of damnation, writes in The Nation that, "The global system will either be reformed in fundamental ways or we will watch passively as the destabilizing dynamics of unregulated markets continue to deliver random destruction around the world, compounding the loss and misery for innocent bystanders."

President Clinton, apparently a Nation reader, has moved this issue to the top of a top-heavy international agenda. The president announced his new policies to contain the crisis in confidence. Fresh in his mind is the idea of "early intervention" or the idea that we as a people should get to these problems earlier, before they get out of hand. We need more disclosure, better supervision, and weeding out of improper investments.

The only difference between the old financial regulation and the new one is that the first is domestic and the second is international. In other words, just do more of the same, yet on an international scale. The government, in concert with international or cross-border agencies, should get more information, watch its protectorates more closely, and perhaps ban or make impossible the use of high-powered investment strategies. Tighten the web of public-private partnership. In this regulatory utopia, there is no such thing as a redundant safety system.

In the emerging bureaucratese of world financial regulation, there is a problem of "transparency." There is not enough of it, because outsiders don't know what the insiders are really doing. Markets work best, it is alleged, when everyone has wide access to information. In downturns, where innocent mistakes are made, disclosure of minutiae will feed the need for transparency and ward off the beast of fear.

One way to alleviate the contagion of failure and fear and further failure is to provide "liquidity," which turns out to be a pool of funds generated by governments (typically taxpayer revenues, borrowings, freshly printed money, or new forms of fiduciary media). When confidence sinks and markets in individual securities cannot be made at some politically tolerable level, the government pumps in new funds. Contagion is stopped, and the problems of transparency no longer matter. The market is up, because people have bought on the dip.

"Early intervention" is the name for ambitious disclosure requirements which will fight the "transparency" problem. Better supervision will tend to isolate a financial institution that has the virus before it can be announced to the general investing public and start the rapid spread of fear. New restrictions on asset choice will assure that the new money doesn't chase the old "bad" investments but instead is channeled toward new, "appropriate" investments.

The first point to note is the quest for transparency and the injection of liquidity work at cross-purposes. Transparency is a fool's paradise. If any metaphor were appropriate to the real marketplace, it would be cloudiness. The closer you are to a company, a product, or a trade, the more you will know about it. The farther, the more ignorant you are. Trade occurs when one party places a lower value on the thing they give up in exchange for the thing they get. A dollar is not equal in value to the cup of coffee it can buy.

The same applies to the buying and selling of shares and loans in companies by financial institutions. It is false that stock X seller and buyer "know" the same thing in the same respect in an exchange. And it is acutely false that the information that feeds complex motives for securities transactions can ever be made more "transparent." Human cognition undercuts this model of economic action. Outsiders can never know what insiders know and the laws demanding ever more disclosure of information will never resolve this basic condition. Information and the knowledge that comes from it is not costless. It is scarce, it is a product, and you negotiate for more or less of it in trade.

Liquidity is also a product. More liquidity for a particular security reduces the value of information about that security to the average investor. Broad market liquidity, provided to support broad market values, is indiscriminate capital. Transparency, such as it is, is made irrelevant when liquidity is high. Why? Because you can reverse your decision quickly and not worry about the risk of loss. If liquidity supports the values in the market, why would new and better information be necessary?

But when liquidity drops out, everyone is made ignorant all at once. Thus, stampede to the exits. What do shrewd investors demand then? More information to make sure that they can protect themselves from further damage. Normally, we would think of that as rational behavior. Under the convoluted logic of epidemiological economics, people who know more and who try to avoid the flu are acting irrationally. The desire to be the first to avoid a contagion is thought by regulators to be an irrational response. After all, interventions of various kinds can be a source of confidence.

Early intervention is founded on false beliefs. One is that disclosure will equalize the trading position of all people in the market. Another is that good supervision is the best way to monitor the fluctuating values of investment portfolios, rather than the techniques, choices, and entrepreneurial insights of the investment firms' principals. Another is that disclosure and supervision can uncover hidden "bad" investment practices before they are revealed and jeopardize the market as a whole. The truth is market players are more sophisticated than the market watchers. If a Meriwether wants to push the envelope, there are ways to do it which no regulatory regime can anticipate.

The role of oversight, of layers of auditors and reviewers that are required for the needs of self-regulating capital, is a matter of judgment and firm prerogatives. There is no silver bullet to control risk takers during a full moon. There are merits to voluntary disclosures and alternately, to keeping business property confidential. In LTCM's case, the price of being secretive to creditors and others, of not having an open book (or maintaining a proprietary technique as losses mounted) was that suspicions worked against them. Connections, perhaps, overcame suspicions.

Normally, however, unwarranted secrecy will impose a cost during a failure, either in preventing a quick forbearance decision or in minimizing value destruction. In free markets, those who live by the sword of secrecy will die by that sword. But it's hard to imagine a less free financial system than the one we are in now, mired in the complexities of investment systems designed by the likes of Meriwether and Nobelists. Can such innovators, right or wrong, crude or complex, survive when threatened by pressures now looming, the self-inflicted wounds of memory loss, unprincipled drift, incremental intervention and corruption?

World regulators have been ex-tending the public-private partnership so long that no one can even imagine the separation of government and economy, much less the separation of government and capital markets. By promoting confidence over value creation, they perpetrate a gross fraud on the American public, not unlike the welfare scam perpetrated on the poor. It is a system ill-suited for the private management of the world's long-term capital. Rather, it is the system best suited for long-term capital destruction.

* * * * *

Jeff Scott, adjunct scholar of the Mises Institute, is vice president and financial analyst at Wells Fargo in San Francisco, California. Further Reading: Ludwig von Mises, Theory and History (Auburn, Ala.: Mises Institute, [1957] 1985).


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