Remembering the Freedom to Fail

On this D-Day anniversary, let us be reminded of the freedom that the soldiers fought for: freedom from totalitarianism, tyranny and oppression. Concentrated power is the single most common source of evil, determining winners and losers to further its personal interests—Hitler’s Germany is but one extreme example of it. But Nazism is long dead; as we remember our fallen heroes let us focus our right to liberation to another fortress of power, one that is far less evil but far more influential in today’s world: the Federal Reserve.

Last night I finished Roger Lowenstein’s When Genius Failed: The Rise and Fall of Long-Term Capital Management, a book Mike recommended and now a book I’m recommending to you, our reader (let’s not kid ourselves; there’s only one of you). It depicts the events surrounding a hedge fund called Long-Term Capital Management (LTCM), a fund so arrogant it felt as though it could predict the future by examining the past. Over a dozen major banks had their fingers deep in the fund even though the partners refused to tell anyone what exactly their portfolio consisted of, scared that the word of their strategy would spread. And then, in 1998, everything changed. Events the fund did not predict—Russia’s default of its loans and the Asian crises—wrecked havoc on its portfolio and the fund was losing millions every day. If the fund went bankrupted, the Federal Reserve feared that it would send shocks throughout the worlds’ economy, possibly collapsing a financial system that was already on its knees.

While the Fed did not send LTCM the $4 billion it needed to hold on, it did call in the presence of the major banks on Wall Street to organize a deal. After a lot of pushing and prying the banks complied, even though most of them didn’t agree to the terms, and LTCM held on. In fact, it held on so well, it turned around after the markets started returning to normal. Meanwhile, the partners of LTCM remain millionaires to this day. Thinking it was doing the world a favor, it manipulated the outcome.

Because of the Fed’s intervention, the banks were able to save a fund that should have completely and utterly failed. While one could argue that the banks would’ve have got together and save LTCM because they had a vested interest in doing so. But the Fed’s intervention occurred at the last minute—the banks clearly thought it wasn’t worth it. The banks should have been taught a lesson that can only be learned by paying the penalty of massive losses: don’t invest in a fund that a) claims to be clairvoyant and b) refuses to say what they’re doing. But no one needs to learn a lesson more than the fund’s partners, who stayed on for another year after the banks bought, and made six figure salaries. By all but forcing cooperation, the Fed prevented losers from losing, like a principle telling a teacher to inflate the grades of a star athlete. By denying one of the most basic freedoms in a capitalist society—the freedom to fail—lessons are not learned. John Meriwether, the original founder of LTCM, started a new fund in late 1999, raising as much as half of a billion dollars. This new fund (JWM Partners) would follow many of the same strategies as LTCM. Let us pray…