Korean chaebol, hedge funds, and double standards

What's the difference between Korean chaebol in the run-up to the Asian financial crisis of 1997-98 and hedge funds today?  They were both excessively leveraged, but at least the first generated real economic value, argues Danny Leipziger, the World Bank's VP for Poverty Reduction and Economic Management (PREM). 

Just about a decade ago, Korea suffered through its most severe financial crisis in its history when international credit markets froze up and a nation with an impeccable record of economic management was humbled by a massive liquidity crisis. While the proximate cause was financial contagion affecting an economy whose financial markets had been forced open without requisite regulation, many observers blamed the problem on the excessive leverage of Korean conglomerates, the fabled chaebol that produced Hyundai, Samsung and Lucky Goldstar. What made the chaebol infamous was in part their drive to enlarge and the financing methods used to achieve greater size?leveraging.

The generation of a large balance sheet with small amounts of equity is viewed differently by financial markets at various moments. For hedge funds, the key to leveraging is to risk small amounts of equity to make huge gains, betting that people will lend you funds to make these bets and that you will win many more times than you will lose. The sub-prime crisis and its aftermath show the perils of this financial strategy, and as is usual in deep financial crises with systemic spillover dangers, the government usually steps in and the taxpayers help bail out the excessive risk-takers.

Contrast this to the fate of many of Korea?s chaebol, who were not leveraged twenty to one, as were many hedge funds that recently collapsed in the U.S. crisis, but by three to one in the typical case before the crisis deepened. When interest rates were forced to exorbitant rates by IMF programs that Joe Stiglitz rightly criticized, there was no solvent chaebol left in Korea. This was a natural consequence of 25 percent interest rates applied to highly leveraged firms faced with short term debts that could not be rolled over and slim profit margins. The consequence of this "excessive leveraging" was a massive retrenchment of Korean firms and a deep two year recession in Korea that left marked scars on the economy. In the end, Korea emerged stronger in terms of corporate financing and corporate governance, but with a black mark on its copybook.

Those managing the bailout went to great pains to point out the flaws of the Korean approach -- using credit, admittedly some of it at publicly subsidized terms -- to grow fast and capture export markets. Leverage allowed Korea to expand its exports at a pace that was unheard of in the postwar period and to penetrate OECD consumer markets in record time. Hence the prototypical American consumer now driving a Hyundai, watching TV on a Samsung plasma screen and talking on an LG cell phone. And as a corollary, we have witnessed the Korean worker made dramatic strides in standards of living in one generation.

One might have expected a louder hue and cry against hedge funds that were speculating in financial markets and obtaining credit at easy terms from lenders when the current crisis unraveled. Instead we have witnessed unprecedented liquidity being pumped into the markets at non-distress rates, essentially blurring the difference between illiquidity and insolvency. We have seen the world's central banks provide enormous amounts of credit to avoid larger scale collapse. What is not so clear is the real economic benefit that the speculating hedge funds were generating. At least in the case of Korea, there were real economic benefits to be generated, employment to be created, and international markets to be penetrated. This is not to absolve some chaebols of their misdeeds -- pledging poor collateral, cross ownership among chaebol affiliates, use of cheap government credit and the like -- yet there does seem to be a double standard in the way the international community is dealing with the current crisis caused by excessive and under-regulated leveraging and the way in which Korea was pilloried in the aftermath of the 1997 crisis.

Comments

[conundrum]

That's a great argument - the only problem is that hedge funds are not the ones going under. Instead, it is investment banks or mortgage banks that are going bust. Admittedly, high leverage also seems to be one of the main drivers for those institutions but they are probably still less leveraged than many hedge funds. Thus, it’s not just leverage per-se but also other variables that determine access to liquidity during a crisis. The most interesting part is that ex-ante most observers probably would have argued that hedge funds pose a much greater risk (as Danny Leipziger seems to imply) than the Bear Stearns or Citibanks of this world. Is it thus wrong to bail out these institutions? Maybe, but it’s hard to argue that the failure of these institutions won't pose any systemic risk to the financial system. Hence, it’s not surprising that both Korea and the Fed decided to bail out their respective institutions. And Danny is right on his main point – at least some observers (but definitely not all) seem to apply a double standard in evaluating those policies.

[nocountry]

Does it make any sense to compare the leverage of hedge funds to Chaebol without discussing what assets are held on their respective balance sheets? Hedge funds hold liquid assets, and are often, uh, hedged, so the volatility of their assets may not be all that great.

This is just a cheap shot at hedge funds.

[th]

Conundrum is right - it is not hedge funds that are the problem but the banks.

But banks are more leveraged than most hedge funds. Even ignoring its off-balance sheet exposures, Bear Stearns was leveraged 33:1 at the end of 2007.

Another example, Citigroup, at the end of 2007 was 19x leveraged (again only accounting for on-balance sheet items).

As for whether to "bail out" these institutions, Bear Stearns was bankrupt. Is it not better to ringfence the problem than risk a "chaotic unwinding of positions"? After all, Bear had exposure to a notional $13.4 trillion of derivatives contracts. Under the original $2 offer the equity left in Bear was essentially worthless.

http://federalreserve.gov/newsevents/testimony/bernanke20080403a.htm
http://www.econbrowser.com/archives/2008/03/not_a_bailout.html
http://www.bearstearns.com/sitewide/investor_relations/sec_filings/proxy/index.htm

[Ken Houghton]

Actually, hedge funds have been going under, but since they aren't required to be registered (forget regulation; I want a database of who ran which hedge fund and what before-fees performance they claimed), they just quietly go out of business.

(Quietly is a relative term. For instance, I can tell you that George Handjinicolaou used to run a hedge fund because I like keeping track of my former bosses, and I see that he's now the EMEA Regional Director of ISDA--but I can't tell you if he left the firm, or sold it, or it folded. Otoh, the people in Derivatives and Fixed Income IT at Bear Stearns have a fate being discussed 24/7 by Bess Levin at Dealbreaker, among other.)

To borrow from Bruce Cockburn: "If a hedge fund falls in the forest, is anybody out there? Does anybody care?" Besides some HNW investors who aren't exactly going to go on CNBC and rend their clothing, generally no.

Btw, Dr. Rodrik, is there a link to the full statement?

[greatzamfir]

To follow up on Ken Houghton, hedge funds going under is no big deal, mainly because they have few employees, and their employees will in general find new jobs. Industrial complexes on the other hand have enormous amounts of employees, and if these lose their jobs, it can cripple entire regions.

So, hedge funds go under all the time. A bit more at the moment. But people who work for hedge funds, and people who invest in them know this risk, and it is part of the game.

Are they good for the economy? Who knows. Are industrial complexes good? Apparently people pay them for their services, so they must be doing something right.

[Per Kurowski]

Exactly the point I have been trying to argue for more than a decade now, with little luck, being no credible PhD against so many credible PhDs.

There is nothing wrong with a hangover... if the party was worth it.

But the banking regulators, trying to avoid hangovers at any costs, through their minimum capital requirements for banks that are based exclusively on the risk of default as assessed by the credit rating agencies, introduced an artificial risk adverseness into the financial sector and which now has it financing public sector, consumers and whatever else could be construed as safe and AAA.

We just measure the pain when there is a financial crisis, but we never measure the results of the full boom bust cycle. Clearly the full Korean cycle seems a lot better for the long term sustainable growth than the current US boom bust cycle.

If we are going to use risks to direct capital flows then we are much better of with a system that does not stay with the simplicity of a risk of default but introduces, as an example, units of risks of default per decent long term job created.

If we just go down the current regulatory route, the only one left standing will be the last bank in town, which is the same as the last bank in the world; and we will all have to work for it as economic efficient alternatives to automated bank teller machines.

And, to top it up, not only do our current bank regulations lack sense and purpose but they are also extremely dangerous… as they do only guarantee that we will follow the credit rating agencies over some precipice, like we for instance did in the case of the subprime mortgages.

[Naz Onuzo]

The double standards argument is not new, and it comes up every time there is a crisis in the "developed" world. Looking at a standard IMF SAP package, it is impossible to see any "developed country" applying it in time of a crisis. Yet time and again developing countries were made to do so. However I would argue that the double standard exists because the developing countries needed the money the IMF provided. This is increasingly no longer true, so there will be less arguments about double standards going forward.

[burritoboy]

Echoing what other people have said: the hedge funds actually haven't been blowing up that much more than usual up till now (yes, blowing up more than usual, but not much much more than usual). The banks were leveraged more (sometimes 10 times more) than most hedge funds.

And, while we might not know about smaller hedge funds going under, the collapse (collapse, not winding down due to mediocre performance) of any 1 billion+ hedge fund is fairly widely reported in the business press. It's unlikely that there were big ones that quietly exploded.

Further, if I was a provider of credit, liquid collateral (securities) are generally far better than an industrial asset. You can (at least in typical times, sometimes markets seize up) price a portfolio in seconds.

What's the price of a Korean shipyard that's been operating as a division of a massive and sometimes Byzantine conglomerate? It has some value, maybe even a high value, but not a value that's obvious or simple. And, of course, the market in Korean shipyards may just as equally seize up as any other market.

[Veronica]

I wonder your opinion about how the IMF and the world’s central banks should have coped with the economic crisis in the United States. Are there other alternatives to cope with the problem? I agree that their solution for the economic crisis in the United States is less fair than one for the Korea financial crisis. But, when I consider the negative social effects such as bankruptcy of domestic economy, their double standards might be better choice than committing similar errors.

[Highgamma]

Of course hedge funds have been going out of business, but we have not seen them "blow up". By blow up, I mean that they lose more money than they have in capital. I don't care if a bunch of rich people lose a lot of money. I care if they lose so much money that they go bankrupt and post a threat to the financial system. That's what happened to Bear Stearns.

So, this time at least, hedge funds appear to have been adequately capitalized. Investment banks and banks seem to have been inadequately capitalized. Boos to the banks and (muted) cheers for the hedge funds.

[Chui Tey]

I don't think we really should be comparing the merits of investment in productive capacity vs investment in housing. The former makes goods cheaper, the latter makes housing more expensive.

[Nicholas Shaxson]

Martin Wolf had a good comment about all this, here:
http://www.ft.com/cms/s/0/c8941ad4-f503-11dc-a21b-000077b07658.html
This section is fun:
Imagine that we set up a hedge fund with $100m from investors on the normal terms of 2 per cent management fees and 20 per cent of the return above a benchmark. We put our $100m in Treasury bills yielding 4 per cent. We also sell 100m covered options on the event, which nets us $10m. We put this $10m, too, in Treasury bills, which allows us to sell another 10m options. This nets another $1m. Then we go on holiday.

There is a 90 per cent chance that this bet will pay off in the first year. The fund then grosses $11m on the sale of the options, plus 4 per cent interest on the $110m in Treasury bills, for a handsome 15.4 per cent return. Our investors are delighted. Assume our benchmark was 4 per cent. We then earn $2m in management fees, plus 20 per cent of $11.4m, which amounts to over $4m gross. Whatever subsequently happens, we need never give this money back.

The chances are nearly 60 per cent that the bad event will not occur over five years. Since the fund is compounding at a rate of 11.4 per cent a year after fees, we will make well over $20m even if no new money is attracted into this apparently stellar enterprise. In the long run, however, the bad event is highly likely to occur. Since we have made huge profits, our investors have paid us handsomely for the near certainty of losing them money.

The immediate response may be that so naked a scam is inconceivable. Well, imagine a fund that leverages investors’ money by borrowing massively in short-term money markets in order to purchase higher-yielding paper. Assume, again, that the premium gives a correct estimate of the risk. With sufficient leverage, this fund, too, is likely to make profits for years. But it is also very likely to be wiped out, at some point. Does this strategy sound familiar? It certainly should by now. . .

The more one believes this is how an unregulated financial system operates, the more worried one has to become.

[Blissex]

The crucial difference is that Korean chaebol executives are not Republican party donors, but Wall Street and Greenwich types are indeed. There is no double standard because there are two completely different situations. There is one standard for USA players who understand how the world works, and another for stupid foreign people who create value added even if with a little bit of financial trickery. «The more one believes this is how an unregulated financial system operates, the more worried one has to become.» It is not finance, it is insurance. Every time insurance is unregulated, players take the premiums and run without providing sufficient reserves, as the FT article you quote says.