Investment Firms Reassess Risk
By Ianthe Jeanne Dugan
Washington Post Staff Writer
Friday, October 9, 1998; Page G01
NEW YORK, Oct. 8—Wall Street is suffering from a credit crunch so
broad and so sudden that it is imperiling the profits of investment firms and
affecting trading in many financial markets.
Rather than take chances on high-profitability business, boards of directors
are handing down marching orders to eliminate as much risk as possible,
limit the inventory of bonds, stocks and other securities on hand, and cut ties
to shaky borrowers. Though most firms are wary of discussing their
company's specific strategies, many Wall Street executives acknowledge
the sweeping trend.
"People are reviewing and refining their credit practices and their credit
standards," said Mark Brickell, a managing director at J.P. Morgan. "As
they raise the bar, credit may become less available and more expensive for
enterprises like hedge funds, emerging market countries, or highly-leveraged
corporations."
The scramble to reduce risk comes at the end of a long stretch of huge
profitability in the banking and brokerage industry, a time when big capital
cushions and reserves were built up. For many firms, the losses suffered in
the current turmoil will reduce profits but not endanger their overall health.
But the near-collapse two weeks ago of the highflying Long-Term Capital
Management L.P. hedge fund has focused widespread attention on the
huge leverage and risky trading strategies that had become favored on Wall
Street. Even before the Long-Term Capital debacle became public, virtually
every major firm had suffered big trading losses in overseas markets and
exotic securities.
Recently, many began to publicly document their risk, to offset rumors and
allay uncertainty. Salomon Smith Barney, a unit of the newly formed
Citigroup and the nation's third-largest securities firm, reported today that it
lost about $700 million in global trading from July to September. In July, the
firm vowed to stop making bets with its own capital in the U.S. bond
market.
Hedge funds -- unregulated investment vehicles for wealthy individuals and
businesses -- and many brokerage houses have investments they are unable
or unwilling to sell at the current depressed market prices, such as debt
from Russia and other troubled countries. But they are often now being
forced to sell to raise cash to meet margin calls and new risk-exposure
guidelines.
"Everybody suddenly is getting out of the risk business," said Hunt Taylor, a
partner with Tass Management, a hedge fund advisory firm in New York.
Investment banking firms have sent out teams of credit managers to comb
through the books of its hedge funds clients and other trading partners. "We
got calls saying, 'We need to see your whole portfolio right away,' " one
hedge fund manager said. " 'We want to see how much leverage you have
and reduce it.' "
Those balance sheets were worrisome. With economic turmoil throwing off
the traditional relationships between currencies, debt and equities around the
globe, the funds' asset bases in many cases were way off peak levels.
Several hedge funds were cut off and either scrambled to find financing
elsewhere or shut their doors. Reports abound about Wall Street financial
institutions whose credit lines have been pulled. For those that still get loans,
collateral requirements are being raised -- in many cases doubled -- and
interest rates are going up.
"Banks extended credit too easily for too long," one hedge fund manager
said. "Now, they're getting extreme in the opposite direction. Credit
departments were asleep for seven or eight years. Now they're waking up
and saying 'Wow, look at all this exposure we have out there.' "
Lehman Brothers Holdings Inc., an investment bank that wound up with
relatively minimal exposure to Long-Term Capital, has four people on staff
entirely devoted to analyzing its lending and trading relationships with hedge
funds, according to Maureen Miskovic, global risk manager. The company
has dealings with 54 funds now. "Throughout the market, collateral
requirements are increasing," she said.
"In recent months, we've seen unprecedented moves in global markets," a
Merrill Lynch & Co. spokesman said. "Risk assessment procedures, stress
simulation models and hedging strategies are being evaluated and updated
throughout the industry."
Wall Street got into trouble partly because firms had relied on sophisticated
computer models to assess risk and many of the assumptions that were built
into those models are no longer valid.
"There were so many assumptions that were reasonable in the past that are
not reasonable anymore," said a risk manager at a major firm. "It used to be
that having investments in many countries would reduce the risk. Now,
when equity markets fall, they fall around the world."
Models to assess risk are loaded with historical data. None of that data had
the sharply widened spreads of August in which the corporate and junk
bond markets moved in one direction and the U.S. Treasury bond market
moved in a different direction. "Going forward," one Wall Street executive
said, "you work that into your models."
Models generally measure the normal rate of fluctuation in prices,
currencies and interest rates. As one Wall Street executive put it: "None of
us has models that measure panic." But panic is what ensued when
Long-Term Capital teetered on the edge of failing, a result of global
economic strife throughout the summer and Russia's devaluation of the
ruble and default on its government debt on Aug. 17.
The Federal Reserve noted in a recent report that some large U.S. banks
have sharply tightened lending standards to large corporate borrowers
during the past month, indicating an aversion to risk and concerns about
slower economic growth. Lending standards have not yet been tightened for
consumers or small businesses, the report said.
The Federal Reserve has criticized lenders for becoming too lax. So, too has
the Office of the Comptroller of the Currency, which regulates national
banks. The Fed said in its recent report that banks may become so
risk-averse that even creditworthy borrowers could suffer.
Many investors worry aloud that a growing credit crunch among financial
institutions is exacerbating the tumult in world markets. With so few firms
willing to commit their capital to trading, big orders to sell or buy securities
cause larger price moves than they otherwise would.
Firms are also less willing to underwrite corporate stock and bond offerings,
making it difficult for companies to raise capital to invest in plants and
equipment.
"The heightened perception of risk will inevitably alter behavior in ways that
will curb growth," said Maureen Allyn, chief economist at Scudder Kemper
Investments. "Low-cost capital was supporting the capital spending boom.
Capital costs are now rising, as investors become more skittish about
funding new equity offerings and are demanding higher interest rates on
corporate debt."
Salomon was among the first to crack down on risk, shutting down the bond
arbitrage unit set up years ago by Long-Term Capital chief John W.
Meriwether. In September, several hedge-fund directors and Wall Street
executives said, Salomon began aggressively pushing to raise collateral
levels for loans and began severing ties with several hedge funds. Salomon
would not comment.
Meanwhile, ING Barings sharply cut back its emerging markets trading
operation, while some executives at CIBC Oppenheimer Corp.
emerging-markets unit recently resigned.
"We're not even calling it emerging-market asset class anymore," one Wall
Street executive quipped.
"It's called emerging-market liability class."
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