Don,
excellent reading behind the orchestrated rate cut talks & global financial crisis from WSJ Online.
A Hedge Fund Falters, So the Fed
Persuades Big Banks to Ante Up
By ANITA RAGHAVAN and MITCHELL PACELLE
Staff Reporters of THE WALL STREET JOURNAL
At an extraordinary gathering Wednesday night, Wall Street's biggest
power brokers agreed to prop up one of their most aggressive offspring,
Long-Term Capital Management L.P., a highflying hedge fund that was on
the verge of collapse.
Heeding a plea by Merrill Lynch & Co. Chairman David Komansky to put
aside any misgivings, Travelers Group Chairman Sanford I. Weill,
Goldman, Sachs & Co. Senior Partner Jon Corzine and J.P. Morgan &
Co. Chairman Douglas "Sandy" Warner were among those who agreed to
have their organizations pony up more than $3.5 billion to shore up
Long-Term Capital, a creation of ostensibly some of Wall Street's most
brilliant minds.
The rescue was the culmination of increasingly intense negotiations among
Long-Term Capital's lenders, dealers and the Federal Reserve that began
last weekend as rumors spread that the fund was close to foundering.
Long-Term Capital, which uses borrowed money to make
multibillion-dollar bets all over the globe, had tried for weeks on its own to
draw in more capital to shore up its rapidly failing positions, even
approaching famed global investor George Soros, who said no.
Claims for Billions
As it became increasingly clear that Long-Term Capital was teetering on
the edge of collapse, with lenders pressing claims for billions owed to
them, top executives of 16 investment and commercial banks gathered at
New York Fed headquarters in lower Manhattan in an effort to coordinate
a rescue.
The presence of so many of Wall Street's elite in the paneled elegance of a
Fed meeting room and the Fed's intense involvement reflect both the
enormous size and the complexity of Long-Term Capital's highly leveraged
balance sheet and the timing of its problems.
Long-Term Capital, with assets currently estimated at $80 billion, had
borrowed heavily on generous terms from Wall Street's biggest names,
and it held a complex array of derivatives and futures contracts on a
variety of instruments that trade on markets in a number of countries.
Unwinding so many complex bets could have meant big losses for
Long-Term Capital's counterparties and lenders, perhaps jeopardizing the
financial health of some of them.
As if that weren't reason enough to draw the attention of chief executives
and the president of the New York Fed, William McDonough, who
hopped a flight Tuesday night from London to New York, all this occurred
at a moment of growing anxiety -- both in markets and in government
circles -- about the health of the world economy.
In response to fears that market turmoil could lead to global recession,
Fed Chairman Alan Greenspan Wednesday suggested that he may soon
cut U.S. interest rates, President Clinton has asked Mr. Greenspan and
Treasury Secretary Robert Rubin to convene their international
counterparts to seek new solutions, and high-level efforts are under way in
Washington and in Latin American capitals to prevent Asia's and Russia's
woes from infecting another continent.
Exercising Clout
While the Fed has no jurisdiction over risk-taking hedge funds like
Long-Term Capital, it is responsible for the safety of the nation's banks.
And it was that clout, together with the self-interest of several big firms that
already had lent billions of dollars to Long-Term Capital, that helped
fashion the rescue.
The aim: give Long-Term Capital a respite from loan repayments and
margin calls that it wouldn't have been able to meet otherwise. Once global
markets calm down, Long-Term Capital could unwind some of its failed
bets and repay some of its debts. But the firm's long-term future -- and
that of its legendary founder John Meriwether -- remains in serious doubt.
The rescue package "buys it six months," says one person familiar with the
meetings. "Then there's two choices: Either they buy it back from us,
hopefully at a profit, or we decide, 'OK, let's liquidate over a period.' "
Terms of the pact reached late Wednesday call for more than a dozen
firms to put in $300 million apiece in exchange for a 90% stake in the
hedge fund. Five of the firms will also form a new committee to oversee
Long-Term Capital's overall strategy, procedures, controls and even
compensation. They would also have an option to buy 50% of the
management company for one dollar.
Long-Term's situation was so dire that if the bailout plan hadn't been
sealed Wednesday night, the hedge fund wouldn't have been able to meet
margin calls Thursday, people familiar with their situation say. Goldman's
Mr. Corzine told the group that his investment bank wasn't ponying up the
cash because of its own exposure, but rather because of the risks to the
system that a collapse of Long-Term Capital would pose. Some
executives, however, questioned whether Wall Street securities firms
should be trying to rescue a group of trigger-happy traders that had wound
up in such a mess.
In its brief existence as a highflying hedge fund, Long-Term Capital -- with
the help of two Nobel-laureate partners -- made a name for itself with its
complex, billion-dollar bets on the difference between interest rates on
various kind of bonds. That strategy failed the firm last month, when
Russia's financial debacle prompted investors world-wide to flee all
manner of risks. That made many interest rates move in the opposite
direction than the firm was betting. The upshot: Long-Term Capital's
capital was down 44% in August, to $2.3 billion, and now stands at just
$600 million.
Almost every major Wall Street securities firm and many large commercial
banks have extended credit lines to Long-Term Capital. Although the fund
managed just $4.8 billion at the start of the year, it borrowed heavily to
boost its returns. According to one Wall Street executive, the value of its
positions at the end of August topped $125 billion.
But the size of those positions is believed to have since been whittled
down to somewhat more than $80 billion as the fund has sold assets under
pressure from lenders.
Wednesday's talks were set to start at 10 a.m., but were delayed amid
reports that Goldman had lined up a buyer -- believed to be investor
Warren Buffett -- for some of Long-Term Capital's assets, according to
people familiar with the situation. But the talks resumed at 1 p.m. after no
buyer had come forward. A spokesman for Mr. Buffett wouldn't
comment.
It was Herb Allison, Merrill's president and chief operating officer, who
presented an initial bailout proposal, detailing how each firm would be
asked to contribute about $250 million for a stake in the hedge fund, the
same people said. Merrill's Mr. Komansky argued that while there are
better uses for the sums involved, "there are times you have to step up to
the plate."
One of the hotly debated issues at the meeting was whether a collapse of
Long-Term Capital would put the entire financial system at risk, the same
person said. Salomon Smith Barney's Mr. Dimon argued that while there is
no way of knowing the extent of the risks posed by the situation, why take
the chance?
After a lengthy debate, a poll was taken: One after another, a
representative of each firm indicated how much the firm was willing to ante
up. Most firms agreed to throw in $250 million; some, arguing that their
exposure to Long-Term Capital was modest, put in about $100 million,
bringing the initial tally to about $3 billion-about $500 million short of the
group's target.
After a short break, the firms reconvened, putting pressure on some
holdouts to fork over some cash. But the group was unsuccessful in
convincing some of the stragglers. In the end, the only course left was for
the biggest participants to add $50 million apiece, bringing the contribution
of most of the firms to $300 million.
"We greatly appreciate the willingness of the consortium to provide capital
which we are confident will stabilize our fund and enable us to continue to
be active in the marketplace," Mr. Meriwether said in a statement.
The bailout effort marks an embarrassing fall from grace for Long-Term
Capital, whose brain trust of partners includes David Mullins Jr., former
vice chairman of the Federal Reserve Board; Stanford University scholar
Myron Scholes, who won the Nobel Prize in economics for his work on
the pricing of options; and Robert Merton, another Nobel laureate in
economics.
"They have star power. You can't find another hedge fund in the world
with multiple Nobel laureates," says Stephen Henderlite, a research
executive at Tremont Partners Inc., a Rye, N.Y., hedge-fund advisory
firm. "In terms of sheer brain power, there isn't another firm that has come
down the pike that has looked as good on paper."
Before his incarnation as hedge-fund honcho, Mr. Meriwether was one of
the most successful "Masters of the Universe" in the 1980s at Salomon
Brothers. He also figured prominently in "Liar's Poker," the best-selling
book that portrayed the firm's swaggering culture. But that career ended in
August 1991, when he resigned in the midst of the Treasury-bond
bid-rigging scandal that also cost Chief Executive John Gutfreund his job.
After Mr. Meriwether settled with the U.S. Securities and Exchange
Commission, he assembled a team of financiers, economists and
academics, and retreated to the relative quiet of Greenwich, Conn., where
he launched Long-Term Capital in an office overlooking Long Island
Sound.
The firm's recent losses follow four years of substantial returns to
investors. The fund returned 42.8%, after fees, in 1995, and 40.8% in
1996, before slipping to 17.1% in 1997, according to people familiar with
its results.
Mr. Meriwether's impressive track record had allowed the fund to set
some of the most restrictive conditions in the business, including a minimum
investment of $10 million, to be locked up for at least three years. The
fund has never disclosed to investors exactly how it makes or loses
money. At year end, it gives investors only a rudimentary outline of its
portfolio.
The partners in the firm have a substantial amount of their own money at
risk. More than one-third of the fund's capital came from the firm's
principals, Mr. Meriwether told investors in a recent letter.
Wall Street professionals were shocked at the level of indebtedness, or
leverage, that lenders would allow the firm to incur. Although investors can
typically borrow only 50% of the value of stocks they hold, there are no
such limits on loans secured by debt securities.
One person close to Long-Term Capital tried to put an optimistic spin on
the agreement Wednesday night, saying he couldn't imagine a scenario
under which the participating banks would insist on liquidation of the fund.
Under the rosiest potential scenario for Mr. Meriwether and his partners,
he said, the fund's investments would recover value as bond rates begin
moving in the right direction, and the participating banks that want to sever
their ties to the firm would be paid with money raised from new investors.
Others, he said, would keep their capital in the fund.
Despite its reputation as an industry heavyweight, Long-Term Capital isn't
among the world's largest hedge-fund managers. George Soros's Soros
Fund Management and Julian Robertson's Tiger Management both
manage about $20 billion in a series of different funds. But because few
funds employ the level of leverage used by Long-Term Capital, Mr.
Meriwether's fund has an inordinate impact on the markets relative to its
size.
Quantitative Methods
Like many so-called "quant" funds, which use computer models and highly
complicated quantitative trading strategies, Long-Term Capital is highly
secretive about its operations, even with investors. That lack of
"transparency" has also made some hedge-fund investors wary.
Mark Kenyon, who runs the U.S. asset-management business for
Geneva-based Union Bancaire, says the bank declined to invest on its
own behalf because of concerns about the three-year lock-up, the high
fees and the lack of transparency. But high-net-worth clients of the bank
did invest, so Mr. Kenyon later found himself seeking information from the
hedge fund on their behalf.
"They wouldn't tell us how much leverage they used or what investments
they were making," he recalls. "We were told they didn't give out that kind
of information. And if we were unhappy about that, we could have our
clients withdraw."
Yet until recently, the firm hasn't lacked for capital. With limited
exceptions, it has been closed to new investment since July 1995. And a
year ago, when the fund had ballooned in value to about $7 billion, Mr.
Meriwether took the unusual step of returning $2.7 billion to investors,
saying the fund had too much capital.
Chance to Invest More
In a Sept. 2 letter to investors, Long-Term Capital said losses "occurred in
a wide variety of strategies, distributed approximately 82% in
relative-value trades and 18% in directional trades." Emerging markets
accounted for only 16% of the losses.
As the hedge fund's equity has plummeted, its wealthy investors have
found themselves stuck. In the wake of the disastrous results of recent
months, the earliest that investors can seek redemptions is year end. And
even then, only 12% of the equity could be withdrawn, according to the
letter Mr. Meriwether sent announcing the August results.
In spite of the results, however, Mr. Meriwether tried to persuade
investors to put up more capital. The firm "believes that it is prudent and
opportunistic to increase the level of the Fund's capital to take full
advantage of this unusually attractive environment" in the bond-arbitrage
markets, he wrote. The fund, he continued, is "offering you the opportunity
to invest in the Fund on special terms related to LTCM fees."
Talks With Soros
In recent weeks, Long-Term Capital has offered to cut its fees to an
annual 1% of assets and 12.5% of profits for new investors, according to
several people knowledgeable of the firm's pitch. Long-Term Capital also
has held discussions recently with Soros Fund Management about a $500
million investment by Soros hedge funds into Long-Term Capital,
according to someone knowledgeable about the talks. Soros declined to
make an investment, this person said. Stanley Druckenmiller, Soros's chief
investment strategist, declines to comment.
Also in recent days, commercial banks and other lenders have been
attempting to sell some of the leveraged securities held by the hedge fund.
The situation raises again questions of banks' risk-management systems.
After the 1994 bond-market rout, many commercial and investment banks
strengthened their risk-management practices to avoid debacles. But the
lure of high fees on derivative products and the increasingly lax lending
standards of recent years contributed to the willingness to take more risks.
--Steven Lipin and David Wessel contributed to this article. |
