"Seeing a Fund as Too Big to Fail, New York Fed Assists Its
Bailout"
[According to one school of thought, until governments allow
prices to reach their market determined bottom, prices can never
recover -- hence the inability of Japan's markets to rebound.
--''''> ]
September 24, 1998
By GRETCHEN MORGENSON
NEW YORK -- The Federal Reserve Bank of New York
has helped organize the rescue of a large and
prominent
speculative fund, indicating that regulators recognize
that the failure of such a fund would damage already
fragile world markets.
Under an agreement reached late yesterday, the fund,
Long-Term Capital Management L.P. of Greenwich, Conn.,
received a cash infusion of more than $3.5 billion from
a consortium of commercial banks and investment firms.
The fund, whose founder is John Meriwether, a former
vice chairman of Salomon Inc., and whose partners
included two Nobel prize winners, is said to be have a
portfolio worth $90 billion.
The deal came after representatives of 16 banks and
brokerage houses met at the offices of the Federal
Reserve Bank of New York in downtown Manhattan. It is
extremely unusual for the Federal Reserve to get
involved in the bailout of such a fund, known as a
hedge fund, a virtually unregulated type of investment
firm, which despite its name, speculates in high-risk
trades in markets around the world.
A spokesman for the New York Federal Reserve Bank, the
biggest of the Fed's 12 regional banks, declined to
comment.
But the Federal Reserve Bank's actions show that
regulators are deeply concerned about the impact that a
liquidation of Long-Term Capital's trades would have on
brokerage firms and banks already struggling with huge
losses from worldwide market turmoil.
Regulators in the past have encouraged creditors and
borrowers to work together to avoid the kind of panic
selling of a portfolio that could harm other investors
in a particular market. For example, during the
downturn in real estate in the early 1990's, the Fed
asked banks to work with developers on the ropes. After
the stock market crash in 1987, the Fed made capital
available to securities firms that might have been on
shaky ground.
For the Fed to get involved with a speculator like Mr.
Meriwether is an indication that this time around, the
asset of greatest concern is not commercial real estate
or stocks. This time, it is bonds.
Long-Term Capital has been hurt by the same market
developments that have led to losses at many investment
firms.
As turmoil in Russia grew, culminating with the
country's de facto default on some debt and its
devaluation of the ruble, investors fled risky
securities.
Many took refuge in the United States Treasury market,
where prices surged, driving yields to record lows.
This confluence of events hurt Mr. Meriwether, who had
been a big buyer of riskier bonds; adding insult to
injury, the firm had also sold Treasury securities as a
hedge for its non-Treasury bond holdings. When Treasury
prices rose, Mr. Meriwether wound up on the losing end
of both sides of his trades.
And like many hedge funds, Long-Term Capital made its
bets on borrowed money. At times, the value of its
positions exceeded its capital by 50 or 100 times.
Recently, for example, Mr. Meriwether's firm was said
to be holding positions worth $90 billion, while its
capital stood at $2.3 billion.
The Fed may have been prompted to act quickly on
Long-Term Capital's problems because it realizes that
many of the world's hedge funds and most of the big
brokerage houses have billions of dollars in trades on
their books that are identical to those skewering Mr.
Meriwether.
"The Fed is aware of the precarious position that
exists among the largest dealers who have positions in
virtually every fixed-income product versus
Treasuries," said one trader, who spoke on the
condition of anonymity. "If Long-Term Capital had to
take off its trades, all the hedge funds and dealers
would be killed."
Why? Because having a seller liquidating billion-dollar
positions in these markets would drive them even lower
than they now are. This could cause other failures
among hedge funds and make dealer firms' losses
increase, causing another wave of selling.
Even without panic selling, things have been bad for
Long-Term Capital since August. At the beginning of the
year, the firm had around $4.8 billion in capital. By
Sept. 2, that capital had dwindled to $2.3 billion.
His losses rising, Mr. Meriwether wrote a three-page
letter to his investors. He explained that his fund was
down 44 percent in the month of August alone and was
off 52 percent for the year. Some 82 percent of the
losses came in so-called relative value trades, a
specialty of Mr. Meriwether's, which identify small
price differences between, say, a futures contract on a
particular bond and the security itself. The remaining
18 percent was lost in trades in which Long-Term bet on
a certain issue, up or down. Included in this group
were losses in emerging markets, including Russia.
In the letter, Mr. Meriwether affirmed his belief in
the trades his firm had made. He asked investors to
consider making additional investments to the firm. By
all accounts, no one did. Indeed, at about this time,
the firm went to Soros Fund Management asking for an
infusion of $500 million. The request was denied.
In the weeks since Mr. Meriwether wrote his letter, the
market has hammered Long-Term Capital relentlessly.
Treasuries have kept rising and all other debt has
continued to lag. Even if he did not try to liquidate
some of his trades, having to assess the value of his
portfolio each night, as all funds are required to,
meant that he did need to put up more capital.
It was no surprise, then, that in recent days, bond
traders have suspected Mr. Meriwether and his
associates of trying to unload some of their holdings
to meet margin requirements. Last Friday, for example,
Long-Term Capital bought a number of Treasury futures
to liquidate one side of a huge trade. The buying moved
the spread between the futures and the so-called cash
market in that particular issue by one-quarter of a
point, an enormous move in the world's deepest, most
liquid securities market.
Terms of yesterday's bailout were not given. But
bankers say that the institutions -- including Goldman,
Sachs, Merrill Lynch, Morgan Stanley Dean Witter, J. P.
Morgan, Chase Manhattan and UBS of Switzerland, among
others -- agreed to put up roughly $250 million each in
return for an equity stake in Long-Term Capital.
It is believed that existing equity holders, also known
as limited partners, would end up with a greatly
diminished ownership in the firm, between 10 and 20
percent of their original stakes. A spokesman for
Long-Term Capital declined to comment on yesterday's
developments.
Mr. Meriwether, of course, has faced adversity before.
He left his position as vice chairman of Salomon
Brothers in 1991 after Paul Mozer, one of the firm's
Treasury traders, was caught trying to corner the
market in two-year Treasury securities. Mr. Meriwether
formed Long-Term Capital in 1994, along with the
Salomon Brothers alumni Lawrence E. Hilibrand and Eric
R. Rosenfeld, and Robert H. Merton and Myron S.
Scholes, both Nobel laureates in economics.
With its stable of star traders, Long-Term Capital
attracted money from banks, brokerage houses and
wealthy individuals, all of whom agreed to lock up
their investments until at the earliest, the end of
this year.
Even if Long-Term Capital rides out this storm, the
world of hedge funds will probably never be the same.
Many investors will likely flee all such funds, and
regulators will probably scrutinize their operations a
lot more closely. Mr. Meriwether himself will be under
the scrutiny of an oversight committee appointed by the
banks that bailed him out.
Copyright 1998 The New York Times Company |
