Wall St. Struggles to Save Big Fund
By Steven Mufson and John M. Berry
Washington Post Staff Writers
Thursday, September 24, 1998; Page A1
A huge private investment fund run by Wall Street legend John
Meriwether and two Nobel Prize-winning economists teetered on the
verge of collapse yesterday as losses mounted on more than $100 billion
of bets it made in financial markets around the world.
In an attempt to avoid a new bout of global market turmoil that might be
caused by a fire sale of the fund's assets, chief executives and other top
officials from two dozen of the world's largest banks and brokerage firms
spent six hours hammering out a preliminary agreement yesterday at the
New York Federal Reserve Bank to provide a rescue plan of more than
$3.5 billion for the Greenwich, Conn.-based fund, called Long-Term
Capital Management L.P.
The money is not a bailout of the firm's investors but rather a takeover of
the firm by its creditors, who are attempting to buy time so they can
recover some of its losses.
The negotiations at the New York Fed underscored the seriousness with
which regulators regard the turmoil surrounding Long-Term Capital. The
fund, like many similar "hedge funds" on Wall Street, used a complex,
computer-based strategy to invest in bonds and currencies from around
the globe - and officials fear that its demise could reverberate well beyond
the narrow confines of Wall Street. Traders said banks already are
tightening credit in response to the crisis, a credit crunch that eventually
could affect loans to individuals and small businesses.
The high-level negotiations are likely to cast further attention on the largely
unregulated business of hedge funds, which use borrowed money to
wager on the direction of financial markets. Their web of international
transactions has played a key role in linking financial crises in one part of
the globe to seemingly unrelated markets elsewhere.
A source close to the negotiations described hedge funds as "the
connectors of the global economy." The leaders of many developing
countries, such as Malaysia, have placed the blame for a regional
economic collapse at the feet of hedge fund managers.
Long-Term Capital has trading contracts based on securities worth nearly
$1 trillion, an investment banker close to the talks estimated, and its
agreements involve institutions scattered all over the world. The fund's
arcane series of transactions linked its fortunes to securities ranging from
Russian treasury bonds to Danish mortgages, from the British pound's
value against the U.S. dollar to the volatility of the American stock
exchanges.
In a statement last night, Long-Term Capital said it believed the infusion of
new funds would provide enough breathing room for the company to
manage its investments - and if the markets cooperate, recover some of
its losses. The deal came with a price, however. The consortium of banks
lending the money will now own 90 percent of the firm and appoint an
oversight committee that will direct its overall strategy and make sure it
reduces its exposure to markets.
The committee will consist of representatives from Goldman Sachs & Co.,
Merrill Lynch & Co., Morgan Stanley Dean Witter, Travelers Group Inc.
and UBS Securities Inc. - firms with some of the largest exposures to
Long-Term Capital's troubles.
Long-Term Capital had an enviable track record before this year, but a
series of miscalculations combined with unusual international economic
upheavals have hammered the fund's performance. Earlier this month,
Long-Term Capital said it had lost $2.5 billion, or 52 percent of its net
assets, in trading so far this year, most of it in less than two months - and
the losses are said to have climbed even further this month.
The fund's swift decline was propelled in part by its strategy of borrowing
heavily to finance large market bets. The heavy borrowing, or high
leverage, meant that once the fund suffered losses, it was forced to sell
some of its other holdings to meet margin calls from creditors concerned
that the fund's collateral was no longer sufficient to meet minimum loan
requirements. Being forced to sell while markets were in turmoil only
compounded the fund's losses - and added to turmoil both in emerging
markets and in the United States, where it was easier to unload
investments such as Treasury bonds.
"When positions move away from them, the value of the collateral shrinks
and so they owe more collateral. To get the collateral, they have to sell
something else," said one source.
Long-Term Capital's troubles have been compounded by the difficulty of
untangling such large positions in a short time. "Once the Street knows
you're a wounded animal or cornered bear, you're not going to get a good
price," said Steven Lonsdorf, president of Van Hedge Fund Advisors.
Hedge fund sources said that in late August, Long-Term Capital asked the
Quantum Fund, run by hedge fund titan George Soros, for an injection of
half a billion dollars in new capital, but that Quantum declined.
But the investment firms and banks that did business with Long-Term
Capital had more at stake. "The alternative they all have is if Long-Term
goes bankrupt, a lot of banks can lose," said an official of one major bank
involved in the talks. The financial institutions could be vulnerable because
of credit lines extended to Long-Term Capital, or because they are on the
other side of market bets the firm placed.
The major banks and investment houses do not want a forced liquidation
of Long-Term Capital's positions. Indeed, many are willing to sit with the
positions and wait for them to recover. The banks are trying to avoid fire
sales of assets that could pull down prices in stock, bond and currency
markets worldwide, but one source said there may be sales that would
cause problems in particular markets - such as, say, Danish mortgages -
that are small and illiquid.
"It's easier to close out some positions than others," a source said.
Prior to this year, Long-Term Capital had nearly tripled the money of its
investors. Meriwether, formerly the head of bond trading at Salomon
Brothers Inc., teamed up with Nobel laureates Robert C. Merton of
Harvard University and Myron S. Scholes of Stanford University to use
mathematical formulas to arbitrage, or take advantage of differences in the
values of securities between different markets.
Long-Term Capital generally borrows money to buy securities, pledging
some or all of the value of the securities as collateral for the loan. Then,
Long-Term Capital creates "derivatives" using those securities. Derivatives
are financial instruments whose value is tied to an underlying market index,
currency, stock, bond or commodity. As a hedge, they can help
companies protect themselves from unexpected changes in such things as
interest rates, foreign currency fluctuations and swings in commodity
prices.
But Long-Term Capital used them to place bets that went bad when
global markets started to lurch in directions, and magnitudes, that defied
the fund's statistical models.
Market sources said that some of the ways Long-Term Capital lost
money included: losses related to the Russian bond market, the defaulting
of ruble currency hedges by Russian banks, an incorrect bet on Danish
mortgages and German bonds, a misguided bet that volatility in the
American markets would drop off, and a wrong bet on the value of the
British pound against the dollar. Stock and bond prices that were
supposed to converge, diverged instead and liquidity dried up in many
markets.
In a Sept. 3 letter to his shareholders, Meriwether said: "We expected that
sooner or later . . . we as a firm would be tested. I did not anticipate,
however, how severe the test would be."
The losses struck a blow to the reputation of Meriwether, who gained
fame in the 1980s as a bold bond trader. In the book "Liar's Poker,"
written by a former Salomon Brothers bond trader, Meriwether was
described as being dared by the Salomon chairman to bet $1 million on a
hand of poker using serial numbers on a dollar bill. Meriwether reportedly
offered to make the bet $10 million, prompting the then-Salomon chief to
walk off in disbelief.
Staff writer Kathleen Day contributed to this report. |
