Washington Post - 09/24/98
By Steven Mufson and John M. Berry
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. |
