Scale of Fund's Bad Bets Begins to Emerge
Swiss Bank Reports $650 Million Loss; Work on Rescue Effort Continues
By Steven Mufson and Ianthe Jeanne Dugan
Washington Post Staff Writers
Friday, September 25, 1998; Page A01
The magnitude of bad market bets placed by a huge private investment fund began to emerge yesterday as Swiss banking giant UBS AG announced that it lost $650 million in its dealings with the fund and Federal Reserve officials asserted that the $3.5 billion rescue package put together Wednesday was needed to head off disruptions to the world financial system.
Fourteen of the world's biggest financial institutions continued yesterday to negotiate details of the plan, designed to rein in the management and stem losses at Greenwich, Conn.-based Long-Term Capital Management L.P., one of the most aggressive and highflying of the so-called hedge funds, which use borrowed money to wager on movements in currency, bond and stock markets around the globe.
One banker involved in the talks Wednesday said that many of the banks and investment houses had agreed to inject new money into the fund only after the Federal Reserve Bank of New York officials had warned a group of 16 senior Wall Street officials that failure to aid the fund would result in "chaos" in financial markets and damage economic growth worldwide.
The banker said the New York Fed officials were concerned not only about the prospect of losses to institutions that had entered into contracts with Long-Term Capital but also at the prospect of a "domino effect" if the sell-off of about $100 billion in market bets placed by Long-Term Capital triggered financial distress at other institutions.
Though the imminent collapse of Long-Term Capital was averted, world markets shuddered in response to news of the costly package and to the possibility of further losses for major banks. In trading yesterday, bank stocks led a drop of 152.42 points, or 1.9 percent, in the Dow Jones industrial average, which closed at 8001.99, and the dollar fell against the yen over concerns that currencies would be affected by the sell-off of Long-Term Capital's holdings.
In an all-day meeting Wednesday with 16 banks and investment houses held at the New York Fed's offices in lower Manhattan, central bank officials provided constant servings of petits fours, coffee and warnings about the risks to the financial system, according to one banker present. But some Wall Street and financial officials questioned the unusual role of the New York Fed in organizing assistance for an unregulated private investment fund.
"Why should the weight of the federal government be brought to bear to help out a private investor?" former Federal Reserve chairman Paul A. Volcker said during a meeting in Boston. "It's not a bank."
At one point Wednesday, when talks slowed and one participant wondered aloud whether the banks were simply putting "good money after bad," central bank officials said that without a rescue plan the banks' own capital base would eventually be put in jeopardy. "The central bank officials' role was active," said one banker who was present.
"This is the rewriting of the too-big-to-fail doctrine right here," said Roger C. Altman, a former deputy treasury secretary who is now with Evercore Parnters in Manhattan. That doctrine holds that a handful of institutions -- such as Citicorp -- can never be allowed to fail because the entire financial system would collapse. While conceding that the collapse of Long-Term Capital would have had "bad implications," Altman said: "We all had the sense that the doctrine applied to relatively few financial institutions. Few people would imagine it applied to a hedge fund."
Others questioned whether the attention paid to Long-Term Capital was a result of the firm's good connections. Its managers include famed bond trader John Meriwether, two Nobel laureates in economics and David Mullins, former senior Treasury official and former vice governor of the Federal Reserve Board in Washington.
A spokesman for the New York Fed said the size of Long-Term Capital's problems justified the New York Fed's involvement. "These huge numbers are outlandish beyond what anyone could have imagined," he said, referring to the scope of Long-Term Capital's role in international markets ranging from trading in Japanese yen, British pounds and Danish mortgages to U.S. Treasury bills, American stock options, and German, Russian and Brazilian bonds.
The New York Fed spokesman also noted that the rescue package for Long-Term Capital was put together with private investors. "They are putting private money at risk," he said. "There is no taxpayer exposure. . . . Nowhere does it get written that it is protected by the government."
Bankers involved in the Long-Term Capital talks said their goal was to inject enough capital into the fund to convince markets that it wouldn't be forced into a fire sale of its holdings to meet minimum collateral requirements by its creditors. In some markets, Long-Term Capital was such a huge participant that it simply couldn't find buyers for its holdings at any price. Traders of mortgage-backed securities said that yesterday there was already an easing of selling pressure as a result of Long-Term Capital gaining more time to unravel its holdings.
One banker compared Long-Term Capital to a poker player. Its hand wasn't bad, but he said that in order to be a big poker player in Las Vegas, "you're only as good as your stack" of chips. The new money injected Wednesday will give Long-Term Capital more time to play out its hand and wait for the most opportune moment to unwind its holdings.
Nonetheless, bankers and investment houses were stunned at the size of Long-Term Capital's holdings. Many of them thought they were the largest counterparty, or trading partner, for the Connecticut firm, and were surprised to find that there were more than a dozen other institutions holding the other end of similarly big contracts with the firm.
"There was a feeling that Long-Term Capital was not disclosing enough information to its counterparties," one banker present at Wednesday's meeting said.
Many of the banks and investment houses at the New York Fed had placed similar bets on world financial markets, bets that went badly wrong especially after the Aug. 17 Russian default of ruble-denominated debts led to a flight from emerging markets and after the Aug. 31 plunge in U.S. stock markets. But unlike Long-Term Capital Management, the banks and investment houses had bigger capital bases and other sources of income, such as brokerage fees or other long-term loans.
"All Meriwether had was a gym and a trading room," said one banker.
Meriwether, the head of Long-Term Capital, had previously enjoyed a good reputation in the business of bond trading and hedge funds.
Nonetheless, Meriwether came in for heavy criticism at Wednesday's meeting from chief executives, many of whom wanted him ousted immediately from the firm.
Today, the consortium of banks is expected to announce an agreement under which Meriwether and his management team continue to run the corporation, but under the close scrutiny of an "operating committee," which includes one representative from each bank, according to a source close to the talks.
An oversight committee -- consisting of one representative from each of the five banks leading the negotiations, Merrill Lynch, Morgan Stanley, UBS, Travelers and Goldman -- will work full time at Long-Term Capital's Greenwich headquarters and have authority over investment strategies, capital structure, risk management, compensation, hiring and firing.
They will report regularly to a separate board consisting of representatives from each of the 14 banks, of which UBS was the biggest creditor. Eleven banks contributed $300 million apiece. Three banks contributed a total of $300 million. Two institutions, including Wall Street giant Bear Stearns, refused to participate in the rescue plan.
Mufson reported from Washington, and Dugan reported from New York.
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