September 27 1998 sundaytimes
Banks are being forced to find $3.5 billion to save a hedge
fund from a collapse that could threaten the American
financial system. Garth Alexander reoprts from New York
The bankers who met at the Federal Reserve Bank of
New York last week knew they were facing a crisis. They
had been called in by the Fed's William McDonough to
arrange a bail-out for Long-Term Capital Management
(LTCM), a highly borrowed hedge fund facing imminent
collapse.
What the bankers did not know was the size and nature
of LTCM's problems, and how seriously its collapse
would affect America's financial system.
For a moment on Wednesday morning the bankers
thought they had found an easy solution. The meeting
was temporarily adjourned on the news that Goldman
Sachs had lined up a buyer - thought to be Warren
Buffett. But by early afternoon it was clear there was no
buyer, and the bankers, who had already lent billions of
dollars to LTCM, were told they would have to inject
$3.5 billion into the company to prevent what a Fed
official called "the potential paralysis of the global
financial system".
One investment banker, James Cayne, the head of Bear
Stearns, categorically refused to join the bail-out,
claiming that as LTCM's clearing agent he was already
exposed to a risk of more than $500m. Other bankers
haggled over their contributions to the rescue package.
Some called for LTCM's liquidation, arguing that selling
its $80 billion of assets would not drive down asset
prices, cause panic selling by other institutions and
create a global crisis.
Nobody really knew if it would or not. LTCM, run by John
Meriwether, a legendary former Salomon bond trader,
had always conducted its business in great secrecy,
telling its investors and lenders nothing about the
complex, computer-calculated positions its high-powered
team of scholarly traders took in derivatives and futures
contracts. None of the bankers could be sure what
damage might be done by forcing Meriwether suddenly
to unwind his worldwide contracts.
Finally, Salomon Smith Barney's Jamie Dimon argued
that, because it was impossible to know how big the
risks were, it was better for the banks to join the bail-out
and avoid the chance of precipitating a catastrophe.
The banks eventually agreed to put up $3.5 billion, and
take over 90% of the fund.
AS the shockwaves from the LTCM debacle swept
around the world - prompting a fall in many stock
markets and a tumble in the dollar (which sank to $1.70
to the pound on Friday) - bankers began to worry that
there may be other large hedge funds on the verge of
collapse.
What makes the situation so scary is that so-called
"quant" or quantitative funds, such as LTCM, are able to
assume an amount of risk that is far greater than their
capital. In late August, with a capital base of $2.3 billion,
Meriwether controlled assets of $125 billion. Some
bankers believe that by using off-balance-sheet swaps
and other instruments, he may have managed to
leverage his assets earlier this year to nearly $400
billion, more than 100 times LTCM's capital.
Many of his investment decisions were made on the
assumption that American interest rates would rise.
Following the collapse of the Russian economy and a
general flight to quality - which meant a move into US
treasury bonds that has forced interest rates lower -
Meriwether found himself facing margin calls from his
bankers, and has been forced to par down his positions
and his capital. Last week LTCM had only $600m in
capital left.
Hedge funds are inherently risky. They are largely
unregulated investment vehicles, usually incorporated in
the Caribbean or other offshore locations. Under
American law, only rich people or institutions are allowed
to invest in them; LTCM accepts no investment under
$10m and will not return investments for at least three
years.
The Fed's intervention in LTCM's bail-out has sparked a
debate over whether the American government should
have any role in rescuing hedge funds, even if it does
not (as in this case) inject any public funds. One of the
strongest critics of the Fed's action is Larry Tisch,
whose CNA Financial has a $10m stake in LTCM. He
told the New York Post: "We have to get away from
creating organisations and then realising that we have
to protect them because of the too-big-to-fail theory. If
you take risk, you should pay for the risk."
Tisch, a billionaire financier, has made a 182% return
on his investment in LTCM. He says he is leaving his
money in the fund and is confident it will recover.
Another critic is Roger Altman, a former US treasury
deputy secretary. He says: "This shows that the risks
inherent in the global capital markets of today are much
bigger than many had thought. The notion that an
institution could have that amount of liability and could
have posed a serious threat to the financial system
connotes a degree of risk that is quite stunning."
Peter Bakstansky, the Fed spokesman, justified the
Fed's role precisely because of that threat. He says:
"We are always interested in the potential for systemic
upset and contagion."
UNTIL now governments in emerging markets have led
the complaints about hedge funds, which they have
blamed for precipitating the collapse of their stock
markets and currencies. But western regulators may
now be forced to consider the risk that hedge funds
pose to their own financial systems.
In America last week several congressmen called for
new regulations to monitor and control hedge funds, of
which there are thought to be about 2,500 with some
$200 billion of capital. But a more pressing need may be
to improve the monitoring and risk assessment of banks
with big exposures to derivatives and hedge funds.
Andrew Smithers, head of an economic consulting group
in London, warns that America's "financial asset bubble"
could be about to explode, dragging down some of its
biggest financial institutions. He believes the main
reason for this is the huge investment in derivatives.
With the increasing concentration of financial risk
among a smaller number of bigger institutions, the
chances of serious bankruptcies "rise day by day".
The latest report of the US Comptroller of the Currency
says the notional amount of derivatives in the portfolios
of American-based banks reached $28 trillion in the
second quarter, and 95% of that was held by the
country's top eight banks. The off-balance-sheet credit
exposure to derivatives of those eight banks stood at
243% of their risk-based capital.
Smithers believes bankers, who hedge (or insure) their
equity investments with options, have failed to take into
account the systemic nature of market risk. He refers to
the underpricing of options as "catastrophe myopia" and
believes the world could be in for a rough time. "I don't
know of any asset bubble that has been followed by a
soft landing," he says.
ON Thursday, Switzerland's UBS said it would take a big
loss in its third quarter because of its exposure to
LTCM. It said it was writing down its previously
undisclosed 15% stake in the hedge fund, resulting in a
charge of 950m Swiss francs (£402m). When asked why
he had trusted the bank's money to LTCM, Marcel
Ospel, the chief executive, said, "Long Term Capital
Markets has always been called the Rolls-Royce of
hedge funds. It has a very successful record. It has an
extremely good team."
Other banks appear to have placed similar trust in it,
although Barclays, under Martin Taylor, and JP Morgan
both insisted on collateralising their exposure (with
secure investments, such as US treasury bills and
cash), and said they have suffered no losses.
Until recently the banks had nothing but praise for
Meriwether. His brilliant team, with two Nobel prize
winners, a former Fed vice-chairman and dozens of
PhDs, had produced stellar returns. The fund returned
42.8%, after fees, in its first year of operation in 1995. It
returned 40.8% in 1996, and 17.1% last year. In
December Meriwether returned $2.7 billion of the $6
billion he was managing, claiming he had "excess
capital" after larger-than-expected returns and high
reinvestment rates. Some of the investors who had their
money returned, including PaineWebber, complained
bitterly at the time. They must be sighing with relief now.
Meriwether, 51, may have lost much of his personal
fortune as a result of the fund's restructuring. Several of
his 15 partners are believed to have been bankrupted.
Meriwether was one of the most successful "Masters of
the Universe" in Salomon Brothers' heyday. He
pioneered Salomon's immensely profitable
bond-arbitrage department, which looked for small
differences in the pricing of bonds around the world and
then took positions on the assumption that the prices
would eventually move into equilibrium.
He recruited a team of top-flight mathematicians and
economists to construct computer models that could
seek out opportunities and calculate the risks, thus
allowing him to make huge and confident bets. His
success spawned imitators throughout the
financial-services industry, and spurred the phenomenal
growth of options and so-called "rocket science"
derivatives.
Michael Lewis, in his book Liar's Poker, described
Meriwether as an icy cold gambler, who once challenged
John Gutfreund, his boss, to a $10m bet on guessing
the serial numbers on a dollar bill. His huge bets on the
trading floor made his team the most profitable unit at
Salomon. But when the firm was implicated in rigging
bids at treasury bond auctions in 1991, he resigned
(even though he was not personally culpable).
Three years later he and some old Salomon colleagues
opened LTCM on Steamboat Road, Greenwich,
Connecticut, an hour's drive north of New York. The new
firm, which pursued the same trading practices he had
developed at Salomon, was quickly dubbed by Wall
Streeters "Salomon North".
It received enthusiastic encouragement from Wall
Street, and was lent money at favourable rates. Many of
Wall Street's biggest bosses, including Merrill Lynch's
David Komansky, Bear Stearns' James Cayne, and
PaineWebber's Donald Marron, put their personal
savings into the fund. Meriwether, according to fund
sources, was almost arrogant in refusing to accept some
investors, particularly those who demanded to know how
his fund made money. He charged a 2% management
fee (1% is normal) and kept 25% of the profits (most
hedge funds charge 20%).
But signs that the models he was using were not -
despite the efforts of his talented designers - making
adequate allowance for the shocks being felt by the
global financial system began to appear last year when
his returns sank to 17% (compared with the 30% rise in
Standard & Poor's 500 index). By May this year he was
caught up in the general collapse of the American
mortgage derivatives market, which, according to some
dealers, may have cost LTCM several billion dollars.
Earlier this month he announced that the fund had lost
$1.8 billion (44% of its capital) in August alone "largely
due to sharp increases in volatility and widespread shifts
towards greater liquidity in global fixed-income and
equity markets". He said these losses "occurred in a
wide variety of strategies involving G7 government
fixed-income markets, equity-related instruments and
emerging-market debt".
Ironically only two months earlier Salomon, now a part of
Travelers Group and merged with Smith Barney,
announced that it was closing its bond arbitration
operation. It said increased market efficiency and small
profit potential had made the operation too risky.
Most of the other big hedge funds appear to be all right.
Lois Peltz, managing editor of the MAR Hedge Fund
newsletter, says: "Most of the 1,200 funds we follow are
doing better than the S&P so far this year. Only 10 have
suspended their funds and are not allowing
redemptions." Soros's $11 billion Quantum Fund is up
9.5% on the year. Julian Robertson's $20 billion Tiger
Fund is up 19%.
III Funds, one of America's most respected series of
funds with $1.9 billion of capital, admits that it faced
$80m of redemptions last week. Its $475m HRO fund
was forced into liquidation earlier this month. If the
markets stay volatile, more crashes will follow.
What is a hedge fund?
Hedge funds are built on leverage. As LTCM's
near-meltdown highlights, the word "hedge" is a
misnomer. With a small capital base, the funds use large
amounts of money invested by clients or borrowed from
banks to place what are effectively huge bets on
movements in currency, bond and stock markets. The
result can be much greater returns than through more
orthodox investment. But the risk of heavy loss is also
much increased.
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