World of speculation/ Crisis clarifies risky operations of hedge funds
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By Junichi Miura
Yomiuri Shimbun Correspondent
NEW YORK -- On Sept. 23, New York Federal Reserve Bank President William McDonough cut short his trip to London and returned to New York, secretly calling together top executives from 14 leading banks and securities houses that represent Wall Street, including J.P. Morgan, Chase Manhattan, Goldman Sachs and Merrill Lynch.
During the hastily arranged meeting, McDonough asked the executives to cooperate in extending funds to bail out a financially troubled U.S. hedge fund, Long-Term Capital Management LP (LTCM). He reportedly emphasized the need to prevent New York from triggering a global financial crisis.
In the past, U.S. monetary authorities have not resorted to the so-called convoy system to protect financial institutions, and they have even been critical of bank bailouts by their counterparts in Japan and other countries.
Heated discussions at the meeting continued until late that evening, with the U.S. monetary authorities taking the unusual step of becoming a go-between to rescue a group of speculators, rather than a financial institution.
The plight of the LTCM made it increasingly apparent that the leading U.S. and European banks and securities houses have been heavily exposed to hedge funds by investing in them or lending to them to a far greater extent than had previously been thought.
Should the LTCM collapse, those financial institutions would suffer major damage, with their loans and investments becoming unrecoverable, which would in turn trigger a global financial crisis.
The executives of the financial institutions accepted McDonough's appeal and agreed to extend emergency loans totaling 3.6 billion dollars to the LTCM.
These prestigious banks and securities houses had invested heavily in the LTCM, but not because they swallowed its publicity campaign boasting of the two Nobel economics laureates on its staff. Instead, they did so because of the hedge fund's impressive performance.
The LTCM, run by John Meriwether, a former bond whiz kid at Salomon Brothers, boasted high returns on its fund management--as high as 46 percent in 1995 and 41 percent in 1996.
Wooed by such high returns, even Italy's central bank had invested as much as 250 million dollars from its foreign currency reserves.
The crisis at the LTCM has made clear the true nature of the often mysterious workings of hedge funds and the high risks involved. The secret of hedge funds' high returns on investments lies in their peculiar system of operation.
As the Cold War came to an end, physicists specializing in rocket technology and in calculating the trajectories of ballistic missiles at the U.S. National Aeronautics and Space Administration found new jobs at hedge funds and brushed up their skills in financial dealings using advanced mathematics.
Hedge funds use computer-assisted hedging techniques, analyzing data from economic and market indicators, to work out the most profitable way to buy and sell such financial commodities as government debt.
The Quantum Fund, run by U.S.-based speculator George Soros, calculates the difference between the theoretical value of currency and shares, based on the economic fundamentals of certain countries, and their current market value. When the fund determines that the market value is overrated compared with its theoretically derived value, it sells off its shares in that market. As prices then fall, the fund buys back into the market, earning sometimes huge profits.
Soros leaped to world fame in the autumn of 1992 when he earned a massive amount from his speculative selling of the British pound. At that time, he noticed that the high value of sterling was at odds with the country's weak economic state, since under the European Monetary System the currency was only allowed to fluctuate within a fixed range.
Sensing a once-in-a-lifetime opportunity, Soros instructed his team to take a big risk on pound trading, and in the process, reportedly earned 1 billion dollars.
Hedge funds are known for making leveraged investments, in which a relatively small amount of capital is invested to return possibly huge profits.
In the case of LTCM, the value of capital deposited at the fund was about 4 billion dollars, while loans from banks and other financial institutions totaled 125 billion dollars.
By using these funds as deposits and fees for futures contracts, the fund was handling derivatives trading worth 1.25 trillion dollars--which exceeds China's total gross domestic product.
While returns on successful fund management are high, losses from mismanagement can also rapidly spiral downward.
In preparation for a possible financial crisis in Russia, LTCB had its portfolio of investments diversified so as to limit any possible losses. However, the fund suffered an instant loss of 3 billion dollars, which was far in excess of the computer-assisted risk-management models produced by the fund. The fund fell into a trap, as it relied too heavily on computer-assisted fund management.
The value of portfolios managed by hedge funds is currently estimated at 300 billion dollars. The scale of derivatives transactions made on the basis of this amount of capital is hard to measure.
As organizations such as pension funds, which are typical hedge fund clients, compile their financial statements for 1998, many hedge funds have a sizable amount of assets that mature at the year-end.
While the results of fund management are due to be disclosed at the year-end, rumor has it that many hedge funds could be on the brink of collapse due to portfolio mismanagement.
Should their clients rush to cancel their fund management contracts with hedge funds, the latter, as well as the financial institutions that invest in or lend to them, could be heavily hit, which may send a shock wave through the financial market, which had become ever more unstable.
(With reporting by Yomiuri Shimbun Staff Writer Hirohisa Sakamoto) |
