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Game theory in the popular press.

The Brightest and the Brokest

A high-flying hedge fund collapses. But it owes so much to lenders that the Fed organizes its rescue

John Greenwald
5 October 1998
Vol. 152 No. 14
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Washington and Wall Street buzzed last week with outraged talk of "moral hazard," and for once it had nothing to do with Bill Clinton's sex life. Instead people were talking about the danger created when government backing for private lenders encourages them to take bigger risks--in search of bigger rewards. That danger was demonstrated in dramatic fashion when the Federal Reserve had to engineer the rescue of Long Term Capital Management, a high-flying hedge fund that as recently as August controlled high-risk, global investments worth more than $120 billion--enough to buy all of AT&T.

Though the partners and investors in Long Term Capital are sophisticated and wealthy (the minimum price of admission was $10 million), Federal Reserve officials feared letting them go bankrupt. So many of the nation's biggest banks and brokerages had loaned so much money to Long Term Capital that its collapse could have severely damaged those lenders, forced a spiral of securities sales and shaken confidence in the already wobbly world financial system. Long Term Capital, if not exactly too big to fail, loomed too large on the balance sheets of institutions like J.P. Morgan and Merrill Lynch.

Supporters of the bailout stressed that the Federal Reserve only facilitated the deal, and that the $3.5 billion in rescue capital came from 16 large banks and brokerages, rather than from taxpayers. Yet the critics pointed out that the rescuing banks are backed by taxpayers through federal deposit insurance. Moreover, they enjoyed that federal backing while throwing the money at Long Term Capital that enabled it to pursue its exotic--and, for three years, very profitable--speculations. "Why should the weight of the Federal Government be brought to bear to help out a private investor?" demanded former Fed Chairman Paul Volcker. "It's not a bank."

Last week's bailout raised twin fears in Washington and on Wall Street as tall as Manhattan's Twin Towers. The first: that Long Term Capital's financial troubles are shared by many of the country's 4,000 hedge funds--lightly regulated and often secretive, high-risk vehicles for sophisticated investors. The banks and brokerages that have loaned them money could be carrying big and undisclosed potential liabilities. If those lenders get caught in a cash squeeze, they could respond by cutting back on lending, even to low-risk borrowers.

The second fear is that the Long Term Capital bailout could encourage banks to make still more risky loans, confident that the government won't let them get into trouble. In this regard, the rescue was rich in irony: it came as the Senate passed a bill that would make it harder for ordinary citizens to seek bankruptcy-court protection from banks and other creditors.

John Hsu, whose investment company manages some $500 million in assets, observes that "given all the losses that U.S. banks suffered in the late 1980s and early 1990s, you would think they would remember what went wrong." Concurs Ken Guenther, executive vice president of the Independent Bankers Association of America: "Why wasn't the Fed blowing the whistle on these totally inappropriate, crapshoot investments by some of the biggest banks in the country?"

Such outrage was mingled with shock that a star-studded fund like Long Term Capital, whose seasoned investors had nearly doubled their money from 1994 to 1997, could have got so deeply in trouble. The fund was headed by legendary trader John Meriwether, who helped make Salomon Brothers the top bond house of the 1980s, as recounted in the best seller Liar's Poker by Michael Lewis. The partners, who worked out of waterfront offices in tony Greenwich, Conn., included Nobel-prizewinning economists Myron Scholes and Robert Merton and former Fed Vice Chairman David Mullins. As their price for the bailout, the creditors acquired a 90% stake in the fund, which effectively removed Meriwether and his partners from power. But huge management fees that the partners have collected could still leave some ahead of the game by tens of millions of dollars.

Last week's rescue was particularly embarrassing for Fed Chairman Alan Greenspan, who just two weeks ago assured Congress that hedge funds "are strongly regulated by those who lend the money. They are not technically regulated in the sense that banks are, but they are under fairly significant degrees of surveillance." On the other hand, Treasury Secretary Robert Rubin, a former co-chairman of Goldman Sachs, had put out a word of caution, saying that "people who extend credit tend to get a little less careful" in good times.

Star-struck lenders had virtually showered money on Meriwether and his band of supposed geniuses. While the term hedge refers to techniques for reducing risk, funds such as Meriwether's often do just the opposite by using vast sums of borrowed money to make highly speculative bets in global markets. At the peak of its borrowing, the secretive fund reportedly carried a debt load 100 times as great as its net assets, or ownership capital. This would be like putting down $1,000 of your own money to buy a $100,000 house--in a flood plain on the San Andreas fault. "Most hedge-fund managers believe that a leverage ratio in excess of 50 to 1 is exceptionally large and very risky," says Hunt Taylor, executive director of Tass Management, a hedge-fund consulting firm.

But Wall Street insiders say what really spooked the Fed was indications that Long Term Capital had off-balance sheet derivative contracts with a value of more than $1 trillion. Derivatives are financial instruments that bet on the future direction of interest rates, stock indexes or currencies. Defaults representing less than 1% of that whopping sum could have sunk the fund and punished banks and investment firms around the world.

Why did Long Term Capital suddenly lose money after years of winning? Short answer: the fund's investing formulas were blindsided by the financial meltdown that has spread so rapidly from Asia to Russia and Latin America. In essence, Meriwether's computers were programmed with historical relationships among various global bond yields and other financial instruments. They looked for discrepancies in those relationships and bet that they would return to their historical norms. But the deepening global crisis caused a flight to the safety of U.S. Treasury bonds, which drove up prices that Meriwether's computers said should be falling. The resulting losses chopped Long Term Capital's net worth from $4.8 billion in January to just $600 million last week.

In a Sept. 2 letter to investors, Meriwether called for patience and said the fund was "seeking to raise additional capital." Among those reportedly approached was George Soros, head of the $10 billion Quantum hedge fund, who spurned a request for a $500 million cash infusion. It was also rumored that billionaire investor Warren Buffett might help.

With the fund collapsing, a Who's Who of Wall Street bankers and brokers feverishly huddled for two days on the 10th floor of the Federal Reserve Bank of New York City last week to draw up a rescue package. Among the princes present: Merrill Lynch chairman David Komansky, Travelers Group chairman Sanford Weill, and Goldman Sachs senior partner Jon Corzine.

In the end the banks and investment firms had little choice but to put up the money. Bert Ely, president of a financial consulting firm that bears his name, observes that the lenders "want to avoid a fire sale" of fund assets.

Some congressional leaders were clearly uncomfortable with the lack of disclosure of the dangers posed by bank lending to hedge funds. Says House banking chairman Jim Leach, who plans to hold hearings in the next week or two: "The question that remains for the economy is what other risk exists in the hedge-fund and derivatives industries." The answer, of course, is of vital interest to U.S. taxpayers as well as to investors. Talk of "moral hazard" will thus remain a hot issue from Washington to Wall Street and Main Street.