September 26, 1998

Hedge Fund's Bets Top $1.2 Trillion

By JOSEPH KAHN and PETER TRUELL

he speculative investment fund rescued by a consortium of Wall Street banks this week made complex bets on international financial markets with a total value drastically higher than previously estimated, financiers who studied its books said Friday.

They said the fund, Long-Term Capital Management, used its $2.2 billion in capital from investors as collateral to buy $125 billion in securities, and then used those securities as collateral to enter into exotic financial transactions worth $1.25 trillion.

Long-Term Capital's portfolio had been previously estimated at $90 billion.

Using such a small amount of money to gamble on transactions worth far more is extraordinary even in Long-Term Capital's risky world of hedge funds, the largely unregulated pools of investment funds now receiving increased Government scrutiny. How and why bankers who dealt with Long-Term Capital allowed it to make such astonishing bets remains unclear. [News analysis, page B1.]

The financiers who studied Long-Term Capital's books said the hedge fund had sold some positions since the end of August, reducing the total size of its holdings. Before it was taken over by the consortium of banks and brokerage houses Wednesday, Long-Term Capital also used up much of its capital base to pay loans. Those people said the hedge fund's capital base had shrunk to $600 million and its securities holdings to about $100 billion before the creditors took control of the fund with a $3.5 billion bailout package.

But the look at the accounting books of Long-Term Capital at the end of August provides a glimpse into its operating style.

It also shows the extent to which the hedge fund's backers, including many of the leading Wall Street investment banks, allowed the fund's star manager, John W. Meriwether, to amass such an enormous speculative portfolio.

In part because of Long-Term's Capital huge exposure to financial markets, and worries that a collapse could destabilize financial markets around the world, banks that did business with the fund elected to arrange a bailout and assume control of it rather than let the fund fail.

Some Wall Street executives said the total quantity of securities held by Long-Term Capital would have been difficult to sell. That is especially true since the securities were used as collateral for the $1.25 trillion in derivatives and forward contracts, in many cases bets on the direction of interest rates and bond prices.

The fact that Long-Term Capital took huge risks through derivatives and forward contracts does not mean that its collapse would have resulted in losses equivalent to their total value. But the sheer size of the fund's bets made them difficult to unravel,without unsettling the markets that Meriwhether gambled in. Especially when the market is moving against the trades, as they were in Long-Term Capital's case, selling its derivatives and futures contracts might have proven prohibitively costly for the banks that had money at stake.

To offer a comparison, when the venerable British investment bank Barings P.L.C. collapsed three years ago, a rogue trader in its ranks had gambled on changes in prices of Japanese Government bonds and the direction of Japanese interest rates through financial instruments worth$30 billion. When the bonds and interest rates moved in the other direction of the bets Barings had made and those contracts tumbled in value, Baringsfaced losses of $1 billion and collapsed.

Long-Term Capital's total exposure to financial market bets was about 40 times that of Barings and it did not have much more capital than Barings did.

In a further sign of the Government's concern over how Long-Term Capital's near-collapse happened, Treasury Secretary Robert E. Rubin announced late Friday that United States agencies responsible for supervising financial markets would conduct a study on hedge funds and their relationships with creditors.

In a statement issued after markets had closed, Rubin said the Treasury Department had been closely following developments related to Long-Term Capital. Congressional Republicans also announced they would hold hearings exploring all aspects of the hedge fund industry, including regulation and supervision.

In comments earlier Friday, Rubin disputed the idea that hedge funds should be regulated like banks and put under some form of Government control. "I don't think it is a question of reining people in," Rubin told reporters in Washington. But he said Long-Term Capital's situation had raised some concerns.

"There are questions about disclosure and other issues, and my guess is there will be a lot of discussion and debate about that," Rubin said.

The fallout from Long-Term Capital's near collapse extended to Europe, with Dresdner Bank A.G. of Germany and Crédit Suisse Group of Switzerland detailing losses from investment firm, which is based in Greenwich, Conn.

But neither had exposure comparable to UBS A.G., Europe's largest bank, which took a $689 million charge against third-quarter earnings to write down its stake in the hedge fund, an adjustment that will probably cause the bank to post a loss for the quarter.

Some European markets were also off sharply. United States stock markets fell in early trading but recovered to post a solid gain. Investors were nervously watching developments to determine whether other big players in the universe of 3,000 hedge funds, many of which had bond market positions not unlike those of Long-Term Capital, would face pressure from banks to sell securities to pay off margin loans, potentially weakening the already-fragile world bond market.

Peter Bakstansky, a spokesman for the New York Federal Reserve, which arranged the private-sector rescue of Long-Term Capital, was cautious when asked if there might be other hedge funds that were at risk or if the bailout of Long-Term Capital had succeeded. But he indicated that initial signs were good. "The firm is operating," he said, "and the market reaction at this point seems to be reasonable."

The New York Fed pulled together the consortium of private banks and brokerage houses early this week to rescue Long-Term Capital. Fed officials said they feared that a sudden liquidation of the hedge fund's holdings might send shock waves through the world financial system.

But the Fed's quick action to save the hedge fund from collapse has raised other questions. Some Wall Street bankers say privately that they felt strong-armed by the Government into putting up the $3.5 billion for the bailout. Bakstansky, the spokesman for the New York Fed, denies this, saying some banks chose not to participate in the bailout and that the Fed had no way of forcing them to partake.

But perhaps the main question raised early on in the takeover of Long-Term Capital was how so many well-regulated and risk-conscious banks could have leant so much money to a single speculative investor, albeit one with a stellar track record for producing outsized return in recent years.

Even if hedge funds escape direct regulation as a result of the Long-Term Capital bailout, regulators seem certain to scrutinize the links between banks and hedge funds. Banks provide much of the capital the hedge funds need to take highly leveraged positions in stock, bond and currency markets.

The Financial Services Authority of Britain has ordered 55 banks and other financial institutions to provide information on their exposure to Long-Term Capital and to other hedge funds. Swiss bank regulators asked UBS for details about its involvement in Long-Term Capital.

The consortium of financial institutions participating in the rescue announced Friday that the duration of their recapitalization was three years, suggesting that they expected a slow resolution of the firm's trading positions.

An oversight committee is being formed at the direction of the consortium to include representatives of Goldman, Sachs; Merrill Lyunch; J. P. Morgan; Morgan Stanley Dean Witter; Travelers Group, and UBS.

The oversight committee, which now controls 90 percent of the equity in Long-Term Capital, has assumed authority over all aspects of the fund's operations.