September 25, 1998

Hedge Fund Bailout Rattles Investors and World Markets

By GRETCHEN MORGENSON

EW YORK -- The $3.5 billion rescue of a big, risky investment fund verging on collapse unnerved markets around the world Thursday, raised a clamor for a government investigation and created fear that other enormous hidden losses might become evident in the weeks and months ahead.

Rather than contain the problem and bring stability to Wall Street, the cash infusion late Wednesday by a consortium of banks and brokerage firms to salvage Long-Term Capital Management LP only seemed to rattle investors. Banks began to tighten lending requirements to other investment funds, raising fears of a credit shortage.

U.S. stocks fell broadly, with the Dow Jones industrial average losing more than half its 257.21-point gain on Wednesday. Shares of financial stocks were particularly hard-hit.

Long-Term Capital, with a portfolio worth $90 billion, is one of the best-known hedge funds, financial investments that cater to the rich and make big and often risky investment bets with the hope of spectacular returns. The recent turmoil in financial markets, particularly the collapse in Russia, led to staggering losses for Long-Term Capital.

Investors tried to absorb not only what had happened to Long-Term Capital and its founder, the Wall Street bond trader John Meriwether, but what the deal to salvage the fund meant for markets now.

As details of Long-Term Capital's fall to earth began to trickle out and the shock among traders, brokers and bankers began to fade, worry set in. Members of Congress called for an inquiry into what went wrong and resentment grew that an elite firm, populated by industry stars and two Nobel laureates, was saved from a disaster of its own making.

By midday, it was clear that Long-Term Capital's problems were not going to be confined to the firm and a few high-roller investors. The ripple effect started with UBS AG of Switzerland, Europe's largest bank, which said its risky investments with Long-Term Capital and ownership stake in the fund would result in an accounting charge equivalent to $685 million against the bank's earnings. Its stock fell 10.8 percent.

Of deep concern to the financial world is what impact the fund's debacle will have on worldwide bond markets, which have already been badly shaken by events in emerging markets in the last two months. Fear of a pullback in lending by major financial institutions also grew Thursday, as banks were awakened to the risks in their previous easy-money attitudes toward borrowers. If difficulty in borrowing money lasted more than a few weeks, it could cause a significant slowdown in the U.S. economy.

The implications of Meriwether's troubles are great for hedge funds, which operate relatively freely in world markets with little oversight from regulators. Many believe that Long-Term's near-collapse and its effective takeover by big banks and brokers will translate into increased client nervousness and rising redemptions of shares at other firms. For funds operating in the already damaged bond market, redemptions would cause a continued drop in the value of those portfolios. And if some of these areas sustain further damage, like high-yield bonds, heavy redemptions could damage plain-vanilla mutual funds.

Finally, there is worry on Wall Street that the debacle will bring increased scrutiny by regulators to hedge funds. Rep. John LaFalce, D-N.Y., the ranking minority member of the House Banking Committee, said Thursday that "the virtual collapse and bailout of Long-Term Capital Management makes clear that the banking committee must continue its inquiry into potential risks posed by any gaps in the regulation of hedge funds." He said he would call on Rep. Jim Leach, R-Iowa, the chairman, "to do precisely that."

The specter of Long-Term's near-failure is not going away any time soon. Indeed, it will dog the financial industry through at least the end of the year. Traders said the possibility that its $90 billion portfolio might be sold would keep much of the fixed-income markets frozen. If the Federal Reserve cuts interest rates next Tuesday, as many expect, that would hurt many of Long-Term Capital's trades, which were bets on higher rates.

An immediate reaction to Long-Term's woes was that major banks and brokerage firms began demanding increased margins, or partial payments from their hedge fund customers on new trades.

Thursday, the details of the bailout were being firmed up. Late in the day, investors in the fund were waiting to hear where they stood. It is expected that existing investors will end up with 10 percent of their original stakes in the firm and that the consortium of banks and brokers will hold a combined 90 percent.

An oversight committee with representatives from the banks will direct overall strategy at Long-Term Capital. In one of the many paradoxes attending the crisis, Meriwether will be reporting to people who were, in some cases, very junior traders on his desk at Salomon Brothers in the 1980s.

In addition to the shock on Wall Street that Meriwether's best-and-brightest firm had almost closed, there was also anger that the firm was not allowed to fail.

"The public-policy implications of such a bailout are considerable and very negative," said Stephen Modzelewski, a hedge fund manager at the Watermark Group in Princeton, N.J., and a former Salomon trader. "To rescue a large, overly risky hedge fund can only encourage other hedge funds to increase their risk profiles to imprudent levels and to discourage global financial institutions from requiring prudent margins from their large hedge fund customers."

A former Federal Reserve chairman, Paul Volcker, also expressed doubt about the idea of the U.S. central bank moving to help save Long-Term Capital, a risk-taking securities-trading operation. Bloomberg News reported that in a speech in Boston, Volcker asked, "Why should the weight of the federal government be brought to bear to help out a private investor?"

A week before the Long-Term bailout was negotiated at the headquarters of the Federal Reserve Bank of New York, Alan Greenspan, the Fed chairman, testified to Congress that bankers knew exactly what they were doing in the policing of hedge funds, and their attendant risks. On Sept. 16, he assured Rep. Richard Baker, R-La., that risk in hedge fund lending was well under control.

The most significant question that remains unanswered is what impact the rescue of Long-Term Capital will have on world markets and on the U.S. economy.

While the deal between Long-Term Capital and its creditors put an end to rumors of impending crisis that had plagued the firm in recent weeks, it did nothing to inject badly needed money into the non-Treasury fixed-income markets. If anything, the fact that the portfolio of money-losing trades still exists added to a view that the market is paralyzed and will remain so for quite some time.

Even though Long-Term says the $3.5 billion infusion will allow it to keep its trades in place until they work, the widespread belief on Wall Street is that these things are for sale. For investors who want to sell their high-yield bonds, emerging-market debt, convertible securities and even some mortgage-backed issues, there is still no place to go. As the year's end approaches and hedge funds and dealer firms in these securities try to get out, the market may get even less liquid than it is now.

Some of the higher-quality markets will likely recover, however, from current, beaten-down levels. This includes AA-rated corporate bonds, some U.S. government agency issues and zero-coupon Treasuries. Riskier issues will stay in the doghouse.

But a great concern that has emerged from the Long-Term Capital debacle is that it may result in a protracted reduction in credit available to businesses. Even though they have been warned by regulators for months, banks tend to require a disaster of this magnitude to awaken to the risks involved in lax lending. Borrowing will be harder to obtain, and to the degree that the economy's growth has been fueled by credit, that growth may now be stunted.

Charles Peabody, an analyst with Mitchell Securities, said he feared a recession in such a credit squeeze. "Regulators are going to go into the examination process at banks and begin identifying specific risk areas and require more capital against them," he said.

Amid the gloom on Wall Street Thursday, there was gallows humor. One trader said he soon expected to see someone wearing a sandwich board that read, "Will Manage Market-Neutral Hedge Fund for Food."