New York Times, September 24, 1998, print version.
Text in brackets [ ] is from online version. Not all differences are noted.
By Gretchen Morgenson
The Federal Reserve Bank of New York has helped organize the rescue of a large and prominent speculative fund, indicating that regulators recognize that such speculators are an increasingly significant factor in world markets. [...that regulators recognize that the failure of such a fund would damage already fragile world markets.]
Under an agreement reached late yesterday, the fund, Long-Term Capital Management L.P. of Greenwich, Conn., which is said to be have a portfolio worth $90 billion, received a cash infusion of more than $3.5 billion from a consortium of commercial banks and investment firms. [The fund, whose founder is John Meriwether, a former vice chairman of Salomon Inc., and whose partners included two Nobel prize winners, is said to be have a portfolio worth $90 billion. ]The deal came after representatives of 16 banks and brokerage houses met at the offices of the Federal Reserve Bank of New York in downtown Manhattan.
It is extremely unusual for the Federal Reserve to get involved in the bailout of such a fund, known as a hedge fund, a virtually unregulated type of investment firm, which despite its name, speculates in high-risk trades in markets around the world. A spokesman for the New York Federal Reserve Bank, the biggest of the Fed's 12 regional banks, declined to comment.
But the Federal Reserve Bank's actions show that regulators are deeply concerned about the impact that a liquidation of Long-Term Capital's trades would have on brokerage firms and banks already struggling with huge losses from worldwide market turmoil.
Regulators in the past have encouraged creditors and borrowers to work together to avoid the kind of panic selling of a portfolio that could harm other investors in a particular market. For example, during the downturn in real estate in the early 1990's, the Fed asked banks to work with developers on the ropes. After the stock market crash in 1987, the Fed provided liquidity to securities firms that might have been on shaky ground.
For the Fed to get involved with a speculator like Long-Term Capital's chief, Mr. Meriwether, is an indication that this time around, the asset of greatest concern is not commercial real estate or stocks. This time, it is bonds.
Long-Term Capital has been hurt by the same market developments that have led to losses at many investment firms. As turmoil in Russia grew, culminating with the country's de facto default on some debt and its devaluation of the ruble, investors fled risky securities. Many took refuge in the United States Treasury market, where prices surged, driving yields to record lows.
This confluence of events hurt Mr. Meriwether, who had been a big buyer of riskier bonds; adding insult to injury, the firm had also sold Treasury securities as a hedge for its non-Treasury bond holdings. When Treasury prices rose, Mr. Meriwether wound up on the losing end of both sides of his trades.
The Fed may have been prompted to act quickly on Long-Term Capital's problems because it realizes that many of the world's hedge funds and most of the big brokerage houses have billions of dollars in trades on their books that are identical to those skewering Mr. Meriwether.
"The Fed is aware of the precarious position that exists among the largest dealers who have positions in virtually every fixed-income product versus Treasuries," said one trader, who spoke on the condition of anonymity. "If Long-Term Capital had to take off its trades, all the hedge funds and dealers would be killed."
Why? Because having a seller liquidating billion-dollar positions in these markets would drive them even lower than they now are. This could cause other failures among hedge funds and make dealer firms' losses increase, causing another wave of selling.
And like many hedge funds, Long-Term Capital made its bets on borrowed money. At times, the value of its positions exceeded its capital by 50 or 100 times. Recently, for example, Mr. Meriwether's firm was said to be holding positions worth $90 billion, while its capital stood at $2.3 billion.
Even without panic selling, things have been bad for Long-Term Capital since August. At the beginning of the year, the firm had around $4.8 billion in capital. By Sept. 2, that capital had dwindled to $2.3 billion.
His losses rising, Mr. Meriwether wrote a three-page letter to his investors. He explained that his fund was down 44 percent in the month of August alone and was off 52 percent for the year. Some 82 percent of the losses came in so-called relative value trades, a specialty of Mr. Meriwether's, which identify small price differences between, say, a futures contract on a particular bond and the security itself. The remaining 18 percent was lost in trades in which Long-Term bet on a certain issue, up or down. Included in this group were losses in emerging markets, including Russia.
In the letter, Mr. Meriwether affirmed his belief in the trades his firm had made and called the market environment "unusually attractive". [quote omitted in online version.] He asked investors to consider making additional investments to the firm.
By all accounts, no one did. Indeed, at about this time, the firm went to Soros Fund Management asking for an infusion of $500 million. The request was denied.
In the weeks since Mr. Meriwether wrote his letter, the market has hammered Long-Term Capital relentlessly. Treasuries have kept rising and all other debt has continued to lag. Even if he did not try to liquidate some of his trades, having to mark his positions to market each night [having to assess the value of his portfolio each night, as all funds are required to], meant that he did need to put up more capital. [meant that his paper loses required more capital].
It was no surprise, then, that in recent days, bond traders have suspected Mr. Meriwether and his associates of trying to unload some of their holdings to meet margin requirements. Last Friday, for example, Long-Term Capital bought a number of Treasury futures to liquidate one side of a huge trade. The buying moved the spread between the futures and the so-called cash market in that particular issue by one-quarter of a point, an enormous move in the world's deepest, most liquid securities market.
Terms of yesterday's bailout were not given. But bankers say that the institutions -- including Goldman, Sachs, Merrill Lynch, Morgan Stanley Dean Witter, J. P. Morgan, Chase Manhattan and UBS of Switzerland, among others -- agreed to put up roughly $250 million each in return for an equity stake in Long-Term Capital.
It is believed that existing equity holders, also known as limited partners, would end up with a greatly diminished ownership in the firm, between 10 and 20 percent of their original stakes. A spokesman for Long-Term Capital declined to comment on yesterday's developments.
Mr. Meriwether, of course, has faced adversity before. He left his position as vice chairman of Salomon Brothers in 1991 after Paul Mozer, one of the firm's Treasury traders, was caught trying to corner the market in two-year Treasury securities. Mr. Meriwether formed Long-Term Capital in 1994, along with the Salomon Brothers alumni Lawrence E. Hilibrand and Eric R. Rosenfeld, and Robert H. Merton and Myron S. Scholes, both Nobel laureates in economics.
With its stable of star traders, Long-Term Capital attracted money from banks, brokerage houses and wealthy individuals, all of whom agreed to lock up their investments until at the earliest, the end of this year.
Even if Long-Term Capital rides out this storm, the world of hedge funds will probably never be the same. Many investors will likely flee all such funds, and regulators will probably scrutinize their operations a lot more closely. Mr. Meriwether himself will be under the scrutiny of an oversight committee appointed by the banks that bailed him out.
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