On 24^th August 1998, the Federal Reserve Bank of New York summoned in 14 banks to set an emergency bailout fund to rescue the failing hedge fund Long Term Capital Management P L (LTCM). Fed refused to call this a bail out, for it did not involve public fund, and that the Fed took the lead mainly for the sake of preventing destruction in America and World economy. Is it true? The banks that include in this bail out participation were, Goldman Sachs, Merrill Lunch, Morgan Stanley Dean Witter, Travelers group, UBS, BT Alex Brown, J.P. Morgan, CS First Boston, Salomon Smith Barney, Barclays Capital, Deutsche Morgan Grenfell, Chase Securities, Societe Generale, and Lehman Securities. It was quoted in the Daily Telegraph that, in August when Russia devalued its Ruble and defaulted its bonds, LTCM had already faced the problem. At that time, Goldman Sachs and AIG put together a rescue package for LTCM and had the backing from LTCM Chairman John Meriwether. It is understood that Goldmans needed AIG’s AAA-rated balance sheet to carry the positions. Bankers say the positions would have been bought at a discount to LTCM’s capital base and it was quoted by the Telegraph as saying: "If Goldman had pulled off this deal, it could have overseen the orderly liquidation of LTCM’s positions, possibly in secret. It might just have managed to save its flotation if it had done so." Unfortunately, the deal did not go through, mainly due to the side stepping by another bank to approach the fund and the called off by Goldman on its plans to go public. It was on this failing rescue by the private banks that Fed had stepped into picture.

How LTCM failed in its operation?

According to a report, LTCM had share capital of about $5 billion but had left about $2.2 billion under management at the end of August. With this as a base, they received bank loans over $40 billion, which they used for securities worth $125 billion. The managers then used those securities to build up investment positions over $1.25 trillion via financial transactions, such as option writing, spread trading and futures etc.

LTCM is a hedge fund that involved mainly in bond’s spread trading, they usually have long position in one country and short position in the other to take advantage in interest rate movement. As they involve in interest rate spread and arbitrage trading, it is considered less risky than outright positions taken by hedge funds such as Tiger and Quantum Fund, this explain why LTCM can leverage up to such a frightening high level of 1,000 times. The firm did well, with returns of 42.8%, 40.8% and 17.1% in its first three years. Big profits were possible because LTCM was highly leveraged. A mere 5% profit in its operation would have doubled its original paid-in-capital. But leverage works two ways. When investments go sour, modest capital is easily impaired, even wiped out. 

In August’98, Russia devalued its currency, Ruble, and called on default its bonds and short term debts payment, this was exactly where the problem of LTCM began. When LTCM was long in Russia’s Bonds and short in U.K. Gilts and U.S. Bonds, its positions started to go against him. First, the default of Russia’s Bonds had made the holding of LTCM’s Russia bonds as good as no value. This immediately created a margin call for LTCM to top up. Second, U.K. and U.S. interest rate continued to soften, as such the Gilts and Bonds price had gone up further. The short positions by LTCM on these instruments had caused further losses to them. The $3.5 bn injection by the fourteen banks was therefore needed to meet LTCM’s margin call, so as to stay in its portfolio.

In mid to late September, several US houses had been seen as big buyers of Gilts, which market talk suggested that it was linked to the unwinding of LTCM’s short positions. According to the Sunday Business, a six banks committee had been charged with liquidating LTCM’s positions. On 28^th September, there was talk in the swaps market that one US house moving UK spreads just by asking for 10-yr offers in size. Apparently, the market was worried that the house either had knowledge of LTCM’s positions or was charged with liquidating some of them. Such talks had certainly made the market even more jitter. The short-term worries for LTCM are mainly two folds. First, the injection of $3.5 bn from the 14 banks looks more like to serve as a margin call then any other purposes. Will there be any subsequent margin call fall due? If there is, are the banks prepared to continue to support the bail out? Second, will LTCM’s shareholders panic on the fund performance and ask for early redemption? Hope these factors had been taken into account when the banks injected the $3.5 bn bail out.

Implications

1. Could LTCM be just the start of a downfall for many to come?

   In a global derivatives market of about $30 trillion, hedge fund have been in control of about $3 trillion (this has not taking into account the amount hold by banks’ own treasury department) therefore any failing in hedge fund operation will have a great impact to world economy. Out of a total of 4,000 hedge funds operate in the financial world, there are quite a few actually operate similar to what LTCM has been doing. If a reputable and good track record hedge fund like LTCM can fail, I am sure there will be many more to come. Banks who have involved in the financing of these hedge funds may become more prudent and require them to put up additional margin. This will force hedge funds to liquidate some positions to reduce their commitment, which create further panic in the market. There is thus a risk that other hedge funds will fail and will be forced to dump their holding, causing new dislocations. As for hedge funds’ shareholders, usually they have a mandate not to redeem their units unless a notice of at least three months period has been given to the fund. This means a time bombs where panic investors rush to redeem their units has yet to occur, and this could be a potential crisis to the world economy. Like what Mr Alan Greenspan had said, hedge funds may eventually prove to be self-destructive in the future.

2. Could this be another crisis that adds to a further world credit crunch?

   Since July’98, the stock markets in Asia had lost about $2 trillion in their market capitalization. Other assets in Asia, such as properties, had lost another $1 trillion due to the falling price in these assets. Between Jan’98 to August’98, Wall Streets market capitalization had shrunk from $11 trillion to $9 trillion, a drop of $2 trillion within eight months. During this period, Russia and Latin America markets were hit badly and the European markets corrected a fair bit too. If we sum up the amount of damage it has been done since July’97, the world’s wealth has actually evaporated more than $8 trillion over a period of one and a half year, this has never happened in our history. Now, there is a crisis in hedge funds, those banks that had badly beaten in Asia, are now facing a potential bad debt from their lending to the funds. These financial institutions may have to resort into prudent lending policy to protect their own assets and inevitably causing tight liquidity in the financial world.

   Some questions may be raised in this shocking event. First, with the continue high leverage employed by hedge funds in their operation, could emerging countries with small reserve on hand capable of preventing the speculative attack by the fund? Second, giving that the Federal Reserve Bank of New York has stepped out and organized this bailout (at least indirectly). Will this give incentives for other financial institutions to continue this type of absurd lending? Last but not least, why Federal Reserve has been so unwilling to impose control to these hedge fund and is always in denial that such activities by the fund has actually contributed to part of the world financial crisis? Perhaps hedge funds have grown too big for Fed to impose control now, or could it be this is part of Fed ….. ? Anyway, your guess will be as good as mind.