[PEN-L:251] Hedge fund bets exceeded 1.25 trillion dollars

[Louis Proyect <lnp3@xxxxxxxxx>]

September 26, 1998

Hedge Fund's Bets Top $1.2 Trillion

By JOSEPH KAHN and PETER TRUELL

The 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, Barings faced 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.

Copyright 1998 The New York Times Company




Louis Proyect
(http://www.panix.com/~lnp3/marxism.html)