The Star (Maylasia) October 11, 1998
Lesson in hedge fund's near collapse
The recent near collapse and bailout of a large US-based hedge fund has shattered several myths and exposed some facts about the global financial system. Malaysia had long sounded alarm bells about the power and manipulation of highly-leveraged hedge funds and their role in the Asian crisis. Now it is revealed that Long Term Capital Management, with a capital of US$4bil, had borrowed up to US$200bil and taken contracts worth over US$1tril. Its imminent collapse got the US authorities to mobilise a massive bailout, which critics are calling Western crony capitalism. MARTIN KHOR reports.
THE crash of a major hedge fund in the United States has cast a long and threatening shadow over the international financial system. It seemed ironically fitting that the near collapse and bailout of Long Term Capital Management (LTCM) came just as thousands of the world's leading financial statesmen were gathering to ponder over the world's financial woes at the annual meetings of the international Monetary Fund and World Bank in Washington.
For more than a year, Malaysia had led a few of the affected Asian countries to demand that Western nations and the IMF take action against hedge funds to prevent their aggressive speculation from destroying currencies and destabilising economies.
But these calls were brushed aside and even derided. The hedge funds are doing a wonderful job, said their powerful supporters, they help keep the wheels of global finance whirring along.
The events and revelations arising from the LTCM affair have now shattered three things:
THE cloud of complacency and protection that powerful financial authorities of the North had placed over the hedge funds, to deny the potential threat they posed to the global financial system.
THE continuous chorus of denial by the same authorities that hedge funds have the power to move markets, including to attack the currencies of developing countries and wreck their economies.
THE pretence by Northern political leaders and the IMF that failed companies should never be bailed out as this is a cardinal rule of the free market - a message preached by them to developing countries but now breached by the US central banking authority itself. Despite this shattering of myths, it is doubtful the Western authorities will do much to discipline the hedge funds. Or if they do, it might be to reduce the risks of the funds' activities threatening their financial systems.
It is unlikely they will take effective action to prevent the hedge funds making profits from speculating on the currencies or stocks of developing countries.
The news broke on Sept 23 that the Federal Reserve Bank of New York had organised 16 banks to come to the rescue of LTCM, one of America's largest hedge funds.
The fund had equity of more than US$4bil, but due to losses of US$2bil this year it was slashed to US$2.3bil at the end of August and reduced further since.
The banks, many of which had lent to and some had invested in LTCM, pumped in a fresh amount of US$3.5bil capital to keep the firm afloat. Without the bailout, LTCM would have collapsed, and that would have disrupted US financial stability since the fund was at the centre of a huge and intricate web of financial dealings.
The news was shocking as LTCM was managed by an apparently unbeatable team, led by Wall Street whizz-kid John Meriwether and staffed by Nobel prize-winning economists who invented complicated mathematical models applied to financial markets.
Bankers had such confidence in this dream team that they lent massively to and also invested in LTCM.
The second shock was the tremendously high "leverage" (value of loans obtained as a ratio of equity) enjoyed by LTCM.
The Financial Times revealed that the company had built a total market exposure (in credit) of US$200bil earlier this year. Now, it still has an exposure of $100bil.
Since LTCM's capital before its crisis was between US$4bil and US$5bil, this implies its leverage had climbed to over 40 times. In other words, for each dollar of equity, creditors were overall lending it US$40.
But the web of transactions spun by hedge funds goes even far beyond their direct leverage.
"LTCM's notional gross market position, adding together the value of all outstanding derivative and other financial contracts, could be several times that," according to the FT (Sept 28). It has been estimated that the gross value of LTCM's contracts exceeded one trillion dollars.
The high degree of leverage enjoyed by some hedge funds might not have been exposed if LTCM had not faced liquidation, as the funds are secretive and untransparent.
Datuk Seri Dr Mahathir Mohamad had last year attacked the manipulative, speculative methods of hedge funds which he said obtained their financial power through being able to leverage up to 20 times their capital.
At the time, international financial policy-makers paid no attention to this criticism, preferring to blame the Asian crisis on domestic policies.
The revelation of LTCM's leverage of a factor of 40 or more has now lent credence to the Malaysian assertion that hedge funds have the power to dominate movements in financial markets, and that they used that in Asia.
The way the high leverage was obtained was described by the FT (Sept 26-27) as follows:
"LTCM was able to borrow such large sums of money by operating a merry-go-round: assets were used as collateral to borrow money with which more assets were bought which were then used as further collateral to borrow more money, and so on."
Since the lending was backed by collateral (mainly government bonds), the net losses would not have exceeded US$10bil. The FT argues that what was at stake was not so much these direct losses but the indirect losses the banks would have incurred on their own positions if markets had tumbled after the dumping of LTCM'S portfolio.
These indirect losses could have been many times larger and may have caused some banks to tip over. Indeed the financial system could have suffered a seizure. Justifying the bailout, Federal Reserve chairman Alan Greenspan told the US Congress: "Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants ... and could have potentially impaired the economies of many nations, including our own."
But the bailout was not purely to rescue the system. A third shock was the revelation that so many prestigious banks and influential individuals had invested in and had lent to LTCM, thus exposing the close inter-connections between banks, hedge funds and individual financial operators and officials.
Europe's biggest bank, UBS of Switzerland, set aside US$682mil for expected losses from its dealings with LTCM. The Bank of Italy (the country's central bank) disclosed it had invested US$250mil of foreign reserves in LTCM. Sumitomo Bank of Japan had $100mil investment and Dresdner Bank of Germany is expecting a US$143mil loss on its investment.
The US financial authorities and the financial institutions involved in the bailout are now being criticised for practising "crony capitalism" in bailing out not only their own institutions but also their directors, staff and friends who had personally invested in LTCM.
Investment bank Merrill Lynch had an exposure of US$1.4bil to LTCM. According to the FT, the firm's chairman had a personal investment of US$800,000 and 123 of its senior executives had invested US$20mil of their own money in the fund. The bank played a major role in the bailout.
Another revelation is the lack of prudence of Western financial institutions in their lending to hedge funds. The IMF and rich nations are fond of deriding financial institutions in developing countries for their loose lending and the regulators for not doing their job, which contributed to the Asian financial crisis.
But the Western banks have also been massively careless and the regulators have been amiss as shown in the LTCM affair. Just as Asian banks overlent for shares purchases, Western banks foolishly lent to hedge funds to speculate in financial markets.
"Many of the top commercial banks supervised by Greenspan's Fed had lent money to LTCM, offering 100 cents for every dollar of collateral, without imposing any overall borrowing limit," reported John Plender of the FT.
"The big investment banks had made similarly imprudent loans to a firm that generated huge volumes of business in securities and derivatives trading for them."
Finally, the hedge funds debacle will by no means end with LTCM. More crises involving other funds are on the cards.
For example, hedge-fund operator Everest Capital Ltd has lost US$1.3bil of the US$2.7bil it was managing at the start of the year. Two of its hedge funds suffered losses in emerging markets, especially Russian bonds and Latin American stocks.
Also, the fallout from LTCM hit another hedge fund, Convergence Asset Management, whose value has fallen 15% to 20% in September and 30% for the year to date.
Convergence has equity of about US$500mil, has leverage of up to 15 times, and specialises in bond arbitrage trading.
We can expect more shocks from hedge funds, which can win big for their millionaire owners, but can also lose big for their investors, creditors and the financial system.