Bailout of Hedge Fund for Wealthy Rattles Wall Street

The massive bailout of a tottering private investment fund, in a deal overseen by the Federal Reserve Bank of New York, triggered a mix of outrage and fear on Wall Street on Thursday and helped send the stock market plunging anew.

The $3.5-billion deal to save Long-Term Capital Management, a fund whose well-heeled investors include two Nobel laureates, was organized by Wall Street’s major investment banks--many of which have lent the fund huge sums in its ill-fated pursuit of high-risk trading strategies.

The deal was immediately lambasted by many other investment pros as setting a dangerous example, especially given the constant carping by U.S. officials that Japan and other troubled economies must allow their sickly financial firms to die rather than risk throwing good money after bad by supporting them.

Most troublesome to many critics was that the bailout, announced late Wednesday, occurred under the auspices of the New York Fed, with the major lender meetings held in the Fed’s Manhattan offices.

The rescue was attacked as a bailout for rich investors, a privilege that would never be accorded to the vast majority of smaller investors. And it was viewed as likely to embolden other big-time speculators to continue their high-risk ventures, confident that they will in the end be protected from failure.

“Shameful,” declared Charles Pradilla, strategist at investment firm Cowen & Co., echoing the comments of other Wall Street veterans. “They should have let it hang and let the lenders hang.”

In unusually pointed remarks, Paul Volcker, who was Fed chairman between 1979 and 1987, commented to reporters in Boston that although he did not know the specific details of Long-Term Capital’s bailout, “Why should the weight of the federal government be brought to bear to help out a private investor?”

In the stock market, investors overall appeared concerned that the answer to Volcker’s question may be that the global financial system--wracked by 14 months of currency devaluations, plunging stock markets and sinking economies--is in even worse shape than current Fed Chairman Alan Greenspan implied in Senate testimony on Wednesday.

“When a crack appears [in the financial system] you have to keep that crack from spreading,” said Ray Dalio, an investment fund manager at Bridgewater Group in Wilton, Conn.

He and others believe that the Fed now is extremely concerned that investment and trading losses at major banks, brokerages and private money firms worldwide could have a domino effect: One major firm could be unable to pay off loans to another, causing a cascade of defaults that would be difficult for regulators to halt.

Those fears sent the Dow Jones industrial average down 152.42 points to 8,001.99 on Thursday, just a day after the index had leaped 257 points as Greenspan hinted strongly that the Fed will soon reduce short-term interest rates to bolster the U.S. economy amid growing financial strains.

The market’s losses on Thursday were led by already beaten-down bank and brokerage stocks.

“Maybe the Fed thinks it knows something that the rest of us don’t” about the level of stress in the economy, said James Grant, editor of Grant’s Interest Rate Observer in New York.

Near midday today in Tokyo, that market’s main stock index was down 3.2% to 13,749, nearing recent 12-year lows.

The near-demise of Greenwich, Conn.-based Long-Term Capital, run by 52-year-old John Meriwether--long one of Wall Street’s star traders--occurred under circumstances not unlike those that triggered the collapse of Orange County’s investment fund in 1994.

As a so-called hedge fund, one of several thousand such funds worldwide that invest on behalf of wealthy investors and institutions, Long-Term Capital was able to make massive bets on market trends using not only its investors’ capital, but also a huge amount of leverage--that is, borrowed money.

With leverage, a bet that is correct can yield spectacular profits in a short period.

But the downside if the bet is wrong can result in equally spectacular losses.

Long-Term Capital is believed to have had assets exceeding $80 billion, much of it purchased on credit extended by Wall Street’s major investment houses, including Goldman, Sachs & Co. and Merrill Lynch & Co.

And like Orange County’s then-$18.5-billion investment fund, Long-Term Capital has made major bets on the direction of interest rates. Specifically, Long-Term Capital--which invests using complex computer-generated formulas--expected the differences in bond yields in Japan, the United States and smaller countries to narrow in recent months.

Instead, as Asia’s economic crisis infected Russia and Latin America, bond yields soared in many foreign economies when investors fled those markets for the relative safety of U.S. Treasury bonds, in turn pushing U.S. bond yields to record lows.

Similarly, in 1994 the Orange County fund, directed by then-county Treasurer Robert Citron, made leveraged bets that U.S. interest rates would stabilize. The bet went awry as the Federal Reserve continued to boost rates throughout 1994 to cool the U.S. economy.

As the Fed raised rates, the value of Orange County’s fixed-rate bond investments plunged, ultimately leading to the county’s bankruptcy declaration in December 1994 when it was unable to repay major brokerages that had lent the fund money.

Long-Term Capital’s situation, however, was believed to be far more dire because of the size of its investment portfolio and because of the potential for its losses to filter into the world financial system via its many lenders--and via the investors who took the other side of Long-Term Capital’s rate bets using so-called derivative securities.

Unable to come up with payments due soon to certain creditors, and unable to attract new capital from its current investors, the fund by Tuesday was rumored to be headed for collapse. That spurred 16 major banks and brokers to begin talks that led to Wednesday’s announcement, presided over by New York Fed President William McDonough, of a $3.5-billion capital infusion from those firms, which in addition to Merrill and Goldman included Wall Street heavyweights Salomon Smith Barney and J.P. Morgan.

With the infusion, the fund’s new investors will gain control of Long-Term Capital, slashing the value of Meriwether’s and other partners’ stakes.

Most important, the infusion will buy time for the fund’s complex investments--many of which apparently involve derivative securities that represent high-octane market bets--to perhaps pay off, or at least regain some value, should global interest rates begin to recede.

The Fed, should it indeed cut rates at its policy meeting on Tuesday, would be aiding Long-Term Capital and other investment firms that have suffered giant losses amid global markets’ stunning volatility this year.

But precisely because Long-Term Capital was well-known--and because its roster of partners includes such financial experts as Robert Merton, a Harvard Business School economist who won the Nobel Prize for economics last year, and Myron Scholes, another Nobel laureate in finance--many observers wondered aloud on Thursday why it shouldn’t have been permitted to fail.

Although the bailout does not involve Federal Reserve funds or other government money, many experts said it smacks of hypocrisy that the Fed should help engineer a deal to save a private fund whose failure could well serve as an arguably needed warning to other investors about the perils of excessive speculation.

Given Washington’s drumbeat to other nations about the need for financial discipline--and to allow lenders that make mistakes to pay for their errors--the deal sends the wrong message, many argue.

“I guess mutual funds for millionaires get special treatment,” said Grant, who, like others, noted that individual investors who have invested in emerging-market funds over the last year have been forced to swallow huge losses.

“This smells terribly bad,” said a money manager at one major Los Angeles institution. He noted that the time Wall Street is affording Long-Term Capital to work out its bad portfolio bets was exactly what Orange County thought it could not get from major brokerages in 1994--triggering the bankruptcy.

Because market interest rates fell in 1995, Orange County’s securities losses might have been far less than what was realized as the investment fund was liquidated by mid-January 1995, at county supervisors’ order.

But Wall Street has long argued that it did not force Orange County’s bankruptcy, and that in fact the county’s lenders wanted to work with the fund to lessen the extent of the losses.

From the Fed’s point of view, however, Orange County’s debacle did not pose the kind of risk to the world financial system that Long-Term Capital’s mess poses, many analysts say.

Long-Term Capital, like the nation’s mega-banks, had simply become “TBTF” in market jargon: too big to fail.

Cowen’s Pradilla, while criticizing the bailout, said it is apparent that the Fed accepted a guiding role because “they couldn’t afford another squeeze” on the banking system, given losses already taken by financial firms in the wake of East Asia’s deep recession, Russia’s economic collapse and the sharp declines in Latin American markets since July.

“The Fed’s mandate is to protect the financial system,” noted Bridgewater’s Dalio.

With each major loss suffered by banks and brokerages, those institutions are likely to become less willing to extend credit to companies and governments, threatening a full-scale “liquidity” crisis that could quickly spiral out of control.

Indeed, markets have been buffeted by rumors that the losses yet to be announced by some financial firms are staggering.

In protecting Long-Term Capital, however, Wall Street is sure to bring new calls for regulation of both hedge funds--which today operate with little regulatory oversight worldwide--and of the derivatives market, the multi-trillion-dollar yet little-understood global market of securities and currency bets and counter-bets that ties together most of the planet’s financial giants and leading corporations.

E. Lee Hennessee, head of Hennessee Hedge Fund Advisory in New York, said that while most hedge funds never come close to using the leverage Long-Term Capital used, she sees a need for greater disclosure of borrowing by the funds, particularly in the case of bond-market bets.

“Whatever else comes out of this, one of the problems is a lack of disclosure” of hedge-fund leverage and of who has lent how much to whom, she said.