Hedge-fund crisis shatters myths

The Long-Term Capital Management (LTCM) debacle has laid bare misconceptions propagated by the North surrounding hedge funds and shattered several myths about the global financial system. This episode brings to light Western banks' reckless lending practices and the substantial use of leverage by these funds giving them considerable power to move financial markets. The bailout of LTCM has, in turn, left US financial authorities open to accusations of practising the very "crony capitalism" they have often attributed to the afflicted Asian countries in crisis.

by Martin Khor

PENANG: The crash of a major hedge fund in the United States and reports of losses and impending crises in other hedge funds have cast a long 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.

However, to date, no new measures have been announced by the US or international financial authorities to tighten control over the activities of these funds.

A few of the affected Asian countries (Malaysia a year ago, and more recently Hong Kong) had demanded that the Western nations and the IMF take action against hedge funds to prevent their aggressive speculation from destroying currencies and destabilizing 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.

Shattered myths

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 own financial systems.

It is unlikely they will take effective action to prevent the hedge funds from making profits from speculating on the currencies or stocks of developing countries. The news broke on 23 September that the Federal Reserve Bank of New York had organized 16 banks to come to the rescue of LTCM, one of America's largest hedge funds.

The fund had equity of more than US$4 billion, but due to losses of $2 billion this year, that had been slashed to $2.3 billion at the end of August and reduced further since.

The banks, many of which had lent to and some of which had invested in LTCM, pumped in a fresh amount of $3.5 billion in 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 whiz-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 þleverage" (value of loans obtained as a ratio of equity) enjoyed by LTCM.

The Financial Times revealed the company had built a total market exposure (in credit) of US$200 billion earlier this year. Now, it still has an exposure of $100 billion.

Web of transactions

Since LTCM's capital before its crisis was between $4 and $5 billion, this implies its leverage had climbed to over 40 times. In other words, for each dollar of equity, creditors were overall lending it 40 dollars.

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 Financial Times (on 28 September). According to estimates, the gross value of LTCM's contracts exceeded $1 trillion.

The very 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.

Malaysian premier 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 twenty 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 forty 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 power in Asia.

The way the high leverage was obtained was described by the Financial Times (26-27 September) 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 $10 billion. The Financial Times 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 itself 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 interconnections between banks, hedge funds and individual financial operators and officials.

Europe's biggest bank, UBS of Switzerland, set aside US$682 million for expected losses from its dealings with LTCM. The Bank of Italy (the country's central bank) disclosed it had invested $250 million of foreign reserves in LTCM. Sumitomo Bank of Japan had a $100 million investment and Dresdner Bank of Germany is expecting a $143 million loss on its investment.

The US financial authorities and the financial institutions involved in the bailout are now being criticized 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.

The investment bank Merrill Lynch had an exposure of $1.4 billion to LTCM. According to the Financial Times, the firm's chairman had a personal investment of $800,000 in LTCM and 123 of its senior executives had invested $20 million 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 Western regulators have been amiss, as shown in the LTCM affair. Just as Asian banks overlent for share purchases, Western banks foolishly lent to hedge funds to speculate in financial markets. "Many of the top commercial banks supervised by Mr 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 Financial Times.

"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 $1.3 billion of the $2.7 billion 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 has hit another hedge fund, Convergence Asset Management, whose value has fallen 15-20% in September and 30% for the year to date.

Convergence has equity of about $500 million, has leverage of up to 15 times, and specializes 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. (Third World Economics No. 195, 16-30 October 1998)

Martin Khor is the Director of Third World Network.