October 01, 1998
Long Term Capital Management's billion-dollar losses last week were the focus of a congressional hearing today. Phil Ponce and guests discuss Wall Street's bailout plan and the danger of hedge funds.
|KWAME HOLMAN: Last week, inside this unassuming office building in Greenwich Connecticut, a firm called Long Term Capital Management, announced investment losses so large they threatened economic stability worldwide. It was -- for the most part -- the general public's introduction to the arcane investment world of "hedge funds."|
| Hedge funds
generally are open only to wealthy institutions and individuals. They
use their money to leverage
the borrowing of even larger sums to make a wide range of investments,
from stocks and bonds to the most complex financial instruments. There
are thought to be about four thousand such funds. They are not regulated
and do not have to disclose where they invest their money. Long Term was
started four years ago by former Salomon Brothers vice president John
Merriweather and 15 other partners, including Nobel economists, Myron
Scholes and Robert Merton. The group was well-known for relying on complicated
mathematical formulas intended to predict everything from currency and
bond rates to broader global economic trends . But last week, Long Term
disclosed that it lost some key bets, amounting to some 2 billion dollars
in the month of August alone, almost half of its assets, and tried to
recoup its loses with more than a $100 billion in risky bond market investments.
Fund manager Merriweather said only 10% of the losses were due to the
collapse of the Russian economy -- that a majority of Long Term's commitments
were in the U.S. and Europe. With so much money at stake, the Federal
Reserve Bank of New York organized a bailout of Long Term involving a
select group of Wall Street banks and several from Europe. They all contributed
to a rescue package totaling $3.5 billion. That action -- and the risk
even one hedge fund failure could threaten the general economy -- was
the focus of a hastily called hearing before the House Banking Committee
today. Federal Reserve Chairman Alan Greenspan and William McDonough,
president of the New York Federal Reserve, explained why monetary authorities
involved themselves in a private investment issue.
WILLIAM McDONOUGH: Two factors influenced our involvement. First, in the rush of Long Term Capital's counter parties to close out their positions, other market participants -- investors who had no dealings with Long Term Capital -- would have been affected as well. Second, as losses spread to other market participants and Long Term Capital's counter parties, this would lead to tremendous uncertainty about how far prices would move. Under these circumstances, there was a likelihood that a number of credit and interest rate markets would experience extreme price moves and possibly cease to function for a period of one or more days and maybe longer. This would have caused a vicious cycle: a loss of investor confidence, leading to a rush out of private credits, leading to a further widening of credit spreads, leading to further liquidations of positions, and so on. Most importantly, this would have led to further increases in the cost of capital to American businesses and to American households.
Regulating hedge funds.
KWAME HOLMAN: And Chairman Greenspan warned the kind of crisis Long Term Capital suffered could happen again.
ALAN GREENSPAN: So that the question, basically, is can we improve the system? I'm not sure I know at this stage how in this particular instance, other than making certain that the technical capabilities of the banks who lend money to these sophisticated organizations, are up to the ability of knowing when they're putting monies at risk.
KWAME HOLMAN: But Massachusetts Democrat Barney Frank asked Greenspan whether Long Term's crisis was enough to convince him federal regulation of hedge funds was needed.
REP. BARNEY FRANK: Now, we talk about the risk. And Mr. Greenspan has said that this may happen again. So then the question is, if it was so important as to justify this intervention now, how do you persuade us to do absolutely nothing, except wait again and trust entirely in your discretion to deal with it if it happens again? Now, I understand you say that we can't regulate the hedge funds. But can we not regulate the people who invest in the hedge funds?
ALAN GREENSPAN: The hedge funds, as far as I can see, cannot be regulated directly in this country. Two things will happen: either you regulate them and they will disappear because the nature of their business, they would perceive, cannot be effective if it's regulated, or far more likely, they will move to a different venue and trade, because they don't need the United States particularly. Now, starting with the premise that we can't do anything, the question really then gets to what do we do in lieu of that to protect the American financial system, which is what it's all about. And in my judgment, the most effective, indeed, really the only significant, effective means that we have to make certain that they, that group of hedge funds, does not create a problem is by making certain that the banks and others who lend them money have direct supervision themselves, as they do, and due diligence to make certain that when they lend money, they're doing it most sensibly.
JIM LEHRER: And to Phil Ponce.
PHIL PONCE: For more on the hedge fund rescue package Iím joined by Richard Medley, an international economic and political adviser to many Wall Street hedge funds, and Frank Partnoy, law professor at the University of San Diego and author of "Fiasco, Blood in the Water on Wall Street." Welcome, gentlemen. Mr. Medley, for purposes of clarity and in very plain language, please, give us a definition of what a hedge fund is.
RICHARD MEDLEY: A hedge fund is really just a bunch of people who get together to put money in one big pot and then use it many times over. In other words, if you put $100 million together, you may have 300 or 400 million dollars of debts out of that $100 million pot. Anything Ė no more narrow definition really encompasses everybody who would want to be called hedge funds today.
PHIL PONCE: And the people, Mr. Medley, the people who can invest Ė not just anybody can invest in a hedge fund. Tell us who can.
RICHARD MEDLEY: Well, technically you have to be financially sophisticated they say. You have to have somewhere over $10 million in net assets, and you have to really be aware of the risk that youíre going into or supposedly aware of the risk youíre going into, to invest in a hedge fund.
PHIL PONCE: And, Mr. Medley, there is a limit as to how many people can be in a hedge fund?
RICHARD MEDLEY: Well, before you get regulation by the FCC Ė and thatís called the 99 rule Ė you can only have 99 investors before you regulate it.
PHIL PONCE: So, in other words, if you want to take part in a hedge fund, you have to be one of the Ė one of that select group, and how do you find out about getting into a hedge fund?
RICHARD MEDLEY: Well, I donít know if anyone would want to find out about getting into a hedge fund now, but if you did, they tend to move in circles through banks and through representatives called funds that gather money together from wealthy investors.
PHIL PONCE: I guess the point Iím trying to get at, itís a fairly exclusive group of people who can get into this, even if they want to, is that correct?
RICHARD MEDLEY: Absolutely. And as a matter of fact, a lot of these funds are so-called offshore funds, and if youíre an American citizen, you canít get into them at all.
PHIL PONCE: Professor Partnoy, anything you want to add to the definition.
FRANK PARTNOY: The key to understanding hedge funds is that theyíre unregulated. This is a very special kind of pot that investors are putting money into. Itís an awfully big pot. Itís an awfully risky pot, and the one thing that Americans should understand is that hedge funds arenít subject to the same kinds of regulation as mutual funds, and, as a result, theyíve really become the Ferrari, if you will, of investment funds taking on enormous risks that mutual funds and other investments we might partake in wouldnít incur.
PHIL PONCE: And, Professor, when you say that they take part in risky investments, again, in plain terms what kind of risky investments are you talking about?
FRANK PARTNOY: Well, this is the "d" word. This is a word that I noticed was missing from your introduction and is missing from a lot of the debate here. The "d" word, of course, is derivatives. And one of the things that hedge funds do is take their capital, borrow money, based on that capital and then invest in these complex financial instruments called derivatives. Itís telling that Long Term Capital, for example, had investments in derivatives of approximately 1.25 trillion dollars, thatís trillion with a "t." Derivatives are difficult to explain, but in simple terms theyíre instruments whose value is linked to or derived fromóthatís the derivation of the word "derivative," something else, some other underlying financial instrument or index.
PHIL PONCE: And Professor, my understanding is also that in the case of Long Term Capital Management, they were making predictions on directions that certain instruments were going to be heading and basing their investment strategies on that, is that a fair description?
FRANK PARTNOY: Thatís correct. Thatís my understanding. Thatís typical of what hedge funds do. The funds have complex computer models that look at past price behavior, how different groups of investments have performed over time, and they try to make money by betting on discrepancies between different kinds of investments. One thing Ė
RICHARD MEDLEY: Iím sorry. Iíd like to just add Ė
PHIL PONCE: Go ahead, Mr. Medley.
RICHARD MEDLEY: -- that those kinds of Ė that is true that there are hedge funds that do that, but, in fact, the number of hedge funds that do mainly that are really relatively small part of the hedge fund universe. If there are three thousand or four thousand hedge funds, our best estimate is maybe thereís one hundred that really do only derivatives and only the kind of trades that we were just talking about. Many, many hedge funds are simply big dumb elephants that invest in dollar/yen and say we think the dollar is going up, or the yen is going down. It's really, you know, not that complicated in most cases.
PHIL PONCE: So, Mr. Medley, what is Ė
RICHARD MEDLEY: Itís directional.
PHIL PONCE: Mr. Medley, what is it that Long Term Capital Management did wrong? What were they doing and what went wrong?
RICHARD MEDLEY: Well, I think itís very simple. Long Term Capital did three Ė violated three fundamental tenets of managing money. One is they went out into very illiquid markets. That means that when they needed to get out, if they were wrong, and all hedge fund managers are wrong more than theyíre right, when you need to get out, you canít. Thereís no one there to buy the thing from you. And so the price continues to drop and drop and you lose more and more money. The second thing that they did Ė the cardinal sin that they violated was that they went into instruments they didnít really know about, instead of just doing what they set out to do, which was pure mathematics, pure convergence trade on the basis of interest rates versus other interest rates. They started investing, from what we can understand now, in things like gold. What does gold have to do with a very complicated mathematical strategy, not much, I say, and the third thing they did is they didnít realize that they were in an increasingly crowded field, and they started leveraging themselves up even more. Big hedge funds like the Soros Fund and others get leveraged sometimes two or three times, that is, if theyíve got a billion dollars, theyíve had 2 billion dollarsí of investments, or 3 billion dollars. Long Term Capital, from what we can tell, off of a $4 billion base, had $1.25 trillion worth of debts Ė thatís insane.
PHIL PONCE: Professor, how did that insanity happen? The word on the street, according to reports, was that Long Term Capital Management had some of the best talent Ė had these Nobel Prize winners, had these fancy computer models.
FRANK PARTNOY: Thatís right, the best talent in the world. A couple of Nobel laureates, all of the smartest people in the business were trying to get jobs at Long Term Capital when I was working in the business. It really was the premiere place to be, and it's astonishing that they would lose this much money. I think it has since sent some shock waves through the system. One of the problems with trying to assess what Long Term Capital was doing and what other hedge funds are doing is that we really donít know. We donít have any idea. We donít have any idea what the hedge funds are, are limited to, because there really isn't any regulation, there arenít any limits on what the hedge funds can do, and so while it might be correct to say that only a hundred hedge funds today are gambling using leverage and buying and speculating with derivatives, it might also not be the case, and we simply donít know. We donít have good information about the hedge funds. Itís startling, for example, that we donít even know how many hedge funds there are. You would think that a basic number such as how many hedge funds there are would be publicly available; itís not. Estimates vary in the range of three to four thousand. People just donít know, and we donít know exactly what it is theyíre doing. Even the most sophisticated counter parties with Long Term Capital, the creditor banks, such as Merrill Lynch, Morgan Stanley, and Goldman Sachs, really didnít have any idea what it was that Long Term Capital was up to.
PHIL PONCE: Professor, should the Federal Reserve have stepped in and come to the rescue?
FRANK PARTNOY: No. I donít think so. I think it was an enormous mistake, and I think that the comments that you hear from the Fed today should be quite frightening for any average investor. The Fed is basically admitting that it didnít understand what the problem was, and that it was afraid of how we individual investors would react to some sort of large scale sell-off. My understanding is that Long Term Capital wasnít exclusively invested only in illiquid markets; it was also invested, for example, in treasuries, U.S. treasury bonds and treasury futures, and those, of course, are the most Ėamong the most liquid markets there are. So I think it was a mistake for several reasons. One reason is that now if youíre hedge fund and you know that this is the reaction that the Fed will take, you have incentives to take on additional risks.
PHIL PONCE: Let me ask Mr. Medley about this. Will this encourage other hedge funds to play it fast and loose, knowing that the Fed might step in and help them?
RICHARD MEDLEY: I donít know anyone on the planet whoíd want to be John Merriweather today. I think the Ė
PHIL PONCE: John Merriweather, the Ė
RICHARD MEDLEY: John Merriweather, one of the principals of Long Term Credit. He really has been destroyed. His reputation has been destroyed. We hope financially heís been destroyed; he certainly deserves to be. And I think the moral hazard argument only comes in if youíd step in and rescued these guys. These guys donít deserve to be rescued at all. But I think what the Fed did was coming in and saying look, youíre a hundred percent right, we donít know what the actual damage might have been, and with Japan at 12-year record lows in the stock market, with Russia cratered, with Brazil on the brink, with the U.S. stock market going down every day 2, 3, 4 percent, I donít think we can afford to take the risk, the "what if" factor. Letís make sure these guys are destroyed personally and corporately so they never Ė so no one else says hey, we can be bailed out. That takes care of the moral hazard, but not stepping in at this moment in world history was really too much of a risk to take.
PHIL PONCE: Mr. Medley, if the point you make is a strong one, that is to say that the Fed didnít know what was going on, does that not argue in favor of regulation?
RICHARD MEDLEY: It certainly does. It certainly argues in favor of the people who lend money to hedge funds, knowing who else has lent money, how much money is lent totally. And one of the most remarkable things about Long Term Credit is Ė from what we know, none of the people who were lending them these billions and billions of dollars knew the total amount of exposure that Long Term Credit had to other institutions that were lending them money. The fact that there was no cumulative count going and that the lenders would Ė the lenders would stay there and listen to Merriweather when he said I refuse to tell you what else we owe, is another mark of failure Ė of systemic failure, a reason Ė a good reason for the Fed to step in and a good reason for us all to rethink credit limits.
PHIL PONCE: Gentlemen, thatís all the time we have. Mr. Medley, Professor, thank you both very much.