WHAT IS A HEDGE FUND?
 

Explainer

Newspapers report that Long-Term Capital Management--the high-profile hedge fund run by a hotshot bond trader and two Nobel laureates--nearly plunged the world into financial ruin last week. And it's not just journalists who say so. Intent on forestalling global financial disaster, a group of big-money Wall Street banks convened by the Fed ponied up almost $3.5 billion to bail out the fund.  What are hedge funds? Why are their meltdowns so spectacular? A hedge fund is nothing more than a pool of money which a manager invests for a group of wealthy investors (minimum buy-in is often $10 million). Hedge funds promise an investment strategy that makes money when the market rises and when it falls. The hedge fund manager takes 15 to 20 percent of profits, the rest goes to investors. Sounds grand, but how does it work? Long-Term's manager, backed by a star-studded research division, dealt in so-called derivatives. Derivatives are financial creations whose value is based upon, or derived from, the price of some underlying item, like stocks, bonds, commodities, or currencies. For example: stock options are a wager on the future price of, say, AT&T stock; commodity futures are a wager on the future price of, say, pork bellies. Both count as derivatives, as do more exotic creations like swaptions and quantos (don't ask).  Derivatives permit a fund manager to reduce certain kinds of risk. Suppose the manager is holding a portfolio whose value rises when interest rates rise but falls when interest rates fall. Adding an appropriate derivative--one which bets for an interest rate fall--to the portfolio mitigates losses if, in fact, interest rates fall. (Hence the name "hedge funds"--one investment position offsets, or hedges, another investment position.) Of course hedge fund managers do more than just bet both for and against some outcome. At the end of the day, they must bet on something, right? It seems that Long-Term was betting on the yields of bonds from G-7 countries (no one is sure since Long-Term won't disclose details of its dealings). By analyzing historical data, Long-Term developed predictions about the relative rates of return on different countries' bonds. The firm used a series of hedges--which means buying derivatives--to make sure that they were insulated from general rises and falls in interest rates, stock exchanges etc... That's the beauty of hedging with derivatives--they let you bet on precisely what you want to. In theory, other perturbations are not supposed to affect your assets. But something happened that the financial "rocket scientists"--so named because many have doctorates in math or physics--either didn't expect or couldn't conceive of. An article by MIT economist Paul Krugman considers just what might have gone wrong. (He thinks the rocket scientists were smart but naïve. In other words, their computer models didn't sufficiently account for extremely unlikely but extremely serious developments, like economic crisis in Russia and political gridlock in Japan.) Krugman also thinks that investors were naïve to believe that Long-Term offered return without risk. The chance of things going wrong may have been slim, but when things went wrong, they went spectacularly wrong. One key feature of derivatives is they can get you in a pot of trouble very quickly. If you buy stock, and its price falls by 10 percent, you've simply lost 10 percent of your money. But if, for instance, you buy a so-called call option (which is a bet that the stock will rise) and the stock falls by 10 percent, you may lose all your money. (A call option allows you to buy the stock at a specified price, known as the strike price. If the market price falls and stays below the strike price, then the option is worthless.) There are even derivatives--such as futures contracts--with which you can lose more than your original investment if you bet on the wrong horse. No one but Long-Term really knows what Long-Term held, but the fund's asset pool has reportedly shrunk to one-tenth the size it was in January.

WHAT GOES AROUND
 

NEWSWEEK October 12, 1998

The big hedge-fund bailout helps some fat cats, but makes our                      case for free global markets look awfully thin.                       By Allan Sloan                         The collapse and rescue of the biggest hedge fund in the United States                      shows how dangerous preaching can be. For 15 months, as financial                      markets in country after country collapsed like straw huts in a typhoon,                      the United States lectured the rest of the world about the evils of crony                      capitalism--of bailing out rich, connected insiders while letting everyone                      else suffer. U.S. officials and financiers talked about letting market forces                      allocate capital for maximum efficiency. Thai peasants, Korean                      steelworkers and Moscow pensioners may suffer horribly as their local                      economies and currencies collapse--but we solemnly told them that was                      a cost they had to pay for the greater good of the world. Capital should                      be free to flow to the places where it gets the highest and best use.                      Cronyism bad. Capitalism good.                       Then came the imminent collapse of Long-Term Capital Management                      L.P., the quintessential member of The Club, with rich fat-cat investors                      and rich hotshot connected managers. Faster than you can say "bailout,"                      crony capitalism U.S. style raised its ugly head--the New York branch of                      the Federal Reserve Board orchestrated a $3.65 billion rescue by 14                      banks and brokerage houses. John Meriwether and the rest of the guys                      who ran the fund onto the rocks got to keep their jobs. The fund's                      investors, whose stakes would have been wiped out in a collapse,                      salvaged about seven cents on the dollar, with a chance to recover more                      if things go well. The rescuers even agreed to pay a management fee on                      their rescue fund, albeit at less than half of Long-Term Capital's normal,                      obscene rate.                       It may even be that the fund's managers outfaced a team led by Warren                      Buffett, America's smartest investor (and a board member of                      NEWSWEEK's parent, The Washington Post Company) and risked                      setting off a worldwide financial meltdown to get a better deal than a                      cut-rate Buffett offer that would have ousted them. Long-Term Capital's                      supporters insist that Buffett's offer had technical glitches, and that it was                      yanked off the table almost instantly before Long-Term could help solve                      them. So take your pick. Either Buffett and his partners were trying to                      use Long-Term's distress to make a good deal for themselves, or                      Long-Term rolled the dice with the world's financial system. Or both.                      Either way, it was not one of capitalism's more edifying moments.                       How on earth can anyone justify bailing out rich managers and rich                      investors at the same time that we're insisting welfare mothers shape up,                      and Congress may soon make it harder for little people maxed out on                      credit cards to get a fresh start? Not a bad question. Fed Chairman Alan                      Greenspan argued with passion and at least some justification in                      congressional testimony last week that the Fed didn't dare let Long-Term                      Capital go out of business because its failure could have triggered                      worldwide havoc. Markets are already nervous about the seemingly                      endless series of financial collapses, which started when Thailand                      devalued its currency in July of 1997, and have hopscotched across the                      globe. The International Monetary Fund has thrown billions into the pot,                      with little success so far. And now, the so-called "Asian contagion" may                      be about to become the "U.S. mess."                       And make no mistake about it: hedge funds are a nob's game. They're                      restricted to rich investors, and they have to tell little or nothing to                      anyone, unlike regular mutual funds, which have to make endless                      disclosures. The idea is that rich investors know what they're doing, and                      that the banks and brokerage houses that lend money to hedge funds will                      keep an eye on things. Long-Term Capital was the hedge fund of hedge                      funds: it had two Nobel laureates on staff, not to mention some of the                      best and brightest traders and computer jockeys on Wall Street. It                      wouldn't accept an investment of less than $10 million, and it insisted you                      commit the money for at least three years. It wouldn't even tell you what                      it was doing with your money. And talk about snooty. At the end of last                      year, Long-Term refunded $2.7 billion to investors, many of whom didn't                      want their money back, in order to maximize returns and to increase                      Long-Term managers' stake in the fund to 30 percent from about 20                      percent.                       When the government orchestrates a bailout of such an outfit, it's                      tempting just to demonize Long-Term's managers, investors and lenders                      for greed, foolishness and blindness. Heaven knows, they deserve it. But                      instead of piling on, let's look at what the Long-Term Capital saga tells us                      about the way markets work. This account is based on research, public                      records and background sessions with players and with people familiar                      with what the players have to say. Sorry to be so vague, but the people                      who really know what went on aren't exactly shouting it on the record                      from the rooftops.                       Let's start with the offer faxed to Long-Term Capital on Sept. 23 by a                      group consisting of Buffett, Goldman Sachs and American International                      Group, a giant insurance holding company. Buffett and partners offered                      to buy out the fund's investors for $250 million, and to put another $3.75                      billion into the fund to bring its capital into some reasonable balance with                      its borrowings, which totaled about $80 billion. The terms Buffett offered                      were far less favorable to Long-Term's investors--and especially to its                      managers, whom he would have fired--than what the Fed-led bailout                      ultimately offered.                       Buffett wasn't offering public charity. He was trying to do what he                      preaches: buy something for much less than he thinks it's worth. Ditto for                      Goldman Sachs, which made tons of money dealing in bankruptcies,                      salvaging financially distressed real estate like New York City's                      Rockefeller Center, and scarfing up property that regulators acquired                      during the savings-and-loans collapse of the 1980s. American                      International Group isn't a bunch of cupcakes, either. These folks weren't                      out to save the world's financial markets; they were out to make a buck                      off Long-Term Capital's barely breathing body.                       The reason Long-Term Capital was in such dire straits was the financial                      meltdown in Russia this past summer. Ironically, in less than a decade as                      a capitalist country--make that a pseudo-capitalist country--Russia                      inflicted more damage on the world's capitalists than it did in 70 years as                      a communist country. Russia managed the amazing feat of defaulting on                      ruble-denominated bonds even though it can print rubles. It had promised                      a week earlier to pay its debts, so its default was a special shock.                      Investors yanked their money from almost everywhere and sought safety                      in the United States. Specifically, they bought lots of 30-year U.S.                      Treasury bonds. That's because, for reasons too involved to go into, it's                      easier to buy and sell large quantities of 30-year bonds than it is to buy,                      say, 30-year Treasuries that were issued three years ago and are now                      27-year bonds.                       The enormous buying pressure on 30-year Treasuries made those bonds                      much more expensive than 27-year Treasuries. So instead of the spreads                      between 30-year and 27-year Treasuries narrowing, as Long-Term                      Capital's computer-driven trading strategy predicted, the spreads grew.                      A similar thing happened in Europe, as investors flocked to German                      bonds, considered the safest on the Continent. This messed up the bet by                      Long-Term Capital and many other players that the move to a single                      currency, the euro, would cause interest rates on bonds of various                      European countries to move closer together. Instead, spreads widened                      as investors pounded into German bonds. These things weren't rational,                      but they happened. And Long-Term, which prided itself on being a clutch                      of astute traders, couldn't handle it.                       If Long-Term Capital had not hocked itself to the eyeballs, it would have                      lost some money, but its survival wouldn't have been in doubt. But even                      by the free-swinging standards of hedge funds, Long-Term was a player.                      The firm convinced itself--and presumably, its lenders--that its strategy                      was low-risk, and it was safe to borrow 20 or more dollars for each                      dollar investors had in the fund. It started the year with about $4.7 billion                      of investors' capital, and it borrowed as much as $120 billion. That's a                      mighty thin cushion if things go bad--which they did in July, when                      investors' panicky retreat from Russia picked up steam. And in August,                      when things got worse.                       We'll skip some of the gory details. Suffice it to say that Long-Term                      Capital looked for money everywhere. But the more it looked, the                      jumpier potential investors became. Hoping for one-stop shopping, the                      fund approached megahitters like Buffett and Goldman. Buffett got to                      examine the books. Others may have gotten a look, too.                       By late September, the fund's lenders figured out something was wrong,                      and were getting ready to pull the plug. By then, the fund had shrunk to                      $80 billion of assets from the aforementioned $125 billion. But its                      capital--the lenders' cushion--was down to about $600 million. That's a                      lot of money, but it's less than one hundredth of the borrowings. A rescue                      plan mounted by Merrill Lynch and J.P. Morgan came to naught. By                      Sept. 23, when New York Fed chief William McDonough convened the                      now famous emergency meeting, things were desperate. People didn't                      expect the fund to survive past Sept. 24 without some sort of rescue.                      Rather than risk the consequences of a collapse that could have damaged                      them in any number of ways, the 14 players forked over their $3.65                      billion. They got 90 percent of the fund. Do the math, and you see this                      values the remaining 10 percent at a tad over $400 million. That's much                      more than Buffett's $250 million. And by staying in the fund, the old                      investors get a chance to profit when (and if) the fund starts making                      money again. Meriwether and company don't have to file for                      unemployment insurance just yet. They've been seriously hurt,                      considering that their stake in the fund, worth around $1.4 billion at the                      start of the year, is now valued at around $120 million. But that's enough                      to keep most of them off food stamps--though some of the partners went                      into hock to raise investment money and may end up in personal                      bankruptcy. But they're still employed and get another couple of spins at                      the roulette wheel.                       The new investors are also paying them a fee of 1 percent of assets a                      year, plus 15 percent of any profit the fund makes above a benchmark                      currently in the 5 percent range. That's less than the normal fee, 2 percent                      of assets and 25 percent of profits. But it's a helluva lot of money, even                      though the new investors get a half interest in the management company,                      which effectively reduces the fee by 50 percent. Why pay anything? The                      explanation is that the fund has to keep paying its 170 employees while it                      works down its positions, and has to give them an incentive to hang                      around. Just wait until the firm's payroll leaks into the public domain; the                      shouts will be astounding.                       Last week, for the first time in years, a Greenspan congressional                      performance--he appeared to explain the bailout--evoked criticism and                      sharp questions rather than the usual adoration. Criticism of the bailout is                      rising abroad--payback, of sorts, for years of America's boastfulness,                      triumphalism and preaching of capitalist values that were discarded when                      they became inconvenient. If Greenspan's political support crumbles, so                      will America's ability to influence events. Markets run on credibility, and                      just spewing hot air won't cut it. As the Prophet Hosea observed, "They                      have sown the wind, and they shall reap the whirlwind."