The derivatives market and LTCM

For those not familiar with the situation, Long Term Capital Management (LTCM) was a hedge fund run by John Meriwether, a legendary trader who, after a spectacular career, had left Salomon Brothers following a scandal over the purchase of US Treasury bonds. This had not tarnished his reputation or dented his confidence. Asked whether he believed in efficient markets, he replied: “I MAKE them efficient”. Moreover, the fund’s principal shareholders included two eminent experts in the “science” of risk, Myron Scholes and Robert Merton, who had been awarded the Nobel prize for economics in 1997 for their work on derivatives, and a dazzling array of professors of finance, young doctors of mathematics and physics and other “rocket scientists” capable of inventing extremely complex, daring and profitable financial schemes. The fund had investors that were the crème de la crème of society. (A hedge fund is a private investment partnership that is NOT subject to strict governmental oversight)

The fund’s operations were conducted in absolute secrecy. Investors who asked questions were told to take their money somewhere else. Nevertheless, despite the minimum initial payment of $10 million frozen for three years, there was a rush to invest and the results appeared to be well up to expectations. After taking 2% for “administrative expenses” and 25% of the profits, the fund was able to offer its shareholders returns of 42.8% in 1995, 40.8% in 1996, and “only” 17.1% in 1997 (the year of the Asian crisis).

But because of the reputation of the managers, big banks continued to lend massive amounts of money to the fund in terms of margin. The banks’ staggering lack of curiosity about the fund’s activities is particularly disturbing in view of the astronomical sums involved. At the beginning of the year, LTCM had capital of $4.8 billion, a portfolio of $200 billion (borrowing capacity in terms of leverage) and derivatives with a notional value of $1,250 billion. But in September, after mistakenly gambling on a convergence in interest rates, it found itself on the verge of bankruptcy.

William J. McDonough, president of the Federal Reserve Bank of New York, (who just announced retirement) called on the cream of the international financial establishment to refloat the fund which was virtually bankrupt. And, in only a few hours, 15 or so American and European institutions (including three French banks) came up with $3.5 billion in return for a 90% share in the fund and a promise that a supervisory board would be established

The CATO institute argues that the intervention also is having more serious long-term consequences: it encourages more calls for the regulation of hedge-fund activity, which may drive such activity further offshore; it implies a major open-ended extension of Federal Reserve responsibilities, without any congressional authorization; it implies a return to the discredited doctrine that the Fed should prevent the failure of large financial firms, which encourages irresponsible risk taking; and it undermines the moral authority of Fed policymakers in their efforts to encourage their counterparts in other countries to persevere with the difficult process of economic liberalization.

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