With easy availability of funds at favourable terms, LTCM increased its leverage and exposure. With a capital base of $4.8 billion LTCM borrowed money from banks and companies to purchase securities with an estimated value of $200 billion – a 50 to 1 degree of leverage, considered extremely high in the industry. Moreover LTCM used these securities as collaterals to enter into speculative financial derivatives thereby increasing its exposure to $1.25 trillion.
LTCM was involved in market neutral arbitrage. Most of LTCM’s exposure was in the US, European and Japanese markets. By using sophisticated computerized models, LTCM placed highly leveraged bets on the interest rate spreads between risky bonds and safe US treasury bonds. Primarily because of large amount of derivative contracts, LTCM was bound to make substantial profits or losses if yield spreads changed. This model worked successfully for three years but it changed suddenly in August 1998 when Russia defaulted on its debt. Although LTCM was not engaged in the Russian markets, the global flight to safety that followed Russia’s turmoil soured many of its bets which counted on interest rates on riskier bonds moving closer to the US and German government bonds. As a result of ‘flight to safety’, the prices of safe bonds rose and the yield differentials on which LTCM’s bet were based, widened instead of narrowing. Because of the high degree of LTCM’s leverage, it was faced with margin calls and was forced to liquidate at huge losses. Between August and September 1998, LTCM lost 90 per cent of its equity. By mid September 1998, LTCM’s equity had dropped to $600 million, a loss of more than $4 billion.
In early September, LTCM informed the Federal Reserve Bank of New York of the problem it faces. In an unexpected move, the Federal Reserve quickly stepped in and organized a bailout package by persuading some of the big players in global finance capital such as Travelers Group, Bankers Trust, Barclays, Chase, Merrill Lynch, Goldman Sachs and other elite financial institutions to invest a total of $3.5 billion in LTCM. The fallout of the collapse of LTCM on global financial markets would have been diasastrous. The fear of huge losses by banks and financial institutions would have triggered yet another chain of breakdowns. Because of their involvement with LTCM, two Swiss banks, namely, UBS and Credit Suise Group, suffered huge losses. The top executives of UBS resigned taking moral responsibility for their involvement with the fund.
Despite sharp criticism, the US authorities have defended the bailout programme on the gorund that the collapse of LTCM would have sparked a major crisis in Wall Street and the global financial system. In his testimony before the US House of Representatives Banking Committee, Federal Reserve Baord Chairman, Alan Greenspan, said that the bailout programme was necessary because of the fragility of international markets. ‘‘Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own’’, observed Greenspan.
The bailout programme raised several questions. Firstrly, LTCM is not the only hedge fund that went bust after the Russian turmoil. As mentioned earlier, there were five hedge funds that failed along with LTCM but they had been allowed to go out of business without any support from the Federal Reserve. Critics argue that the sheer size of LTCM’s trading position as well as its connections in Wall Street ensured its bailout. They view the bailout plan as a perfect example of Western style crony capitalism. Secondly, the bailing of LTCM militates against the recent US policy of ‘‘no bailouts’’ of financial institutions under any circumstance. By baility out LTCM, the US Federal Reserve has done exactly the opposite of what it has been advising the rest of the world (e.g., Japan) against such bailouts. Thirdly, the Federal Reserve has no authority to bailout hedge
funds that are beyonds its jurisdiction. The role of the Federal Reserve is only restricted to banks. Lastly, although the bailout programme provided 90 per cent of LTCM’s equity to its rescuers there was no change sought in the top management of the fund. It is ironic that Meriwether and his team members were allowed to again run LTCM with a management fee on 1 per cent plus 12.5 per cent of profits.
In a nutshell, the bailout programme of LTCM can be explained by quoting an old banking joke : ‘‘If you owe a bank 1000 dollars and can’t pay, you are in trouble. But if you owe a billion dollars to the bank, and can’t pay, the bank is in trouble!’’ However, recent media reports indicate that the Federal Reserve has decided to close down. LTCM. According to reports, the New York Federal Reserve President William McDonough, announced in early October 1999 that LTCM is ‘‘very close to being out of business.’’
The LTCM episode has exposed the US’s doublespeak and reaffirmed the need to regualte the hedge funds. But any move on the part of regulatory authorities to regulate hedge funds is likely to be resisted by the industry. Even a moderate call for greater transparency is opposed by the hedge funds industry on the ground that if the portfolio investment is ‘‘leake’’ to the marketplace it can be used by other market participants against the funds managers and thereby against the best interest of the investors.
There is an urgent need for greater regulation of hedge funds. In this regard, a beginning could be made by imposing limits on their borrowings and making it mandatory for hedge funds to provide regular information about their activities and derivatives positions to not only creditors and investors but also to the regualtory authorities. Apart from regulating hedge funds, equal attention should be paid to banks that pump billions of dollars into hedge funds and other highly leveraged institutions without knowing exactly what these funds are doing with their money. Most of the money invested by hdege funds worlwide belongs to the banks are under no regulatory oblgation to disclose their exposure to hedge funds. With respect to hedge funds and OTC derivatives, bank regulation is fundamentally flawed. A significant restructuring is required to check the weaknesses in a bank’s credit assessment process which allow very large exposures to hedge funds.
At the policy level, the recent busting of hedge funds and in particular the near collapse of LTCM has raised several important issues related to the systemic instability in the global financial system. One issue, which needs closer attention, is related to the financial system of source countries, where these funds originate in the first place. The near collapse of LTCM has significantly exposed the fragility and systemic instability in the so-called sound financial markets of the developed countries. Because of increased leverage and unhedged exposure, hedge funds can bring a financial crisis of a recipient country to the doors of a source country. It will be incorrect to assume that the source countries can remain insulated from negative extenalities. In fact, it is in their self-interest to strictly monitor and regulate the operations of hedge funds. Unless hedge funds are regulated in source countries, the global financial system remain unstable and recipient countries will have no other option but to keep away from such funds. Therefore transparency, regulation, supervision and prudential controls in source countries are as equally important. If the G-7 countries are really concerned about the growing instability of the global financial system, they can begin by dealing with these issues closer to home.
[ Excerpted from
‘Taming Global Financial.
Flows’, by Kavaljit Sing.
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