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To All,
Here is some follow on discussion regarding hedge funds and the
recent bailout. This is a continuation of the thread I sent to
this list on Friday. Please note that this information is a
discussion that is occurring on the Omega list. I am not the
author of these comments. I am just distributing the info to
those who may find it interesting. So, unfortunately I cannot
answer any questions. Enjoy the reading (if you can!).
Regards,
Tim
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First, let me say that I don't know all of the specifics of this fund or
the
heroics going on to clean up the situation. But this isn't the first
time this
has happened and sadly, it won't be the last.
Let me see what I can answer:
> First, let me see if I'm correctly understanding the situation:
>
> (1) The brokerage firms who loaned Long Term Capital money to prevent a
> margin call now own 90% of the Hedge Fund. These loans were backed by
> various Banks who are being tacitly backed by the Federal government who
> is being backed by the taxpayer.
Well, basically the Fed sat in on the meeting and agreed that this
situation
must not go further, and so the Fed assures first of all that there will
be no
liquidation of the fund and 'persuades' the firms involved that they
will agree
to a deal. Period. After that, the Fed doesn't have to do much more than
make
sure the firms have access to cheap overnight money and that the
situation is
exactly as they thought as the deals are checked and double checked.
>
> (2) Hedge Fund investors have now lost 90% of their equity.
Absolutely. The ultimate drawdown.
>
> (3) The brokerage firms who now own 90% of LTC are now invested in a
> situation almost as highly-leveraged as what existed prior to the loans.
Not exactly. The capital base of those firms taken as a whole is much
larger
than the original capital under management of LTC. The questions is: If
the
problems with these deals are due the opposite party being unable to
make
delivery or make payment or honor part of a derivative or even FX or
debt
[counterparty risk], what's the term of the problem [how long until it
can
indeed clear], and is there any way to 'make' the problem go away? [For
example,
when Mexico froze all FX cash settlements in the early 80's, banks found
that
they had risks they never dreamed they had. If you were due Pesos at
your
account and they didn't show, you were still overdrawn, and so was the
person
who then expected them from you...and so on and so on. In Mexico's case,
the Fed
stepped in after the banks had suffered for three days at 100% overnight
rates.
>
> If this is true, what happens if/when this House of Cards begins to
> collapse? Do the brokerage firms then go to the Banks who then go to
> the Federal Government who then goes to the Taxpayer for yet another
> Savings-and-Loan-type Bail Out?
Unlikely in this case. It sounds like these are of two problems:
Derivative risk
[which often is because mark to the market derivatives aren't watched
closely
enough and in volatile, unusual markets, risks happen that these naive
risk
systems haven't taken into account] or counterparty risk [which would
be, as
people have already said here, Russian banks, Central American Banks or
Asian
Banks that can't [or in the case of FX exchange controls] are unable to
settle
their end of deals.
> What does the Federal Government do? Do they, under massive negative
> public pressure, back away from their tacit support of the Bank loans?
>
> If so, do we have a potential Bank collapse on our hands?
Again, both unlikely at this point on this deal. It sounds like an awful
large
amount of money, and to a $4 bill fund, it is. To a handful of firms
that can
get easy overnight money from the Fed until the deals are unwound, it'll
be a
pain in the ass, but won't probably drag anyone down UNLESS the markets
go to
the next level of volatility.
> Do we face the prospect of an OTC market collapse due to contractual
> payment obligations being broken by bankrupt brokerage firms?
Again, not from this problem alone, but you could see a reluctance from
higher
grade of firms to enter into deals or take the names of certain firms if
this
continues and then that might start it all to unravel. That would also
make the
Fed get more active, since the illusion of serenity is the most
important thing
at the moment. The one caveat here would be if the stock market started
to just
drop out of bed--there are some Wall ST firms that have tons of these
deals on
their books, and though they have gotten better at marking it to the
market, you
have to guess that there is at least one there waiting to happen.
>
> How does all of this effect already-weakened foreign economies and what
> effect does that then have on our own economy?
Well, let's say that Asian banks were involved in the problem here. If
you were
the head of the credit committee at your conservative bank, would you be
letting
the dealers in swaps and derivatives take six month risk on odd
derivatives with
an Asian bank? Or a Russian bank? If another fund goes down, are you
even
willing to take their name in the Fed funds lending market? basically,
some
nations or regions might find that they are paying much higher rates to
even
make their overnight borrowing needs--as someone pointed out here
earlier today:
Liquidity crisis 101.
>
> What, if anything, can Alan Greenspan do to keep such a downward spiral
> from accelerating out of control?
Anything he can do make it all seem to be under control. That might be
lending
all he can to firms that need it, or calling a bank and basically
demanding they
take the name of Asian Bank 123, or Russian Bank 334.
> Are there other Hedge Funds beside LTC who have gone through (or are
> close to going through) the same scenario? If so, who and how many and
> just what is our total potential exposure?
Honestly? There is literally no way to tell. But if I was a risk taker,
and I
am...this is not an isolated instance. If Greenspan and Bill McDonough
are good
at their jobs and very lucky, the other fires that they put out will get
zero
press. If they are unlucky, one much worse will go bust before they get
control
of it.
> Did you *really* mean it when you said, "there are no regulations or it
> isn't clear which agency has jurisdiction"...or were you just being
> facetious?
On some instruments, there are really no regulations for some funds,
some really
big funds. And even something as simple as foreign exchange can cause
this in a
crisis, if FX controls cause payment problems in the environment we face
now
where just a hint of liquidity problems will cause panic.
The other problem is that the products have grown much faster than the
risk
measurements used by the banking firms and much faster than the knowlege
of the
regulators--and this is always bad news.
>
> Is there reason for concern? Is it Trailing Ticks I'm hearing or "Tick,
> tick, tick, tick,...,BOOM"?
Well, there's always risk, as they say. And think about this: What does
it mean
that you can get overnight money in Japan for FREE and yet, no one is
willing to
take any? Why are people so excited about the Fed cutting rates? The
long bonds
have come down more than a percent in what, 60 days? I never like it
when the
market is so far ahead of the government...it means they are not in
control.
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September 24, 1998
Dollar lower as giant hedge fund requires bailout
NEW YORK (Reuters) - The dollar fell Thursday on concern that an
emergency
bailout of a well-respected hedge fund foreshadowed
losses for Wall Street firms and slower U.S. growth because of global
economic turmoil.
The Dow Jones industrial average fell 152.42 points to 8,001.99,
erasing
most of Wednesday's 257 point gain. Also weighing on the
dollar were expectations that U.S. interest rates would soon be heading
down
in the wake of remarks by Federal Reserve Chairman Alan
Greenspan Wednesday.
The dollar's losses came as financial markets in many centers
retreated,
digesting news that the New York Federal Reserve Bank had
organized a group of 15 major U.S. and foreign banks to save Long-Term
Capital Management, a Connecticut-based fund that until
recently few thought would ever go under.
The dollar ended at 1.6740 German marks, down from 1.6785 at
Wednesday's
close and at 134.93 Japanese yen compared with
135.85.
Long-Term, which boasts two Nobel prize winners and prominent
ex-investment bankers among its officers, saw its capital all but
wiped out by adverse market movements around the world this summer.
The consortium of firms put up a $3.75 billion stake because the fund
was
seen as too big to fail. Closure could have forced it to unload
an estimated $90 billion of investments across a spectrum of unsteady
markets and may have exacerbated losses at other investment
firms.
But the infusion may only be a temporary cushion if markets continue
to
move against the fund, dealers said.
"The thinking is even though they said they don't have to liquidate
now,
it seems that them may have to eventually anyway," said
Jeffrey Yu, a senior foreign exchange dealer at Sanwa Bank Ltd.
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Among the hardest hit was UBS AG,a Swiss bank, forced to take a
writedown of
950 million Swiss francs ($684-million) on its 15-per-cent stake in the
firm. UBS' third-quarter loss will be as much as a billion Swiss francs.
Credit Suisse Group said its 1998 revenue would be cut by $55-million as
a
result of its participation in the bailout.
Dresdner Bank AG,which said losses this year stemming from its
investment
would total 240 million German marks ($144-million), did not join in the
rescue.
But the elite of Wall Street did, including Merrill Lynch & Co. Inc.,
Chase
Manhattan Corp., Bankers Trust Corp., Goldman Sachs Group Inc., J.P.
Morgan
& Co. Inc., Travelers Group Inc., Morgan Stanley Dean Witter & Co. and
Lehman Brothers Holdings Inc.
All threw in $300-million each, apart from Lehman, which anted up
$100-million.
Several individuals familiar with the situation said Lehman, Merrill and
other Wall Street houses would have been in difficulty had the hedge
fund
been forced to liquidate its portfolio.
Representatives from UBS, another of the $300-million contributors to
the
bailout, and five of the Wall Street investment banks will form a
committee
to oversee the fund's operations.
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"A worried group of leading US bankers goes into a secret, smoke-filled
meeting
on Wall Street and emerges with a plan to stop contagion spreading
through US
markets. September 1998? No. October 24, 1929, at the start of the
crash, when
J.P. Morgan and its allies famously stepped into the market in an
attempt--briefly successful--to restore confidence...the bailout of Long
Term
Capital demonstrates the extent to which the global financial crisis is
now
touching the US..." [Financial Times, Friday September 25, 1998. I thank
Bob
McGovern for pointing this quote out to me in his wonderful 'Spreading
Nite-Fax.']
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