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David:
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:
David L. Miller asked:
> 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.
Best,
Tim Morge
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