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Friday, September 25, 1998 Published at 11:39 GMT 12:39 UK

Business: The Company File

Wall Street rescue for hedge fund

Losses on Russia's financial markets broke LTCM

The world financial crisis has claimed its first American victim - one of the notorious hedge funds for high-risk investments. Now the US Federal Reserve bank has stepped in to organise the fund's rescue.

Director of Barings Asset Management Michael Hughes explains how the Asian crisis ties in with the troubles of hedge funds
The US authorities moved to "facilitate" negotiations between the hedge fund, Long-Term Capital Management, and leading New York investment banks after it became clear that the hedge fund was on the brink of collapse.

The news hit Wall Street shares which saw sharp falls that have spilled over to share markets around the world as investors fear further fallout from the financial crisis gripping Asia, Russia and Latin America.

The fifteen commercial banks agreed to contribute $3.75bn to rescue the fund, with each bank putting up between $100m to $300m each in return for a controlling stake in the company. They include Deutsche Bank, Barclays, Chase Manhattan and JP Morgan.

An oversight committee made up of five leading investment banks, Goldman Sachs, Merrill Lynch, Morgan Stanley, Travelers Group, and UBS, will take over management of the firm.

The boss of LTCM, John Meriwether, said he "greatly appreciates the willingness of the consortium to provide capital which we are confident will stabilise our funds."

[ image: The Federal Reserve moved in to rescue LTCM]
The Federal Reserve moved in to rescue LTCM
Goldman Sachs reportedly told the emergency meeting at the NY Federal Reserve headquarters that it was putting up the money because of the risk to the financial system that a collapse of the fund would pose.

Some reports suggest that LTCM's situation was so dire that without the rescue late on Wednesday night it would have been unable to meet margin calls for money this morning. That could have meant potential losses of billions of dollars for the banks who had invested in the fund.

UK Authorities notified

US Treasury Secretary Robert Rubin made an unusual appearance on breakfast television to reassure the markets.

"I think the system can handle everything that I am aware of..I do think the risk to our economy is real, and as the crisis has affected more countries, that risk has become greater," he said

The Federal Reserve contacted the main UK banking regulator, the Financial Services Authority, about the rescue on Tuesday, according to its director-general Howard Davies.

The LTCM had a heavy exposure on the London International Financial Futures Exchange (LIFFE), and one of the UK's biggest banks, Barclays Bank, has had to step in to help with the rescue.

In a statement, Barclays said it expected no negative impact on its balance sheet of the bail-out, which would allow the inherent value of the fund to be re-established over time.

French banks Credit Agricole, Paribas, and Societe Generale were also reportedly putting up $100m each to participate in the rescue.

Russian losses

Long-Term Capital Management specialised in bond arbitrage, trying to exploit differences in the price of government debt in different countries.

It is believed to have lost heavily when Russia effectively defaulted on its short-term GKO bonds last month.

At the beginning of September it admitted that its capital base had shrunk by half, to $2.3bn.

But because of its use of so-called derivatives, the fund's exposure was estimated at $40bn to $80bn - the sum total of the bets it had made around the world about the direction of bonds.

Derivatives are financial instruments which can be used to increase the leverage of an investment, but the financial exposure of the investors will grow at the same time.

The 'flight to quality', in which investors have fled from emerging market bonds into safe US Treasury bonds, has also hurt the fund.

By the time of the rescue, the fund's capital had shrunk to around $250m.

Financial contagion feared

The worries about the hedge fund show how events in emerging markets can interact with the financial solvency of core institutions.

The big banks had all lent money to the hedge fund, which was run by John Meriwether, a former bond trader at Wall Street trading house Salomon. He had recruited two Nobel prize winners and a former vice president of the Federal Reserve Board to his board.

With mounting losses, the hedge fund was desperately searching for more money, at one point asking George Soros, the guru of all hedge funds, to invest. He refused.

But with its futures contracts expiring, the collapse of the LTCM fund could have caused a cascade of demands for money. One bank alone had an $880m exposure.

If the banks were to pay up such sums, they in turn would have needed to call in loans from other clients, or restrict lending, which could have caused a contraction in the whole financial system.

If the big banks had found it difficult to raise the money, their solvency would also have been threatened.

It was this factor that meant the Federal Reserve - which is responsible for supervising the banks - felt it was necessary to step in.

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