Three Mile Island in Hedge Fund Land

The hedge fund business just experienced its own personal Three Mile Island. At least we hope the Long Term Capital debacle is just Three Mile Island, and not Chernobyl, which would shut down all investment in unregulated managed pools.

Like Three Mile Island, which virtually eliminated the possibility of more nuclear power plants being built in this country, LTCM will prevent anyone from ever again amassing a leveraged sum that far exceeds the boundaries of common sense, let alone the margin requirements. Unfortunately, unlike Three Mile Island, the fallout in hedge fund land hurts those of us who run by hydro or natural gas or plain old No. 6 oil to generate solid returns.

That's too bad, because what I do for a living has nothing to do with what the geniuses at Long Term -- and I use that term loosely -- claimed to be doing, or were actually doing with investors' dollars. I am a stock picker. If I find a stock that I think will go up, I buy it. If I find a stock that I think will go down, I sell it. Occasionally, I borrow money from a brokerage house to buy something of terrific value, but it is never more than can be returned rather promptly -- read tomorrow -- to the lender.

Long-Term, on the other hand, had nothing to do with investing, per se. I think it represented a kind of wayward blackjack book, where bets were placed at virtually every casino in the world. Most of the bets didn't look like bets. They were contracts, or pieces of paper, that, to labor the analogy, paid off small sums if Long Term "pushed," larger sums if it won, and smaller sums if it lost. Long Term allegedly did not care which cards came up: It had figured out a system where no matter what the cards, it was supposed to make money.

LTCM was so confident that it borrowed money from every casino in the world. Heck, the casinos were thrilled to lend it. They didn't even ask for a lot of collateral, because, hey, they liked these kinds of bettors. They don't eat or drink and they drop plenty of dough on underwritings. What's worse, the pit bosses put their own money with these card sharps. Let's make it even worse: They put their clients' money in with these guys and everybody borrowed more house money to make the bets bigger.

Then one day, Long Term found a casino that didn't play by the rules, the Russian tables. Here Long Term had leveraged to the hilt, but whether blackjacks came up or sixes or sevens, there was no payout; truly market-neutral! So Russia knocked it out. That's all that happened to Long Term.

I wish it were more complicated than that, but the Nobel laureates simply believed that all tables were created equal, silly them.

Now we all have to suffer the consequences. If the pit bosses, I mean the brokerage honchos, hadn't looked the other way or were on vacation in the Hamptons when Russia went bust, the situation would not have deteriorated to the point where the New York Fed had to break a few heads and get everybody to pony up so brokerages left holding Long Term's worthless markers didn't collapse. And believe me, they would have, because the markers that Long Term has left frankly are not really understandable, and indeed, salable, to anybody, or they would have been sold already.

I suspect that the intense pain felt by the 14 unwilling consortium members as they realize that it takes a Nobel laureate to understand just how awful the situation really is, will be enough to rein in the next guy. But no matter, we have to waste a lot of taxpayer time and money trying to pass rules that will never be broken again because no one but the dominion of arrogance that was Long Term Capital would ever get away with this amount of ridiculous leverage. That era ended with the closing of the third quarter.

>To order reprints of this article, click here: Reprints