Last fall, Long Term Capital Management, a billion-dollar Greenwich, Conn., hedge fund run by bond guru
John Meriwether and a cadre of quantitative whiz-kids and
Nobel Prize winners, nearly tanked -- almost taking the U.S. stock market with it.
LTCM was eventually rescued by its Wall Street lenders in a bailout engineered by the
New York Federal Reserve Bank a year ago this evening. The resulting $3.5 billion
rescue plan, hammered out by the heads of 14 major financial firms, sent shivers down Wall Street.
Exactly a year later, the Long Term Capital risk is gone, chalked up as a costly learning experience, and hedge funds are doing surprisingly well, thank you. Meantime, the risks inherent in the aggressive use of leverage, best illustrated by the demise of Meriwether's bunch, have sobered some in the hedge fund industry but failed to trickle down to individual investors.
"Last year scared the hell out of everybody," says John Purnell, an investor with
Polaris Capital of Columbia, S.C., a so-called fund-of-funds that invests in several hedge funds and private investment partnerships. "There's simply no threat of that magnitude out there, where one person or one fund was investing with leverage at a 100-to-1 ratio" of the instruments in a portfolio like LTCM held, Purnell says.
But, examining individual investors, "it looks like tulip bulbs to me," pipes David Shaw, the head of
D.E. Shaw, referring to the 17th-century Dutch speculation craze. "I'm alarmed at the amount of margin lending, but also that so many people are planning to retire on assets that are of questionable value."
So, as the market cools, hedge funds are again doing what they were meant to do: outperform the broader market. "After four years of a roaring bull market in which hedge funds have not kept pace, we are now seeing a change," wrote Lois Peltz, doyen of hedge funds, in this month's issue of industry rag
MAR Hedge.
LTCM Makes Its Mark
30-year Treasury bond yield over two years |
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| Source: Baseline, ILX |
For the first seven months of 1999, 60% of hedge funds outstripped the until-recently unstoppable
S&P 500 benchmark index. For all of 1998, only 13.5% of hedge funds beat the S&P.
"Long Term Capital was the best thing to ever happen to hedge funds," argues Jack Doueck of
Stillwater Partners. "LTCM taught the world that you just don't take a call from Meriwether, plunk down your money and walk away without asking any questions."
Even wizards such as David Shaw are drawing the curtain back. "Do we tell our investors our formulas? No. But we now write risk papers for our investors to allow people to understand what we're doing," he told an alternative-investment conference this week, adding sheepishly: "I don't know why we didn't do this a long time ago." (
Bank of America (BAC Quote) last year lost
$372 million on a $1.4 billion loan to D.E. Shaw, a hedge fund and trading firm that saw its own problems last year.)
So, a year after the scare, hedge fund investing is going legit. The huge
California Public Employees' Retirement System last month got the OK from its board to invest up to $11 billion, or roughly 25%, of the state pension fund's actively managed portfolio, in hedge funds known as an "hybrid investments."
"Hedge funds were absolutely discredited by the end of 1998. They were slightly below mafia captains in the social hierarchy," says Hunt Taylor of hedge fund consultancy
Tremont Advisors. "Now Calpers, the nation's largest public pension fund, says they'll allocate a quarter of their portfolio to hedge funds. It changes everything."
So what else has changed? In some respects, nothing. Some would invest with the Long Term Capital founders again. Asked what they would do if Meriwether, the former
Salomon Brothers bond trader and founder of LTCM, came knocking for new money a year later, six out of eight hedge fund investors interviewed for this story said they would at least hear him out or consider investing. And if Meriwether sold used cars?
Recall that in July 1998, LTCM had $4.1 billion in investor capital. Using loans from nearly every brokerage and investment bank on Wall Street, Meriwether put roughly 60,000 trades on LTCM's books, including $500 billion in notional positions in the futures markets.
By August, as the Russian markets crumbled, LTCM was down to $2.5 billion in capital, but it was still supporting $125 billion of balance sheet assets, according to the
President's Working Group on Financial Markets report, issued in April 1999.
Now, investment firms such as
Merrill Lynch (MER Quote) and
Deutsche Bank, says Doueck, have edged back into hedge fund lending. A Merrill spokesman says the firm never stopped lending to hedge funds, and a Deutsche spokeswoman declined to comment.
The spirit of LTCM still haunts the fixed-income markets, where credit spreads have to recover from 1998. "The Long Term Capital bankruptcy was the most visible manifestation of a lack of liquidity" in bond markets, says
Myron Scholes, a former partner in LTCM and Nobel Prize-winning economist who, along with colleagues, invented the widely used
Black-Scholes options-pricing formula. "We're still seeing it. Credit spreads have widened to even higher levels than in the summer of 1998."
In response to the LTCM crisis, the President's Working Group recommended earlier this year that hedge fund managers should make quarterly reports available on their funds' financial health. But there are no laws requiring them to.
New regulations on margin lending haven't arrived yet, either. Tom Reuss, former House Banking Committee chairman, called on
Fed Chairman Alan Greenspan to cut the percentage of stock purchases that investors are allowed to borrow; that level, called the margin limit, has been set at 50% since 1974. The reason lies with the individual investor.
Whatever wisdom securities firms gained from the LTCM damage, it didn't trickle down to the individual-investor community. Trading on margin became a tragic footnote at two Atlanta daytrading shops and the industry was vilified for its practices, especially those involving margin.
Some numbers: Americans are on a margin-debt binge -- that is, buying stock with borrowed money. At midyear, stock-purchase loans totaled $180 billion, seven times the level of 1990 and by far the most ever recorded, according to the not-for-profit
Financial Markets Center.
Margin debt accounts for 1.2% of the stock market's value, the most since the crash of 1987, but within historical limits. "Before LTCM, the bond markets had built up about 10 years worth of leverage -- maybe $100 billion -- that came out of the market in six weeks," says one major hedge fund investor. "Where did that credit go? From the bond to the stock market. There's much more leverage in the stock industry than two years ago."
Byron Wien, chief U.S. investment strategist for
Morgan Stanley Dean Witter, recently estimated the stock market is 35% to 38% overvalued.
Where's the bogeyman? Take a look in the mirror.
