LTCM's Fall Leads to Chillier Feelings on Wall Street

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The free flow of capital on Wall Street is freezing up like the Hudson River in winter, and the hedge fund industry -- particularly fixed income-related funds that thrive on high-octane leverage -- may never be the same.

Why? Simply, trust between counterparties on Wall Street is evaporating because of one hedge fund's blowup. It's not clear how much damage

Long Term Capital Management's problems have caused, but it's clear that the high-risk hedge fund run by

Salomon

alumnus and bond-trading legend

John Meriwether

has changed the face of the investing game in a way his quant models could not have predicted.

As this process unfolds, many on Wall Street expect heads to roll on many trading desks as liquidity dries up. Those facing the most trouble include traders of high-yield debt, convertibles, distressed securities and mortgage-backed securities. Moreover, the plight of LTCM has spurred calls for greater regulation, and the banks that helped finance LTCM's aggressive investment tactics are now unlikely to escape unscathed.

So-called risk-oriented hedge funds try to make big bucks in the fixed-income market by heavily leveraging their underlying portfolios to take advantage of small price differences in the markets. Wall Street investment banks that lent to these hedge funds are now in a prisoner's dilemma. Their bond-trading desks are essentially frozen, no one's taking big positions, and no one's sold out of any big positions until everyone figures out what Long Term Capital needs to unwind its massive array of bad bets.

And all that unwinding is already crimping balance sheets.

UBS

announced a writedown of $950 million stemming from LTCM losses. Multiply that writedown by 15 or so other banks that had not only an equity interest in Long Term Capital, but had extended closely guarded lines of credit, and that gives some idea just how much pain remains. As they say, a billion-dollar writedown here, a billion-dollar writedown there, and pretty soon you're talking about real money.

The list of possible victims includes just about the entire industry:

Bankers Trust

(BT)

,

Barclays

(BCS) - Get Report

,

Credit Suisse

,

Deutsche Bank

,

Goldman Sachs

,

J.P. Morgan

(JPM) - Get Report

,

Merrill Lynch

(MER)

,

Morgan Stanley Dean Witter

(MWD)

,

Travelers

(TRV) - Get Report

,

Lehman Brothers

(LEH)

and French banks

Credit Agricole, Societe Generale

and

Paribas

.

Institutions like

Bear Stearns

(BSC)

, which acted as clearing agent for Long Term Capital, and Lehman Brothers, were said to be the most at risk had the Fed not ordered the $3.5 billion rescue. "Without it, firms rumored to be on the edge, like Lehman Brothers, might be out of business," says a San-Francisco based hedge fund manager who requested anonymity.

What about other hedge funds?

III Offshore Advisors

, a West Palm Beach, Fla., fixed-income house, has been forced to liquidate its $450 million

High Risk Opportunities Hub

hedge fund, one of four managed by

Warren Mosler

. Mosler's bets rely in large part on leverage, not unlike Long Term Capital. "Their counterparties are going to have qualms about lending them any more money in a big way," says the hedge fund adviser. "Those days are gone."

Talk of more regulation for banks and hedge funds is already picking up steam.

House Banking Committee

Chairman Jim Leach, R-Iowa, says he will hold hearings before Congress adjourns on the question of how much risk exists in the hedge fund and derivatives industries. "Has the thin line between hedging and speculation changed the nature of international finance to such an extent that trade in goods and services is jeopardized rather than advanced?" Leach asked in a statement Friday. "Who are the losers from Long Term Capital? Do they include endowment, pension and mutual funds? And are the pockets of ordinary citizens jeopardized?"

William Mullen, executive director of the

Hedge Fund Association

in Washington, D.C., says the organization is in "wait and see" mode, but Congress is already hot on the Long Term Capital trail.

More regulation might be the answer, but on the margin side or the leverage side? Hedge funds answer to no oversight institution, either state or federal, even though the funds make speculative, multibillion-dollar bets with borrowed money in markets all over the world.

Federal Reserve

Chairman

Alan Greenspan

has already called for reduced use of leverage on the part of hedge funds.

But the managers call for better due diligence and transparency on the part of the banks -- and the investors in LTCM. "Let the banks ask these funds to show them the books," says Jack Doueck, principal at market-neutral fund of funds shop

Stillwater Capital Partners

in New York. "I have to do that for any loan I get."

"Aside from the guys like

Soros

who mostly make the directional bets on interest rates, a lot of hedge funds are going to go bankrupt and drop out of the business," says Dan Pierce, head of fixed income strategy at

BankBoston.

"It will bring a much-needed contraction to the industry."