By ANITA RAGHAVAN and
MITCHELL PACELLE
Staff Reporters of THE WALL STREET
JOURNAL
At an extraordinary gathering Wednesday night, Wall Street's biggest power brokers agreed to prop up one of their most aggressive offspring, Long-Term Capital Management L.P., a highflying hedge fund that was on the verge of collapse.
Heeding a plea by Merrill Lynch Co. Chairman David Komansky to put aside any misgivings, Travelers Group Chairman Sanford I. Weill, Goldman, Sachs Co. Senior Partner Jon Corzine and J.P. Morgan Co. Chairman Douglas "Sandy" Warner were among those who agreed to have their organizations pony up more than $3.5 billion to shore up Long-Term Capital, a creation of some of Wall Street's ostensibly most brilliant minds.
The rescue was the culmination of increasingly intense negotiations among Long-Term Capital's lenders, dealers and the Federal Reserve that began last weekend as rumors spread that the fund was close to foundering. Long-Term Capital, which uses borrowed money to make multibillion-dollar bets all over the globe, had tried for weeks on its own to draw in more capital to shore up its rapidly failing positions, even approaching famed global investor George Soros, who said no.
Manhattan Gathering
As it became increasingly clear that Long-Term Capital was teetering on the edge of collapse, with lenders pressing claims for billions owed to them, top executives of 16 investment and commercial banks gathered at New York Fed headquarters in lower Manhattan in an effort to coordinate a rescue.
The presence of so many of Wall Street's elite in the paneled elegance of a Fed meeting room and the Fed's intense involvement reflect both the enormous size and the complexity of Long-Term Capital's highly leveraged balance sheet and the timing of its problems.
Long-Term Capital, with assets currently estimated at $80 billion, had borrowed heavily on generous terms from Wall Street's biggest names, and it held a complex array of derivatives and futures contracts on a variety of debt instruments that trade on markets in a number of countries. Unwinding so many complex bets could have meant big losses for Long-Term Capital's counterparties and lenders, perhaps jeopardizing the financial health of some of them.
As if that weren't reason enough to draw the attention of chief executives and the president of the New York Fed, William McDonough, who hopped a flight Tuesday night from London to New York, all this occurred at a moment of growing anxiety about the health of the world economy. In response to fears that market turmoil could lead to global recession, Fed Chairman Alan Greenspan Wednesday suggested that he may soon cut U.S. interest rates, President Clinton has asked Mr. Greenspan and Treasury Secretary Robert Rubin to convene their international counterparts to seek new solutions, and high-level efforts are under way in Washington and in Latin American capitals to prevent Asia's and Russia's woes from infecting another continent.
Exercising Clout
While the Fed has no jurisdiction over risk-taking hedge funds like Long-Term Capital, it is responsible for the safety of the nation's banks. And it was that clout, together with the self-interest of several big firms that already had lent billions of dollars to Long-Term Capital, that helped fashion the rescue.
The aim: give Long-Term Capital a respite from loan repayments and margin calls that it wouldn't have been able to meet otherwise. Once global markets calm down, Long-Term Capital could unwind some of its failed bets and repay some of its debts. But the firm's long-term future -- and that of its legendary founder John Meriwether -- remains in serious doubt.
The rescue package "buys it six months," says one person familiar with the meetings. "Then there's two choices: Either they buy it back from us, hopefully at a profit, or we decide, 'OK, let's liquidate over a period.' "
Terms of the pact reached late Wednesday call for 11 firms to put in $300 million apiece and four other firms to put in between $100 million and $125 million each -- all in exchange for a 90% stake in the hedge fund. Five of the firms will also form a new committee to oversee Long-Term Capital's overall strategy, procedures, controls and even compensation. They would also have an option to buy 50% of the management company for a dollar.
Long-Term's situation was so dire that if the bailout plan hadn't been sealed Wednesday night, the hedge fund wouldn't have been able to meet margin calls Thursday, people familiar with their situation say. Goldman's Mr. Corzine told the group that his investment bank wasn't ponying up the cash because of its own exposure, but rather because of the risks to the system that a collapse of Long-Term Capital would pose. Some executives, however, questioned whether Wall Street securities firms should be trying to rescue a group of trigger-happy traders that had wound up in such a mess.
In its brief existence as a highflying hedge fund, Long-Term Capital -- with the help of two Nobel-laureate partners -- made a name for itself with its complex, billion-dollar bets on the difference between interest rates on various bonds. The strategy failed the firm last month, when Russia's financial debacle prompted investors world-wide to flee all manner of risks. That made many interest rates move in the opposite direction than the firm was betting. The upshot: Long-Term Capital's capital was down 44% in August, to $2.3 billion, and now stands at just $600 million.
Almost every major Wall Street securities firm and many large commercial banks have extended credit lines to Long-Term Capital. Although the fund managed just $4.8 billion at the start of the year, it borrowed heavily to boost its returns. According to one Wall Street executive, the value of its positions at the end of August topped $125 billion.
But the size of those positions is believed to have since been whittled down to somewhat more than $80 billion as the fund has sold assets under pressure from lenders.
Wednesday's talks were set to start at 10 a.m., but were delayed amid reports that Goldman had lined up a buyer -- believed to be investor Warren Buffett -- for some of Long-Term Capital's assets, according to people familiar with the situation. But the talks resumed at 1 p.m. after no buyer had come forward. A spokesman for Mr. Buffett wouldn't comment.
It was Herbert Allison Jr., Merrill's president and chief operating officer, who presented an initial bailout proposal, detailing how each firm would be asked to contribute about $250 million for a stake in the hedge fund, the same people said. Merrill's Mr. Komansky argued that while there are better uses for the sums involved, "there are times you have to step up to the plate."
One of the hotly debated issues at the meeting was whether a collapse of Long-Term Capital would put the entire financial system at risk. Salomon Smith Barney's Mr. Dimon argued that while there is no way of knowing the extent of the risks posed by the situation, why take the chance?
After a lengthy debate, a poll was taken: One after another, a representative of each firm indicated how much the firm was willing to ante up. Most agreed to throw in $250 million; some, arguing that their exposure to Long-Term Capital was modest, put in about $100 million, bringing the initial tally to about $3 billion -- about $500 million short of the group's target.
After a short break, the firms reconvened, putting pressure on some holdouts to fork over some cash. But the group was unsuccessful in convincing some of the stragglers. In the end, the only course left was for the biggest participants to add $50 million apiece, bringing the contributions of most to $300 million.
"We greatly appreciate the willingness of the consortium to provide capital which we are confident will stabilize our fund and enable us to continue to be active in the marketplace," Mr. Meriwether said in a statement.
The bailout effort marks an embarrassing fall from grace for Long-Term Capital, whose brain trust of partners includes David Mullins Jr., former vice chairman of the Federal Reserve Board; Stanford University scholar Myron Scholes, who won the Nobel Prize in economics for his work on the pricing of options; and Robert Merton, another Nobel laureate in economics.
"They have star power. You can't find another hedge fund in the world with multiple Nobel laureates," says Stephen Henderlite, a research executive at Tremont Partners Inc., a Rye, N.Y., hedge-fund advisory firm. "In terms of sheer brain power, there isn't another firm that has come down the pike that has looked as good on paper."
Before his incarnation as hedge-fund honcho, Mr. Meriwether was one of the most successful "Masters of the Universe" in the 1980s at Salomon Brothers. He also figured prominently in "Liar's Poker," the best-selling book that portrayed the firm's swaggering culture. But that career ended in August 1991, when he resigned in the midst of the Treasury-bond bid-rigging scandal that also cost Chief Executive John Gutfreund his job.
After Mr. Meriwether settled with the Securities and Exchange Commission, he assembled a team of financiers, economists and academics, and retreated to the relative quiet of Greenwich, Conn., where he launched Long-Term Capital in an office overlooking Long Island Sound.
The firm's recent losses follow four years of substantial returns to investors. The fund returned 42.8%, after fees, in 1995, and 40.8% in 1996, before slipping to 17.1% in 1997, according to people familiar with its results.
Mr. Meriwether's impressive track record had allowed the fund to set some of the most restrictive conditions in the business, including a minimum investment of $10 million, to be locked up for at least three years. The fund has never disclosed to investors exactly how it makes or loses money. At year end, it gives investors only a rudimentary outline of its portfolio.
The partners in the firm have a substantial amount of their own money at risk. More than one-third of the fund's capital came from the firm's principals, Mr. Meriwether recently told investors.
Long-Term Capital specializes in bond arbitrage, placing complex and highly leveraged bets on the spreads between interest rates on various types of bonds. Its core investments were convergence trades -- betting that interest-rate spreads would narrow -- in the U.S., Japanese and larger European bond markets. But the opposite happened in the global flight to quality that followed financial turmoil in Russia, and in a Sept. 2 letter, Mr. Meriwether informed investors that the fund was down 44% in August and 52% for the year.
Wall Street professionals were shocked at the level of indebtedness, or leverage, that lenders would allow the firm to incur. Although investors can typically borrow only 50% of the value of stocks they hold, there are no such limits on loans secured by debt securities.
One person close to Long-Term Capital tried to put an optimistic spin on the agreement Wednesday night, saying he couldn't imagine a scenario under which the participating banks would insist on liquidation of the fund. Under the rosiest potential scenario for Mr. Meriwether and his partners, he said, the fund's investments would recover value as bond rates begin moving in the right direction, and the participating banks that want to sever their ties to the firm would be paid with money raised from new investors. Others, he said, would keep their capital in the fund.
Despite its reputation as an industry heavyweight, Long-Term Capital isn't among the world's largest hedge-fund managers. Mr. Soros's Soros Fund Management and Julian Robertson's Tiger Management both manage about $20 billion in a series of different funds. But because few funds employ the level of leverage used by Long-Term Capital, Mr. Meriwether's fund has an inordinate impact on the markets relative to its size.
Quantitative Methods
Like many so-called "quant" funds, which use computer models and highly complicated quantitative trading strategies, Long-Term Capital is highly secretive about its operations, even with investors. That lack of "transparency" has also made some hedge-fund investors wary.
Mark Kenyon, who runs the U.S. asset-management business for Geneva-based Union Bancaire Privee, says the bank declined to invest on its own behalf because of concerns about the three-year lock-up, the high fees and the lack of transparency. But high-net-worth clients of the bank did invest, so Mr. Kenyon later found himself seeking information from the hedge fund on their behalf.
"They wouldn't tell us how much leverage they used or what investments they were making," he recalls. "We were told they didn't give out that kind of information. And if we were unhappy about that, we could have our clients withdraw."
Yet until recently, the firm hasn't lacked for capital. With limited exceptions, it has been closed to new investment since July 1995. And a year ago, when the fund had ballooned in value to about $7 billion, Mr. Meriwether took the unusual step of returning $2.7 billion to investors, saying the fund had too much capital.
Chance to Invest More
In the Sept. 2 letter to investors, Long-Term Capital said losses "occurred in a wide variety of strategies, distributed approximately 82% in relative-value trades and 18% in directional trades." Emerging markets accounted for only 16% of the losses.
As the hedge fund's equity has plummeted, its wealthy investors have found themselves stuck. In the wake of the disastrous results of recent months, the earliest that investors can seek redemptions is year end. And even then, only 12% of the equity could be withdrawn, according to the letter Mr. Meriwether sent announcing the August results.
In spite of the results, however, Mr. Meriwether tried to persuade investors to put up more capital. The firm "believes that it is prudent and opportunistic to increase the level of the Fund's capital to take full advantage of this unusually attractive environment" in the bond-arbitrage markets, he wrote. The fund, he continued, is "offering you the opportunity to invest in the Fund on special terms related to LTCM fees."
Talks With Soros
In recent weeks, Long-Term Capital has offered to cut its fees to an annual 1% of assets and 12.5% of profits for new investors, according to several people knowledgeable of the firm's pitch. Long-Term Capital also has held discussions recently with Soros Fund Management about a $500 million investment by Soros hedge funds into Long-Term Capital, according to someone knowledgeable about the talks. Soros declined to make an investment, this person said. Stanley Druckenmiller, Soros's chief investment strategist, declines to comment.
Also in recent days, commercial banks and other lenders have been attempting to sell some of the leveraged securities held by the hedge fund.
The situation raises again questions of banks' risk-management systems. After the 1994 bond-market rout, many commercial and investment banks strengthened their risk-management practices to avoid debacles. But the lure of high fees on derivative products and the increasingly lax lending standards of recent years contributed to the willingness to take more risks.
--Steven Lipin and David Wessel contributed to this article.