How a Big Hedge Fund Marketed
Its Expertise, Shrouded Its Risks

By STEVEN LIPIN, MATT MURRAY and JACOB M. SCHLESINGER
Staff Reporters of THE WALL STREET JOURNAL

How could so many have been so wrong?

There was no rogue trader. Nor is there evidence that anyone was manipulating a market. Instead, the collapse of Long-Term Capital Management L.P. and the threat that its failure could paralyze global finance arose from a lack of controls in a business that shrouds itself in secrecy.

The last-minute rescue of Long-Term Capital on Wednesday has begun to shed light on a vast and complex network of loans, deals and relationships among risk-taking hedge funds and the world's biggest and most-sophisticated financial institutions. It suggests that only the topmost insiders of Long-Term Capital knew before its near-collapse the extent of its highly leveraged global bets -- and just who had backed them with how much money.

Now the world knows that Merrill Lynch & Co., J.P. Morgan & Co., Goldman, Sachs & Co. and Travelers Group, Inc. -- the elite of America's financial powerhouses -- as well as a few dozen other global heavyweights, either didn't know about or were comfortable with the risks they were taking in their dealings with Long-Term Capital. But sophisticated models that were supposed to evaluate risk didn't work. Bankers overestimated the value of collateral amid market turmoil. And they were fixated on their own narrow risks without regard to, or perhaps knowledge of, Long-Term Capital's overall risk profile.

More worrisome still, the federal regulatory agencies, the guardians of the U.S. financial system and, by extension, the global financial system, were in the dark. With no authority to regulate or even monitor private investment funds like Long-Term Capital, the Securities and Exchange Commission, the Federal Reserve and others relied on the institutions they do regulate -- commercial and investment banks -- to be the government's eyes and ears.

"Hedge funds are strongly regulated by those who lend the money," Federal Reserve Chairman Alan Greenspan told a congressional hearing just 10 days ago. "They are not technically regulated in the sense that banks are, but they are under fairly significant degree of surveillance."

Yet William McDonough, president of the New York Fed, didn't seem to think there was enough scrutiny. Even as his deputies were scrambling earlier this week to bring together the banks and securities firms that would provide $3.5 billion to buy Long-Term Capital a respite from its problems, Mr. McDonough was in London urging banking regulators from around the world to pay more attention to the risks and complexities of derivatives and other hybrid investments.

"The nature and amount of these risks depends in large part on difficult-to-observe factors, such as the quality of controls and the degree of correlation among markets under stress," Mr. McDonough warned.

And Treasury Secretary Robert Rubin wasn't nearly as sanguine as Mr. Greenspan about the ability of banks to monitor their clients' risks. In a counterpart to Mr. Greenspan's congressional testimony, Mr. Rubin told the same hearing that while hedge funds are monitored by creditors, "that assumes the creditors are careful. And I think one of the problems you have is at a time like this, where you've had five, six, seven years of good results ... people who extend credit tend to get a little less careful. And I think that's one of the problems in our system."

As Long-Term Capital teetered on the edge of collapse Wednesday, the Fed pressured bankers to broker the bailout of what was, in essence, a partnership of high-tech gamblers. "You had a very large entity that was hemorrhaging, with very large exposures at stake," says Peter Bakstansky, spokesman for the New York Fed, which engineered the bailout and which, as the central bank's window onto Wall Street, plays a crucial role monitoring the safety and soundness of the capital markets. "We are always interested in the potential for systemic upset and contagion, particularly when large amounts are involved."

The bailout averted a possible bankruptcy filing that could have dumped huge amounts of securities onto the markets. Financial firms like Long-Term Capital are governed by a peculiar provision of bankruptcy law that, in effect, would allow creditors to sell the collateral that secures two types of financial products widely used by Long-Term Capital: repurchase agreements and swaps. (In conventional bankruptcy filings, a judge effectively freezes the sale of assets of a debtor.)

With Long-Term Capital's $80 billion balance sheet and additional exposure in the form of off-balance-sheet agreements, a bankruptcy filing could have touched off a simultaneous effort by all its creditors to dump the securities backing the huge positions. Now, the parties involved can unwind their positions in a more orderly manner.

The disclosures about Long-Term Capital's precarious position and the desperation that brought together the heads of Wall Street's biggest firms to craft a bailout sent shock waves through the stocks of financial institutions Thursday. So did the decision of UBS AG, which had the largest exposure among banks tied to Long-Term Capital, to write down its entire exposure to the firm of $678.5 million. And the bailout already is drawing fire from critics who question the wisdom of rescuing wealthy speculators based in Greenwich, Conn., when entire emerging economies can't get similar help from the world's wealthiest nations.

From its headquarters in the Connecticut suburb, Long-Term Capital earned billions of dollars for its partners and their clients. The driving force behind Long-Term Capital was a handful of brilliant men. Two of them -- Myron Scholes and Robert Merton -- won Nobel prizes for economics. Another, David Mullins Jr., is a former vice chairman of the Federal Reserve. Their leader: John Meriwether, hailing from Salomon Brothers, where he built a reputation as a masterful trader before being caught up in that firm's government-bond-trading scandal in 1991. Together, the partners used sophisticated computer models to bet billions of dollars, most of it borrowed from others, on the way markets would move.

Awestruck by the brainpower and storied pasts of the Long-Term Capital partners, some of the best financial minds on Wall Street backed the firm to the hilt, sending it wealthy clients, lending it money at extremely favorable terms and even, in some cases, investing their own funds. David Komansky, Merrill's chairman and chief executive, James Cayne, Bear Stearns Cos.' chief executive, and Donald Marron, PaineWebber Group Inc.'s chairman and chief executive, were among the executives who invested personal stakes in Long-Term Capital.

The low-cost loans were one important harbinger of eventual trouble, according to finance experts. "Long-Term did get terms that were better than the normal run-of-the-mill hedge funds, and they were imprudent terms," says Stephen Modzelewski, a principal at Watermark Group, a hedge-fund-management company. The lenders "were not requiring adequate capital to support the risk-taking activities. Nobody was asking if there was any good-faith money behind the trades; they were just assuming there were Ph.D.s. To a certain extent, I think Wall Street had stardust in its eyes."

Such attractive financing terms enabled Long-Term Capital to amass a gargantuan portfolio of assets. In late August, Long-Term Capital was supporting a balance sheet of $125 billion of assets, about 54 times its capital base of $2.3 billion at the time, say people familiar with the situation. And that was modest compared to the leverage the firm employed before it began to run into trouble. Earlier this year, for instance, Long-Term Capital was supporting positions, including off-balance-sheet swaps, that were almost 100 times its capital base, those people say. (Even now, it has capital of roughly $600 million supporting assets of $80 billion.)

Secrecy was another part of the formula for disaster. Hedge funds by their nature don't want clients -- or anyone else -- to learn what they are doing, at least not until their bets are in place. And Long-Term Capital was more scrupulous about secrecy than most hedge funds. Unlike other funds, Long-Term Capital wouldn't disclose the nature of its trades even after it made money with them. Investors who insisted on knowing such details were told bluntly that the firm didn't work that way -- and that if they didn't like it, they could take their money elsewhere. But only, of course, after the three-year minimum investment period had expired.

That combination of secrecy and arrogance may have accelerated Long-Term Capital's slide into near collapse. "The problem with Long-Term is that they have been treating their clients like trash," says a Geneva-based banker who deals with hedge funds. When Long-Term Capital tried to shore up its finances earlier, before things spun out of control, few were willing to invest more money, the Swiss banker says.

"If they had had a better relationship with some of their clients, they would have been in a better position to raise more money," he says. "When I called people who had put money with the firm, none wanted to put more in."

Investment and commercial banks that were lending money to the firm or were selling or buying derivatives from it had a somewhat better picture, at least of their part of Long-Term Capital's dealing. But apparently, no one outside Long-Term Capital knew the full extent of the firm's global portfolio of bets. Thus it was impossible for anyone outside to assess the full panoply of risks facing Long-Term Capital and, by implication, every firm that dealt with it.

"No one had their arms around the whole situation because of the lack of transparency," says an executive at one firm that dealt with Long-Term Capital.

And that raises the specter that another similar failure could be brewing somewhere in the world. "I don't think this is a one-shot deal," says Edward Furash, a bank consultant in Washington. "You just don't know where the others are."

Much of Long-Term Capital's success in previous years apparently was the result of its sophisticated models, devised by its Nobel laureates, to predict how various markets would act and react in essentially normal times. While Long-Term Capital won't comment, bankers who were present at the meeting to craft the bailout say that the firm's models failed to take into account what might happen in the event of a world-wide financial crisis that caused unusual reactions in markets.

That was precisely what happened in mid-August when Russia suddenly devalued its ruble and defaulted on some of its debt. Those actions touched off a world-wide flight to safety that resulted in heavy purchases of U.S. Treasury bonds and widespread sales of riskier debt instruments. Both moves flew directly in the face of Long-Term Capital's leveraged bets and set up the conditions that quickly pared the value of its assets.

"You're not talking about a lone trader making a mistake; you're talking about a situation where they had their models wrong," says Henry Hu, professor of law at the University of Texas and an expert in risk management. "When these rocket scientists design the models, they don't take into account the low probability, but high-stress events."

Shortly after Russia's devaluation and default in August, rumors started flying that Long-Term Capital had sustained big losses and was scrounging to meet margin calls from lenders. Only then did bankers start pressing the firm for a more-detailed accounting of its risk profile.

According to one banker, "Over the course of the last month, there have been an awful lot of people visiting, talking to and making sure they knew the status of Long-Term. People have been very focused on this for some time, and the individuals in Long-Term have been very good about telling people how they were doing and keeping their bankers in touch. But what was very clear was that if you drew a straight line and continued to be forced to unwind at this pace, they were eventually going to run out of money."

Of course, the banks' biggest concern was that their own proprietary positions were covered. In many cases, they were: Banks such as J.P. Morgan and Barclays, among many others, had collateralized their exposures to Long-Term Capital through T-bills and cash, which would clearly hold their value. As Long-Term Capital's problems worsened, the firms that had lent it money stepped up their demands for more collateral.

"Everybody knew" Long-Term Capital was in serious trouble, says a banker who was at the rescue meetings. "Everybody was making margin calls when appropriate. This didn't sneak up on people. What happened is it sped up. It overtook itself."

Still, through the end of last week, Long-Term Capital was meeting margin calls by selling securities and drawing heavily on a longstanding $900 million credit facility headed by Chase Manhattan Corp.

Over the weekend, though, the situation became critical. Before the Fed intervened on Sunday to coordinate the rescue, several banks discussed unwinding their exposures, a process that would have cost most banks only a few million dollars in fees, so long as all the banks didn't do it at once. But when the Fed entered the picture, any such notions were set aside in the interest of preventing a rush to unwind.

Most bankers were aware that Long-Term Capital's market exposure was large enough and cut across enough varied markets that if the fund were forced into sudden liquidation, markets around the world would be disrupted yet again. Many illiquid securities held by Long-Term Capital would have to be dumped at well below face value.

"There was a very clear recognition that given the leading positions of the firms and their relationships with Long-Term, that if any single firm decided to cut and run, then the value of everyone's collateral would begin to deteriorate," says a bank chief executive who was at the Fed meetings. "You'd just have a run.

"Basically, there is now a three-year period to unwind this," he says. "We definitely believe something has to be realized over time."

--Mitchell Pacelle and Anita Raghavan contributed to this article