THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 338

306 PA R T I I I FYI Financial Institutions The Long-Term Capital Management Debacle Long-Term Capital Management was a hedge fund with a star cast of managers, including twenty-five Ph.D.s, two Nobel Prize winners in economics (Myron Scholes and Robert Merton), a former vice-chairman of the Federal Reserve System (David Mullins), and one of Wall Street s most successful bond traders (John Meriwether) It made headlines in September 1998 because its near-collapse roiled markets and required a private rescue plan organized by the Federal Reserve Bank of New York The experience of Long-Term Capital demonstrates that hedge funds are far from risk-free, despite their use of market-neutral strategies Long-Term Capital got into difficulties when it thought that the high spread between prices on long-term Treasury bonds and long-term corporate bonds was too high, and bet that this anomaly would disappear and the spread would narrow In the wake of the collapse of the Russian financial system in August 1998, investors increased their assessment of the riskiness of corporate securities and the spread between corporates and Treasuries rose rather than narrowed as Long-Term Capital had predicted The result was that Long-Term Capital took big losses on its positions, eating up much of its equity position By mid-September, Long-Term Capital was unable to raise sufficient funds to meet the demands of its creditors With Long-Term Capital facing the potential need to liquidate its portfolio of $80 billion in securities and more than $1 trillion of notional value in derivatives (discussed in Chapter 14), the Federal Reserve Bank of New York stepped in on September 23 and organized a rescue plan with its creditors The Fed s rationale for stepping in was that a sudden liquidation of Long-Term Capital s portfolio would create unacceptable systemic risk Tens of billions of dollars of illiquid securities would be dumped on an already jittery market, causing potentially huge losses to numerous lenders and other institutions The rescue plan required creditors, banks, and investment banks to supply an additional $3.6 billion of funds to Long-Term Capital in exchange for much tighter management control of funds and a 90% reduction in the managers equity stake In the middle of 1999, John Meriwether began to wind down the fund s operations Even though no public funds were expended, the Fed s involvement in organizing the rescue of Long-Term Capital was highly controversial Some critics argue that the Fed intervention increased moral hazard by weakening discipline imposed by the market on fund managers because future Fed interventions of this type would be expected Others think that the Fed s action was necessary to prevent a major shock to the financial system that could have provoked a financial crisis The debate on whether the Fed should have intervened is likely to go on for some time money, particularly if it has leveraged up its positions, that is, has borrowed heavily against these positions so that its equity stake is small relative to the size of its portfolio When Long-Term Capital was rescued it had a leverage ratio of 50 to 1, that is, its assets were fifty times larger than its equity, and even before it got into trouble it was leveraged 20 to In the wake of the near collapse of Long-Term Capital, many U.S politicians have called for regulation of these funds However, because these funds operate offshore in places like the Cayman Islands and are outside U.S jurisdiction, they would be extremely hard to regulate What U.S regulators can is ensure that