The Hurricane George of the financial markets - the disaster of a hedge fund known as Long-Term Capital Portfolio LP - could prompt a storm of lawsuits against the 14 securities firms and banks that joined forces last week to bail it out.
The private consortium's $3.5 billion ownership stake in the almost-bankrupt hedge fund - taken at the prodding of the Federal Reserve Bank of New York - has angered its members' own institutional shareholders. They say the firms let their swashbuckling client get in over its head, then forked over more money to save it.
The near-collapse may result in increased federal oversight of now-unregulated hedge funds. It also could mean stricter regulation of the loans banks make to let hedge funds leverage their bets on global market moves to goose returns. Expect major institutional investors to keep the financial stocks they own on a tighter leash, too.
Certainly, UBS AG will get a closer look. The Swiss bank says it will take a $685 million write-off against earnings this quarter to cover its losses from the Greenwich, Conn., investment fund's bad bets on European interest rates.
"If a brokerage got hurt so the stock price goes down, then there's a significant chance of an investor lawsuit," says hedge fund lawyer Roger Joseph of Bingham & Dana in Boston.
Money managers with big holdings in banks and securities firms, while stopping short of mentioning legal action, are fighting mad.
"Brokerages are taking extraordinary risks that as shareholders we weren't aware of," complains Rand L. Alexander, a partner at Wellington Management Co. in Boston. The $10 billion Hartford Advisers Fund LP he runs is a big holder of Travelers Group Inc. and Merrill Lynch & Co., both among those bailing out Long-Term Capital. Mr. Alexander is particularly miffed at Travelers, which now owns the Salomon Brothers unit that spawned Long-Term Capital founder John Meriwether, who played the eponymous $10 million game in the book "Liar's Poker." He resigned from Salomon following an early-1990s bond-trading scandal.
"This is not what we bought the stock for:for you to gamble with the shareholders' money," Mr. Alexander says.
Another Merrill investor, Richard Dahlberg, chief investment officer of equities at Pioneer Group in Boston, as well as manager of Pioneer II Fund, says it's only a matter of time before the truth sinks in with retail investors: The country's biggest banks and securities firms are providing a $3.5 billion bailout to protect their own interests.
"This is the kind of stuff that will get the people to revolt against the holy triumvirate -- the securities industry, banks and the Federal Reserve," says Mr. Dahlberg, who recently joined the firm from Salomon Asset Management. "You got consumers who are a day late on mortgages and they get soaked by the very same guys" extending more credit to Long-Term Capital.
But one lawyer sees the current bailout as a way for brokerages to [set ital] avoid lawsuits. George Mazin, a partner in the Roseland, N.J., law firm Lowenstein Sandler, says brokerages remember the 1994 Askin Capital Management case, where investors sued and argued that the securities firms liquidated their holdings before allowing the loss-plagued fund to earn back enough money to repay them. "They may have learned their lesson," Mr. Mazin says, "and they're doing everything possible to avoid lawsuits."
The Fed's push for a private rescue -- to prevent a meltdown of global markets if Long-Term Capital had been forced to liquidate an estimated $80 billion in leveraged positions plus billions more in derivative investments --may have given Wall Street investment banks an unfair advantage over the pension and mutual funds they serve.
The group, which included 10 investment banks, now has the advantage of knowing what Long-Term Capital might have been preparing to liquidate. They could unwind their own firms' positions and get out before prices plunge.
"The entire credit market has been compromised," says one peeved hedge fund manager, who spoke on the condition of anonymity. "They have inside information. They are going to front run. This is a disaster for fairness in the marketplace."
Long-Term Capital may be the first in a string of troubled funds. One consultant counts at least 120 other hedge funds that employ similar fixed-income arbitrage strategies.
Of course, Long-Term Capital was highly leveraged even by hedge fund standards. It borrowed $26 for every $1 of capital. Only 15% of hedge funds employ leverage greater than 2: 1, according to a late-1997 study by Van Hedge Fund Advisors in Nashville, Tenn., which has invested $200 million in a variety of hedge funds for high-net-worth individuals.
"There will be a silver lining in that advisers and investors will do a lot more due diligence and ask a lot more questions as to what managers have in their portfolios," says Van president Steve Lonsdorf.
Wall Street wasn't the only place consumed by Long-Term Capital late last week. So, too, was Capitol Hill -- a rare diversion from Monicamania.
House Banking Committee chairman Jim Leach, R-Iowa, says he will hold a hearing about hedge funds before Congress adjourns, but declined to say when. "It is important to know who the losers are from the collapse of Long-Term Capital," Mr. Leach said at a press conference Friday. "Is it only big financial firms? Or do the losers include endowment, pension and mutual funds ... ordinary citizens?"
Others are hoping banks will see restrictions on how much they can lend to hedge funds. What got Long-Term Capital in trouble -- it actually managed just $500 million in investor capital -- was that it borrowed to the hilt as it placed an estimated $80 billion worth of bets on a variety of interest rate changes. Then Russia blew up. That wreaked havoc on Long-Term Capital's quantitative analysis on potential interest rate movements.
Regulators will "bear down and establish parameters for how much leverage banks can provide," predicts Lee Hennessee, managing director at hedge fund advisers Hennessee Group LLC in New York.
Anna Robaton and Marlene Givant Star contributed to this report.Co., both among those bailing out Long-Term Capital.
Mr. Alexander is particularly miffed at Travelers, which now owns the Salomon Brothers unit that spawned Long-Term Capital founder John Meriwether, who resigned from Salomon following an early-1990s bond-trading scandal.
"This is not what we bought the stock for: for you to gamble with the shareholders' money," Mr. Alexander says.
Another Merrill investor, Richard Dahlberg, chief investment officer of equities at Pioneer Group in Boston, as well as manager of Pioneer II Fund, expects a public backlash. "This is the kind of stuff that will get the people to revolt against the holy triumvirate -- the securities industry, banks and the Federal Reserve," says Mr. Dahlberg. "You got consumers who are a day late on mortgages and they get soaked by the very same guys" saving Long-Term Capital.
The Fed's push for a private rescue -- to prevent a meltdown of global markets if Long-Term Capital had been forced to liquidate tens of billions of dollars in leveraged positions -- may have given investment banks an unfair advantage over the pension and mutual funds they serve.
The group, which included 10 investment banks, now knows what Long-Term Capital might have been preparing to liquidate. They could unwind their own firms' positions and get out before prices plunge. "The entire credit market has been compromised," says one peeved hedge fund manager. "They have inside information. They are going to front run. This is a disaster for fairness in the marketplace."
Long-Term Capital may be the first in a string of troubled funds. One consultant counts at least 120 other hedge funds that employ similar fixed-income arbitrage strategies.
Of course, Long-Term Capital was highly leveraged even by hedge fund standards. It borrowed $26 for every $1 of capital. Only 15% of hedge funds employ leverage greater than 2: 1, according to a 1997 study by Van Hedge Fund Advisors in Nashville, Tenn., which has invested $200 million in a variety of hedge funds for high-net-worth individuals.
"There will be a silver lining in that advisers and investors will do a lot more due diligence and ask a lot more questions as to what managers have in their portfolios," says Van president Steve Lonsdorf.
Wall Street wasn't the only place consumed by Long-Term Capital late last week. So, too, was Capitol Hill -- a rare diversion from Monicamania. House Banking Committee chairman Jim Leach, R-Iowa, says he will hold a hearing about hedge funds before Congress adjourns.
Others foresee restrictions on how much banks can lend to hedge funds. What got Long-Term Capital in trouble -- it actually managed just $500 million in investor capital -- was that it borrowed to the hilt as it placed an estimated $80 billion worth of bets on a variety of interest rate changes. Then Russia blew up. That wreaked havoc on the fund's quantitative analysis of potential interest rate movements.
Regulators will "bear down and establish parameters for how much leverage banks can provide," predicts Lee Hennessee, managing director at hedge fund advisers Hennessee Group LLC in New York.
