Financial Times FRIDAY SEPTEMBER 25 1998

MERIWETHER: Emperor stripped bare

The rescue of John Meriwether's hedge fund is a defining moment for Wall Street, says Richard Waters

The timing could hardly have been more apt - or more alarming. At the very moment on Tuesday when Alan Greenspan, the chairman of the Federal Reserve Board, was warning the US Congress of the dangerous new fragility that has crept into the financial markets, Wall Street's finest were gathering in New York to rescue an institution which has the potential to disrupt already jittery markets and even start a credit crunch.

The object of their concerns was not a bank that had lent unwisely. Nor was it an emerging market that had become too dependent on fickle foreign capital - the usual suspects that keep central bankers awake at night.

It was a hedge fund called Long-Term Capital Management, run by one of Wall Street's "masters of the universe", John Meriwether. It was as if one of America's great financial institutions was facing ruin.

This is an affair that goes to the heart of the most sophisticated modern financial operations. Mr Greenspan has warned Congress for some months that it is the instability of the financial system, rather than the state of the global economy, that poses the most immediate threat to American prosperity. To judge by his comments before the Senate earlier this week, he still remains a fan of modern markets - but he worries that the speed and mercilessness of the markets may sometimes wreak havoc.

By making it possible to carve up risks more effectively, said Mr Greenspan, derivatives such futures and options help create a more efficient mechanism for directing capital to the most suitable users at the lowest cost. He added, though: "It is a system more calibrated than before to not only reward innovation but also to discipline the mistakes of private investment or public policy."

Long-Term Capital provides a vivid example of how that savage the discipline can be. Thanks to his vaunted reputation, Mr Meriwether, who used to run Salomon's bond-trading operations, was able to draw down vast pools of money from the markets.

Unfortunately, contrary to its name, Long-Term Capital turned out to be a short-term institution. The money sucked in threatened to flow out again - just as it had from Indonesia or South Korea. And with its near-collapse, Long-Term Capital is testing an entire form of finance built on the technology of the derivatives markets, to destruction. It also turns out to pack an unexpectedly large punch: more than $100bn could be at risk, according to people involved in the bail-out.

One measure of Long-Term Capital's importance is the manner in which it was pulled back from the brink on Wednesday night.

The New York Fed, which is charged with ensuring the smooth running of the nation's financial markets, does not use its powers of persuasion lightly. Yet it took the unusual step of nudging some of the country's biggest banks to come up with extra support for Mr Meriwether. If the hedge fund's exposures do indeed reach anything close to $100bn, then the institution's power to disrupt the financial markets was as great as any fair-sized bank or country. The clear message: this fund was too big to fail.

By contrast Barings, the UK investment bank that was sunk by Nick Leeson's unauthorised trading in Japanese stocks, suffered the opposite unhappy fate: it could be allowed to fail without fear that the ripples would submerge other institutions as well.

But Long-Term Capital is dangerous not only because of its sheer size. Just as important, the very nature of its complex investments meant that, if it failed, no one really knew what the consequences might be.

When Drexel Burnham Lambert, the creation of junk bond king Michael Milken, folded in 1990, the effects in the financial markets were direct and measurable. The market for sub-investment grade debt that Mr Milken had invented went into a tailspin: but the effects were limited, largely foreseeable - and junk bond finance soon revived to become a driving force on Wall Street again by the mid-1990s.

With Long-Term Capital, though, things are far less clear. In common with other hedge funds, it was not subjected to any requirements to disclose the nature of its investments. With their exposure to an array of international markets, often through highly leveraged derivative instruments, hedge funds such as Long-Term Capital have become agents of the financial contagion that has swept around the world since Russia defaulted on its foreign debts. When funds like these retrench across the board, the contagion can leap across oceans, spreading from Asia to Latin America.

Because of this uncertainty, the banks that lined up to back Mr Meriwether do not - indeed cannot - yet fully understand what they have bought. But they took the view on Wednesday evening that it was better to save the fund and find out what was wrong during a period of relative calm, rather than let it go under, and discover the worst in a forced liquidation: it was simply not possible to predict what knock-on effects this would have triggered.

While the bomb has been defused for now, however, the story is far from over. Three questions stand out.

First, and most immediately, what happens to Long-Term Capital and its massive exposures? If calm returns to the financial markets, the banks that saved the fund may find that by early next year they can wind down many of its investments and even show a profit for their troubles. That is what they hope.

But that is a big if. It is difficult to see exactly how contagion and instability will be brought to and end. Also, the presence of such a large fund as Long-Term Capital waiting to be unwound will itself hang heavily over the markets. So will the heightened level of fear prompted by this week's events.

Second, there is the question of whether there are more such bombs waiting to go off - and in particular whether (if there are) Wall Street will have the appetite to come to the rescue next time.

This is a question that will preoccupy credit-risk managers and central bankers in North America and Europe in the coming weeks. But the fact that they are only just beginning to try to find out the extent of the exposures to hedge funds is hardly an encouraging sign. Like indulgent parents, they may have allowed these offspring to grow into unruly teenagers that they can no longer understand or control.

If more funds fail, the appetite for further bail-outs may well prove limited. The Wall Street houses that lined up to back Mr Meriwether have been engaged in a flight from risk ever since Russia defaulted. As the head of one big investment bank put it in August, the time had come to "batten down the hatches." That means scaling back their balance sheets, reducing exposures to markets that are considered the most scary, cutting back lines of credit to more doubtful institutions - including hedge funds.

Among the people to line up behind Mr Meriwether was Sandy Weill, chairman of Travelers and the man who will control America's biggest financial institution when his acquisition of Citicorp is completed in two weeks' time. Mr Weill has already made it clear that he does not have any appetite for this type of risk: within months of buying Salomon Brothers last year, and enraged by that banks' hefty losses from forms of trading very similar to Mr Meriwether's, he closed down Salomon's own high-risk bond trading positions. He is unlikely to keep dipping his hands into his pocket if other hats are passed around.

The third, and perhaps most troubling question is what on earth can be done in the long term, to the financial system to limit the risk of more problems like Long-Term Capital's?

Heavier regulation of hedge funds might be one option, but it would probably prove ineffective. Unlike commercial or investment banks, these funds are not required to hold certain levels of capital as a buffer against losses - a luxury Mr Meriwether took to the extreme by piling a mountain of liabilities on a relatively slender capital base.

As one US financial regulator said yesterday, capital rules would probably prompt the hedge funds simply to shift their operations to an off-shore centre like the Cayman Islands. The only sure-fire way of building a fence around a domestic financial system is to erect the sort of currency controls that Malaysia has just imposed - hardly an option for a developed economy.

That suggests that Wall Street will have to discipline itself. And this time around, it may have received the sort of surprise that will induce more caution, at least for a time.

Other financial debacles in the derivatives markets have been blamed on the failure of individual institutions, rather than any inherent danger in the markets themselves. When Orange County was pushed into bankruptcy four years ago, it was blamed on the naivety of Robert Citrone, the county treasurer who had decided to dabble in high finance. When Bankers Trust, an early pioneer of the derivatives markets, came unstuck , it was put down to a lack of control over the bank's gung-ho traders.

This time, Wall Street will find it harder to shrug the debacle off. Some of the best-known investment and commercial banks believed devoutly in the methods that Mr Meriwether and his troops were using. They invested heavily in them, too. This was a fund, after all, that could boast not one but two Nobel laureates, including one of the men credited with developing the theory for pricing options, the intellectual foundation on which the derivatives markets have been established.

Mr Meriwether and his cohorts numbered themselves among the emperors of modern finance. The emperor, it turned out, had no clothes.