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 1.
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 do is ensure that