CNNfn September 23, 1998 8:42 p.m. ET

Hedge fund gets help

Long-Term Capital in pact for infusion after trading strategies result in losses

Managed Funds Association

NEW YORK (CNNfn) - Long-Term Capital Management, a renowned hedge fund that is considered Wall Street's "Dream Team," late Wednesday reached a $3.5-billion bailout agreement with its principal lenders to stay afloat.
The bailout puts an end to speculation the hedge fund -- started in 1994 by former Salomon Brothers trading legend John Meriwether as well as two Nobel laureates -- would need to liquidate billions of dollars of investments to meet minimum capital requirements.
A consortium of major commercial and investment banks -- which include Goldman Sachs, Merrill Lynch, Morgan Stanley Dean Witter, Travelers Group and UBS Securities -- will provide the equity infusion, which will raise the fund's net asset value to more than $4 billion.
"We greatly appreciate the willingness of the consortium to provide capital, which we are confident will stabilize our fund," said Long-Term Chief Executive John W. Meriwether in a statement.
As part of the agreement, a committee consisting of representatives from the lenders will oversee Long-Term's trading and risk reduction activities.
The hedge fund's dire capital needs drew the attention of the Federal Reserve Bank of New York, which was directly involved in the negotiations.
The hedge fund has been battered since the end of the summer through its arbitrage-trading strategies, people familiar with the matter said.
Among the strategies employed by the Greenwich, Conn.-based money-management firm was one in which Treasury bond futures were "shorted" -- borrowed securities were sold in hopes that they could be bought back at a lower prices. At the same time, the hedge fund invested in higher yielding (and higher risk) mortgage-backed or corporate debt securities.
The strategy -- known as playing a credit spread -- generates huge profits so long as Treasury bond prices remain stable or drop.
But since the stock market began plunging in July, bond prices have skyrocketed as investors fled for cover in the quality of securities that were backed by the U.S. government. From a yield of 5.6 percent in late June, bond prices have rocketed, sending the yield (which moves in the opposite direction) down to 5.16 percent.
In addition, Long-Term Capital placed huge bets in the equity derivatives market.
By August, Long-Term Capital recorded losses of 44 percent -- pushing its year-to-date losses to 52 percent, according to "MAR Hedge," a Manhattan-based newsletter that tracks hedge funds.
By mid-September, the hedge fund with its capital base of $2.3 billion, recorded trading positions totaling $107 billion, yielding a leverage ratio greater than 50 to 1 -- high by any measure.
"It's very difficult to get that kind of leverage. Hedge fund managers have seen Long-Term liquidating to other funds," said one person familiar with the situation.
Speculation now has spread throughout the financial community that Long-Term is having difficulties meeting its minimum capital requirements -- its so-called "margin call."
Investors said the hedge fund is unwinding its trades. As evidence, the current discrepancy between the cash and futures prices for the benchmark 30-year bond has increased to unusual levels.
On Wednesday, the long-bond ended down 7/32 in the cash market while bond futures rose 11/32.
"That's a huge basis shift. If you look at the historical moves, I'd be surprised if you find anything close to that," said another hedge fund manager who requested anonymity.
At the beginning of the year, Long-Term Capital actually returned roughly half of its capital base -- then at $6 billion -- to investors. In a letter sent to investors last September, Meriwether explained its capital base had reached excessive levels.
"Their ability to deliver superior returns was being compromised given the substantial asset base and for that reason they returned capital to limited partners," one person familiar with the situation said.
It's also understood that the partners -- including Meriwether, former Fed Vice Chairman David Mullins, and Nobel laureates, Myron Scholes and Robert Merton -- may have lost most, if not all, of their personal investments in the firm. It's unclear what the bailout plan will mean for the partners.
-- from staff and wire reports