The Long Term Capital Debacle
Long Term Capital Management was a hedge fund managed by a group that included two Nobel Prize winners and 25 other Ph.D.s. It made headlines in September 1998 because it required a private rescue plan organized by the Federal Reserve Bank of New York. The experience of Long Term Capital Management demonstrates that hedge funds are not risk free, despite their being market neutral. Long Term Capital expected that the spread between long term Treasury bonds and long term corporate bonds would narrow. Many stock markets around the world plunged, causing a flight to quality. Investors bid up the price of Treasury securities while the price of corporate securities fell. This is exactly the opposite of what Long Term Capital Management had predicted. As losses mounted, Long Term Capital’s lenders required that the fund increase its equity position. By mid September, the fund was unable to raise sufficient equity to meet the demands of its creditors. Faced with the potential collapse of the fund, together with its highly leveraged investment portfolio consisting of nearly $80 billion in equities and over $1 trillion of notional value in derivatives, the Federal Reserve stepped in to prevent the fund from failing. The Fed’s rationale was that a sudden liquidation of the Long Term Capital Management portfolio would create unacceptable systemic risk. Tens of billions of dollars’ worth of illiquid securities would be dumped on an already jittery market, causing potentially huge losses to numerous lenders and other institutions. A group consisting of banks and brokerage firms contributed $3.6 billion to a rescue plan that prevented the fund’s failure. The Fed’s involvement in organizing the rescue of Long Term Capital is controversial, despite no public funds being expended. Some critics argue that the intervention increases moral hazard by weakening the discipline imposed by the market on fund managers. However, others say that the tremendous economic damage the fund’s failure would have caused was unacceptable. Hedge funds have continued to fail in the years since the Long Term Capital bailout. In September 2006, Amaranth Advisors lost its bet on natural gas futures and dropped $6 billion in one week. This is currently the largest hedge fund collapse in history. Other funds have suffered significant losses for their investors, including Advanced Investment Management (lost $415 million), Bayou Management, LLC (lost $450 million) and Lipper Convertibles (lost $315 million). Hedge funds are a high risk game for well heeled investors.