News: Analysis & Commentary: THE MONEY CRISIS
LONG-TERM CAPITAL MANAGEMENT: WHAT YOU NEED TO KNOW
The rescue deal is done, but questions remain. Herewith, some answers
Not since J.P. Morgan gathered fellow bankers at his offices at 23 Wall Street to stem the stock market panic of 1907 have bankers organized such an elaborate emergency bailout to calm nervous markets. On Sept. 23, some 91 years later, representatives of 14 major banks and brokerage houses got together at the Federal ReserveBank of New York to deal with the collapse of Long-Term CapItal Management.
The Fed hosted the meeting and may have done some behind-the-scenes arm twisting. But as in J.P.'s day, it was the close-knit club of Wall Street chieftains who exerted pressure on each other to pony up $3.6 billion for the bailout. The deal got done because the firms were united in self-interest. They believed that it was necessary not only to protect themselves from big losses owing to their exposure to LTCM, but also from even bigger losses that could threaten the financial system.
But even as the historic private bailout was finalized on Sept. 28, many serious questions remain about why it was necessary and how the deal will work going forward. Here are some of them:
Can the consortium that controls Long-Term Capital Management dispose of the firm's $100 billion in assets without further roiling the markets?
The consortium is giving itself three years to unwind the Long-Term Capital Management portfolio, plenty of time, they think, for an orderly liquidation. They assume that global markets will recover sufficiently during that time and that interest rates will move in their favor, allowing them to dispose of LTCM's positions, cut their losses, and even make a profit.
But dealers are already sitting on large inventories of securities acquired from LTCM. That makes it harder to sell many of the securities that LTCM holds. Already, financial institutions are shrinking their balance sheets and reducing risk capital, which backs their own proprietary trading and that done by hedge funds. Less risk capital means fewer purchases of financial assets. At the same time, the leverage that is applied to the available risk capital has declined, meaning even less buying capacity. "Who is going to buy those assets?" asks a portfolio manager. "All of that paper has to be redistributed. It's going to put enormous pressure on spreads."
Were there any implicit or explicit guarantees or support offered by the New York Fed to the firms in the consortium?
It's possible the mere presence of the Fed made some participants feel they had better cooperate. But "it would be unique in my experience if there would be any quid pro quo," says Rodgin Cohen, a partner at Sullivan & Cromwell, which represents many of the banks in the bailout. Further, Deutsche Bank, which isn't even regulated by the Fed, ponied up $300 million for the bailout. It's unlikely Deutsche would agree to lesser treatment than, say, Chase Manhattan Corp., which also put up $300 million, if Chase was getting any Fed favor.
The main card the Fed has is subtle and very limited. If a firm doesn't participate in such an exercise, it may find itself out of favor with a powerful regulator. "If there is a margin call in the future, you may come out on the wrong side," says one banking source. Some sources speculate that Bear Stearns, which declined to participate in the bailout, could encounter a frosty reception if it needed help from the Fed. Says one analyst, "[Bear Stearns CEO James E.] Cayne better hope he doesn't get in trouble himself."
Peter Bakstansky, a senior vice-president and spokesman for the Fed, denies that there were any implicit or explicit guarantees to rescue LTCM. "We don't get into the moral hazard business. We don't wink at bad loans," he says. "That's not how the world works."
In the midst of Fed-brokered negotiations with the consortium, Berkshire Hathaway, American International Group, and Goldman, Sachs & Co. offered to buy out LTCM for $250 million and commit $3.75 billion to running the portfolio. LTCM did not accept the offer. Why?
Many market players say that LTCM's investments are ultimately winning positions. "It's like a poker player who has a really good hand but not enough chips," says David Berry of Keefe Bruyette & Woods. "The other guy keeps raising the ante and he can't stay in the game." Rather than accept the offer from Berkshire, AIG, and Goldman, which valued the portfolio at $250 million and required LTCM chief John Meriwether to walk away, Meriwether and his team gambled on getting a deal that would leave them with a 10% equity stake and the opportunity to share in any upside. Since the consortium agreed to inject $3.65 billion for a 90% stake in LTCM, their offer valued that 10% stake at about $400 million.
Isn't there a possibility that the consortium of 14 investment and commercial banks will engage in illegal market practices--manipulation, collusion, frontrunning, or the like?
A spokesman for the consortium says that its agreement will put Chinese walls and barriers in place to prevent collusive activity. Some money managers say that consortium members may even quietly use their privileged information to bet against LTCM's positions, which could undermine any collusion. Others, though, are wary about this unusual arrangement. After all, an operating committee of six institutions, Merrill Lynch, Goldman Sachs, J.P. Morgan, Morgan Stanley Dean Witter, Travelers, and UBS will be allowed to share market information and even each have a representative on-site at LTCM's Greenwich (Conn.) headquarters. "It has the potential, if it's not managed properly, to be a huge collusive activity," says one money manager.
Some individuals in the consortium members have big investments in LTCM while their firms are participating in the bailout. Won't there be serious conflicts of interest?
There is the appearance of conflict. For example, Merrill Lynch & Co. CEO David Komansky had $800,000 invested in LTCM through a fund of funds in his deferred compensation plan, while Merrill is putting up $300 million for the bailout. And Merrill executives have a total of $22 million invested in LTCM through the same deferred comp plan, which is now worth $2 billion.
But this is an insignificant portion of Komansky's wealth. "Any suggestion that this relatively minor investment would motivate this decision is ludicrous on its face," says a Merrill spokesman. Komansky has much more riding on doing a good job as chief executive, and not just because he has $100 million in Merrill stock alone.
Under the deal, LTCM and its investors will be allowed to keep 10% of the firm. Why should LTCM, which created such a mess, and its investors be allowed to retain any equity?
The thinking among consortium members may have been that a sliver of equity would keep the 14 partners who own Long-Term Capital Management involved in managing the bailout. But even if these men, including Meriwether, should make some money when the bailout is complete, some of the LTCM partners may have to declare personal bankruptcy, says a source close to the firm. The partners and some of their employees had all their money in the partnership, which was virtually wiped out. The partners made grievous mistakes, but even if they retain some equity, they have been subjected to a vicious punishment.By Leah Nathans Spiro, with Suzanne Woolley, in New York