The hypocrisy of it is mind-boggling, even by Wall Street standards. Long-Term Capital Management, a piggy bank for the rich, makes a series of atrocious bets. Its managers, stern advocates of the free market when other people's fortunes are at stake, are bailed out in a Federal Reserve-engineered rescue that leaves them--astonishingly--still owning 10% of their firm despite their market-roiling mismanagement.

It's easy to lash out at LTCM and at hedge funds in general. And yes, new regulation is necessary--but not aimed randomly at the funds. Instead, regulators should focus on the high-octane "fuel" that powered LTCM directly into a brick wall. What is really to blame here is the excessive use of leverage, especially when investing in derivatives and currency. Whether such leverage be employed by a hedge fund or trading desks at a bank or securities firm, it is currently almost entirely unregulated.

The mistake would be to regard John Meriwether's brazen brainchild as representative of all hedge funds instead of a style of investing. Most of these private investment partnerships just buy and sell stocks at the levels of leverage available to all investors. Among the funds that use stocks alone, leverage is modest. According to figures compiled by Hennessee Group LLC, a leading consulting firm for hedge fund investors, such funds beefed up their equity portfolios with leverage by just 32% as of January, 1998--a far cry from the more than 25-to-1 ratio employed by LTCM.

Such massive bets as LTCM placed can go cataclysmically bad. But they would be impossible if some limits were placed on leverage. Regulators need to ride herd by setting trigger points at which investors would be forced to disclose their leverage but not necessarily their investment strategies. Gauging precisely where to place the limits is the job of the Fed and other agencies.

These rules should apply to any investment vehicle doing business with U.S. financial institutions. This includes so-called offshore funds run by U.S. hedge funds and other trading firms.

True, limiting leverage may make some high-tech investment strategies difficult or impossible. It might also cut into the derivatives business of banks and Wall Street firms. If that's the case--well, so be it. LTCM's near-disaster proves that the risks from overblown leverage don't justify the rewards they can provide a few superrich traders and their bankers.

Seven years ago, one regulator pointed out that the market "is too important a national resource and it works too well to be put at risk by regulatory change for the sake of change." That official was David Mullins, then vice-chairman of the Federal Reserve, who went on to become one of the brains behind LTCM. Mullins was discussing the Salomon Brothers bond-trading scandal, in which his future partner John Meriwether played a role. But while Mullins was right about inappropriate regulation, he should also recognize that the market is also too important to be placed at risk by the irresponsible excess of a few traders.

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