Commentary: Hedge Fund Disaster? What Hedge Fund Disaster?

If you think Wall Street has a short memory, you're dead wrong. No, the folks who work on Wall Street, regulate Wall Street--and, above all, invest in its wares, notably its hedge funds--don't have a bad memory. They don't have any memory at all. Just take a look at the aftermath of the crisis in the financial markets caused by Long-Term Capital Management. It happened just two years ago. But as far as Wall Street and its regulators are concerned, it never happened at all.

Long-Term's principals are back in business--doing exactly the same kind of high-stakes trading strategies that got the financial world in an uproar two years ago. Meanwhile, regulators and Congress have done absolutely nothing--enacting not a single new law or regulation--to prevent a repetition of the combined secrecy and hubris that sent the financial world reeling. Now, as then, the financial world is relying on sound lending practices by bankers and major brokerages--something totally absent two years ago--to prevent another LTCM crisis.

It's an old and familiar story by now. Led by former Salomon Brothers trader John W. Meriwether, Long-Term engaged in various forms of arbitrage--wagers that relationships between the markets eventually return to historic patterns. The Russian debt default of August, 1998, and the crisis that followed, skewed those patterns dramatically. By betting on those relationships with vast sums of borrowed money, and then losing, Long-Term almost sent some of the nation's largest banks and brokerages into a tailspin.

FATAL STRATEGIES. The denouement of the Long-Term saga was a controversial Federal Reserve-sponsored bailout. In an upcoming book on Long-Term Capital, Where Genius Failed, journalist Roger Lowenstein chronicles the succession of losing trading strategies that proved fatal to this $4.7 billion hedge fund. Lowenstein argues convincingly that the bailout squandered an opportunity to give the markets a dose of needed discipline. By rescuing LTCM and its creditors, the Fed made it easier for Wall Street to forget that the crisis had ever taken place. That is precisely what happened--as proven by the fact that Meriwether is back in business, big-time. And major institutions, their identities cloaked by the opacity of the hedge-fund world, are again lending him money.

Meriwether's new trading operation is called JWM Partners. It has raised a respectable $400 million, and in the first half of the year it has climbed 7%, which is fairly typical for arbitrage funds. How much borrowed money did Meriwether use to get those returns? The fund is not commenting for the record, but a source close to the fund says JWM is using leverage in the range of 12 to 18 to 1. That's less than the 30 to 1 leverage previously used by LTCM, but vastly more than the 2 to 1 leverage typically used by hedge funds. And steep enough to make that 7% return seem ridiculously low in comparison to the risk.

Only self-restraint by everyone concerned can keep Meriwether from going back to the leverage that proved disastrous two years ago. That's because regulatory oversight is unchanged. And efforts to force hedge funds to improve their disclosures have gone nowhere. Take the bill that was introduced in Congress last September by Representative Richard H. Baker (R-La.), chairman of the House capital markets subcommittee. Baker's bill would require the largest hedge funds to provide regular public disclosures of their positions, including their use of leverage.

Hedge-fund managers hate the Baker bill, and so far they are getting their way. It is languishing in committee. And a similar fate seems likely for a little-publicized effort by the Commodity Futures Trading Commission to beef up hedge-fund disclosures. The CFTC's proposed regulation ran into a brick wall of hedge-fund opposition from the moment it was published in the Federal Register on Apr. 17. "Post-LTCM, market participants are wary and chastened," goes a July 6 comment letter from Tudor Investment Corp., run by hedge-fund magnate Paul Tudor Jones. Sure--"wary and chastened" enough to give John Meriwether 12 to 18 to 1 leverage. This tired old argument will carry the day--until regulators cure themselves of their Long-Term Capital Management amnesia.

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