New York Times, September 25, 1998
The concept of "too big to fail" has now been extended to a huge hedge fund that was run by people thought to be financial wizards. The bailout of the fund by a consortium of the country's leading financial institutions is a reminder of how fragile the world's financial markets now are, and of the risks of making big bets that markets will act in predictable ways.
The hedge fund was run by John Meriwether, the former Salomon Brothers official widely viewed as a Wall Street genius. His forte was in trading bonds, buying those that were relatively cheap and selling those that were relatively expensive. The idea was to make a little money on each trade, and make a lot of money overall by using borrowed money to buy bonds in large quantities. For very dollar put up by investors in the fund, Mr. Meriwether seems to have borrowed more than $20.
In determining what investments to make, Mr. Meriwether and his colleagues, including two Nobel Prize-winning economists, had sophisticated computers that reviewed historical prices of bonds and other financial instruments and found relationships between them. Strategies were then calculated on the assumption that events hat had never happened before could not happen at all. But they did. Bond prices almost always rise and fall together. But in the current financial crisis, the prices of United States Treasury bonds have soared as investors bought them in search of safety while the prices of most other bonds- backed by corporations or by other governments- have fallen, as investors grew nervous about the risks involved.
Unfortunately, Mr. Meriwether, who at the peak was managing more than $100 billion- the vast majority of it borrowed money- had bet against such an occurrence. After all, that is what happens almost all the time.
The odds were with Mr. Meriwether, whose fund returned profits of more than 40 percent a year in 1995 and 1996, and of 17 percent in 1997, even after hefty management fees. But betting the way he did turns out to be a little like Russian roulette: the odds of winning are very good, but you can't play again if you lose.
Effectively, Mr. Meriwether's fund has been taken over by the banks and brokerage houses that lent money to it. Investors in the fund- who had to put up a minimum of $10 million each- are likely to lose virtually all the money they invested. There is no public money in the $3.5 billion bailout, but it was organized by the Federal Reserve, which stepped in because of fears that shaky financial markets would suffer even more if Mr. Meriwether's fund was forced to liquidate its holdings.
At best, markets will return to normal and the banks that kept Mr. Meriwether's fund afloat will make some money, perhaps even enough to share with the original investors. At worst, markets will continue to sink and the bailout money will vanish.
The great bull market of the 1980's and 1990's has been built in significant ways on leverage, as big players found ways to borrow to the hilt. Now the banks that made the loans are getting nervous and demanding more collateral before lending to other hedge funds. That contraction in credit is prudent, but it will put more pressure on financial markets that are already feeling the strain.
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