The Brightest and the Brokest

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Such outrage was mingled with shock that a star-studded fund like Long Term Capital, whose seasoned investors had nearly doubled their money from 1994 to 1997, could have got so deeply in trouble. The fund was headed by legendary trader John Meriwether, who helped make Salomon Brothers the top bond house of the 1980s, as recounted in the best seller Liar's Poker by Michael Lewis. The partners, who worked out of waterfront offices in tony Greenwich, Conn., included Nobel-prizewinning economists Myron Scholes and Robert Merton and former Fed Vice Chairman David Mullins. As their price for the bailout, the creditors acquired a 90% stake in the fund, which effectively removed Meriwether and his partners from power. But huge management fees that the partners have collected could still leave some ahead of the game by tens of millions of dollars.

Last week's rescue was particularly embarrassing for Fed Chairman Alan Greenspan, who just two weeks ago assured Congress that hedge funds "are strongly regulated by those who lend the money. They are not technically regulated in the sense that banks are, but they are under fairly significant degrees of surveillance." On the other hand, Treasury Secretary Robert Rubin, a former co-chairman of Goldman Sachs, had put out a word of caution, saying that "people who extend credit tend to get a little less careful" in good times.

Star-struck lenders had virtually showered money on Meriwether and his band of supposed geniuses. While the term hedge refers to techniques for reducing risk, funds such as Meriwether's often do just the opposite by using vast sums of borrowed money to make highly speculative bets in global markets. At the peak of its borrowing, the secretive fund reportedly carried a debt load 100 times as great as its net assets, or ownership capital. This would be like putting down $1,000 of your own money to buy a $100,000 house--in a flood plain on the San Andreas fault. "Most hedge-fund managers believe that a leverage ratio in excess of 50 to 1 is exceptionally large and very risky," says Hunt Taylor, executive director of Tass Management, a hedge-fund consulting firm.

But Wall Street insiders say what really spooked the Fed was indications that Long Term Capital had off-balance sheet derivative contracts with a value of more than $1 trillion. Derivatives are financial instruments that bet on the future direction of interest rates, stock indexes or currencies. Defaults representing less than 1% of that whopping sum could have sunk the fund and punished banks and investment firms around the world.

Why did Long Term Capital suddenly lose money after years of winning? Short answer: the fund's investing formulas were blindsided by the financial meltdown that has spread so rapidly from Asia to Russia and Latin America. In essence, Meriwether's computers were programmed with historical relationships among various global bond yields and other financial instruments. They looked for discrepancies in those relationships and bet that they would return to their historical norms. But the deepening global crisis caused a flight to the safety of U.S. Treasury bonds, which drove up prices that Meriwether's computers said should be falling. The resulting losses chopped Long Term Capital's net worth from $4.8 billion in January to just $600 million last week.