The Secret World Of Hedge Funds

Hedge funds are under close scrutiny because of the $3.6 billion private bailout of Long-Term Capital Management LP, facilitated by the Federal Reserve Bank of New York. Outside of Wall Street, little is known about these secretive and largely unregulated investment funds.

Here are some questions and answers about hedge funds.

Q: What are hedge funds?

A: They're investment funds that make sophisticated financial bets with money from wealthy investors. Hedge funds often use the money to speculate on relative differences in interest rates among securities.

Q: How do they do that?

A: They use computer modeling and derivatives. These are often-complex financial instruments whose value is derived from an underlying security, commodity or asset in hopes of producing a profit, no matter which direction stock prices or interest rates move as a whole.

Q: How many hedge funds are there?

A: Nobody knows for sure. Experts estimate there are as many as 4,000 domestic and offshore hedge funds controlling as much as $400 billion in investor equity.

They are not subject to the same kind of strict disclosure and oversight rules as mutual funds because high-rolling investors presumably have the resources to look after themselves. The government doesn't require hedge funds to disclose investors' names or investment strategies even to investors themselves.

Q: How wealthy do investors have to be to participate?

A: Federal securities laws limit participation in each fund to 500 investors. Individuals must have incomes of at least $200,000 in each of the past two years ($300,000 for couples) or a net worth of at least $1 million.

Q: Why should we be concerned about hedge funds?

A: The collapse of a major hedge fund could damage the banking system and the economy. The banks and brokerage firms lending to the fund would face huge losses, and unwinding of the fund's positions could spur panic selling and losses for other investors.

John Meriwether, chairman of Long-Term Capital Management
In the case of Long-Term Capital, three of the companies that joined together to rescue the fund and take control of it - Bankers Trust, Chase Manhattan and J.P. Morgan - are banks that benefit from the taxpayer-financed deposit insurance fund. Some critics suggest that puts ordinary taxpayers at risk, and that banks that lend money to troubled hedge funds may pass the costs on to consumers.

Q: How did Long-Term Capital make its financial bets and what went wrong?

A: It was a two-step process. The fund received about $2.2 billion in capital from its original invesors and it also borrowed money from financial institutions to buy securities worth more than $90 billion. Fund managers then used those securities as collateral to make speculative bets representing $1.25 trillion.

Among those making a minimum investment of $10 million was the government of China. Other countries may also have contributed, but it's hard to tell because of the lack of disclosure rules.

Unfortunately for the fund and its investors, Long-Term Capital's investment models failed to account for the sudden collapse of the Russian ruble in late August or the dramatic intensification of the global financial crisis, which has widened the spread between interest paid on U.S. Treasury securities and other less-safe securities.

Q: Who was running Long-Term Capital when it got into trouble?

A: The 4-year-old fund's chairman, John Meriwether, is one of Wall Street's most celebrated traders. His senior partners include two Nobel laureate economists and a former vice chairman of the Federal Reserve. The fund is based in Greenwich, Conn.

Q: What happened in the past few weeks when Long-Term Capital nearly collapsed?

A: A group of major banks and brokerage firms began talks about chipping in to save it, with officials of the Federal Reserve Bank of New York acting as facilitators and providing office space.

At one point, the fund's managers reportedly turned down a $250 million buyout offer by legendary investor Warren Buffett, American International Group Inc. and Goldman Sachs. The offer was conditioned on Meriwether being ousted.

When it was over, the group of banks and brokerage houses had agreed to put up $3.6 billion to rescue Long-Term Capital and take control of it. In addition to the three banks mentioned above, the group also includes brokerage houses Merrill Lynch & Co., Morgan Stanley Dean Witter, Goldman Sachs, Salomon Smith Barney and several big European banks.

Q: Why did the Federal Reserve get involved?

A: Federal Reserve Chairman Alan Greenspan testified at a recent congressional hearing that the central bank stepped in to avert potential damage to the U.S. and world economies.

Written by Marcy Gordon