The fluke hurricane

The Jonathan Davis Column: The hedge fund saga proves that the unexpected always strikes in the end

NEW YORK: a month after news of the great hedge fund crisis first broke, it is clear that fallout from this traumatic event has yet to run its course. The boss of the Swiss bank UBS has lost his job, thanks in part to the huge losses which it ran up on its lending to the stricken hedge fund, Long Term Capital Management.

The head of Bank America, America's largest bank, joined the list of casualties this week, resigning after disclosing losses of $400m to another hedge fund, D E Shaw. Question marks are also being raised about the future of other prominent bankers who put money into LTCM.

On a broader scale, we have had the rapid and decisive moves by the Federal Reserve, America's central bank, to demonstrate that it is prepared to cut interest rates again and again if necessary to prevent a systemic financial crisis. The bank's chairman, Alan Greenspan, is taking no chances that the crisis might get out of hand.

The markets have arrived at the same conclusion, although as long as the unwinding of LTCM's huge bond and currency positions continues, we are bound to see continued distortions in both the price of bonds and the dollar/yen exchange rate. Some think that Mr Greenspan is prepared to see short term interest rates fall as far as 3 per cent, if necessary, as they did during the long and painful 1990 recession.

But if monetary easing is on the way for certain, are most people clear about how the hedge fund crisis blew up? No seems to be the answer. The popular view remains that this was just another case of cash-rich, herdlike bankers rushing to lend too much money to a bunch of clever speculators - which is how most people regard hedge funds.

The true story, it now emerges, is that LTCM was indeed taking huge, highly leveraged bets on expected movements in the bond and currency markets (also, to a lesser extent, in the stock market). The reason it borrowed so much money was precisely because the expected margins on its complex trading strategies was so small: as little as three to five basis points in some cases (one basis point is the equivalent of 0.01 per cent).

This was classical arbitrage activity, but on a scale that has never been seen before (and presumably will not now be seen again for a good long while). In principle, far from being a social evil, this kind of cross-trading between assets, by keeping anomalies to a minimum, is one of the glues that is meant to hold successful financial markets together.

It is a mistake to assume that what LTCM was doing was reckless speculation on a grand scale. Just as casinos know that they must eventually take money off the roulette player because of their in-built odds advantage, so the high-powered experts at LTCM - with its two Nobel Economics prize winners and a small army of ex-Salomon traders - believed their strategies were 99 per cent certain to pay off over time.

So what went wrong? The answer is that LTCM was hit by a sudden and dramatic reversal in the historical relationship between different yields in bonds and currencies. What caught them out was the magnitude and speed of the change and the extent to which it was suddenly replicated across the whole range of the world's bond and currency markets.

Just as a top poker player can be outdrawn on the last card by a lucky amateur, so the hedge fund wizards at LTCM were dramatically caught out by the turn of events which in turn were triggered by the Russian debt default in July. What hit them was a fluke hurricane, the less than 1 per cent chance which is always out there waiting to pounce when least expected.

Were the partners wise to take this risk? In retrospect, clearly not. It is a graphic reminder that what appear to be long standing and stable relationships in the markets are always vulnerable to dramatic and violent interruptions. The unexpected does always strike in the end.

The good news is that, assuming Mr Greenspan succeeds in stabilising the financial system, the traumatic volatility the hedge fund saga has created produces all sorts of opportunities for the smart investor.