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The Long Term Capital Debacle
Long Term Capital Management was a hedge fund man-
aged by a group that included two Nobel Prize winners
and 25 other Ph.D.s. It made headlines in September
1998 because it required a private rescue plan orga-
nized by the Federal Reserve Bank of New York.
The experience of Long Term Capital Management
demonstrates that hedge funds are not risk-free,
despite their being market-neutral. Long Term Capital
expected that the spread between long-term Treasury
bonds and long-term corporate bonds would narrow.
Many stock markets around the world plunged, caus-
ing a flight to quality. Investors bid up the price of
Treasury securities while the price of corporate securi-
ties fell. This is exactly the opposite of what Long
Term Capital Management had predicted. As losses
mounted, Long Term Capital’s lenders required that
the fund increase its equity position.
By mid-September, the fund was unable to raise
sufficient equity to meet the demands of its creditors.
Faced with the potential collapse of the fund,
together with its highly leveraged investment portfolio
consisting of nearly $80 billion in equities and over
$1 trillion of notional value in derivatives, the Federal
Reserve stepped in to prevent the fund from failing.
The Fed’s rationale was that a sudden liquidation of
the Long Term Capital Management portfolio would
create unacceptable systemic risk. Tens of billions of
dollars’ worth of illiquid securities would be dumped
on an already jittery market, causing potentially huge
losses to numerous lenders and other institutions. A
group consisting of banks and brokerage firms con-
tributed $3.6 billion to a rescue plan that prevented
the fund’s failure.
The Fed’s involvement in organizing the rescue of
Long Term Capital is controversial, despite no public
funds being expended. Some critics argue that the
intervention increases moral hazard by weakening
the discipline imposed by the market on fund man-
agers. However, others say that the tremendous eco-
nomic damage the fund’s failure would have caused
was unacceptable.
Hedge funds have continued to fail in the years
since the Long Term Capital bailout. In September
2006, Amaranth Advisors lost its bet on natural gas
futures and dropped $6 billion in one week. This is
currently the largest hedge fund collapse in history.
Other funds have suffered significant losses for their
investors, including Advanced Investment
Management (lost $415 million), Bayou
Management, LLC (lost $450 million) and Lipper
Convertibles (lost $315 million). Hedge funds are a
high-risk game for well-heeled investors.
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Part 6 The Financial Institutions Industry
required a $10 million minimum investment. Most hedge funds are set up as lim-
ited partnerships. Federal law limits hedge funds to no more than 99 limited part-
ners with steady annual incomes of $200,000 or more or a net worth of $1 million,
excluding their homes. Funds may have up to 499 limited partners if each has
$5 million in invested assets. All of these restrictions are aimed at allowing hedge
funds to exist largely unregulated, on the theory that the rich can look out for
themselves. Many of the 4,000 funds are domiciled offshore to escape all regula-
tory restrictions.
Second, hedge funds are unique in that they usually require that investors com-
mit their money for long periods of time, often several years. The purpose of this
requirement is to give managers breathing room to attempt long-range strategies.
Hedge funds often charge large fees to investors. The typical fund charges a
1% annual asset management fee plus 20% of profits. Some charge significantly more.
For example, Long Term Capital Management charged investors a 2% management
fee and took 25% of profits.
Despite the argument that the wealthy do no need regulatory protection from
the risk incurred by hedge fund investments, the SEC passed regulation in 2006
requiring that hedge fund advisers register. The SEC cited two concerns prompt-
ing the new move. First, they were concerned about the growing incidence of fraud-
ulent conduct by hedge fund advisers. Second, they expressed concern that more
investors were participating in hedge funds through “retailization,” and that this
justified increased oversight. By requiring advisers to register, the SEC can con-
duct on-site examinations. The SEC argues these examinations are necessary to pro-
tect the nation’s securities market as well as hedge fund investors.
Conflicts of Interest in the Mutual Fund Industry
In Chapter 7 we discussed conflicts of interest in the financial industry. We concluded
that many of the corporate governance breakdowns observed recently were due to
the principal–agent relationship. This section extends that discussion to mutual
funds, which have been subject to scandals, fines, and indictments. Several top
mutual funds managers and CEOs have even been sentenced to jail time.
Investor confidence in the stability and integrity of the mutual fund industry is
critical. A large portion of the population is now responsible for planning their own retire-
ment, and most of these investments are being funneled into various funds. If these funds
take advantage of investors or fail to provide the returns they should, people will find
themselves unable to retire or having to scale back their retirement plans. No one argues
that mutual funds can or should guarantee any specific return. They should, however,
treat all investors equally and accurately disclose risk and fees. They must also follow
the policies and rules they publish as governing the management of each fund.
Sources of Conflicts of Interest
Conflicts of interest arise when there is asymmetric information and the principal’s
and agent’s interests are not closely aligned. The governance structure of mutual
funds creates such a situation. Investors in a mutual fund are the shareholders.
They elect directors, who are supposed to look out for their interest. The directors
in turn select investment advisors, who actually run the mutual fund. However, given
the large number of shareholders in the typical fund, there is a free-rider problem
that prevents them from monitoring either the directors or the investment advisers.
Chapter 20 The Mutual Fund Industry
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3
Terry Glenn, head of the mutual funds industry’s Investment Company Institute, quoted in the Wall
Street Journal, September 4, 2003, p. C1.
C O N F L I C T S O F I N T E R E S T
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