Richard Bookstaber
In the aftermath of the Long-Term Capital Management debacle, it is clear that a large hedge fund can have a systemic impact on the market. The high leverage, forced liquidations, declining liquidity, and cascade of widening spreads turned the Greenwich, Connecticut, hedge fund’s losses into a global event. Without an infusion of capital to stem the need to liquidate to meet margin calls from its creditors, LTCM’s demise—and the collateral loss to its creditors—appears to have been inevitable. The natural questions to ask are: What was the cause of the crisis? How can this type of crisis be prevented in the future?
Recent regulatory investigation into LTCM started with an ill-defined target, the community of “highly levered institutions.” There are problems, however, with pointing to high leverage as the critical characteristic in the LTCM crisis and, for that matter, in the general description of hedge funds. The most immediate problem is defining what leverage means. After all, using conventional measures of leverage, the leverage of many hedge funds pales beside the 20+ times leverage of the broker/dealer community. Another problem is understanding why leverage should matter. A hedge fund that holds one-year U.S. T-bills with 10:1 leverage would not be considered in the same league as a fund that is levered 2:1 in riskier and less-liquid Russian Ministry of Finance bonds. Finally, not all ...

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