Fed liquidating hedge fund
On September 22, the New York Fed invited a core group of three firms to a meeting to discuss the LTCM situation.
The core group, later expanded to a fourth firm, formed three working groups to consider possible solutions, one of which came up with the idea of a consortium approach.
Hedge funds’ capital structure is vulnerable to market shocks because most of them offer high liquidity to loss-sensitive investors.
Moreover, hedge fund managers form expectations about each other based on market prices and investor flows.
LTCM generated above-normal returns of 20 percent in 1994, 43 percent in 1995, 41 percent in 1996, and 17 percent in 1997 (Siconolfi 1998).
the likelihood of runs rises as both the market exposure of funds and the price sensitivity of trend followers increase….” “Panic-based crises [are] crises that occur just because agents believe they are going to occur, which is the common feature of most crises in several parts of the financial sector…Hedge fund managers, sharing common investors and interacting with each other through market price, sensitively react to other funds’ investment decisions.This is a major source of “endogenous market risk” to popular investment strategies and subsequent price distortions in financial markets, leading to both setbacks and opportunities in arbitrage and relative value trading.and thus fund managers are cautious, holding more cash prior to crises…If an exceptionally devastating liquidity shock sweeps the market, fund investors may start to request capital withdrawals from their funds in response to the initial loss…In the worst case, hedge funds collectively exit the market, not because of risk itself, but because of fear, which explains the stock market exodus of hedge funds during the Quant Meltdown of 2007 and Lehman Brothers’ bankruptcy of 2008.” “Fund withdrawals…explain half of the decline in the equity holdings of hedge funds [during the great financial crisis]…In September 1998, a group of 14 banks and brokerage firms invested .6 billion in LTCM to prevent the hedge fund’s imminent collapse.
The arrangement was facilitated by the Federal Reserve, though the Fed did not lend any of its own funds. The capital infusion forestalled a fire sale of LTCM assets into already turbulent markets and instead allowed for an orderly liquidation of the hedge fund’s holdings.
FRBNY President William Mc Donough (R) and Federal Reserve Chairman Alan Greenspan (L) testify during a hearing on systemic risks to the global economy from hedge fund operations (Photo: Luke Frazza/AFP/Getty Images) On September 23, 1998, a group of fourteen banks and brokerage firms invested .6 billion in Long-Term Capital Management L. While the Federal Reserve brought the market participants together and oversaw the refinancing, it did not put its own funds at risk.