Moody’s Warns of Potential for LTCM Type Hedge Fund Failure

According to Bloomberg, Moody’s has altered investors to the possibility of a repeat of the 1998 Long Term Capital Management hedge fund crisis.

We should be so lucky. As we have said before, the LTCM crisis has been widely, and in our opinion, mistakenly seen as a vindication of the workings of the financial system. The perps suffered, the markets were saved.

Reality is more complicated. It was lucky indeed that the risks, however great they were, were confined to one massive player. This enabled the powers that be to understand the situation (LTCM had to go over all its positions with its counterparties) and devise a bail-out.

If you read any of the books that covered this event, such as Roger Lowenstein’s “When Genius Failed,” you will see how this exercise consumed a tremendous amount of senior management attention at all the top Wall Street firms, and also required a lot of legal horsepower. It’s hard to imagine Wall Street having the managerial capacity to run several operations like that simultaneously.

What happens if several large firms come unglued at more or less the same time? In a calmer market, you might see a rerun the Amaranth failure: some good news copy, a bit of schaudenfreude, and then back to business as usual. But as with the subprime mess, given how opaque hedge fund holdings are, any fund trading in a style similar to a hedge fund that got in trouble would be at risk of having its credit facilities cut, which would lead to forced selling, which would deepen the crisis (the alternative is that the funds would have to go expose their positions to their prime brokers to prove their solvency, something that they have adamantly refused to do to date).

So all things considered, we should be glad if all we have is an LTCM-style problem.

From Bloomberg:

Moody’s Investors Service warned that the global credit rout may cause a major hedge fund collapse on the same scale as Long-Term Capital Management LP in 1998.

Hedge funds face potential losses on collateralized debt obligations, securities packaging other assets, Chris Mahoney, vice chairman of Moody’s, said on a conference call today. Buyers and sellers of “risky assets” are unable to agree on prices, causing the market to seize up, Mahoney said.

“A possible consequence of the repricing of risk assets would be the failure and disorderly liquidation of a hedge fund or other institution of sufficient size as to disrupt markets, as LTCM threatened to do in 1998,” Mahoney said.

Credit markets started falling in June as two Bear Stearns Cos. hedge funds collapsed because of bad subprime bets. Goldman Sachs Group Inc., the world’s most profitable securities firm and second-largest hedge fund manager, was forced to put $2 billion of its own money into one of its hedge funds and waive some fees after the fund lost 28 percent of its value this month.

Basis Capital Fund Management Ltd. yesterday told investors losses at one of its hedge funds may exceed 80 percent as the U.S. subprime mortgage rout prompted creditors to force the Sydney-based company to sell assets.