Investment and commercial bankers scrambled Thursday to size up their exposure to losses at hedge funds, following the $3.5 billion bailout of the huge Long-Term Capital Management LP.
Some observers said mounting losses at the complex investment funds could become the latest unexpected crisis to hit the banking industry. But others said Long-Term could prove to be an isolated case.
"People are shocked and still trying to figure out what's going on," said a leading banker, who asked not to be identified. "It's just too early to tell if this is the first domino or not."
Added Lawrence Cohn, research director at Ryan, Beck & Co.: "It's not another Latin America at this point, but I'm amazed at the extent this early on."
Though many said they were encouraged by the intervention of the Federal Reserve Bank of New York, fears flared anew at midday when Union Bank of Switzerland said it would take a $717 million third-quarter loss as a result of its dealings with Long-Term Capital.
Long-term Capital is one of the largest of a burgeoning group of investment funds that take elaborate and often risky positions in global financial markets. Long-Term and at least one other big fund have taken big hits in the wake of the Russian economic crisis.
Hedge funds are significantly leveraged, posing a risk for banks. Long- Term Capital of Greenwich, Conn., had parlayed $4 billion of capital into $100 billion of investment positions thanks to funding from a consortium of banks and brokerages.
On Wednesday, many of those firms signed on to bail out the hedge fund, which nearly collapsed from losses on more than $90 billion invested in financial markets around the world. The New York Fed helped facilitate the rescue plan, which involves Wall Street and banking giants.
When a hedge fund goes belly up, a bank can collect its collateral-the securities in which the fund invests. But when those securities lose substantial value, a bank can take a huge hit.
"The commercial or investment bank makes a credit decision about what margin is appropriate," said Ron Reading, a managing vice president with First Manhattan Consulting Group in New York. "But they're operating in a competitive environment."
A firm's ability to get hedge fund trading business is tied to its willingness to provide favorable margin terms, Mr. Reading explained. In turn, margin requirements have shrunk to extremely low levels.
But some experts said many hedge funds are not as leveraged as Long- Term. According to Van Hedge Fund Advisors International, a hedge fund consulting firm in Nashville, 54.3% of 5,500 U.S. hedge funds use a low level of leverage while 30.1% do not use any at all.
"The perception is that hedge fund managers are a bunch of cowboys in the Wild West, but the vast majority of hedge funds use very little leverage or none at all," said Steven A. Lonsdorf, president of Van Hedge.
He added that more banks have become involved with hedge funds in recent years, which has increased the risk.
Banks with substantial trading operations are considered to have the greatest exposure to hedge funds. Chase Manhattan Corp. and Citicorp have huge global trading operations. Spokesmen for those banks declined to comment.
For its role in the debacle, UBS called the events "extraordinary" in a statement issued Thursday, adding that the bank's "structural earnings power remains unaffected."
Traders extending leverage to Long-Term Capital were likely swayed by the star power of its management, said Cynthia A. Glassman, partner at Ernst & Young, Washington. Long-Term is headed by John Meriwether, a former Salomon Brothers vice chairman, and two Nobel Laureates.
"The people that run that fund are very highly respected so they have a lot of credibility," Ms. Glassman said. "They are not your run-of-the-mill hedge fund people. They are people the market respects.
"These were character loans. They were relying on the people."
Still, many on the street are worried there are more losses to come. Investment banks considered at-risk include Merrill Lynch & Co., Goldman, Sachs & Co., Salomon Smith Barney Inc. and Morgan Stanley, Dean Witter & Co.
Spokesmen for those banks declined to comment. But sources said Merrill Lynch is expected to announce substantial losses from hedge fund trading by the end of the week.
In the near term, bank analysts said the Long-Term Capital bailout has produced two effects. First, margin requirements for hedge funds are likely to rise. Second, banks are likely to demand more disclosure about the funds' finances.
However, Ms. Glassman said even the best precautions may not have prevented the debacle.
"What happened in the market seemed to catch everyone by surprise," she said, especially "the depth and breadth of the problems and the way they exacerbated each other"
Meanwhile, problems at Long-Term have caught the attention of banking regulators who are now expressing worry about the impact hedge funds could have on markets overall.
"If this pool of money and exposure is not managed very carefully it will cause substantial ripples in the financial markets," said a senior federal banking regulator. "This is much, much bigger than the Russia thing as far as impacting the financial markets."