A hedge fund, according to the Hedge Fund Association, is an investment company whose sole objective is to "preserve capital" . This was a strategy pioneered in the early 60's by the simple action of buying stocks and simultaneously selling them short (short-selling is the practice of purchasing a stock option that rewards the investor if the value of the stock goes down). In this sense, hedge means exactly what it appears to - betting on both possible outcomes so there is virtually no possibility of a loss of capital.

In the late 80's and early 90's as markets became more sophisticated firms developed different ways of investing in options - betting not on the value of stocks for preservation - but on the differences in the valuations of many various components of stocks, bonds and currencies. These bets were built into the underlying securities and were investments that had no face value at all - they were called derivatives. Derivative securities were simply options - and many people who didn't understand that although they were based on bonds they held no real value. When the Fed raised rates 8 times in 1994 & 1995, these derivative investors were wiped out.

A Hedge Fund is supposed to take the risk out of investments. In 1991 John Meriweather who had headed the bond trading group at Salomon Brothers, left and formed a Hedge Fund called "Long Term Capital Management". Head-quartered in Greenwich, CT, they began trading in February, 1994 using technical analysis to discover temporary pricing anomalies. These were called "convergence trades" based on the idea that prices would move in a way that were mathematically predicted. By placing trades in many markets and countries they appeared to be well diversified. In 1995 and 1996 the firm posted returns of 40%. In 1997 the returns were at 20%. They attributed the success to the acuity of the investment managers. Banks, and other investment companies poured money into these investments. But the returns were really a reflection of the intense leverage of the fund.

In August, 1998, Long-Term Capital had 4.1 billion in capital. It had $125 billion in investments. From a lender's perspective, that represents an LTV of 3000%, or a 30:1 liquidity ratio. Mutual funds can borrow 50 cents on every dollar they have invested. Commercial Banks can borrow more, but there are strict liquidity requirements. Because of the way that the SEC doesn't regulate hedge funds, they can borrow as much as their creditors are willing to lend. Long-Term Capital had more than 60,000 trades on the books. On the other side of each of these transactions was a big commercial or investment bank.

On August 17th 1998, Russia defaulted on its loans, and markets around the world roiled. Liquidity spreads widened to an extent rarely seen before as investors dumped illiquid securities. (Liquidity determines how readily an asset can be sold. Treasury bills are liquid. High Yield lower credit rated paper is illiquid. The difference in the rate is compensation for the fact that it is harder to sell illiquid securities.) By August 31 the firm's capital was 2.3 billion, and in September, LTCM was at the verge of bankruptcy. Co-ordinated by the Federal Reserve, 14 large banks got together to bail out the fund to prevent its collapse. At risk was the fear that the big commercial banks and investment firms would start dumping their positions simultaneously, triggering a general financial panic and worldwide collapse.

The LTCM story didn't get much press, and except for the sudden disappearance of $125,000,000,000 in risk capital, the world seemed to go on without much notice. Unless, of course you were in 125's or Subprime. Suddenly there was no market for these products. 

The Chairman of the US Federal Reserve Bank, Alan Greenspan, has defended thepublicly organized bail-out of Long-Term Capital Management (LTCM. Speaking to the banking committee of the US House of Representatives, Mr Greenspan said a failure of LTCM's could have caused substantial damage to banks and investors and might have impaired the economies of many nations, including the United States. Mr. Greenspan insisted that for LTCM's bailout "no Federal Reserve funds were put at risk, no promises were made by the Federal Reserve, and no individual firms were pressured to participate. "The "fragile" condition of the markets had prompted the Federal Reserve to act quicker than usual, he said, promising that the bail-out would be a "rare occasion." Mr Greenspan suggested that it would have been wrong to let LTCM go under. The unwinding of the fund's "complicated portfolio" would have been very risky, and could have seriously distorted financial markets around the world. THIS MIGHT be a repeat of something he already sent, but i got it just like this and it didn't need to be downloaded, but i redid it in my wird program. hope this helps. The long term impact of this has been seen in the markets as they anticipate interest rate increases in the markets - and are met with the reality that the wounds created by the LTCM losses haven't healed enough to bear higher rates.