Markets fear hedge fund collapse may be looming

CONCERN IS growing in the financial markets that a major hedge fund is in difficulty, prompting fears of a repeat of last year's crisis when the Federal Reserve in the US had to mount a $3.5bn bail-out of Long- Term Capital Management (LTCM) in order to stave off a global financial collapse.

The market for swaps, complex interest-rate derivatives which are widely used by hedge funds and the proprietary trading desks of the big investment banks to fund their high-risk trading strategies is, say traders, showing the same signs of distress that was seen after the Russian bond default last August.

This has taken the form of a widening of credit spreads - the interest rate differential - indicative of concerns within the market of a major default. Spreads on 10-year swaps have widened on both sides of the Atlantic from the early 80s (0.8 per cent) to 110 over the past few weeks. Over the past few days the widening has accelerated.

The UK gilts swaps market is one of the most liquid in the world and a favourite haunt of big hedge fund players.

Tiger, the $12bn hedge fund run by New York-based financier Julian Robertson, yesterday dismissed as "rubbish" reports that Goldman Sachs, and Chase had cut its credit lines. Sources close to LTCM have been similarly dismissive of reports that it too was again in difficulty, less than a year after being rescued by a consortium of 13 banks including Barclays, Deutsche and Merrill Lynch.

Other accounts have referred to a big US or Swiss bank having taken a big hit.

Worries about big trading losses have been exacerbated by a number of large trades in both the equity and swaps market yesterday and on Thursday, indicative of an unwinding of big market positions. Goldman Sachs was reported to have unwound a big swaption (combined swap and option) position, and was also rumoured to have lost pounds 200m on European options.

There was talk, too, that the Fed was holding back on raising short- term interest rates to keep one of the big securities houses afloat.

The problems in the swaps market appear to have initially been caused by concern about the pile-up of corporate issues ahead of the fourth-quarter when demand is expected to dry up because of Y2K fears. However, over the last few days talk that a major institution is in difficulty has come to the fore.

Some of the big investment banks yesterday admitted privately to sustaining small losses over the past few days but nothing that would result in a material profits hit let alone a default.

Adrian Davis, swaps analyst at ABN-Amro, said yesterday: "Over the past few months spreads have been widening out because of concern at oversupply in the bond market. However, in the last three or four days they have really blown because of concerns about the viability of a financial institution."

Said another trader: "The markets are very strained. They are very like they were last year. In these kind of markets people will have lost money."

Although hedge funds and Western banks lost up to $40bn when the Russians refused to honour their GKO bonds, the real problem that brought LTCM to the brink of collapse was the widening of credit spreads in the the swaps and high-yielding bond markets which blew its strategy of buying high-yielding bonds in anticipation of yields falling to bits.