NEW YORK (CNNfn) - The Federal Reserve Board may have played a far more pivotal role in orchestrating the $3.5 billion bailout of Long-Term Capital Management than previously suspected.
According to Stanley Druckenmiller, chief investment officer of George Soros' multibillion-dollar Quantum Fund, who claims to have inside knowledge of last Wednesday's bailout meeting, Goldman Sachs, Merrill Lynch and the other heavy-hitting financial institutions had originally devised a plan to take over the cash-strapped hedge fund and rapidly liquidate LTCM. Each agreed to suck up their losses, some to the tune of $800 million, Druckenmiller said.
Under that plan, liquidating the huge positions LTCM was in would cost about $8 billion to $10 billion -- an amount the banking and brokerage firms were prepared to absorb.
But Druckenmiller said Fed Chairman Alan Greenspan objected to the plan, calling the losses from the fund's impending collapse "incalculable."
LTCM, a Greenwich, Conn.-based hedge fund run by former Salomon Brothers trading legend John Meriweather, was rescued from the brink of liquidation by a consortium of 14 commercial and investment banks last week, under a plan that now seems to have been engineered by the Fed.
According to Druckenmiller, Greenspan urged the group to liquidate LTCM more slowly, because doing otherwise could send shockwaves through the financial community.
In his speech before Congress Thursday, Greenspan acknowledged his decision to step in to the LTCM issue came at the recommendation of William McDonough, president of the Federal Reserve Bank of New York.
Those tracking the Fed and the hedge-fund industry say such urging sheds greater light on the severity of the crisis.
"It was clear that
McDonough's advice to Greenspan was if this huge hedge fund had been allowed to be liquidated in a disorderly way it posed a major risk to the overall financial market," David Jones, chief economist for Aubrey G. Lanston, said. "It was that judgment that led the Fed to engineer the bailout. They don't like to call it that, since there was no public money used. But in effect, if the Fed takes the initiative in this kind of thing, it is clear they view it as a threat."
LTCM has been battered since the end of the summer through bad debts and its arbitrage-trading strategies. Some tracking the industry say the fund had leveraged its bets by a ratio of up to 100 to 1.
Jones said the LTCM crisis is merely a symptom of an overall bleak picture in the international economy, which has sent risk-averse investors fleeing to the relative safety haven of Treasuries.
The flight-to-safety trend has left hedge funds, equities and other relatively risky investments hanging in the lurch. That, in turn, has made banks more reluctant to lend to borrowers, which will make credit much more costly and less available to lower-rated companies, Jones said.
"LTCM was just the tip of the iceberg," Jones said, adding the fallout of the hedge fund's near collapse will continue to reverberate through the financial community. "This is a much more powerful force than anyone was anticipating, yet it's difficult to stop. Obviously, the Fed (which lowered interest rates by a quarter of a percentage point earlier this week) was unable to do anything to stop it. You are seeing this in the stock price decline today."