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Collateral damage

The near-collapse of several hedge funds, including Long-Term Capital Management, was a symptom of increasingly reckless market practices, particularly in the handling of collateral. Perhaps the shock will send banks back to revise their repo agreements and to look less at mark to market, more at potential future exposure. By Michelle Celarier.

The eve of destruction

Another fine mess at UBS

To explain the concept of leverage, one hedge fund operator uses the analogy of a racing car: "If you go out and have four vodkas and drive a race car on the city streets, you're gonna crack up and get hurt more than if you're driving a Chevy. And a lot of people have been driving irresponsibly lately."

"Leverage can kill you," admitted an official at the New York Federal Reserve Bank, shortly after the Fed had hosted the rescue of Long-Term Capital Management, which had levered around $4 billion of capital into more than $120 billion on its balance sheet and several times more off balance sheet, before it threatened to spin out of control and take every other car on the road with it. Says Henry Hu, a banking and finance law professor at the University of Texas: "The scary part about LTCM is that it suggests that the world financial system has more structural flaws than any one country".

As it turned out, during the recent dizzying bull market the most sophisticated players in the system had become over-reliant on value-at-risk (VAR) models, mark-to-market valuations and the margin collateral these valuations dictated.

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