The conspiracy theory runs like this: Long-Term Capital Management (LTCM), one of the world's biggest hedge funds, was saved from collapse last week only because it has high friends in high places. Not only is John Meriwether the brains behind the fund, he is among the most respected bond traders in the world and has the connections to match. But even better connected is his close associate on the fund, John Mullins, a former vice-chairman of the United States Federal Reserve. Surely, the conspiracy theorists say, the reason why the New York Federal Reserve orchestrated its US$3.75 billion rescue of LTCM was because Mr Mullins called in some old favours. Why else would LTCM - which as a hedge fund is one of the least popular investment vehicles in the market - receive attention from such high places? The answer that has become the accepted wisdom is that LTCM was too big to fail, and, after all, the Federal Reserve did not use any of its own money. It simply told 15 of some of the largest banks in the world to stump up the cash; otherwise they would suffer from the consequences. Of the 14 US and European banks called in to help LTCM out of the quagmire, many have sizeable creditor and counterparty positions with the fund and would suffer greatly if it was to fail. But many, such as Deutsche Bank, which is stumping up $300 million to LTCM, have no relations at all and are involved simply because, as players in global financial markets, they have no interest whatsoever in seeing yet more volatility unleashed in these already uncertain times. When the dust settles, however, tough questions are likely to be asked. As early as 1993, when sterling was forced from the European exchange-rate mechanism - and financier George Soros was revealed as making GBP1 billion (about HK$13.17 billion) from betting the right way - hedge funds have been a source of fascination and concern. Malaysian Prime Minister Mahathir Mohamad blamed hedge funds for causing the collapse of several Asian markets and damaging currencies including the ringgit, and earlier this year they were the subject of an unprecedented study by the International Monetary Fund. Now new questions have arisen. Why are banks using depositors' money, or shareholders' funds, to invest with such highly leveraged funds? LTCM was almost 20 times leveraged from a capital base of $4.8 billion. How do hedge funds manage to build such huge positions that they end up threatening the very fabric of the financial system? If LTCM is the largest of the hedge funds to face near collapse, are there others in a similar position that may not face such favourable treatment from the Federal Reserve or other central banks? Certainly the answer to the last question is yes: 'Others will undoubtedly go down,' said Mark Thomas, banking analyst at Credit Lyonnais. 'The point of hedge funds is that they are geared. And if they are long and wrong, they will lose.' The banks that have been caught out by being heavily exposed to LTCM are already trying to find out how they became involved. Europe's largest bank, UBS, forced to write off 950 million Swiss francs (about HK$5.32 billion) on its investment in LTCM, is looking for the culprit. The fact is, however, there is no regulation to check hedge funds. Many are domiciled and registered in banking secrecy havens, which have attractive tax advantages and allow them to go about their business unharried by bureaucracy. Increasing regulation for those funds that fall under the remit of the main financial centres in the world would only force more overseas. The truth is that banks need hedge funds. The intense competition for lending that has sprung up around the world has forced banks to extend funds at increasingly slim margins. This has forced them to hedge their risk with sophisticated investors, such as hedge funds, that are able to preserve capital against the ravages of market sentiment or economic turmoil. The manager of one highly successful hedge fund based in London said there was little regulators could, or would, do to try and bring hedge funds under closer scrutiny. He said the whole move had been an over-reaction by the banking community, which has panicked at the size of LTCM's positions. Other hedge funds would probably see significant losses, but they were likely to be funds heavily invested in weak emerging markets, unlike LTCM which was largely invested in developed country bonds. 'The fund would have stayed solvent but for the fact that counterparties increased their margin calls,' the manager said. 'As a result, positions taken by hedge funds suddenly became less solvent, because of the people who sold them the funds in the first place.' The banking community has responded by saying it is taking prudent action at a time when the future course of financial markets is highly uncertain. But the hedge-fund community, perhaps understandably, believes the banks have gone too far. 'They did not need to do what they did. As a result they have potentially made matters worse,' another hedge-fund manager said. When the dust settles on the near collapse and rescue of LTCM, many tough questions will have to be addressed. The answers, however, are not likely to please all, writes SHEEL KOHLI in London.