The LTCM Business

The company’s initial trades primarily arbitraged global bond markets, but by 1995, the fund had diversified its portfolio by entering into domestic and foreign equity arbitrage trades. And why not? LTCM’s strategy did not require an in-depth knowledge of any individual stock or bond but rather a keen understanding of the spreads between yields and prices of its underlying assets—and that was largely the domain of statistical modeling and security market wisdom that came from years of experience—or at least that is what they thought.

The Principals

One of the exceptional features of LTCM was the cast of characters who founded and ran the company. It was a distinguished and impressive group, among whom were two Nobel laureates, a former vice chair of the Federal Reserve System, and some of the brightest, most successful bond arbitragers on Wall Street (known as the “arb boys”). Initially, LTCM had about a dozen principals, but four of them deserve special mention.

John Meriwether (“JM,” as he was called), the founder of LTCM, was the company’s guiding light. He was a tough, respected, nice guy, who started LTCM after leaving his job at Salomon Brothers. In the late 1970s and 1980s, Meriwether built a profitable bond arbitrage group at Salomon Brothers and went on to become vice chair in charge of Salomon’s global fixed-income trading, arbitrage, and foreign exchange businesses.

His trading operation at Salomon Brothers was so successful that, by 1986, the company was devoting half its equity to JM and his team. But in 1991, one of his traders, Paul Mozer, confessed to making false bids at U.S. government security auctions. Meriwether knew the violations were significant and reported them to his bosses, Thomas (Tommy) Strauss and CEO John Gutfreund. All three men understood the infractions were serious and should have been reported immediately to the Federal Reserve and U.S. Treasury. Mozer should have been dealt with deliberately, perhaps fired. Astonishingly, he was not reprimanded. In fact, Mozer was kept as the head of Salomon Brothers’ government bond trading desk, and Salomon delayed too long before disclosing his infractions to the Federal Reserve and U.S. Treasury. The scandal blossomed and resulted in the 1991 resignations of both Gutfreund and Strauss. Leaderless, Salomon Brothers convinced Warren Buffett, head of Berkshire Hathaway Holding Company and major shareholder in Salomon Brothers, to become its temporary CEO, saving Salomon from a potentially worse situation.

Meriwether’s resignation came just a few days after Buffett took the helm at Salomon Brothers. As part of a Securities and Exchange Commission administrative proceeding, Meriwether agreed to a $50,000 fine and three-month suspension.194 After a brief hiatus, he founded LTCM in 1994 and, by 1995, Meriwether plucked from Salomon Brothers eight members of his old team, who were responsible for almost 90 percent of Salomon’s trading profits.

Robert C. Merton shared the 1997 Nobel Prize in Economics with Myron Scholes for their trailblazing work on option pricing. Merton was a brilliant mathematician, who earned an undergraduate degree in engineering at Columbia University, a Ph.D. in applied mathematics at the California Institute of Technology, and a Ph.D. in economics from the Massachusetts Institute of Technology (MIT). While teaching at MIT’s Sloan School of Management and later at the Harvard Business School, Merton made significant contributions to finance in the area of option pricing models. His research linked continuous-time stochastic processes with continuous-decision-making by agents, and this led him into pricing contingent contracts, like options.

Myron S. Scholes, a native Canadian, was one of the most creative dreamers in the LTCM group. He graduated from McMaster University in Canada with a degree in economics and went on to receive a Ph.D. from the University of Chicago. Afterwards, Scholes taught at prestigious academic institutions, such as MIT’s Sloan School of Management, the University of Chicago’s Graduate School of Business, and Stanford University’s Business School and Law School. From the start, Scholes was interested in factors determining the demand for traded securities and the characteristics that differentiated one security’s risk/return profile from another. Scholes met Robert Merton while they were both teaching at MIT and began collaborating on the work that won them the Nobel Prize. Later, the two renewed contact when they were hired by Salomon Brothers as consultants.

David W. Mullins, Jr. became a professor at Harvard University’s Graduate School of Business Administration after completing his undergraduate work at Yale University, receiving his M.S. degree in finance from MIT’s Sloan School of Management, and earning a Ph.D. in finance and economics at MIT. In March 1989, Mullins was selected by President George H. W. Bush to be Assistant Secretary for Domestic Finance, and in December of the same year, he became one of the seven members of the Federal Reserve System’s Board of Governors. Highly regarded and well connected, especially in international circles, some thought that Mullins might one day replace Alan Greenspan as Chair of the Federal Reserve.

These four joined the other principals from academia and practice to form LTCM. Together they helped develop trading strategies which they were confident would bring them all unheard-of profits.

Identifying Small Market Imperfections

LTCM earned its profits during the transition periods when markets were out of equilibrium (i.e., moving from one equilibrium to another). The company was not trying to find a needle in the haystack; rather, it was trying to find a haystack of needles. In other words, LTCM did not devote research time and effort trying to discover rising stars, like Microsoft or IBM. Rather, it searched for a multitude of low-risk arbitrage deals, each earning relatively miniscule returns, but using its billions of dollars of investment funds, LTCM was able to accumulate substantial earnings. Relatively few of LTCM’s trades were outright bets on the direction of individual asset prices but rather were wagers on the spread between asset prices and yields. The goal was to construct a market-neutral portfolio that gained value in rising and falling markets.

To execute its strategies and attain the desired risk-return goals, LTCM needed abundant sources of credit and substantial market liquidity to reverse positions quickly and at firm prices. Maintaining a high credit rating was essential because, without it, LTCM’s sources of finance and trade counterparties would surely disappear.

LTCM used its high-powered research team and expert understanding of securities markets to study relationships between prices of different investment assets, assorted maturities of the same asset, assets and their derivative counterparts, and various types of derivatives. Whenever two assets’ relative values looked out of whack and a rational explanation could be given for why they should converge to their historic norms, LTCM traders exploited the opportunity with as much financial firepower as they could muster, purchasing the relatively underpriced asset and simultaneously selling the relatively overpriced one.

Using a Minimum of Equity Capital

The second facet of LTCM’s strategy was to exploit market imperfections, using as little equity capital as possible. Equity was conserved to pay for necessities, like margin requirements on LTCM’s leveraged (equity and derivative) positions and haircuts on its reverse repurchase agreements.195 The company also earmarked risk capital in case unfavorable price movements caused cash outflows on contracts that were marked to market. Figure 7.1 shows LTCM’s asset-to-equity ratio from June 1994 to July 1998. At times during this period, LTCM’s leverage exceeded 30-to-1.

In the absence of equity, LTCM financed most of its security purchases with reverse repurchase agreements (reverse repos) having 6- to 12-month maturities.196 Under a reverse repo, LTCM bought a bond and used it as collateral for a loan, the proceeds from which LTCM used to pay for a new bond. So long as LTCM’s interest costs were less than the return on its securities, profits could be earned.197

With limited equity at its disposal, LTCM also leveraged its positions by entering into over-the-counter total return swaps. In exchange for paying a fixed or floating rate of interest, these financial instruments gave LTCM the financial benefits of owning the underlyings (e.g., equity indices, bundles of loans, or portfolios of bonds) but at a fraction of the cost in terms of equity expended. For example, with a total return swap on a share index, LTCM could acquire the risk-return profile of a diversified stock portfolio, finance it with fixed-rate or floating-rate borrowings, and use a relatively small portion of its own capital to meet any collateral requirements and mark-to-market obligations.198 The U.S. margin requirement on stocks is 50 percent; so, the savings, in terms of capital conservation, can be considerable.

An example: Suppose LTCM entered into a total return swap on the S&P Stock Index with no collateral or mark-to-market provisions. The swap had a maturity of two years and a $100 million notional principal.199 LTCM was required to pay the London interbank offered rate (LIBOR) plus 1.5 percent, and LTCM received the total return earned on the S&P Stock Index. At the end of Year 1, if dividends equaled 2 percent, and the S&P Stock Index appreciated by 10 percent, LTCM would receive 12 percent of the notional principal and have to pay LIBOR plus 1.5 percent. If LIBOR were 5 percent, then LTCM would receive a net payment equal to 5.5 percent (i.e., $5.5 million) from its swap counterparty.200 By contrast, at the end of Year 2, if dividends equaled 1 percent, the S&P Index fell by 8 percent, and LIBOR were 6 percent, then LTCM would pay its swap counterparty 14.5 percent (i.e., $14.5 million).201

The Effects of Leverage on Risk and Return

LTCM’s leveraged positions elevated its risks and potential returns. Leverage created a considerable difference between the company’s return on total assets and return on equity. To understand why there was such a large difference, round off LTCM’s 1997 equity at $5 billion and see what difference leverage has on the company’s return on equity.

If LTCM started with $5 billion of equity and invested only these funds (i.e., it borrowed nothing) in assets earning 5 percent, at year’s end, it would have earned $250 million, which would be a 5 percent return on both its assets and its equity (see Table 7.1). By contrast, assume that LTCM leveraged its $5 billion equity by borrowing $120 billion and earning a net return on these assets of 5 percent. At year’s end, the $5 billion of equity-financed assets would have earned $250 million (just as before) and its $120 billion of debt-financed assets would have earned $6 billion. The total return on assets would be 5 percent (i.e., [$250 million + 6 billion]/[$5 billion + $120 billion] = 5%), but the return on equity would be 125 percent (i.e., [$250 million + $6 billion]/ [$5 billion] = 125%); see Table 7.1. The return on assets was exactly the same as before, but borrowed funds increased the return on equity twenty-five times.

Table 7.1: LTCM’s Return on Equity and Return on Assets

For highly leveraged firms, like LTCM, any profits on the mountain of debt-financed assets causes the return on equity to skyrocket, but at the same time, losses could quickly wipe out the skimpy equity backing these assets. At the beginning of 1998, LTCM had assets equal to approximately $125 billion and equity equal to $4.7 billion; a mere 3.8 percent decline in asset value would have eliminated all of the firm’s equity.

Elevate Risks to Relatively High but Controlled Levels

LTCM increased the risk of its portfolio because the company understood that greater risk brought the potential for greater returns. To control these risks, LTCM diversified its portfolio and used the statistical tool Value at Risk (VaR). LTCM also employed an extensive and detailed working capital model that gave incentives to traders to finance their positions using term agreements rather than overnight financing to manage liquidity risks.

Diversification LTCM’s managers tried to acquire a portfolio diversified by geographic region, security market, and currency. By owning positions with uncorrelated returns, unexpected negative shocks were likely to be offset (fully or partially) by unexpected positive shocks, thereby smoothing the portfolio’s average return. For example, if LTCM was long European swaps but short U.K. swaps, the unanticipated gains (or losses) on the U.K. swaps might offset (fully or partially) the unanticipated losses (or gains) on the European swaps. Similarly, by making diversified currency bets, LTCM’s returns could be stabilized because the depreciation of one currency might be offset by the appreciation of another.

Value at Risk (VaR) To determine the appropriate level of risk, LTCM relied heavily on VaR analysis to quantify the vulnerability of its portfolio to changes in market prices and returns. VaR is a statistical measure used mainly by institutions that want to determine the downside vulnerability of their actively traded portfolios. With VaR, a company can make statements like: “We are 99 percent certain that our portfolio will lose no more than $105 million during any one day, which means there is a 1 percent chance we could lose more (much more) than $105 million.”202

VaR analyses are based on estimates of volatility, and typically, the historical standard deviation of the asset returns in a portfolio is used as a proxy for this volatility. The academic superstars at LTCM were skilled in advanced econometric and computer techniques; so, they could interpret past data in very sophisticated and meaningful ways; but for all their sophistication, the results of these analyses were meaningless if the future turned out to be significantly different from the past.

The operational goal at LTCM was to lift the risk of its portfolio to 20 percent of net asset value (NAV)203 per year,204 but despite its considerable leverage, the company found this goal almost impossible to achieve. One reason was LCTM engaged mainly in spread trades, which are inherently less risky than outright positions.

Another reason for LTCM’s inability to increase its level of portfolio risk was the fund’s size. LTCM was so large that, when an opportunity presented itself, the fund quickly bought and sold in such large volumes that market prices changed and eroded potential profits. Similarly, when LTCM tried to liquidate its positions, the size of its transactions and the illiquidity of assets in its portfolio caused prices to move adversely and erode the company’s gains. As a result, LTCM had to take smaller positions than desired because it was not sure that they could be liquidated at profitable rates and prices.

Finally, LTCM had difficulty increasing its level of risk because success breeds imitators. Try as LTCM did to keep its strategies, positions, and transactions secret, the financial world was not blind to the sources of this company’s success. Imitators with similar strategies and portfolios began to dot the financial landscape like dandelions in spring. This made the markets more competitive, which reduced the opportunity to earn returns on mispriced assets.

Securing Long-Term Funding

In developing its strategy, LTCM knew that some of its positions could take six months to two years before they earned profits, and, therefore, they needed well-developed and extensive financial backing (liquidity) from banks and other financial institutions to finance the waiting period. LTCM arranged credit lines ($900 million),205 a three-year, unsecured loan ($230 million), and financed most of its security purchases in the six-month to one-year (reverse) repo market, which gave the company a buffer that would not have been present if it had used the short-term reverse repo market. LTCM also stabilized its equity financing by writing a covenant into investment contracts, limiting investors’ ability to withdraw capital from the fund. At first, this covenant locked in investors’ funds for at least three years, but, in 1996, this restriction was eased, allowing investors to cash out one-third of their capital at the end of each year after the first. Therefore, someone who invested $12 million at the end of 1996 could withdraw nothing in 1997, but could withdraw $4 million at the end of 1998, 1999, and 2000.

Without these immense and, at times, unquestioned funding sources, LTCM could never have pyramided its positions to the towering levels it achieved. Brimming with funds during the boom years of the 1990s and eager to do business with the best and the brightest, many banks and dealers ignored time-tested banking principles, such as demanding collateral for loans, ensuring that charges were sufficient for the risks taken, properly accounting for (off-balance-sheet) derivative positions that increased their exposures to LTCM, and demanding business relationships that were transparent instead of obfuscated with crafty financial legerdemain.206 LTCM’s secretive practices created a shield behind which the fund could conceal the extent to which it was indebted. As a result, each counterparty saw only its piece of the business and not the total structure of risks and returns that LTCM had built.

Long-term funding was crucial to LTCM’s strategy because it allowed the company to take positions and then hold them, if necessary, for extended periods. LTCM was a risk taker and often took positions that few others would touch. Of course, LTCM took these positions because it felt the expected rewards were adequate for the risks being assumed. As the company’s portfolio grew and became more diversified, additional risk became easier to take on because most of the nonsystematic risks associated with the new positions dissolved in the vast melting pot of LTCM’s other assets.

To ensure that LTCM had sufficient liquidity, long-term sources of financing were essential, but equally important were the roles of LTCM’s back office and Bear Stearns, LTCM’s agent for clearing, settling, and keeping track of trades. At times, LTCM had thousands of open derivatives positions with a total notional value of about $1.25 trillion. Many of LTCM’s contracts were marked to market, which meant the company had to pay out funds daily to settle its losing trades and had to make sure payments were received on its winning trades. Tracking the cash flows connected to LTCM’s numerous positions was a sophisticated operation. What made this task even harder was LTCM’s custom of hiding its positions by transacting complicated deals using multiple counterparties for different legs of transactions. As a result, netting margin payments was often impossible.

Charging Hefty Fees

LTCM’s fees were head-and-shoulders above the industry average (some would say excessive), charging an annual 2 percent base fee on the fund’s NAV. Most other hedge funds charged 1 percent. In addition, an incentive fee amounting to 25 percent of the increase in the company’s NAV was charged. Most other funds charged 20 percent, but if LTCM’s NAV fell, the 25 percent charge did not kick in until the fund’s all-time high was surpassed.

How could LTCM charge fees so much above the industry average? What would you pay to have the intellectual power this company brought to the table? An article in Institutional Investor characterized LTCM as having “... in effect the best finance faculty in the world.”207 Seven of its twelve founding principals were connected, in some way, to Harvard University or MIT, either as graduates, faculty members, or both. Clearly, LTCM’s principals were able to convince investors that their strategy would work, and, for a while, it seemed they were right.

Catalyst #1: Exogenous Macroeconomic Shocks

LTCM and its many imitators placed major bets that yield spreads in worldwide markets would narrow; but they widened almost everywhere due to a series of major economic shocks. Virtually everywhere you looked (i.e., domestically and internationally) these bets began to hemorrhage cash.

U.S. and Global Yield Spreads Widen

During 1998, U.S. and global yield spreads widened significantly. In the United States, relative to Treasury bonds: (1) the spread on mortgage rates surged from 95 basis points to 120 basis points; (2) the spread on corporate bonds rose from 99 to 105 basis points; (3) junk bond spreads rose from 224 to 276 basis points; and (4) swap rates rose from 35 to nearly 100 basis points. Furthermore, the spread on B-rated bonds relative to triple-A-rated bonds rose from 200 to 570 basis points. Internationally, emerging country debt rose from 300 to 1,700 basis points above the U.S. Treasury bond rate. The same pattern appeared throughout the world. LTCM’s strategy was to bet that spreads would return to normal ranges. As spreads continued to widen, LTCM began to record deep losses.

Global Events that Spurred Yield-Spread Changes

Numerous events converged on LTCM (and the world at large) in 1997 and 1998 to widen the spreads on virtually all financial assets. A statistician, trying to estimate the probability of all these events happening at once, would probably have calculated the odds at about the same level as someone being struck multiple times by lightning and falling space debris.

Asian Tiger Crisis of 1997 One of the first significant events to hit LTCM was the Asian Tiger crisis, which started in Thailand during the summer of 1997, spread to other East Asian countries (the Philippines, Malaysia, South Korea, Indonesia, and Hong Kong), and went on to affect countries as far away as Argentina, Brazil, and (yes) the United States. The 1997 problems were triggered by Asian countries that had long pegged their currencies to the U.S. dollar. Over time, their exchange rates had become unsustainably overvalued. Sensing devaluations were imminent, speculators pounded the markets tenaciously by selling baht, rupiahs, ringgits, and pesos. The central banks of these Asian nations supported their fixed exchange rates until they ran out of international reserves. When they did, their currencies were cut loose to float untethered to the moorings of the U.S. dollar.

When currency crises like these happen, investors typically respond by investing heavily in safe assets and sound currencies, such as dollar-denominated U.S. government bonds and low-risk assets denominated in stable European currencies, such as German marks and Swiss francs. This flight to quality pushed down the yields on financial assets in the developed nations and pushed up the returns on assets in emerging markets, causing spreads to widen. LTCM had bet continuously that spreads would narrow; so, when they widened, the company lost on both sides of its spread positions. But in the stormy clouds of this international crisis, LTCM saw a glimmer of light because wider spreads meant new opportunities to increase its positions and benefit later when the spreads converged to their historically normal ranges. The problem was finding ways to finance these new opportunities in a stressed economic environment.

Because its Asian investments were concentrated mainly in Japan, LTCM weathered the 1997 Asian storm and managed to end the year with a respectable, albeit diminished, return. Even after refunding $2.7 billion to investors at the end of 1997, LTCM’s equity capital was still at a healthy $4.7 billion level. What doesn’t kill you makes you stronger might have been the credo at LTCM as 1998 began.

Russian Default As soon as the Asian crisis left the front pages of the news, a Russian financial crisis began. As during the Asian Tigers crisis, capital flight put significant pressure on the exchange value of the ruble. To complicate matters, the price of oil (a major Russian export) was falling. Russia tripled its interest rates to encourage investors to stay in rubles, but these efforts only served to undermine the ability of domestic businesses to borrow at reasonable rates in order to finance normal business activities (e.g., working capital, capital expenditures, and expansion). Who can afford to borrow when interest rates are more than 200 percent?

Bankruptcies soared, unemployment rose, government budget deficits grew, many banks were threatened with insolvency, and the central bank’s international reserves were depleted. With Russia’s economic and financial systems staggering on the brink of collapse, the International Monetary Fund (IMF) arranged a $22.6 billion bailout in July 1998. Unfortunately, the bailout was not enough to stave off the crisis. The ruble continued to fall. On August 17, Russia devalued the ruble and announced a debt moratorium on $13.5 billion of local currency debt.209

LTCM lost on its Russian bond positions, but the company’s exposures were limited relative to other hedge funds and securities firms. What was important about the Russian ruble crisis was it triggered contagion,210 which spread turmoil to other parts of the world (e.g., Brazil, Turkey, and Venezuela) and affected many other hedge funds in a similar way.

Volatile Political and Economic Climate

Bad economic and political news continued during late 1997 and into 1998, hitting LTCM like relentless sledgehammers. In August 1997, Tellabs, Inc., a company in which LTCM held significant positions, announced the cancellation of a shareholder vote for its acquisition of Ciena Corp. Spreads widened and LTCM incurred heavy cash outflows to meet compulsory margin requirements. In the end, LTCM’s losses amounted to about $150 million. LTCM’s profits were further eroded when an IMF–led bailout of Indonesia ran into problems and rioting forced President Mohamed Suharto to resign after thirty-two years of authoritarian rule; China threatened to devalue the yuan because the Japanese yen’s depreciation had hurt China’s export trade; Iraq was stirring Middle East tensions as it thwarted U.N. weapon inspection teams. All of these events converged and drove a larger wedge between developing nations’ yields and the yields of developed nations. As yield spreads widened, LTCM’s losses mounted.

Catalyst #2: Endogenous Shocks

By 1998, many hedge funds had been built to imitate the past successes of LTCM. As a result, the diversified portfolio that LTCM spent so much time constructing was duplicated many times over. Wider margins put these similarly structured hedge funds under pressure to cover their losses, as well as meet collateral obligations, haircuts, and margin requirements on both new trades and existing positions. Investors fled to safer investments, and hedge fund managers tried simultaneously to reduce their exposure.211

The mass exodus of hedge funds from existing positions caused market spreads to change in predictable but bizarre ways. Relative-value trades that were bets on wider spreads narrowed, and relative-value trades that were bets on narrower spreads widened. It was as if all the care and thought that talented hedge fund managers had put into analyzing and then taking positions were suddenly thrown out the window.212 In June and July of 1998, the situation got worse as Salomon Brothers began liquidating its proprietary bond arbitrage business. Salomon’s decision to exit resulted in a flood of security sales, coinciding with LTCM’s largest pre-crisis withdrawals and helped set the stage for even greater losses for LTCM.

LTCM built what it thought was a portfolio of economically unrelated positions. What it missed seeing was that many of these positions were linked to similar investment fund owners with similar strategies. As a result, the price volatility of these positions was connected by parallel risk tolerances, funding needs, and liquidity requirements. Rather than being uncorrelated, the positions in LTCM’s portfolio turned out to be highly correlated with the portfolios of other hedge funds. This misperception caused LTCM to underestimate its true level of risk, causing the company to move with abandon in the wrong direction. Under normal conditions, LTCM’s asset distribution would have been fine, but when the correlations among returns converged to one (i.e., perfect correlation), the normal protections afforded by diversification were eliminated. Losses on one position were just as likely to be matched, rather than offset by other positions.213

The situation was made even worse by hedge funds and proprietary shops selling positions in anticipation of LTCM liquidating its portfolio. In many cases, these trades were highly speculative because the sellers did not have accurate information about the composition of LTCM’s portfolio.

Value at Risk Analysis Gone Awry

How could LTCM have suffered such heavy losses when it systematically used VaR analysis as a navigation tool for estimating its vulnerability to short-term changes in market prices? The fund had never lost more than 2 percent of its NAV in any month since operations began in 1994. At the 99 percent level of confidence, LTCM’s econometricians assured the principals and investors that the company should lose no more than $105 million per day. With LTCM’s sizeable equity, there seemed to be more than enough cushion to endure any major hit.

Model Risk

On two important levels, LTCM suffered from high model risk. First, the company adopted the risk-management system of Salomon Brothers, where JM and many of his traders had worked previously. This was a mistake because investment banks usually have a larger number of independent income sources and better access to liquidity than hedge funds. These differences are significant because they influence risk exposures and the ability of a financial institution to sustain losses until positions become profitable.

A second source of model risk came from LTCM’s use of VaR as its principal measure of portfolio risk. VaR assumes that the future will be like the past, and the world can be summarized by assuming all possible future events fit neatly into a normally distributed, bell-shaped distribution function.

Table 7.2 summarizes the losses sustained by LTCM in 1998, which amounted to approximately $4.5 billion. Based on VaR, with 99 percent probability, this company’s yearly returns should have varied by no more than about $714 million, which was only about 10.5 percent of LTCM’s equity.214 Otherwise stated, a yearly reduction in returns by an amount greater than $714 million should have occurred roughly once every hundred years. Nevertheless, just for the month of August, LTCM’s performance was down 44 percent, and it was down 52 percent from the previous year.215 On one day (Friday, August 21) alone, LTCM lost $553 million, and four trading days later (Thursday, August 27), it lost an additional $277 million. During the five trading days from Thursday, September 10 to Wednesday, September 16, LTCM lost $145 million, $120 million, $55 million, $87 million, and $122 million, respectively—accumulated losses of $529 million!216 On Monday, September 21, LTCM again lost $553 million, and the following day racked up losses of $152 million.217 According to VaR, losses of such magnitude should happen perhaps once every few millennia, but not during the course of one month.218

Table 7.2: Trades That Caused LTCM’s Losses in 1998

Source: Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (Random house, 2000): 234

Catalyst #3: Feedback Shocks

As LTCM’s position worsened, liquidity evaporated, its counterparties sought to protect themselves, and the services of LTCM’s clearing agent became problematic. LTCM was desperate for funds and wanted to reduce its exposures, but many of these positions were illiquid. The company knew from the beginning that its positions might be difficult to liquidate; so, LTCM positioned itself to have enough funding if things went wrong. Now, it had a portfolio of assets that few potential buyers, such as Salomon Dean Whitter, Société Générale, Bankers Trust, and Morgan Stanley Smith Barney, wanted. Knowing LTCM’s distressed condition allowed these buyers to drive hard bargains.

Aggressive Marking to Market

For credit risk protection as well as conserving and stabilizing its supply of working capital, LTCM negotiated two-way collateral and mark-to-market covenants with its counterparties. The company also negotiated long-term agreements for posting collateral. Therefore, if LTCM ran into trouble, dealers could not change the haircuts or other financing terms on LTCM’s existing positions. Without such recourse, dealers could have tried to collect as much as possible by aggressively marking to market LTCM’s positions in favor of themselves. This aggressive mark-to-market pricing would have caused an even more acute decline in LTCM’s NAV for virtually every position in its portfolio.

During the 1990s, competition for hedge fund business caused many banks and security firms to relax or discard parts of their internal risk-management policies. Rather than impose collateral requirements that accounted for a hedge fund’s potential exposures, these financial institutions were satisfied if they covered just current exposures. Instead of analyzing the joint effects of credit, liquidity, and market risks, they analyzed each risk as if it were independent. Now, the tide had turned, and these counterparties were scurrying to protect themselves from these interdependent risks.

LTCM’s penchant for secrecy and opaqueness exacerbated the problem. In an effort to conceal its profitable positions and trading strategies from the market, LTCM often used different counterparties for each leg of a complex deal. For example, it might take a long position in Royal Dutch Shell (RDS) and a short position in Shell Transport (ST), which as a pair has very little risk, but then use RDS as collateral for a margin loan from JP Morgan and borrow ST from Union Bank of Switzerland. Counterparties knew, at best, their own (bilateral) exposures to LTCM, but they had no idea of LTCM’s overall level of risk. When LTCM came under financial pressure, these counterparties assumed the worst and panicked. En masse, they considered just their own unhedged legs of LTCM’s deals and overestimated the company’s true level of risk. If they had access to LTCM’s records, they would have seen that it had a closely related short position for almost every long instrument and a closely related long position for almost every short instrument. Therefore, the net risk on LTCM’s deals was much smaller than the sum of their parts.

Clearing Services and Legal Uncertainties

LTCM was also in danger of losing the services of Bear Stearns, its agent for clearing, settling, and recording trades.219 Bear Stearns was adamant that it would stop performing these functions the minute LTCM’s deposits fell below $500 million, and LTCM was rapidly approaching this critical threshold. As conditions worsened, the noose tightened.

Another problem stemmed from circulating rumors that LTCM might file for bankruptcy protection in the Cayman Islands. Creditors and counterparties were uncertain of their rights under Cayman law—especially, concerning their ability to net positions, close-out (i.e., terminate) contracts, and sell collateral. This added risk further reduced the willingness of market participants to deal with LTCM.

A Ray of Sunshine: LTCM’s Credit Line

Fortunately for LTCM, one source of liquidity not threatened was its $900 million revolving credit line with a syndicate of banks led by Chase. When this credit line was negotiated in 1996, LTCM paid dearly to exclude the material adverse change (MAC) provision, which would have allowed the bank syndicate to cut or cancel LTCM’s line of credit. LTCM figured (correctly) that, if these funds were ever needed, the MAC provision would probably be in effect. The credit line agreement stipulated that only if LTCM’s equity fell by 50 percent or more at the end of any accounting period could the facility be canceled;220 but LTCM’s accounting period ended July 31, 1998, and at that point, it had more than enough equity to meet this capital threshold.

The Beginning of the End

In May and June 1998, LTCM posted losses of approximately 7 and 10 percent, respectively, then, during July (the lull before the storm), the company almost broke even. The floodgates opened in August 1998, when LTCM’s performance was down 44 percent, with 82 percent of the losses coming from relative-value trades and 18 percent from directional trades.221 Losses of $1.8 billion in August 1998 reduced LTCM’s capital base to $2.3 billion, which was about 50 percent below its year-earlier level. Of these losses, 16 percent were from LTCM’s positions in emerging markets. Despite the portfolio’s illiquidity and size, LTCM still believed its funding sources were more than adequate to ride out any storm, but it soon became apparent that the company’s funding sources would be exhausted long before the profits on healthy trades could be realized.

Figure 7.5 shows the rise and fall of LTCM’s earnings from February 1994 to the third quarter of 1998. Between 1994 and the end of 1997, LTCM turned each dollar of invested funds into more than $4 of accumulated capital, but in 1998, investors watched, in shock, as their accumulated earnings fell from $4 to about 33 cents.

Be Careful What You Wish For

LTCM’s strategy was to profit from mispriced yield and price spreads, but troublesome economic conditions caused them to become disconnected from the historical patterns on which LTCM based its investment decisions and risk measurements. Greater economic and financial turbulence gave rise to an abundance of new opportunities, but the market’s flight to quality, flight to liquidity, and flight from arbitrage threatened LTCM’s sources of credit, as well as the willingness and ability of its counterparties to engage in new trades and to hold open positions.

Beware of Model Risk

LTCM placed large bets using considerable practical experience and sophisticated statistical analyses, but its conclusions were based on a risk management model that ultimately proved to be faulty for two reasons. First, it used risk management parameters that may have been better suited to an investment bank than a hedge fund; second, it did not account for those occasions when markets react and move inconsistently from historical precedent.

LTCM believed in four assumptions that proved wrong. First, it assumed prices would move continuously, which means large discrete price changes would not occur; it was wrong. Secondly, it assumed price volatility would return quickly to its historic average; again, it was wrong. Thirdly, LTCM assumed asset returns were normally distributed so that, with 99 percent accuracy, the company could calculate and control its risk levels; once again, it was wrong—the real world seems to have fat tails, which means extreme events have much larger probabilities of occurring than a normal distribution indicates (i.e., very bad and very good things happen more often than expected). Finally, LTCM assumed that investors’ decisions were independent of one another, in the sense that what they decide today will not influence their decisions tomorrow, and what they decide today will not influence others’ decisions; again, LTCM was wrong. Momentum in the global financial markets kept price and yield spreads moving against LTCM, indicating that decisions were not independent.

All for One and “1” for All

LTCM was not the only financial intermediary to experience profitability and cash flow problems. Losses were endemic to the industry, in part, because other hedge funds emulated LTCM’s successes and adopted similar strategies. When these imitator funds tried to liquidate their positions all at once, market prices turned sharply against them. Correlations among the prices of otherwise unrelated assets suddenly converged to one, their highest level. Portfolios that were once very diversified looked increasingly like a common, industry-wide portfolio. The new correlations made LTCM’s VaR estimates virtually useless indicators of the true risks it faced.

Leverage Is a Fair-Weather Friend

The President’s Working Group on Financial Markets concluded, in 1999, that the principal policy issue emerging from the LTCM collapse was excessive leverage.234 At times, LTCM’s leverage ratio rose above 30:1, which meant, if investment returns increased assets by a little less than 3.5 percent, the company earned 100 percent on its equity, and if they fell by the same amount, the company was insolvent.235 Near the end, this leverage ratio increased to more than 100-to-1. Leverage adds to risk and gives companies more opportunities to succeed and more opportunities to fail. For this reason, the credit risk of leveraged hedge funds, even those with market-neutral strategies and stellar past performances, must be objectively assessed and constantly monitored.

Financial Transparency Is the First Step in Meaningful Reform

The lack of financial transparency was a major source of this financial debacle. LTCM hid its positions by separating trades among half dozen or more counterparties. Even though many of LTCM’s exposures were hedged, counterparties knew and understood only their individual parts of them. Had there been a netting or clearing agent, the perceived systemic risks and contagion effects that LTCM’s failure threatened would have been substantially lower. Hedge funds are here to stay, which is why financial regulators, such as central banks, finance ministries, and treasury departments, as well as securities, commodities, and derivatives authorities, have sought efficient ways to balance regulation with open competition, to promote national and transnational financial health.

In the Long Run, Bet on Global Financial Market Efficiency

In competitive markets, excess profits are difficult to achieve because success invites imitation, and imitation reduces margins on which the original profits were made. Some markets may be slow to react, but over time, profiting from inefficient markets is like picking low-hanging fruit or sweeping money off a table. If it is that easy, others will be sure to follow. LTCM soon had many imitators, and as a result, its proprietary techniques lost their distinctive edge, which meant the company fell victim to its own success.

You Can’t Float Without Liquidity

If the first rule of mountain climbing is “don’t let go of one thing until you have a hold of something else”, then the first rule of hedge funds is “don’t buy what you can’t sell”. When the going gets rough, liquidity is crucial, and if you do not have a ready market into which you can sell your assets, then maybe, a second (or third) look at your assets is needed. Had LTCM been more conservatively leveraged, when economic conditions in 1997 and 1998 went unexpectedly helter skelter, there would have been less need to liquidate portions of its portfolio at fire sale prices just to meet ever-increasing margin calls and collateral requirements.

The problem was that many financial intermediaries had very similar portfolios and risk management systems. They were forced by the market to focus on short-term financial results because their portfolios were marked-to-market daily. In a liquidity crunch, these institutions acted in the same way as LCTM. Their flight to liquidity depressed asset prices and threatened the solvency of these highly leveraged companies.

Some Things Are Worth Doing for the Greater Good

By size alone, LTCM dominated the hedge fund landscape. When it was rescued in 1998, LTCM’s assets were $125 billion, nearly four times greater than the next largest fund.236 LTCM’s failure could have caused widespread contagion, which would have brought significant financial pressures on its counterparties, many of whom were losing considerable amounts because of their comparable portfolio positions.237 The financial crisis could have also put pressure on international exchanges where LTCM represented 5 to 10 percent of the open interest and an even greater percent of the daily turnover; but over and above this, if LTCM’s counterparties were hedged beforehand, a failure could have caused a mass scramble to shore up newly exposed positions. As a result, market prices could have moved even more unfavorably, causing wider and deeper consequences. Credit risks would have been reevaluated, which could have led to a credit squeeze, and the greater uncertainty could have increased the risk premium embedded in nominal yields.

When the greater good is larger than the sum of benefits accruing to the individual vested interests (i.e., in this case, the counterparties to LTCM’s trades and its creditors), there needs to be a way to communicate fully and clearly what is at stake. If private parties have no incentive to limit their bilateral risks to reduce contagion effects, then whose job is it to open the eyes of key players about the externality costs?

What Happened to the Principals, Creditors, Investors, and Consortium?

LTCM’s management company, Long-Term Capital Management L.P., was transferred to the consortium. The recapitalization saved most of the parties involved in this debacle from serious collateral damage. Because the destruction seemed so small, after the dust settled, Myron Scholes called LTCM’s failure the “non-fault bankruptcy of his hedge fund,” but he was probably not considering the damaged reputations and lost jobs at hedge funds and financial institutions around the world.238

The Principals and Employees

Myron S. Scholes retired four months after LTCM collapsed, planning to return to California, where he lectured and researched at Stanford University.239 In August 2000, Scholes began working for Oak Hill Platinum Partners Fund, a hedge fund backed by Robert M. Bass.240 Robert C. Merton, who held a full-time professorship at Harvard University since 1988, continued his heavy schedule of lecturing, researching, and consulting. David W. Mullins, Jr., left LTCM to become chair of vSimplify, a portal company.

Since the fund’s inception, LTCM’s staff members had been the servants of the arbitrage lords and routinely invested all their bonuses back into the company. Those invested bonuses were gone, and by the end of October 1998, many of these employees (about 20 percent) were laid off.

John Meriwether and the other principals lost most of their autonomy to make trading decisions. Nevertheless, as part of the deal, LTCM’s principals got to keep their homes241 and received bonuses of $250,000 for the year they stayed with the company. Many of the principals still faced bitter financial setbacks, but that should be expected because they caused the fiasco and deserved some downside consequences. Some of them were permitted to leave before year’s end for lucrative jobs on Wall Street. Just over a year after the collapse, John Meriwether and five of his colleagues242 at LTCM, had already started a new hedge fund.

Creditors and Investors

The rescue allowed virtually all of LTCM creditors to be paid in full. In an ironic twist of fate, investors who were not principals or part of LTCM’s core group made out much better than you might expect. Altogether, during their four-year roller-coaster ride (i.e., from fortune to despair), John Meriwether and his band of arbitragers earned outside (non-principal) investors an average annual return of slightly less than 20 percent. These investors made out as well as they did because they were forced, at the end of 1997, to take a refund. Therefore, when the collapse occurred, they had nothing (or relatively less) invested in LTCM.

The Consortium

The consortium had mixed results. Spreads did not converge rapidly and economic conditions remained tenuous. As a result, some, but not all, of LTCM’s positions were closed with profits, but overall the results were satisfying because the full $3.625 billion invested by the consortium was repaid.243