Chapter 21
Lessons from Funds: LTCM, Florida, and Orange County
CASE STUDY ONE: LONG-TERM CAPITAL MANAGEMENT1
Event Summary
The significance of the events surrounding the collapse of Long-Term Capital Management (LTCM), and its subsequent loss of $4.4 billion, should not be underestimated. The breakdowns at LTCM include an overexposure to several types of risk: leverage, sovereign, model, liquidity, and volatility risk. In addition, the firm lacked the diverse revenue streams of the Wall Street investment banks to which it liked to compare itself. Overall, the fiasco portrays a failure of the firm to implement a broad-based risk management strategy and to properly stress test its models.
Event Details
Long-Term Capital Management was founded in 1994 and held a prestigious position in the unregulated hedge fund sector as a result of the reputations of its senior management, which included Nobel Prize winners Robert Merton and Myron Scholes. The hedge fund was founded by John Meriwether, who was previously head of fixed-income trading at Salomon Brothers until the firm was implicated in a government securities scandal. Meriwether brought some of the best minds with him to Long-Term Capital. The hedge fund's investors included many of the most prominent names in the financial services industry.
LTCM distinguished itself from the start with several years of above-average returns, which it earned from positions on interest rate spreads and market price volatilities. It used highly sophisticated models in order to target pricing inefficiencies in the markets. According to Federal Reserve Chairman Alan Greenspan's testimony before the U.S. Congress, these models were efficient as long as the markets behaved in the same way in the present and the future that they had in the past. In addition, once the models targeted where profits could be made from pricing anomalies, certain efficiencies were created and the opportunity no longer existed to achieve higher-than-average returns.
In short, the pricing models that were used by LTCM, and increasingly its competitors, were so efficient that they worked to close any gaps that could have resulted in above-average returns. In order to compensate for this trading cycle of diminishing returns, LTCM's trading strategies took on more leverage and risk. LTCM's timing was less than optimal, and it took on increased risk at the very time that the markets became more volatile. This resulted in what some have characterized as an overall failure of risk management at the firm.
An additional risk factor at LTCM was the use of leverage by a fund that garnered a great deal of credibility on Wall Street as a result of its highly respected management team. It was able to borrow 100 percent of the value of collateral and use the borrowed funds to purchase additional securities, which it would post as collateral in order to borrow more money. The hedge fund was involved in a cycle of borrowing and leveraging collateral. This partially resulted from the respect it had in the markets and the failure of any of its counterparties to question very deeply whether the fund had taken on too much risk and whether it could meet its obligations. In its first two years in business, LTCM earned 43 percent and 41 percent return on equity as a result of its strategy to finance and leverage its collateral. Its leverage multiple was on average in the range of 25. This is what a fully diversified investment bank might assume, but not a ratio that a market-neutral hedge fund would be expected to take on.
LTCM also faced an additional strategic issue: It was hard for its models to be effective and for the firm to have a competitive advantage when its trades were copied by most of the major players on Wall Street. LTCM raised funds from the big Wall Street firms: Morgan Stanley, Merrill Lynch, and Goldman Sachs. But with the funding came the request for transparency and a disclosure of its trading positions. This ultimately led to a shadowing of LTCM's trades on Wall Street. And the firm's models failed to account for this shadowing effect, and what it meant if all the firms that were copying its trades moved to dispose of their positions at the same time. What occurred is what could have been predicted: price deflation of the disposed assets and a liquidity crisis.
LTCM's troubles began to surface on July 17, 1998, when Salomon Brothers started liquidating its dollar interest arbitrage positions; in essence, Salomon started selling many of the assets that LTCM owned. This brought down the prices of these positions. The next important piece in the unraveling of LTCM was the government of Russia's announcement on August 17, 1998, that it was “restructuring” its debt, or lengthening the terms of the payout on short-term bonds. In actuality, this comprised a default event, and the markets, with a newly acquired suspicion of all sovereign instruments, witnessed a mass unwinding of credit risk positions.
The strategists at Long-Term Capital remained convinced that their mathematical models would hold up under the stress, and that the markets would behave as they had done in the past. LTCM predicted that the markets could go down by only a certain percentage before they would correct themselves within an assumed time frame. This did not happen.
On one day alone, August 21, 1998, the firm lost $550 million. Half of that money was lost in a single trade: a short position in five-year equity options. LTCM's prime broker and clearing agent, Bear Stearns, increased its demand for collateral, which in turn depleted the fund's available reserves. The fund was on the verge of liquidation in mid-September, and the fear was that this would cause a large chain reaction through very significant market disruption as major broker-dealers moved to cover derivative trades with LTCM. There was an additional fear that the amount of leverage on LTCM's books was unknown.
Control Failings and Contributory Actions
Corporate/Market Conditions
The chairman of the Federal Reserve, Alan Greenspan, testified before congress that a number of market conditions contributed to the central bank's decision to step in and arrange for an industry bailout of the hedge fund; these conditions included “financial market participants” that were already “unsettled by global events” and elevated credit spreads that were placing downward pressure on asset prices. Mr. Greenspan further elaborated that the “plight of LTCM might scarcely have caused a ripple” in the near past, but under present “fragile” market conditions there was a risk of a “severe drying up of market liquidity” (New York Times 1998).
Undertook Excessive Risks
LTCM's models created efficiencies in the markets over time that hampered the hedge fund's ability to earn above-average returns. In order to compensate for the diminishing returns, the hedge fund revised its trading strategy to take on more risk and leverage; this occurred at the very time when the markets were becoming more volatile and investors more risk averse. At the same time, market conditions did not follow past patterns, and LTCM's models—which were predicated on historical cycles repeating themselves—did not perform very well.
Inadequate Stress Testing
LTCM model's were not properly tested for changing market conditions and, in particular, for conditions where investors would turn so risk averse and dump all assets—no matter their performance—at the same time. This was an irrational market condition that had not been witnessed before; in previous times there was a flight to quality with investors fleeing to safe and liquid assets. During 1998 investors started fleeing from all assets. It was at this very moment that LTCM found itself with large losses and the need to unwind its portfolio. Alan Greenspan testified that unwinding a portfolio at this time and in “such market conditions amounts to conducting a fire sale” (Federal Reserve Board 1998).
Strategy Flaw
One of LTCM's largest problems was the shadowing of its trades. This meant that it could no longer achieve returns based on market inefficiencies. It also meant that when the time came to unwind its positions, there would be many more sellers than buyers for the assets it was unloading, and an associated downward price pressure. LTCM opened its books to all the major Wall Street firms in its effort to grow quickly and raise cash; this also meant that it revealed its trading strategy to these same firms.
Corrective Actions and Management Response
The effect on the market of LTCM's unwinding its portfolio was so enormous that the Federal Reserve Bank, in a historic move, initiated a bailout of the hedge fund. On September 23, 1998, the Federal Reserve organized a consortium of 14 banks, which injected $3.6 billion into the fund in exchange for a 90 percent ownership stake. Of the $4.4 billion ultimately lost, $1.9 billion belonged to the LTCM partners and the rest to other investors. And of that $4.4 billion, $3 billion came from two types of complex trades: sophisticated interest rate swaps and long-term options in the stock market. Control of the hedge fund passed to a committee comprised of investors.
Alan Greenspan defended the Federal Reserve's decision to step in and arrange for a rescue of LTCM as a result of the fact that the hedge fund was unwinding its complex portfolio at a time when all assets were being sold at fire sale prices. The concern was that downward pressure on all assets—no matter how safe they appeared in the past—would result in “severe, widespread and prolonged disruptions to financial market activity.” In addition, the Federal Reserve Bank of New York expressed the opinion that the act of unwinding LTCM's portfolio in a “forced liquidation” would lead to a “set of cascading cross defaults” (U.S. House of Representatives 1998).
Lessons Learned
Federal Reserve Chairman Alan Greenspan testified that the rescue agreement reached by the consortium of banks was never a bailout and did not involve public funds. He positioned the agreement as something that was a good investment to the rescue committee if they were able to sell its assets over time instead of under pressure in a forced liquidation scenario. Greenspan stated, however, that “whenever there is public involvement that softens the private-sector losses—even obliquely as in this episode—the issue of moral hazard arises.” He further elaborated that any government involvement can have the impact of raising “the threshold of risks market participants will presumably subsequently choose to take.”
Mr. Greenspan justified the Federal Reserve's rescue effort by claiming: “Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own.” In the end, he reached the conclusion that the Federal Reserve acted in the way it did not to protect LTCM's stakeholders, but to “avoid the market distortions through contagion.” Additional financial institutions would suffer losses in this case (Federal Reserve Board 1998).
CASE STUDY TWO: FLORIDA STATE BOARD OF ADMINISTRATION2
Event Summary
Florida's State Board of Administration (SBA) experienced the equivalent of a run on the bank in November 2007 that was characterized as one of the largest in history; $16.5 billion in assets was withdrawn from the $27 billion fund during the month of November 2007. The outflows followed disclosure that the Local Government Investment Fund (LGIF) was heavily invested in mortgage-backed securities (MBS). The severity of the problem escalated when the fund sold off its higher-quality investments in order to meet its obligations. This left the fund with a larger percentage of troubled securities in the remaining portfolio. The fund later halted all outflows while it restructured and created a separate vehicle for the distressed securities.
Event Details
The Local Government Investment Fund was run by the State Board of Administration as a money market fund for the state of Florida's local agencies, municipalities, and education system. The fund was the largest of its kind in the United States and managed assets for approximately 1,000 state participants. Funds such as the Local Government Investment Fund are required to invest in short-term and safe securities; the Florida fund strayed from this mandate over a few years in an attempt to gain higher yields during a period of relatively low interest rates. This led to the acquisition of more exotic instruments, such as collateralized mortgage obligations (CMOs) and structured products.
The State Board of Administration announced on November 29, 2007, that it would “temporarily not accept or process deposit or withdrawal requests.” The Local Government Investment Fund reopened to investors on December 7, 2007, following a restructuring that placed the “bad paper” into a fund called Fund B that prohibited withdrawals. Fund B primarily consisted of structured investment vehicles (SIVs) that had been devalued by subprime-related market issues.
The state of Florida was now left with a portfolio of securities that it might not be able to sell for a long time. An estimated 14 percent of the LGIF's portfolio was invested in distressed securities. About 86 percent of the portfolio was invested in investment-grade and liquid holdings. The troubled portion of the portfolio was now quarantined in Fund B, which represented about $2 billion in assets. The remaining $12 billion in healthy assets resided in Fund A.
The freezing of redemptions from the Local Government Investment Fund between November 29, 2007, and December 7, 2007, left many schools and local communities scrambling to pay their bills; they relied on the LGIF for access to liquid assets. News of problems with the LGIF led to lines at the state's school districts, with fear emanating from employees that they would not receive monthly paychecks. One local school district met its obligation to employees but canceled $700,000 in payments to external vendors.
The chief financial officer for the northwest Florida school district said on December 1, 2007, that the district “kept all our surplus cash in that pool and now we cannot get access to it.” He added that “we are now flat broke.” He further stated that the district kept its funds in the LGIF after the state's chief financial officer issued a statement indicating that the fund was healthy. The school districts and municipalities that decided to keep their money in the fund in order to avoid “hysteria” now said they felt misled by state officials (Financial Times 2007).
One of the agency's largest municipal banking clients, Hillsborough County, threatened to sue. The run on the bank and subsequent sale of healthy assets left the county with approximately $112 million, or 14 percent, of its $800 million investment in the LGIF exposed to SIVs. Hillsborough requested that counties in Florida that withdrew their funds, such as Orange County, should be required to send the money back. Florida's Orange County had withdrawn $370 million of its holdings from the fund without suffering a loss.
The State Board of Administration came under additional criticism for how it revealed its subprime exposure to constituents. The SBA issued a statement on October 31, 2007, indicating that its investment funds did not contain subprime-related mortgage bonds. However, the report did indicate that the funds had holdings in “less than prime” mortgage-backed securities, which had been downgraded to below investment-grade levels and as a result presented liquidity problems.
A limit on withdrawals of 15 percent of the total value of investments restricted outflows from Fund A. This cap was expected to remain in place until at least March 2008. A review of current investors conducted in December 2007 found that at least one-third had pulled out funds up to the 15 percent limit. The fund was also facing difficulty attracting new investors. One money manager said that his board “is not comfortable with sending any more funds to SBA while they have a lockdown on our investments.”
Florida's State Board of Administration has more than $170 billion of assets under management, including approximately $138 billion belonging to the state's pension system and hurricane fund. It also allegedly has notable holdings in mortgage-backed securities in both Citizens Property Insurance and the Florida Hurricane Catastrophe Fund. A fund director stated that any holdings related to subprime mortgages would be traded out of the funds before hurricane season hit Florida in the summer of 2008. However, it may have been difficult, given valuation and liquidity issues, to sell the holdings by then.
Control Failings and Contributory Factors
Insufficient Compliance Measures
Hillsborough officials requested that the state of Florida roll back the clock to a date before the run on the bank and require counties that withdrew funds to return the illiquid portions. A clerk for the county cited Chapter 218 of the Florida statute as justification for this claim, which requires the State Board of Administration to “purchase investments for a pooled investment account in which all participants may share pro rata, as determined by rule of the board, in the capital gains, income, or losses, subject to any penalties for early withdrawal.” In addition, according to the state clerk, “an order or warrant may not be issued upon any account for a larger amount than the share of the particular account to which it applies; and if such order or warrant is used, the responsible official shall be personally liable under his or her bond for the entire overdraft.”
Undertook Excessive Risks
States, pension funds, and local governments began accumulating riskier securities during a period when interest rates were relatively low. They were consequently able to earn higher yields, but also took on higher risk. In this case, the state of Florida continued to acquire subprime-related securities in the months after it was clear that there was a problem; Bear Stearns announced that two of its hedge funds had lost over 90 percent of their value in July 2007, and Countrywide Financial faced a liquidity crisis in August 2007. The state of Florida continued to purchase investment stakes related to subprime mortgages as late as August 2007 and held on to its holdings through October 2007.
Compensation
The former director of the State Board of Administration, Coleman Stipanovich, was encouraged to take on risk through his compensation agreement. He was provided with financial incentives of up to 8 percent of his annual salary if he increased returns for the state's pension fund. The manager of the Local Government Investment Fund was provided with similar incentives. This drive for return, and encouragement through incentives to bring in returns without the consideration of risk, has led to many operational risk blowups in the past. It can be argued that in Florida's case, it encouraged the state's senior managers to invest in securities that would boost yield, but also led to a substantial increase of risk in what should have been a safely invested money market fund.
Corporate/Market Conditions
Market conditions for all financial institutions and lenders became so precarious during August 2007 that the Federal Reserve stepped in to add liquidity to the markets. The Federal Reserve had last provided cash to the banking system in 1998 during the collapse of Long-Term Capital Management. This suggests that conditions that led to Florida's troubles are at least a once-in-10-years event. When the Federal Reserve moved to cut the discount borrowing rate, it released a statement saying that risk in the markets increased “appreciably.” Jan Hatzius, chief U.S. economist for Goldman Sachs, commented: “In Fed-speak, things are either ‘slightly’ or ‘somewhat.’ Saying that the risks have increased ‘appreciably’ is a pretty strong statement for them” (Gosselin 2007).
Corrective Actions and Management Response
The state of Florida pulled Bob Milligan out of retirement in order to function as the State Board of Administration's interim executive director. He replaced former executive director Coleman Stipanovich, who resigned on December 4, 2007. Mr. Milligan had been comptroller for the state of Florida from 1995 through 2003. At the same time, the state of Florida brought in New York–based BlackRock to help restructure the troubled Local Government Investment Fund.
Mr. Milligan found a problem when he showed up for work in his interim role: Too many people were attempting to manage the crisis, and as a result BlackRock was being given conflicting directions from state executives. Mr. Milligan stated that one of his first tasks was to make it “very clear to them [BlackRock] who they report to and who they are working for, and the lines of communications I want to be followed both in terms of routine things that occur and any extraordinary things that may occur.”
Mr. Milligan, who was 75 years old, said he was putting a system in place for his successor. One recommendation was to hire an experienced money manager and offer an annual salary in the $300,000 to $350,000 range. His predecessor, Mr. Stipanovich, earned approximately $180,000 per year. Mr. Milligan said that the next head of the agency should have private-sector experience running large funds. At least one trustee of the fund commented that the recommended salary level for the next head of the fund sounded too high, and public sector employees should expect to earn less in exchange for the “opportunity to serve.”
Lessons Learned
A peripheral concern in this case is the fees that BlackRock charged as a money manager that was brought in to restructure the troubled state fund. According to the Orlando Sentinel (12/18/2007), local governments were attracted to the LGIF originally because its management fees were relatively low. However, there was concern that BlackRock's fees were too high; they were about 26 times higher than what the state charged. Others contend that the fees were appropriate given the crisis situation that faced the fund. BlackRock was charging a two-tier fee structure, with a higher fee charged for Fund B than for Fund A.
Part of the concern for BlackRock's fees is for what it was charging for Fund B, given that the fund manager advised to let the fund sit for a year or so without any notable active buying or selling of assets. BlackRock argued that the extra fees were necessary because of the complexity of analyzing the securities involved and determining the best time to attempt to sell off some of the assets.
In addition, investment banks that sold mortgage-backed securities to Florida and other states are coming under criticism for fiduciary issues. Lehman Brothers sold the state of Florida $842 million of mortgage-backed debt in July and August 2007—just a few months before the revelation that the state's money market fund held the securities. Bloomberg alleged (12/18/2007) that the investment banks were attempting to offload securities that they knew were distressed to states, which were in search of higher yields and were willing buyers. The states are likely to take the Wall Street firms to court over allegations that they breached their duty to less sophisticated public investment funds.
Counties that left their funds in the LGIF have been placed at odds with counties that pulled out their investments in November 2007. Counties such as Hillsborough argue that the state should have halted all withdrawals when it became apparent that the mortgage-related investments were becoming impaired and were suffering from a lack of market liquidity. This increased the risk for counties such as Hillsborough, which saw its exposure to mortgage-backed securities grow from 3.4 percent of its entire investment to over 14 percent.
A clerk for the county said that he did not want to withdraw his investment at the time because he thought it would “just add to the panic and hurt in the long run.” He added that he was not “worried about 3 percent.” However, the state proceeded to sell off its liquid assets in order to meet its obligations to the counties that were actively withdrawing funds, and as a result counties that decided to stay found that troubled assets now comprised a larger portion of their investments.
CASE STUDY THREE: ORANGE COUNTY MARKET RISK EVENT3
Event Summary
In December 1994, Orange County in Southern California announced publicly that its investment pool had suffered a $1.6 billion loss. This was the largest investment loss ever registered by a municipality, and led to bankruptcy and the mass layoffs of municipal employees. At the center of the case was the county's treasurer, Robert Citron, who was responsible for investing the county's money in interest rate derivatives in order to boost returns for the investment pool that he managed. The Federal Reserve, however, raised interest rates multiple times in 1994, which resulted in significant losses for Citron's investment strategy. Through the purchase of interest rate derivatives, Citron had placed bets that interest rates would fall rather than rise.
Event Details
The $1.6 billion loss was blamed on the unsupervised investment strategy of Robert Citron. Mr. Citron portrayed himself at the time of his trial as an unsophisticated investor who was misled by Merrill Lynch investment advisers, and did not fully understand the risks involved with the recommended strategy to purchase interest rate derivatives. Orange County argued in court that since Mr. Citron had exceeded his authority by leveraging his investment pool by a ratio of 13 to 1, the investment advisers were ultimately responsible for the loss.
Citron placed a bet through the purchase of reverse repurchase agreements that interest rates would fall or stay low, and reinvested his earnings in new securities that were mostly five-year notes issued by government agencies. Mr. Citron's strategy worked until February 1994, when the Federal Reserve undertook a series of six interest-rate hikes that generated significant losses for the fund. The county was forced to liquidate Citron's managed investment fund in December 1994, and suffered a loss of $1.6 billion. A county that was among the most affluent in the United States filed for Chapter 9 bankruptcy, and was forced to put large projects and expansion plans on hold.
Also playing a role in Orange County's bankruptcy were Merrill Lynch and its ex-Marine broker, Michael Stamenson. A training tape that featured Mr. Stamenson was presented as evidence in a lawsuit brought by Orange County against the brokerage firm. In the tape, Mr. Stamenson coaches new brokers that they need the “tenacity of a rattlesnake, the heart of a black widow spider, and the hide of an alligator.” In the end, Merrill's dealings with the county cost the brokerage over $480 million.
In 1998 the Los Angeles District Court upheld Citron's authority to invest in derivative securities, despite the fact that he made “grave errors” and “imprudent decisions.” It was difficult for Citron to represent himself as an “inexperienced investor” and “lay person” after he testified that he had more than 20 years’ experience in the investment industry. Evidence was presented that demonstrated Citron's influence: When Goldman Sachs criticized his high-risk strategy in 1993, he advised the firm to avoid seeking business opportunities with the county in the future.
The group of brokerage firms that were later sued in court for the role they played in the event argued that this was not the posture of an “inexperienced lay person.” Citron had delivered returns that were 2 percent higher than other municipal pools in the state of California, and was viewed as a “wizard” who obtained better-than-average returns in difficult market conditions. He enjoyed his near-celebrity status until December 1994 when everything unraveled and the county declared bankruptcy. Ultimately, Mr. Citron pleaded guilty to six felonies.
Control Failings and Contributory Factors
Employee Misdeeds/Undertook Excessive Risks
Mr. Citron originally portrayed himself as an unsophisticated investor who was misled by Wall Street brokers. However, he eventually pleaded guilty to a variety of misdeeds, including making false statements in order to sell securities to schools and local agencies that had invested in Orange County's investment pool, falsifying financial documents, and failing to pay proper levels of interest to participants in the investment pool.
Failure to Supervise
Mr. Citron appeared to have engaged in his risk-taking strategy without supervision from the county's management. The Wall Street Journal (6/4/1996) reported that the county's supervisors referred to the investment pool as “Citron's portfolio” and hired a lawyer who concluded that they were not responsible for supervising Mr. Citron. Matt Raabe testified that authorization to sell the securities in the portfolio might have been interpreted as an acknowledgment that the board had some responsibility for the loss. The Wall Street Journal contended that this was part of the general pattern within Orange County: “The county's elected leaders washed their hands of responsibility for the county's finances.”
Corrective Measures and Management Response
Orange County declared bankruptcy on December 6, 1994, after it discovered that Mr. Citron's leveraged interest rate bet had produced $1.5 billion in paper losses. The portfolio was later liquidated and resulted in a $1.63 billion real loss.
Orange County's prosecutor sought a seven-year sentence for Robert Citron and a $400,000 fine. Instead, he was sentenced to a one-year jail sentence and a $100,000 fine. He never actually served time in jail; instead, he worked in a clerical position on a work-release program that allowed him to return to his home each evening.
Lessons Learned
It is worth noting that, according to Professor Philippe Jorion in his case study on Orange County,4 a huge opportunity was lost when interest rates started falling shortly after the liquidation of the fund, and a potential gain of $1.4 billion based on Citron's interest rate strategy was never realized. He found the county most guilty of “bad timing.”
Nobel Prize winner Merton Miller also questioned whether liquidation of Orange County's portfolio was the right strategy; he argued that the county had enough money on hand to continue operations and could have recouped its losses within one or two years. According to the Wall Street Journal (6/4/1996), several Wall Street firms were allegedly standing by in an attempt to buy portions of the investment pool. But for legal reasons the county decided to declare bankruptcy despite the fact that some experts, including Mr. Miller, contended that there were other options.
The lessons learned from this debacle include the lack of employment of classic risk management techniques by Citron and his investors, including the use of value at risk (VaR), and the lack of honest analysis of how the county was managing to realize above-market returns.
NOTES
* This information is the sole property of Algorithmics Software LLC and may not be reprinted or replicated in any way without permission.
1. Algo First database of operational risk case studies.
2. Ibid.
3. Ibid.
4. Jorion, Philippe. 1995. Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County. Orlando, FL: Academic Press.
REFERENCE
Gosselin, Peter G. 2007. “Fed Gets Message, Lowers Key Rate,” Los Angeles Times. August 18.
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