CHAPTER 16

Hedge Fund Case Study

Long-Term Capital Management

The yin and yang of hedge fund experience is revealed in the short, dramatic life of LTCM. In its 5 brief years, it reached the apex of hedge fund success—spectacular returns, clamorous investors, and extremes of arrogance and conspicuous consumption. When the end came suddenly, the corpse was preserved on life support temporarily, to harvest its organs. But LTCM’s true believers—its partners and employees, who had invested their life savings in the fund—were mostly wiped out.

This story illustrates the life cycle of a very successful, then spectacularly doomed, hedge fund. It is drawn from several sources, particularly Lowenstein’s “When Genius Failed” and Lewis’s “How the Eggheads Cracked.”

Origins: JM (John Meriwether)

John Meriwether ran the “quant arbitrage” desk at Salomon Brothers in the late 1980s and early 1990s, and was instrumental in the securitization movement in the prior decade (described colorfully in Lewis’s Liar’s Poker). He had a reputation as a superb developer of talent, and an early adopter of “quant” strategies—trading strategies that use extensive data analysis to identify systematic relationships between the prices of assets, in order to exploit deviations that occur. At the quant desk, he built a staff of “rocket scientists”—mathematicians and scientists who had little financial experience but world-class statistical abilities; they fit poorly in the fraternity or club world of Wall Street. Their unit generated most of Salomon’s profits each year in the late 1980s and early 1990s, and Meriwether secured them a guarantee of 15 percent of all profits generated. When he was tarnished in an internal scandal in the early 1990s, Meriwether formed his own hedge fund, LTCM, capitalizing it at the then-unheard-of sum of $2.5 billion.

The LTCM team possessed an exceptional pedigree. Two of its senior members were finance academic superstars: Robert Merton of Harvard and Myron Scholes of the University of Chicago. Along with Fisher Black, Scholes authored the Black–Scholes formula, the definitive method of pricing options. Merton and Scholes both shared the Nobel Prize in economics. The LTCM team also included former Federal Reserve vice chair David Mullins; early investors included many of the leaders of white shoe Wall Street firms.

The Rise

With a stellar reputation came exceptional pricing power. LTCM demanded, and got, deep trading discounts from clearing brokers, and the lowest interest rates on borrowed money—the latter especially valuable when the fund borrowed as much as $30 for every dollar in equity. Such high rates of leverage were unheard of in the hedge fund world, although not uncommon in commercial banking. LTCM’s partners were comfortable with leverage because they were convinced that their investments had as little risk as those of regulated commercial banks.

At first, in 1994, this seems to have been true. The team’s core skills pertained to fixed-income arbitrage: betting on systematic differences in the pricing of bonds. For example, they would execute a “paired trade” in which they would short (bet against) newly issued Treasuries of a particular maturity, while going long in seasoned (less recently issued) securities of the same maturity. The trade was premised on the expectation that the prices of the newer versions of the security, which were more liquid, would be bid up, while the older versions were depressed. Eventually, this anomaly would resolve and price relationships would be restored. Such disparities might be very small, so profits mandated that high volumes be traded, using borrowed money (i.e., high leverage). LTCM earned returns approaching 100 percent per year in 1994 and 1995, and seemed to do no wrong. Partners oozed arrogance and demanded ever tougher terms from the firm’s suppliers and counterparties.

Success bred overconfidence. By 1996, the firm began to dabble in convertible arbitrage (buying convertible bonds and shorting the issuer’s stock, in the belief that the two assets prices would converge), and then straight equity arbitrage. By late 1996, the firm’s portfolio included increasing volumes of derivatives: equity options and interest rate swaps. For every dollar in equity, the firm had positions of $200 or more in derivatives.

By 1997, the partners were tired of sharing their seemingly limitless gains with clients, and they began returning client investments. By late in the year, nearly all of the remaining equity was owned by LTCM’s partners or employees. While this had the unintended consequence of protecting some former investors from the blowup of the summer of 1998, it also shrank the fund’s equity base and left it less able to absorb those blows.

The Fall

Even in 1998, a large portion of LTCM’s portfolio was based on fixed-income arbitrage positions—expectations that anomalous spreads among different bonds would right themselves, given time. But when Russia unexpectedly defaulted in the summer of 1998, things began to unravel. As investors rushed to the safety of Treasuries, “irrational” spreads became magnified. The partners at LTCM felt that, given time, things would rectify as they always had before, but time was an asset that LTCM lacked. LTCM also lacked the capital to buy more time for them to rectify. Lenders issued margin calls, demanding that LTCM liquefy positions, regardless of losses, to deliver cash. As Keynes once said, “The market can remain irrational longer than you can remain solvent.”

As LTCM’s portfolio collapsed and lenders demanded their cash back, clearing brokers prepared to cease processing LTCM’s trades. This would have rendered the fund completely illiquid, and under the circumstances, insolvent. Because so many top institutions had investments in the fund, which they had in turn pledged as collateral for their own loans, it was believed that if LTCM failed, it could take down many other financial institutions as well. The New York Federal Reserve Bank convened a consortium of Wall Street banks to put LTCM into receivership: They loaned it about $300 million in bridge financing for the express purpose of unwinding the firm’s portfolio and shutting it down. Three of the government officials involved in creating that consortium were shown on the cover of Time magazine, dubbed “The Committee to Save the World.”

The process took about 18 months, so LTCM staggered on into 2000. A final tally of its losses included those from an eclectic array of strategies:

Traditional fixed-income arbitrage losses:

Equity and related arbitrage losses:

Derivatives losses:

LTCM had nearly $4 billion in equity at the beginning of 1998. It could have absorbed the losses associated with its traditional arbitrage strategies, and probably even its extensions into equity arbitrage. The killing blows came from derivatives.

Founding investors who had seen their positions quadruple in the 4 years from Spring 1994 to Spring 1998 experienced 90%+ declines in the summer of 1998.

The Aftermath

LTCM ceased to be by early 2000. Meriwether established a new boutique hedge fund within months: JMW partners. Most of the partners rebuilt their lives in other investment operations, although they lost the vast majority of their net worth when LTCM imploded. As noted earlier, ironically, LTCM partners’ arrogance inadvertently protected most of their investors, who had money forcibly returned to them in 1997.

This same pattern was repeated on an even larger scale in 2008 in a number of Wall Street institutions. Ironically, the experience that many of those leaders had in the LTCM debacle of 1998 helped prepare them for a crisis two orders of magnitude larger a decade later.

Hedge Fund Founder Bio

George Soros, Quantum Fund

Born: 1930, Budapest, Hungary

Firm: Quantum Fund (since 1978); Soros Fund (1973 to 1978); Double Eagle Fund (1969 to 1973)

Cofounders: Jim Rogers; Stanley Druckenmiller (each later left Soros and formed their own funds)

Style: Pioneer of global macro

Annual return: Over 20 percent (1969 to 2010)

AUM: $27–29 billion (2011)

Differentiation: Soros is extraordinarily well connected in both financial and government circles, giving him an insight—and possibly inside information—into likely actions of major corporations and governments. Known as “the man who broke the Bank of England,” he bet in 1992 that Britain could no longer maintain the pound’s value against the Deutschmark; his shorts of the pound earned $1.8 billion in profits in one week in September.

Soros background: Born of a well-to-do Jewish family in Budapest; emigrated to the UK in 1949 to study at the London School of Economics. Spurned by City firms, his first financial job was an entry-level position at a brokerage firm run by Hungarian émigrés. Moving to New York in 1956, Soros migrated into research, rising to be the head of research for Wall Street brokerage Arnhold and S. Bleichroder in 1967. Left to found Double Eagle fund—the double eagle was the symbol of the Austro-Hungarian empire—in 1969.

Color: Soros is a protégé of philosopher Karl Popper, naming one of his charities the Open Society Institute in honor of Popper’s masterwork, The Open Society and Its Enemies. A prolific author, he promotes his theory of “reflexivity”—the idea that little can be predicted with assurance because humans will react to conditions to make predictions self-cancelling. Soros is a prominent philanthropist, and his donees include the Democratic Party and its candidates.