UnRisk 7

“The More Things Change…LTCM Part 1”

In late 1998, Long Term Capital Management (“LTCM”) encountered financial difficulties that required a bail-out by banks, orchestrated by the Federal Bank of New York. In August/ September 2006, Amaranth, a multi-strategy hedge funds (aren’t they all?) lost $6 billion after massive natural gas trades went awry. The hedge fund which had assets of $9.2 billion was eventually wound up. A spokesman for Amaranth gave the following reasons for the losses: “We did not expect that the market would move so aggressively against our positions!”

LTCM is now history and the lessons were forgotten surprisingly quickly. Yet, the problems at Amaranth bear a scary resemblance to the events that brought LTCM undone. Over the next two postings, I have set out a brief history of the LTCM saga.

In the Long Run…

Keynes noted that in the long run we are all dead. LTCM showed that the proposition also held in the short run. In fact, they demonstrated that it is possible to self destruct in a surprisingly short time. LTCM is a story of the confluence of many divergent trends - quantitative finance, risk modeling and derivatives trading. Naturally, it is also about the staples of financial markets – fear and greed.

LTCM was a hedge fund based in Greenwich, Connecticut, USA. The fund was formed in 1994 by a group of ex-Salomon Brothers traders led by John Meriwether. The key principals (in addition to Meriwether) included Eric Rosenfield, Lawrence Hilibrand, William Krasker, Victor Haghani, Greg Hawkins and David Modest. LTCM principals included Nobel price winners Robert Merton and Myron Scholes and former regulators including former Federal Reserve Board Vice Chairman David Mullins.

The core Group had worked together in Salomon Brother’s fixed income arbitrage operations. The individuals did not fit the mould of traditional rough and tumble traders. Most were highly qualified, holding Ph.Ds in economics, finance, mathematics, science or related disciplines. The unifying element was the enigmatic Meriwether. He had hired many of the key players. A graduate of the University of Chicago, Meriwether was one of the earliest to embrace quantitative finance and to realise its potential to unlock trading riches.

He attracted fierce loyalty amongst employees, backing them unquestioningly. There is a story about Meriwether that encapsulates his relationship with his hires. A trader asked Meriwether’s view of a trade that he was considering. “My trade was when I hired you,” Meriwether is reported to have responded. The fact that he paid them extraordinarily well even by the extravagant standards of financial markets also helped in the bonding.

The fixed income arbitrage group’s mythology was built around a famous incident. In the aftermath of the stock market crash in 1987, traders at Salomons gathered to discuss strategies. Real world disasters generally create volatility. Traders see them as trading opportunities. Calamities do not result in considered focus on the human tragedy. Disasters cause reflection on which stocks will go up or down and what the currency and interest rate markets reaction is likely to be. Traders often also make side bets amongst themselves when such events occur. After, the 2004 tsunami in Asia, the traders at one bank ran a book on the final casualty number from the disaster.

In 1987, at Salomons, there was a difference of opinion. The traditionalists, John Gutenfreund (Head of Salomons) and Craig Coats (Head of Government bond trading), thought that interest rates would fall. This is what had generally happened in the past. They bought a truck load of 30 year bonds hoping to profit from rising prices as interest rates fell.

Meriwether’s boys – the arbitrage group – did not share the consensus view. They noticed that the market disruption had resulted in a lower risk trading opportunity. The 30 year bond consists of 60 interest payment (semi-annual interest coupons) and a final principal payment (the corpus). They could buy the coupons and corpus separately at a lower price than the 30 year bond itself. They did precisely this, buying the components separately, and selling the 30 year bond short, to lock in a profit.

The arbitrage group’s trade made money. Gutenfreund’s trade – which quickly gained the sobriquet “the Whale” – lost a similar sum. Coats, a competitor of Meriwether in the battle for succession within the firm, was furious. In the end, the bond desk’s attempts to best Meriwether precipitated a scandal. Salomons was accused of breaking the rules that governed the US government bond auctions. Both Mozer and Meriwether were forced to leave Salomons. It was MAD (mutually assured destruction).

The trades themselves marked a boundary. The purchase of the bonds represented the old – traditional trading. The arbitrage group’s quantitative and research driven trade represented the new world of trading. In time the arbitrage group’s profits came to represent the bulk of Salomon’s profitability. Meriwether’s power and influence reached extraordinary heights. Despite deep resentment from other employees, Meriwether and his team were given a lucrative profit sharing arrangement. It was supposedly secret. Few things remain a secret in trading rooms and financial markets for long.

Modus Operandi

After leaving Salomons, Meriwether gradually put together LTCM. He assembled his old team. This time they would be in complete control. Their profits would not have to subsidise the bloated and unprofitable activities of a full-service investment bank.

The presence of Merton, Scholes and Mullins was puzzling. Merton and Scholes were at heart academics engrossed in research. Despite consulting gigs, they were unworldly when it came to the trading wars. Mullins was a career central banker. But they were names.

After LTCM collapsed, Merton joined a new venture started by some ex-bankers. It was a cutting edge financial services firm focused on developing vague new products. A bank I knew was approached to invest in the new venture. The CEO of the bank got to meet Merton. He couldn’t stop talking about it. He was as excited as if he had met Paris Hilton. He had got to shake Merton’s hand. He spoke with naked adoration about his meeting which it turned out had been cut short. Merton had to take a call from the Head of an Asian Central Bank. The CEO spoke in awe about Merton’s fingers on the pulse of global capital.

The hedge fund was established with capital of $4,000 million. The capital came from banks, institutional investors and some private investors. The principals, wealthy in their own right, invested significantly in LTCM. In some case, they invested their entire assets in the fund.

LTCM’s structure included strategic partners. Two dozen partners invested at least $100 million each in the fund in return for access to LTCM’s technology, modeling, analytics and investment strategies. In reality, anyone who had worked with the arbitrage group would have known that their modus operandi resembled a neutrino star – a black hole. Things only went into the group. Nothing every emanated from the group who operated with an obsessive secretiveness. The strategic partners were rumoured to include central banks or governments. Competitors grumbled that LTCM enjoyed privileged market information and access to special financing facilities.

Investors paid a 2% management fee on asset under management and 25 % incentive fee on earnings after a threshold level of return.

Secret Trader’s Business

LTCM was vague about how the money would be invested. The buzz words were “relative value” and “convergence” trading. LTCM emphasised research and sophisticated analysis of markets. They spoke of “proprietary” modeling techniques. The principals bristled with indignation if anybody suggested that LTCM was a “hedge fund”. In the early 1990s, being a hedge fund did not quite have the cachet that it does today.

There was allusion to identification of “small pricing discrepancies between securities” and “taking advantage of value discrepancies”. There were “long run equilibrium values” and trading to capitalise on movement away from equilibrium values due to “short term market disturbances”. LTCM was going to purchase “cheap” or “underpriced” securities and “hedge” them by undertaking short sales of “expensive” securities with “similar” characteristics. Profits would result when pricing differences corrected. It was the old buy low sell high and the sell high buy low strategy. There were some old favourites as well - tax arbitrage and the standard carry trades.

LTCM’s used leverage, up to 25 times. Individual strategies only yielded small profits. Leverage was needed to accentuate the returns. LTCM assured potential investors that risk would be low because the fund would not take directional risks and outright positions. The low risk would allow the fund to use a lot of leverage.

LTCM did not talk about what would happen if markets did not converge or revert to the blissful equilibrium state. The fund would have to hold positions through to maturity to realise the pricing anomaly. The fund intended to take large positions. The mantra was that relative value trading required assuming positions when temporary market disturbances created trading opportunities. LTCM would provide liquidity to the market.

Myron Scholes explained LTCM’s trading strategy to his old mentor at the University of Chicago, Merton Miller, in the following terms: “think of us [LTCM] as a gigantic vacuum cleaner sucking up nickels from all over the world”.

Let the Good Times Roll

LTCM’s initial performance was exceptional. The peak was 1995 and 1996 when they generated returns of over 40 % pa. The performance was remarkable given that the risks appeared low. LTCM was living up to its heady billing.

During this time, LTCM was heavily focused on its usual trading strategies perfected during the Salomon years. The high returns and low risks appear in hindsight to have been driven by a fortunate combination of factors. LTCM had hit a sweet spot. They were able to exploit once in lifetime opportunities due to the creation of the single European currency - the Euro - and tax arbitrage opportunities.

In 1997, returns fell to about 17%. US stocks showed returns of 33%. The 1997 performance was disappointing. LTCM had indicated to investors that its risk profile would be similar to that of equity investments. There was also increased competition. New hedge funds modeled on LTCM had set up shop. Investment banks had also set up internal hedge funds imitating LTCM’s activities.

LTCM increased leverage. LTCM had used only modest leverage until this point, around 8 times against a permitted 25 times. LTCM returned $2.7 billion of its total capital of $7 billion to investors. Most investors were aghast at the mere suggestion that they would be excluded from the high returns that everybody expected LTCM to continue to make for investors. They fought to stay in. New investors sought to get in. LTCM was still a “hot ticket”.

LTCM also “broadened” its trading activities extending them to credit spread trading, volatility trading and equity risk arbitrage. This is often called “style drift”. Inevitably, you drift into the path of the mother of all storms.

© Satyajit Das 2006; All rights reserved.

The above is adapted from Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das (2006, FT - Prentice Hall, London, ISBN 0273 70474 5) available at all good book stores or online at www.pearson-ed.com.

Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading … explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry". He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.