“The More Things Change…LTCM Part 2”
The Perfect Storm
Following their stellar early years, LTCM found 1998 “challenging”. By September, LTCM had lost 92 % of its capital. Its leverage had increased to over 100 times. Meriwether, unflappable as always, advised that: “we’ve had a serious markdown but everything’s fine with us”.
The 1998 crisis had its origins in the Asian monetary crisis the previous year. The collapse of Asian currencies and equity markets triggered far-reaching changes in global markets. Large trading losses had resulted in many traders exiting markets. There was massive uncertainty and a general aversion to risk. There was a flight to quality.
LTCM perceived the increase in volatility levels and credit spreads as a trading opportunity. They placed massive bets on credit spreads (the margin between corporate bonds and government bonds) and stock volatility falling. The principals regarded the market as being driven by a temporary lack of liquidity. LTCM began to act as a liquidity re-insurer. It quickly came to be known as the “Central Bank of Liquidity and Volatility”.
The crisis developed slowly. In May/ June 1998, LTCM took a big loss in mortgage backed securities. In August 1998, Russia defaulted on its debt. LTCM took losses on its Russian securities. Credit spreads increased triggering large losses on LTCM’s credit spread positions. Investment managers and traders sold further pushing prices down and credit spreads up. Equity markets became more volatile. LTCM appears to have lost around $550 million on 21 August alone. The losses related to its credit spread and equity volatility positions.
On 2 September 1998, John Meriwether issued a letter to investors that revealed LTCM had lost 52 % of its value. “As you are all too aware events surrounding the collapse of Russia caused large losses and dramatically increased volatility in global markets….Many of the fund’s investment strategies involve providing liquidity to the market. Hence, our losses across strategies were correlated after-the-fact from the sharp increase in the liquidity premium: the use of leverage has accentuated the losses.” The letter to investors sought new capital from investors on the basis that “… since it is prudent to raise capital the fund is offering you the opportunity to invest on special terms related to LTCM’s fees.” There were no takers.
On 18 September 1998, Bear Stearns (LTCM’s prime broker and principal clearing agent for both exchange and OTC collateral) is rumoured to have frozen the fund’s cash account following a large margin call. On 23 September 1998, AIG, Goldman Sachs and Warren Buffet made an offer to buy out LTCM’s partners and inject $4 billion into the fund. The offer lapsed. LTCM faced the specter of a massive default that would affect the entire financial system, as large positions would need to be liquidated. Having no real choice, the New York Federal Reserve facilitated a re-capitalisation of LTCM. 14 banks invested $ 3.6 billion in return for a 90 % of LTCM.
Weather Forecasts
LTCM had sophisticated risk management systems to quantify the risk of the fund. They had VAR. What had gone wrong with the weather forecasts?
At the beginning of 1998, LTCM’s risk was $45 million at 99% confidence level. This meant that there was only one chance in one hundred that LTCM could lose more than $45 million. After losses in May/ June 1998, LTCM reduced risk to around $35 million. Yet in August 1998, LTCM’s daily profits and losses were up to $135 million against the expected $35 million. In September 1998, LTCM’s profit and loss was moving $100 million to $200 million daily.
LTCM was done in by a combination of market risk, liquidity risk and hatred. The fund’s risk models underestimated volatility and used incorrect correlation factors. LTCM’s models assumed that it would be possible to reduce positions across the entire portfolio rapidly. But not all positions were liquid. Losses required selling the more liquid positions first leaving only the more difficult to shift positions.
LTCM’s positions were very large reflecting its final incarnation as a liquidity provider to the market. This sharply increased LTCM’s losses as it sought to close positions. The market was also remarkably well informed about LTCM’s positions.
When the LTCM principals had traded at Salomon Brothers the purpose of specific trades was not apparent to the market. Trades executed by a dealer may be client transactions or proprietary positions. Once the LTCM principals began trading as a fund all the trades were proprietary. LTCM tried to disguise the transactions, separating components and executing them with different counterparties. The size of positions and their nature made them difficult to hide from other traders.
Many dealers established internal hedge funds that worked closely with special sales desks that serviced hedge funds only. Some had been created to specifically serve LTCM. They worked out LTCM’s trading strategies and then did the trades for their own account. When their risk limits were full, they marketed the same strategies to other banks and hedge funds established to copy LTCM. When the storm hit in mid 1998, everybody was around the same way as LTCM. This meant that all the traders found that they had put on the same trades. This also meant that they all would have to extricate themselves from these positions at the same time. The only people who seemed to have missed this were LTCM itself.
In July 1998, Salomon Brothers shut down their fixed income arbitrage operations. Costas Kaplanis had built a successful operation following the departure of Meriwether’s wunderkids. Large losses led Sandy Weill, the boss at CitiGroup that now owned Salomons, to shut down the operation. The sale of the Salomon positions absorbed scarce liquidity.
As the storm developed, traders and investment managers began to unwind positions with increasing urgency making LTCM’s losses worse and making liquidation of positions more difficult. In August/ September 1998 the rumours of LTCM’s problems triggered more selling. The overhang of the massive LTCM portfolio forced other traders to aggressively liquidate positions anticipating LTCM’s need to sell. Aggressive trading firms are alleged to have used the situation to force LTCM into default and purchase the portfolio at distressed prices.
Valuations of positions were affected by the conditions. Available prices were affected by a huge liquidity premium. Where prices were unavailable the prices used were often very conservative triggering ever larger mark-to-market losses.
LTCM required investors in the fund to invest for a minimum period of 3 years. This meant that LTCM did not have to worry about investors wanting their money back. They had a different problem. The fund had borrowed to leverage their capital and used derivatives. The terms required LTCM to cover any losses with cash – margin calls.
LTCM had historically borrowed and entered derivative trades on generous terms. Dealers regarded LTCM as “special”. The volume of LTCM’s trading were a significant source of earnings for dealers. LTCM’s trading had a large impact upon market prices. The dealers liked to understand the fund’s trading so as to be able to duplicate them. But as losses mounted, the piper had to be paid. The banks began to howl for blood. Mark Twain once remarked that: “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain”. In the end, LTCM ran out of cash.
The wunderkinds had got it all wrong. They had misread the weather report. The principals at LTCM were experts at interpreting the Greek letters (delta, gamma, theta, rho, vega) used to measure risk. Critics now suggested that perhaps they should have focused on a specific Greek word – hubris, meaning over confidence or insolent pride.
Louis Bacon, the principal of Moore Capital, once remarked that: “There are those who know that they are in the game; there are those who don’t know they are in the game; and there are those who don’t know they are in the game and have become the game.” By late 1998, LTCM were very much the ‘game’.
Endgame
The banks worked with the LTCM principals to gradually liquidate the portfolio over about a year. The banks were paid back ahead of schedule. Subsequently, John Meriwether established a new hedge fund (JWM Associates). Many of the original principals of LTCM did not follow Meriwether to his new venture. Scholes set up a separate hedge fund with some of the LTCM gang.
After the fall, the principals grizzled about the cynical way that the dealers had used conditions to rip LTCM apart. It was sour grapes. In financial markets, anybody in distress is bratwurst in waiting. LTCM would have done the same thing given a chance.
Merton and Scholes wandered the lecture circuit. A central theme inevitably was a defense of LTCM and its models. LTCM’s trades were defensible. They made sense – “equilibrium” would prevail in the long run. “Do people really understand what a stock market volatility of 35% means?” “Credit spreads were well beyond the level needed to cover credit losses ever encountered in known history!” The models were fine, the world was wrong. Scholes promoted a new product – liquidity options. They would hedge against the liquidity risk that had scuppered LTCM.
LTCM’s experience with mathematical finance and risk modeling has not discouraged others. LTCM’s models were just been faulty, not advanced enough. Today, everybody assumes that they have better more sophisticated models. John Maynard Keynes once observed that “the market can remain irrational longer than you can remain solvent”.
© 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.
