The “almost-GFC” – the story of LTCM and how one hedge fund almost created their own global financial crisis.

Welcome to Finance and Fury, the Furious Friday edition, where we will continue to look at some derivative disasters.

Last week – went through some of the basics – and a few Australian specific examples –

In todays episode – want to look at the Long Term Capital Management crash in the late 1990s

Similar to some of the cases last week – wouldn’t be surprised if you haven’t heard of this – but it had the potential to spark a larger crisis 

The story is very similar to the GFC- almost like a mini-or pre GFC – and an event that likely created the moral hazard that lead to the GFC – so what happened

1. Long Term Capital Management (LTCM) – they were a major US hedge fund – used absolute return trading strategies
   1. Now – hedge funds are normally defined as absolute returns funds – as the name sort of indicates – they aim to get absolute (or positive) returns over a rolling period regardless of market conditions –
   2. So a traditional asset managers or long only fund tried to outperform a benchmark or index year on year – which can result in a loss – but if the ASX or S&P500 are down by 20% and the traditional manager is down by 15% – done their job
   3. However – an absolute return manager would want to get a positive return in this year
   4. Hence- hedge fund managers employ different strategies in order to produce a positive return regardless of the direction of asset markets.
   5. To do this – they can use a range of strategies – like short selling, or using leverage and high turnover in their portfolios – but also – using derivatives to hedge their positions – but also – to trade traditionally boring (low loss potential assets) like bonds using derivatives
2. Long Term Capital Management was run by some pretty big players –
   1. Launched in 1994 by former Salomon Brothers bond trader John Meriwether
      1. Salomon brothers was famous from the early days – if anyone has seen and remembers the big short movie – the individual who pioneered MBS was from Salomon Brothers – Lewis Ranieri
      2. John Meriwether headed Salomon Brothers’ bond arbitrage desk until he resigned in 1991 amid a trading scandal. According to Chi-fu Huang, later a Principal at LTCM, the bond arbitrage group was responsible for 80–100% of Salomon’s global total earnings from the late 1980s until the early 1990s
   2. LTCM was also run by PhD holders, two Nobel Prize winners on their works in option pricing models and a plethora of finance veterans
      1. One of the PhDs was Myron Scholes – the Black Scholes pricing model is the gold standard used when pricing especially European option – that’s contract that limits execution to its expiration date – as opposed to American which can be executed at any time prior to maturity
   3. trades were conducted through a partnership with Bear Stearns and client relations were handled by Merrill Lynch – so it had very little overhead
      1. They launched a bond trading hedge fund using option pricing – and they did very well initially – from their launch they had $1.25 billion under management
      2. This quickly grew to $100bn in just under 3 years – they were attracting massive inflows due to their annual returns – return of over 21% (after fees) in its first year, 43% in the second year and 41% in the third year
      3. Given the strategy was promoted as being absolute return – low risk/high reward form using bonds of all things – gained a lot of attention

The trading strategy – put simply – it was to buy or sell bonds when prices deviated from the norm using borrowed funds and additional leverage – often in the form of derivatives – then wait for prices to converge again to make a profit 

4. known as involving convergence trading – official definition is to “use quantitative models to exploit deviations from fair value in the relationships between liquid securities across nations and asset classes”
   1. The type of investments were on US Treasuries, Japanese, UK and Italian Government Bonds, and Latin American debt, although their activities were not confined to these markets or to government bonds – which we will come back to
5. At the core – this strategy is known as fixed income arbitrage – How this works – Fixed income securities pay a set of coupons at specified dates in the future –a bond can pay semi-annual or annual coupons to the debt holders – they also have a defined redemption payment at maturity – normally the Face value of a bond
   1. Since bonds of similar maturities and credit quality (or risk of default) can be seen as close substitutes to one another – there tends to be a close relationship between their prices (and yields)
      1. Think about Australian bonds issued – all with FVs of $100 – if the coupons on these are the same at $3 p.a. – so they should all be priced in similar manners – assuming their maturity dates are the same – however – if their maturities are different or they pay different coupons – relative to the interest rate their prices will be different
      2. But – depending on the liquidity of the market – or how easily you can sell the bond – these same or similar bonds can have different prices – as well as having slightly different maturities – therefore you can make an additional premium returns for little to no risk –
   2. Example – LTCM strategies was to purchase the old benchmark – now a 29.75-year bond, and which no longer had a significant premium – and to sell short the newly issued benchmark 30-year, which traded at a premium – Over time the valuations of the two bonds would tend to converge as the richness of the benchmark faded once a new benchmark was issued
   3. Sounds smart – but due to the size in the difference in prices (which was tiny) – not much profit to be made –
   4. But that is where leverage and derivative positions came into the picture – to amplify the returns – LTCM used leverage to create a portfolio that was a significant multiple (varying over time depending on their portfolio composition) of investors’ equity in the fund
      1. also necessary to access the financing market in order to borrow the securities that they had sold short – makes them dependent on the willingness of its counterparties in the government bond (repo) market to continue to finance their portfolio
      2. Using this strategy – if the company was unable to extend its financing agreements, then it would be forced to sell the securities it owned and to buy back the securities it was short on at market prices, regardless of whether these were favourable from a valuation perspective

• This is the next part of the strategy that that was highly risky in hindsight – wouldn’t think so trading bonds – but when you had counter party risks on bonds – it can be if a shock to debt markets occurs

1. By 1996 – started to branch out into riskier asset classes – like Latin American markets –
   1. Was due to limited trading opportunities – as they already had massive positions on the assets and others started to copy their trading strategies – as the magnitude of anomalies in market pricing diminished over time
   2. This was also due to LTCM growing to be a large portion of illiquid markets that there was no diversity in the buyers in them – only had a few large investment banks and managers who joined in on this trading strategy – so some crowding out was going on – started to reduce the functionality of the markets and it was impossible to determine a price for its assets – which was the whole point of their trading strategies – to fund arbitrate in mispriced assets based around their liquidity and maturity
2. In 1997 – a year in which it earned 27%, LTCM returned capital to investors – about $2.7bn
3. By 1998 – the firm had equity of $4.7 billion and had borrowed over $124.5 billion – debt-to-equity ratio of over 25 to 1 – put them in a risky position – as it wouldn’t take much in the way of a loss for them to wipe out all of the equity they had
   1. However – in addition to this leverage position – It had off-balance sheet derivative positions with a notional value of approximately $1.25 trillion – most of which were in interest rate derivatives such as interest rate swaps to hedge against their arbitrage trading going wrong
   2. Derivatives like interest rate swaps were originally developed for the purpose of allowing firms to manage risks on exchange rates and interest rate movements – similar to what we saw last Friday – they also allowed speculation on a massive scale
4. The downfall – in 1997 – Asian crisis was playing out – which spread out into most asset markets by 1998
   1. Although this crisis had originated in Asia, its effects were not confined to that region – created a rise in risk aversion and raised concerns amongst investors regarding all markets heavily dependent on international capital flows – such as bond markets –
   2. LTCM started to lose some money – In May and June 1998 returns from the fund were -6.42% and -10.14% respectively, reducing LTCM’s capital by $461 million
   3. Then these losses started to snowball by August 1998 – when Russia defaulted on its domestic rouble-based debt – leading global markets to panic and causing LTCM to lose US$553 million, or 15% of its capital in a day
      1. In one month, it lost almost US$2 billion in capital – to maintain the magnitude of its existing portfolio, LTCM was forced to liquidate a number of its positions at a highly unfavourable moment and suffer further losses
      2. LTCM only had $400 million of equity by September 1998 – but with liabilities still over $100 billion, this translated to an effective leverage ratio of more than 250-to-1

• However, the bigger problem occurred from a systematic risk point of view, as unfortunately for the markets and the US banking system, LTCM had such large positions in its trading books that it was impossible to sell out. In only a few weeks, LTCM was facing over US$1 trillion in notional derivative default risks.
  1. Takes time to unwind derivative positions – time they didn’t have

1. This was now a problem of the global economy – due to the other banks that were the counter parties to these derivative swaps

7. LTCM did business with nearly every important person on Wall Street – beyond their own funds being lost – Wall Street feared that LTCMs failure could cause a chain reaction in numerous markets, causing catastrophic losses throughout the financial system – Central banks had two responses as events moved quickly –
   1. First – with the Chair of the Federal Reserve moving to aggressively to use monetary policy by cutting US interest rates – where previously they were going to raise them –
      1. followed by over 60 national central banks which also cut rates in short order to avoid LTCM’s crisis turning into a global financial crisis and pushing the world economy into depression
   2. Second – LTCM had to be bailed out to the tune of $3.625 billion after it lost staggering sums through its bad bets in global bond markets
      1. The contributions from the reserves were facilitated from various major banks – Most major banks put in $300 million: Bankers Trust, Barclays, Chase, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P. Morgan, Morgan Stanley, UBS
      2. Few others with smaller amount of $125 and $100 million

• Interestingly – two of the 3 banks – who declined were US banks – those were Bear Stearns, Lehman Brothers – we all saw how the banks and the Fed reciprocated this in 2008 – only banks to not get the generous arm of the Fed – the other bank was a French bank

Summary

LTCM’s demise was an example of the failure of a hedge fund and a classic example of the failure of ‘genius’ – having very smart people (Nobel Prize winners) in theory behind the wheel can still go horribly wrong in practicality  

1. The borrowing level of leverage allowed – 250 to 1 is bad enough – but the $1.25 trillion in notional derivative values when the company had $400m in equity should point to why something like the GFC could have happened
2. Which by this point was a decade away – but these very banks that needed to provide some of the funds are myopic or – they saw that a bail out would happen if they got it wrong and instead – only saw the massive potential for profits –
3. The vital lesson is that no single institution (and certainly no private sector investor such as a hedge fund) should be so important as to be not ‘allowed’ to fail and require bailouts from taxpayers or depositors
4. These sorts of situations indirectly leads to the additional dangers in the financial markets through the moral hazard encouraged – where these companies are now assuming that they are implicitly ‘insured’ by Reserve Banks or the public – hence they have become ‘too big to fail’
5. So a global financial crisis was averted in 1998, but arguably it was only postponed for a later date  

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