In the past decade, the world has seen a number of large-scale financial meltdowns. But first came the bankruptcy of hedge fund Long-Term Capital Management (LTCM) in the summer of 1998, which led global markets to crash. Only a few years later we saw the collapse of equity markets worldwide during the bursting of the .com bubble. We can then fast forward six years to see record bubbles in the housing, mortgage and commodities markets. As all of these bubbles grew, they possessed common factors that led to their inevitable crashes. These factors tie primarily into the lack of discipline and risk management.
LTCM was founded in 1994, came into the spotlight in the mid-1990s and would change money management as we knew it. The initial success of companies like LTCM helped fuel the atmosphere that led hundreds of thousands of people to flock to Wall Street after the recession in the early 1990s. For the first time, in the case of LTCM, there was a group of really smart guys setting up their own shop in Greenwich, Conn. With the billions of dollars they raised from outside investors, they would be the first capital management company to do it “right.” This elite group would be able to maneuver and run trading strategies that the stiff Wall Street banks and broker-dealers would never allow. As their name indicated, they had a “long-term” view of capital management. It changed the way Wall Street looked at risk management.
LTCM was fabled for having the secret recipe that eliminated all market risk. LTCM founders Myron Scholes and Bob Merton later received the Nobel Prize in economic sciences for their work on the Black Scholes options pricing model. Founder and trading legend John Meriwether worked at Salomon Brothers during its huge 1980s success, which was made a legend in the book “Liar’s Poker.”
There were tales of unlimited credit lines with all of the major banks on Wall Street. They were everyone’s biggest client. While banks and brokers alike were lined up and eager to gain LTCM’s business, there was no secret recipe that eliminated risk.
In addition to economic heavyweights such as Scholes and Merton, LTCM’s co-founders included former Federal Reserve Vice Chairman David Mullins. Among other things, Mullins was looked at by some as having key relationships within the government as well as an insurance policy for LTCM.
The fund’s performance was excellent between 1994 and 1996. By 1997, LTCM’s performance started slipping. By the beginning of 1997, the fund had about $5 billion in capital and $150 billion on the balance sheet. That means there was a 30:1 leverage on actual capital in the beginning of 1997. This leverage grew higher as there was an investor payout; however, 30:1 is a good average. As 1997 went on, the fund was starting to lose money. There were many short positions in the equities markets that were causing several key strategies to be negative P&L. Despite U.S., Latin American, European and Asian risk exposure, the fund continued to get into new markets. By 1998, the fund was entering into new positions of Euro-Russian bonds.
In the summer of 1998, LTCM once again changed the way that Wall Street viewed risk. In August 1998, the Russian government defaulted on its debt, causing financial markets around the world to plummet. At this time, LTCM was leveraged more than 30:1 and the market value of its investments was decimated.
LTCM’s primary strategy was bond arbitrage, taking advantage of discrepancies between similar bonds, but it also was involved in privately negotiated swaps contracts, risk arbitrage, convertible bond arbitrage, merger arbitrage and futures speculation. These strategies require significant leverage to be profitable and have the expectation of markets behaving in predictable ways. In addition to the positions being too large, there were liquidity risk issues that were brought on by the nature of the custom swaps and other assets such as Euro-Russian bonds and Latin American Brady Bonds, among other highly-illiquid fixed income instruments. When markets decline rapidly it is nearly impossible to quickly liquidate positions and provide investment-grade collateral to counterparties for margin calls.
FED SETS PRECEDENT
The Federal Reserve’s rescue of LTCM arguably set the precedent for its future involvement in the bailouts of other financial institutions and today’s TARP legislation. At this time, the value on LTCM’s leveraged investments had plummeted, leaving substantial counterparty exposure as a result of privately negotiated swaps and other derivatives deals. When LTCM was about to go under, the Fed had a brief meeting and decided to plant its representative consortium members onto LTCM’s trading desk until they helped stabilize the situation and the consortium’s loan was paid back. In the past, the Federal Reserve would not have been able to plant its own agents in the form of an oversight committee within a capital management company. The reason that the Fed inserted itself into LTCM was to prevent its member banks from losing capital. You can argue that despite the Fed intervention, LTCM had failed and the global markets in Russia as well as the Pacific crumbled anyway.
According to all records, the money that was injected into LTCM was provided by a consortium of banks without any of the Fed’s own liquidity. If the Fed did not actually bail out LTCM, why did they orchestrate the entire scenario and force themselves into the situation?
Although Congress created the Fed, it is not a government institution. As former Fed Chairman Alan Greenspan has said, “The Fed is an independent agency. There is no other agency of government that can overrule actions that they take.”
This encouraged irresponsible risk taking. Once LTCM’s bailout loan was repaid, the firm once again raised billions of dollars from risk-taking investors, which set another precedent that the loss of shareholders’ money could be repaid by getting more money to gamble, with little consequence.
The fundamental strategies at LTCM never accounted for market risk such as potential defaults by governments or trending markets that went opposite quant models. The acclaim that the Black Scholes model had received over the past two decades was enough to solidify a business model. According to many in the industry, the Black Scholes model had made it possible to mitigate pricing risk in the derivatives markets creating a risk-neutral environment.
As the hedge fund industry boomed from the early 2000s to 2007, Wall Street based its algorithm models on LTCM. There was a belief that the smart quant guys could be protected by superior models that would not be allowed to fail. This bailout provided an insurance policy to those who should have been more concerned about properly managing their risk management practices than they were. It is no coincidence that the total number of hedge funds on record grew from a mere 200 in 1988 to nearly 2,000 by 2008.
One could easily argue that the standards of the savings & loan companies, Drexel, Lehman, Merrill, Fannie, Freddie, AIG and the like were no different from each other. In the savings & loan crisis of the late 1980s however, over 50% of the S&Ls that were in business during the early 1970s had disappeared. The Federal Savings & Loan Insurance Corporation that insured the deposits had become insolvent.
What were the lessons of LTCM? Perhaps it is that you can become so big — both in terms of monetary size and reputational prestige — that you are beyond failure. Without the bailout, the lesson may have been something more useful related to risk management, leverage, position concentration and liquidity risk.
It is hard not to connect our recent troubles with what occurred with LTCM. We could say that lessons were not learned; but they were. If you are too big to fail, you know it and work that fact into your risk models.
Jubin Pejman is vice president of Americas for Trayport. Pejman joined Trayport in 2007 and has been responsible for strategic growth and the overall operation of the Americas. Prior to joining Trayport, Pejman spent over 13 years as an investment industry professional. He began his career on the finance desk at Oppenheimer & Co. managing a cash portfolio. Pejman then joined Long Term Capital Management (LTCM) in Greenwich, Conn., where he worked on the trading desk in various finance and risk roles before joining American Express.