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Long Term Capital Management

Summary of the Nature of LTCM:

Long Term Capital Management (LTCM) was a hedge fund located in Greenwich, Connecticut. The founders included two Nobel Prize-winning economists, Myron Scholes and Robert C. Merton. Scholes and Merton, among other things, developed along with the late Fischer Black, the Black-Scholes formula for option pricing. LTCM also included as guiding spirit John Meriwether, a former vice chairman of Salomon Brothers and famous bond trader. David Mullins, a former vice chairman of the Board of Governors of the Federal Reserve System was also part of the LTCM team. Also several important arbitrage analysts from Salomon Brothers joined LTCM. Eric Rosenfeld left Harvard University to join LTCM. It was a very elite group.

The idea behind LTCM was quite simple to articulate but not necessarily that easy to implement. LTCM was to look for arbitrage opportunities in markets using computers, massive databases and the insights of top level theorists. These opportunities arose when markets deviated from normal patterns and was likely to re-adjust to the normal patterns. By creating hedged portfolios the risks could be reduced to low levels. According to the model developed by Merton the risk could be reduced to zero, but in practice some of the crucial assumptions of Merton's model did not hold so the risk of the hedged portfolios was not really zero, as subsequent events proved.

Myron Scholes stated the objective of LTCM in a striking image. He said LTCM would function like a giant vacuum cleaner sucking up nickels that everyone else had overlooked.

The History

Long-Term Capital Management (LTCM) was the management arm of a hedge fund that operated from its founding in 1993 to its liquidation in early 2000. It went through a period of spectacular success from 1994 to early 1998. In August of 1998 Russia defaulted on its debt and the financial markets came unraveled. Historical regularities that had prevailed failed to hold and LTCM which had bet on those regularities nearly went bankrupt. It was saved only by the Federal Reserve Bank of New York sponsoring a bailout of LTCM by its creditor banks. The Fed justified its intervention on the basis of the potential of the failure of LTCM precipitating a financial crisis and the creditor banks were enticed into extending credit to LTCM because their financial losses in a general financial crisis could well be more than what they stood to lose if LTCM defaulted on its loans. As it happened LTCM survived long enough to pay off its indebtedness but by early 2000 it was liquidated.

LTCM had its origins in an Arbitrage Group put together by John Meriwether at Salomon Brothers of Wall Street. Meriwether was a successful bond market trader that parlayed his early successes into a position of prestige and influence within the firm. Although he was an astute trader he was even better at choosing and managing talented people.

Meriwether recruited Eric Rosenfeld and William Lasker from the faculty at Harvard. He also hired Victor Haghani, an Iranian American whose father was an international trader from a Sephardic Jewish family in Iran. Haghani trained in finance the London School of Economics. Haghani was one of Meriwether's star traders. Another was Lawrence Hilibrand who was trained in finance at M.I.T. Another Ph.D. in finance from M.I.T. secured by Meriwether for his group was Gregory Hawkins.

Meriwether's Arbitrage Group was so successful at earning profits for Salomon that they were able to demand a change in the way they were compensated. Meriwether negotiated a 15 percent share of the profit for his traders on their trades. This led to Hilibrand in 1989 receiving $23 million in pay. This arrangement created envy and resentment among the other groups at Salomon.

Meriwether's Arbitrage Group would probably have been content with their arrangement at Salomon indefinitely, but fate intervened. A trader under Meriwether's supervision revealed to him that he, the trader, had made a false bid on Treasury securities. Meriwether reported the confession to others in authority at Salomon but, because the trader had said that there had been only one instance, no action was taken. Later it was found that the trader had lied to the Government many times and the Government wanted someone punished for improper supervision of the trader. Meriwether was asked to resign, which he did although he, and the Arbitrage Group, felt he was being unfairly punished.

The members of the Arbitrage Group lobbied for Meriwether to be brought back but to no avail. In 1993 gave up on returning to Salomon and began to organize the recreation of the Arbitrage Group as a new enterprise. He sought $2.5 billion in financing to be raised from a limited group of investors. The minimum investment was to be $10 million. Merrill Lynch was to handle the financing. The actual legal structure involved the creation of two partnerships, Long-Term Capital Portfolio in the Cayman Islands to be the owner of record for the securities and Long-Term Capital Management in Delaware. John Meriwether and his partners were the principals in the Delaware partnership of Long-Term Capital Management. The office and operations of LTCM would be in Greenwich, Connecticut.

In raising funds Meriwether created the category of Strategic Investors, who would invest at least $100 million. He was successful in bringing in some of the top financial organizations in the world into LTCM despite the fact that the fees charged were exceptionally high. The typical hedge funds charged 20 percent of profits earned plus a one percent of an investor's assets as fees. In contrast LTCM charged 25 percent of profits and levied a 2 percent fee on assets. In addition, investors in LTCM were required to commit their funds for at least three years. Despite the heavy fees and long term committments LTCM was able to raise $1.25 billion. It was not the $2.5 billion that Meriwether set as a target but it was by far the largest funding ever raised for a hedge fund.

Meriwether was able to lure away from Salomon most of the principal figures of the Arbitrage Group. David Mullins, a former vice chairman of the Board of Governors of the Federal Reserve System was also part of the LTCM team. The top people became partners of LTCM. In addition to the traders of the Arbitrage Group Meriwether was able to get two of the top economists, Myron Scholes and Robert C. Merton, to join LTCM. This was a major coup for Meriwether because Scholes and Merton added academic respectability to the hedge fund. Meriwether got Scholes and Merton before they received their joint award of the Nobel Prize in Economics. Fischer Black who would have shared the Nobel Prize with them had he lived a bit long was a respected figure on Wall Street.

Not only did Myron Scholes lend prestige to LTCM from his academic reputation but he was one of the most effective salesmen for LTCM in its quest for investors. Robert C. Merton is without question one of the most brilliant economists of all time but it is not clear that LTCM benefited from his analytical skills. It may, in fact, suffered from his presence in that his model of financial markets should not have been taken as the ultimate description of reality in an enterprise risking billions of dollars.

LTCM started off with abundant funding, a stable of brilliant, experienced traders and two stellar academics. The public had the impression that the firm would make extraordinary profits from arcane knowledge unavailable to anyone else. Myron Scholes summed up the strategy with a metaphor that will last forever. He said that LTCM would make money by being a vacuum sucking up nickels that no one else could see.

In practice LTCM strategy for making money was based up more mundane principles. One of these principles was the power of leverage. This principle can best be expressed by the equation:

requity = rassets + L(rassets - rdebt)

where requity is the rate of return on equity capital, rassets is the rate of return on overall capital, rdebt is the interest rate on debt and L, the leverage ratio, is the ratio of debt capital to equity capital. The equation shows that the rate of return on overall capital is augmented by an amplified difference between the rate of return on overall capital and the interest rate on debt. If the leverage is high and capital earns a rate of return greater than the interest rate on debt then all is well, but leverage is a two-edged sword. If the rate of return on overall capital falls below the interest rate on debt then high leverage can turn a mildly bad year into a catastrophe.

The dark side to the leverage equation is the equation that says what happens to risk as a result of leverage. Risk can be measured in various ways but the common result is that the equity risk of a leveraged firm is the risk of the unleveraged firm multiplied by a factor of (L+1); i.e.,

riskequity = (L+1)riskassets

This formula works for risk as measured by the standard deviation of the rate of return as in portfolio analysis or risk as measured by the volatility coefficient β as in the Capital Asset Pricing Model. The formula assumes the debt is risk-free.

LTCM was operating with a leverage ratio in the neighborhood of thirty. At that leverage ratio LTCM needed a rate of return on capital that was only about one percent higher than its interest rate on debt to reach impressive levels of above thirty percent. Roger Lowenstein in his book When Genius Failed gives the rate of return on overall capital for LTCM as being 2.45 percent in 1995. This means that LTCM was probably making its high rate of return on equity by keeping its cost of capital extremely low. The people at LTCM drove very hard bargains on financing. They were able to get low rates and special deals because the banks did not want to get left out of LTCM business. LTCM was reputed to have a sure fire way to make fabulous profits and to be paying $100 million a year in finance fees. No banker wanted to be left out of that bonanza. It appears from Roger Lowenstein's figure that the secret to LTCM's success was bountiful loans at low rates. These bountiful loans enabled LTCM to achieve a thirty to one leverage ratio. The unusually low interest rates enabled it to achieve a positive differential between its overall rate of return on capital and the interest rate it was paying.

LTCM's speculative positions generally involved banking on market regularities such as the differences between interest rates. It is generally assumed that the markets establish some sort of equilibrium between rates. If differentials deviate from their past values there is the presumption that with time markets will re-establish those equilibrium differences. Sometimes the equilibrium difference between two rates is zero and then one speaks of the convergence of those rates. What happened when markets went into turmoil in 1998 is that investors panicked about risk. They wanted certainty in that uncertain period. Investors fled the unpredictable markets for quality securities, ones with a high degree of certainty. Thus higher differentials for the riskier securities did not stop the flight to quality securities. For LTCM which bet on the reinstatement of equilibrium conditions it was a disastrous time. The firm began to lose hundreds of millions of dollars each day.

In addition to the losses caused by the turmoil in the financial markets there was also the problem that the top traders at LTCM with almost pathological overconfidence began to take unhedged positions in the market, effectively betting huge sums on the direction changes in financial variables would take. One form of this type of position was taking large positions in derivatives, such as options, whose market value depended upon the volatility of an underlying security. When the volatilities increased above historical averages LTCM took market positions that would be profitable only if the volatilities declined. Eventually the volatilities did decline but in the short term these positions threatened LTCM with collapse.

Even with hedged positions which the theory asserted insulated the value of a portfolio from changes in stock price there was risk associated with price jumps. For example, one way to create a perfectly hedged portfolio is to combine share holding with written calls on that stock. If the ratio of shares to the written call options, called the hedge ratio, is the right value the changes in the market price of the shares is exactly offset by the change in the financial obligation associated with the written calls. But this holds true only if the stock price changes by infinitesimal amounts. If the stock price gaps upward before the portfolio holder can re-adjust the hedge ratio the holder can experience considerable losses. Events such as earthquakes, defaults, political revolution and so forth do bring instantaneous changes in price and the models used by LTCM did not allow for this type of risk.

The above point is illustrated by the following graph.

In the graph, S represents the current price of the stock. For a current stock price S a hedge ratio is determined which makes the curve flat at S so any very small change in the price of the stock will leave the value of the portfolio unaffected. But if the price of the stock falls by a significant amount instanteously without the opportunity to adjust the hedge ratio the loss in the value of the stocks held is not fully compensated by the decline in the expense of the written calls held. The losses from a significant decline in the price of the stock are limited to the value of the stocks in the portfolio, but there is no such limit to the losses on written calls when the price of the stock increases significantly. In that situation the cost of fulfilling the obligation involved with the written calls is unlimited and is not offset by the increase in the value of the stocks held. Some firms have found to their chagrin that they lost large amounts of money on fully hedged portfolio that were constructed to protect them against infinitesimal price fluctuations. Fully hedged portfolios involving written calls are not truly risk free. Surprisingly the very smart people at LTCM overlooked a variant hedging strategy that would have made price jumps a boon. There were other conceptual short-comings of LTCM strategies.

It has been known since 1915 when it was pointed out by Wesley Claire Mitchell that the distribution of rates of return in the stock market is not a normal distribution. There are too many extremely large deviations from the average. Surprisingly there are also too many small deviations from the average. The following diagram illustrates how this happens.

Because the tails of the distribution have higher probability than a normal distribution such a distribution is called a fat-tailed distribution. But the probability of small deviations is also higher than for a normal distribution. What are under-occurring are the medium deviations from the mean. A period in which only small deviations occur may beguile the investor into thinking a stock has low volatility when, if fact, a fat-tailed distribution has infinite volatility.

Another chronic problem with LTCM's strategy is that although the traders took a large number of separate positions there was effectively no benefits for risk-reduction through diversification in a financial crisis because, in effect, most of the separate transactions were the same bet on the stabilization of the markets and a return to equilibrium.

With losses of capital by LTCM its bank lenders became worried about the security of their loans. In the fall of 1998 when LTCM was on the brink of failure the Federal Reserve Bank of New York brought the lenders together and brokered a bailout. Some fourteen or so banks contributed about $300 million each to raise a $3.65 billion loan fund. That fund along with the equity still held by LTCM enabled it to withstand the turmoil in the markets. Another financial crisis occurred in the form of unusually high spreads on swaps. LTCM was reorganized and continued to operate. By the next year it paid off its loans and was effectively liquidated by early 2000.

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