The Rise and Fall of Long-Term Capital Management
Bestselling author Roger Lowenstein masterfully tells the story of Long-Term Capital Management – one of the most illustrious hedge funds of its day. A financial market power that made Merrill Lynch’s “thundering herd” seem like a bunch of noisy kids at its heyday, today LTCM is a case study of greed, hubris, and the marriage of academia and Wall Street. If you have ever wondered how top scholars and Nobel prize winners, who are on the cutting edge of human understanding of the workings of financial markets, would perform as hedge fund managers, the story of LTCM gives you the answer.
The Rise of Long-Term Capital Management
1. Meriwether
Meriwether point of revelation about arbitrage – simultaneously selling an overpriced and buying an underpriced asset to make a riskless profit when the prices converged – was when a securities dealer named J. F. Eckstein went t to Salomon, where Meriwether was working in bond arbitrage, to sell a great trade he was in, but couldn’t stay in because he was hit with margin calls. Salomon made the deal. The trade went bad for a while but it turned a handsome profit in the end. Meriwether discovered riding your losses until they turned into gains.
Born in 1947 in Roseland, Chicago to strict Irish Catholic parents, Meriwether was especially good at mathematics and enjoyed gambling, “but only when the odds were sufficiently in his favor to give him an edge,” and golf. He attended Northwestern University on a scholarship for caddies. Afterwards, he taught mathematics there for a year before moving to University of Chicago to get a business degree.
After graduating in 1973, Meriwether was hired by Salomon. The two characteristic trends of the time were the spread of derivatives and computers. His fascination with mathematics attracted him to bonds because the determinants of their value are mostly quantifiable. Trading for the Arbitrage Group gave Meriwether the confidence to take big risks. He would mostly bet on spreads – between two bonds or a bond and a derivative – converging, like the Eckstein trade. The lesson that he did not learn from the Eckstein trade was that although the trade may eventually turn out well, the trader may go broke in the meantime or as John Maynard Keynes put it “Markets can remain irrational longer than you can remain solvent.”
He started hiring Ph.D.’s or, as they are known today, quants:
Eric Rosenfeld, “a sweet-natured MIT-trained Harvard Business School assistant professor”
Victor Haghani, Master in finance from the London School of Economics
Gregory Hawkins, Ph.D. in financial economics from MIT
William Krasker, mathematically minded economist with a Ph.D. from MIT
Lawrence Hilibrand, the nerdiest and smartest, with two degree from MIT.
They created the models the Arbitrage Group traded on while Meriwether protected the socially inept professors from the others in the company, who in turn were annoyed by the complete secrecy under which the “eggheads” operated, and secured the financing of their operations.
Disaster struck at Salomon when the US Treasury found out that Paul Mozer, head of Salomon’s government desk, had been manipulating the treasuries auction process. Heads fell in the turmoil and one of them was Meriwether’s for failing to supervise and discipline Mozer.
2. Hedge Fund
Around that time (early 1990s) Meriwether conceived the idea to start his own hedge fund and do the same arbitrage trades he did at Salomon but at a much larger scale (utilizing more leverage) and with much more freedom. Hedge funds were gaining popularity along with the soaring markets.
Meriwether enlisted the help of Merrill Lynch to raise capital. His ambitious goal was to raise $2.5b, charge 25% of profits and 2% of assets, and lock up investors’ capital for 3 years. His pet academicians from Salomon jumped at the opportunity to join him but that was not enough to attract $2.5b for a new hedge fund (they usually started with 1% as much).
Meriwether went to the very top of academia – to Robert C. Merton “the leading scholar in finance, considered a genius by many in his field.” He was the person who, in the 1970s, tackled the problem of pricing stock options by providing the missing piece to the work of Fischer Black and Myron S. Scholes. Merton saw Meriwether’s offer as a great opportunity to showcase his theories in the real world. Meriwether also hired Myron Scholes. As the author puts it “And with two of the most brilliant minds in finance, each said to be on the shortlist of Nobel candidates, Long-Term had the equivalent of Michael Jordan and Muhammad Ali on the same team.”
Hiring Scholes was a vital move. His name was known and he had the social skills and showmanship to help tip the otherwise slow-moving fundraising process. Another vital hire was David Mulling, vice chairman of the Fed and second to Alan Greenspan. He opened the doors to quasi-governmental accounts around the world.
In the end, $1.25b was raised, including $146m of the 11 partners’ money – “well short of J.M.’s goal but still the largest start-up ever.”
3. On the Run
Meriwether gathered the funds just in time. In 1994, Alan Greenspan increased interest rates, afraid that the economy was overheating. This created a market overreaction, which sent bond yields higher than they should be – a great opportunity for LTCM to apply its arbitrage models.
Because arbitrage takes advantage of tiny spreads (like several hundredths of a percentage point), in order to produce substantial returns high leverage is required. The mathematicians at LTCM, always precisely calculating the odds, figured out that their 30-year treasury arbitrage was 1/25th as risky as owning the bonds outright (instead of being long one and short another), so 25 times leverage was in order.
The next big idea for LTCM was a huge relative value trade in home mortgage securities. The securities backed by bundled mortgages sliced into easily tradable pieces that became all too popular during the crisis of 2008. Again, Meriwether’s quants arbitraged away the tiny spreads between different slices, making nickels on each trade and multiplying them manyfold by being highly leveraged.
Finding proper opportunities – risky enough to generate a return and safe enough not lead to financial problems – was anything but easy. LTCM combed bond markets all over the world.
As more Wall Street firms began hiring scholars, LTCM’s advantage was not the superstar roster anymore. It was rather the experience in reading the models and the better financing terms they had negotiated (actually, forced onto because of their size and high returns) with their counterparties.
4. Dear Investors
Long-Term earned 28% in 1994 (its first year of operation), 20% after fees. In the letter to investors, Meriwether talked with amazing certainty about the chances that the fund will lose money (a measure known as Value-at-Risk or VAR). They could calculate the exact risk of these events thanks to the models built by finance luminaries. Now, like never before, risk could be measured and controlled completely, or so it seemed. And the measure was volatility – the variance of returns around the mean.
The problem with LTCM’s academics’ theory was that it blindly relied statistically calculated volatilities based on historical observations to be reflective of real life future market shocks. This, however, is not the case. Eugene Fama, Scholes’s thesis adviser, had, in the 1960s, discovered that “there were many more days of extreme price movements than would occur in a normal distribution.” Things that should happen about once every 7,000 years actually happen about every 3-4 years. This was a manifestation of what statisticians call “fat tails” – chances of extreme outcomes higher than predicted by a normal distribution.
The Ph.D.’s at LTCM disregarded the possibility of black swan events (made ever so popular by Nassim Taleb’s book). They knew the models were not perfect. But they were also the best they got. There is no way to model the unpredictable.
A great quote from the book attributed to Max Bublitz of Conseco:
You take Monica Lewinsky, who walks into Clinton’s office with a pizza. You have no idea where that’s going to go. Yet if you apply math to it, you come up with a thirty-eight percent chance she’s going to go down on him. It looks great, but it’s all a guess. (p. 75)
In 1995, Long-Term earned 59%, 43% net of fees, despite the Mexican crisis during the year. Return on total assets (including leverage), though, was mere 2.45%. It that point LTCM was leveraged 28 to 1. Taking derivatives (most required no capital upfront) into account, the return was even smaller and leverage even larger.
5. Tug-of-War
Bear Stearns was LTCM’s clearing broker. They negotiated a special agreement that Bear will keep clearing for LTCM as long as the hedge fund kept $1.5b on call at Bear. Both parties were trying to protect against the other harming it.
The relationships between LTCM and its counterparties were very strained because of Long-Terms incessant demand for concessions and better terms for their trades and financing. Meriwether did his best to assure that the company will have the best terms and will not be forced into firesales if their positions went against them for a while.
At the end of their third year, the initial partners’ $146m had grown nine times to $1.4b.
6. A Nobel Prize
Arbitrage was becoming so widespread by the late 1990s that finding opportunities was just about impossible. LTCM had to broaden its areal. Since bond trades were scare, they drifted into equity pairs trading (again arbitrage – for example, selling preferred and buying common stock of the same company) and merger arbitrage, using derivatives to achieve the desired leverage. It also stopped accepting new investors and returned capital to existing clients.
In October 1997, Merton and Scholes won the Nobel Memorial Prize in Economic Science. However, times were grim. “All across Asia, currency and stock markets were imploding.” The events were affecting markets all over the world.
The fund earned 25% (17% net of fees) in 1997 – its worst year so far, but still a remarkable achievement, given the market conditions. By the end of the year LTCM had returned $2.7b to investors and its leverage was 28 to 1 (excluding derivatives).
The Fall of Long-Term Capital Management
7. Bank of Volatility
In a characteristic new trade that will set the company on the road to disaster LTCM began shorting large amounts of equity volatility. Once again putting their faith in history and statistics molded by the academicians’ quantitative models, Long-Term made the bet that deviations from the historical trend will eventually, and rather sooner than later, be corrected. They made these bets using options. The options had to be marked to market every day. Thus, LTCM “wasn’t betting only on the extent of ultimate realized volatility, it was betting on day-by-day inferred volatility.”
Opportunities were still scarce and LTCM further relaxed its risk standards in order to put all that money to work. By now the company had strayed far from its core competencies and was taking largely unmeasured risks.
The situation darkened when the yen and Japanese bond yields started plummeting. This was the opposite of LTCM’s bets. Spreads were suddenly widening instead of narrowing. Russia’s debt was downgraded and capital was flowing out of the country, fear of devaluation was looming. Yet, the professors’ models were showing very low probability that Russia will let its currency fail and they bet on it. In the US equity volatility was increasing – very dangerous for LTCM’s substantial short positions in equity volatility.
Markets in America, Europe and Asia were becoming more and more volatile, and bond spreads were widening – both developments putting LTCM in a very delicate position.
8. The Fall
Through mid-August 1998, LTCM had $3.6b in capital, 40% belonging personally to the partners. It took only 5 weeks for them to lose it all.
On Monday, August 17, Russia partially defaulted on its debt and devalued its currency. By August 21, “traders everywhere wanted out.” Credit spreads and volatility exploded. All events lying way out of the professors’ bell-shaped curves. LTCM was losing money head over fist. “Long-Term, which had calculated with such mathematical certainty that it was unlikely to lose more than $35m on any single day, had just dropped $553m – 15% of its capital – on that one Friday in August.
Meriwether’s idea was to raise capital to wait out the problem until their positions, which they were sure were right, rebound. But under the conditions nobody was lending and there was no market for LTCM’s assets. It didn’t help that everyone at LTCM was highly secretive about their trades and portfolios, to the point that they wouldn’t give any details to prospective investors. Buffett, Soros, Michael Dell, Prince Alwaleed, and the Street were all tapped, but Long-Term drew a blank everywhere.
“Theoretically, the odds against a loss such as August’s had been prohibitive; such a debacle was, according to the mathematicians, an event so freaking as to be unlikely to occur even once over the entire life of the Universe and even over numerous repetitions of the Universe.”
9. The Human Factor
In September, Meriwether broke the news that LTCM was down 44% in August and 52% for the year to the investors. However, he was optimistic about the future. What was happening was just a temporary aberration – no way their analysis was wrong.
Their bankers and brokers, however, begged to differ. As LTCM’s positions were melting, calls for more collateral started coming in. Bear Stearns threatened that it will stop clearing its trades if LTCM’s balance with the company fell below $500m. The partners were still trying to raise money, but they kept getting turned away. It didn’t matter that they were offering much lower fees now. As the company’s capital was dissipating, the chances of anyone coming to the rescue went to zero.
10. At the Fed
Although LTCM was not a bank and hence not regulated by the Fed, the central bankers were concerned. It didn’t bother them that LTCM was likely to fail, its partners, investors and counterparties to lose a lot of money. What bothered them was the threat that LTCM has become to the financial system. Thanks to its extensive presence on many markets and the mindboggling interconnections through derivative contracts, Long-Term was now too big to fail.
The Fed rallied the largest bankers and brokers, most of them creditors to LTCM, put them in a room and, basically, asked them to sort out the mess. The potential loss of LTCM’s contracts was estimated at approximately $3-4b. They had to come up with the sum to save the fund.
Meanwhile, LTCM, helped by Goldman, was still looking for a last minute deal to raise capital to stabilize the fund. The company was hemorrhaging – equity was down to $1.5b, to $1b, to $773m. Buffett was the lender of last resort. His offer - $250m for the portfolio that was worth $4.7b at the start of the year and was currently valued at $774m – was terribly had to swallow for the partners, who were going to be wiped out and out of a job. To stop them from shopping it around, it had less than an hour deadline. However, due to communication problems (Buffett was on a trip in Alaska with the Gates’ and cell reception was awful).
The last chance was getting back to the Fed’s negotiation table. As the discussion stared over, Bear said it was not going to participate in a bailout. After much haggling, the bank consortium agreed to rescue LTCM and temporarily keep the partners running it reporting to an Oversight Committee. But the partners didn’t agree. They say the arrangement as “indentured servitude.”
After another round of haggling between the creditors and the partners, along with an army or lawyers, they signed a deal. LTCM was taken over by 14 banks.
Epilogue
The partners lost much of their personal but they still remained better off than the average American.
After the bailout, LTCM continued cratering. Wall Street companies were facing troubles themselves. Alan Greenspan had to cut interest rates two times to stabilize the situation.
“Even after their historic loss, the Long-Term partners admitted no essential mistake. They had been done in, they argued, by an unforeseeable event – a perfect storm such as strikes once in a hundred years.”
Conclusion
LTCM’s losses from various categories of trades from January 1, 1998, to the bailout:
Russia and other emerging markets:
$430m
Directional trades in developed countries:
$371m
Equity pairs:
$286m
Yield-curve arbitrage:
$215m
S&P 500 stocks:
$203m
High-yield arbitrage:
$100m
Merger arbitrage:
Roughly even
Swaps:
$1.6b
Equity volatility:
$1.3b
While LTCM could have survived the losses from the first seven categories, totaling $1.6b, the catastrophic losses were on the highly leveraged swaps and equity volatility positions.
They super complex models of the Ph.D.’s just told them that some securities were cheap and other expensive and their prices will revert to the historic mean. The real money came from applying this “wisdom” to relatively safe situations, earning hundredths of a percentage point and multiplying the result with insane leverage. In the end, as Warren Buffett put it, these highly intelligent people risked what they had and needed for what they didn’t have and didn’t need. And they lost it - $1.9b of personal wealth.
