My first ever blogpost...!!!

I was always enamored by the LTCM story. I kept coming across parallels of the FED’s intervention in the Bear Stearns case with that of LTCM. So, when I got my hands on “When Genius Failed- the rise and fall of LTCM” in NITIE library I grabbed the chance.

This post is a short summary of LTCM’s strategies and the reason for their failure. LTCM was John Meriwether’s baby. He was the pioneer in the arbitrage concept. LTCM drew heavily from the Arbitrage group he set up in Soloman Brothers in the late 1970’s. Meriwether set up LTCM after he left Solomon Brothers in a cloud. Even the core team of LTCM composed mainly of former Arbitrage Group members.

I was intrigued by the fact that how could the firm evolve into such a size so that its failure would threaten the markets as a whole. The fund was filled academicians from Chicago, MIT, Stanford, LSE and the likes. The firm boasted of names like David Mullins, (former vice-chairman of the US Fed) Merton and Scholes (of the Black-Scholes fame) who later went on to receive the Nobel Prize for their contribution to the world of finance.

LTCM strategy was to concentrate on “relative value” trades in bond markets, i.e. they would buy some bonds and sell some. It would bet on spreads between bonds to either contract or widen. It was envisaged from the start that LTCM would leverage its capital 20-30 times or more. This was a necessary part of the strategy because the spreads it would make would be miniscule. The fund raised $1.25 billion equity to start off. It added a $1 billion capital at a later stage.

One of the first trades involved the thirty-year US Treasury bonds. Six months old off the run bonds were traded at slight discount to the freshly issued on the run bonds. There was a 12-point gap between the two bonds. LTCM bet on the spread to narrow. After all, the US government is no less likely to pay off a bond that matures in 29.5 years and one in 30. The spread in actuality is too low. But LTCM leveraged this arbitrage 25 times. No sooner did LTCM buy off the run bonds than it loaned them to some other Wall Street firm to buy on the run bonds against it.

The major trades done by LTCM were:

1. Russia and other emerging markets: LTCM’s serious troubles started with Russia declaring that it would default on its dollar debt and $13.5 billion Rouble debt. This led to what would be famously called “flight to liquidity”. Investment flocked to the safe US t-bills thus increasing the spreads between t-bills and other bonds.
2. Equity pairs: This trade involved in taking advantage of the difference between different classes of shares of same/similar companies. For example Volkswagen has two shares with different voting rights. LTCM would take advantage of the difference in prices of the two shares.
3. Yield Curves arbitrage: This trade is about taking advantage of mispricing in various stages of the yield curves caused mainly due to lack of liquidity, like the 29.5 year t-bill described above.
4. S&P 500 stocks: Stocks which were going to be part of S&P 500 had to be bought by the index funds which usually lead to an increase in their price on the day they would be a part of the index. LTCM would buy such stocks.
5. Merger arbitrage: This trade is about taking advantage of the difference between the merger share price and prevailing market price.
6. Swaps: LTCM mostly maintained a leverage of around 30x. This was mainly possible through their heavy use of swaps.
7. Equity volatility: LTCM figured the average volatility of the market (S&P 500) was about 15%. So, if the market valued volatility at 20% (volatility is an important factor determining options prices in the Black Scholes formula) LTCM would short the index. This was referred to as “selling volatility”.

All these strategies were very sound on a fundamental basis. Some say that if the firm had enough cash and hadn’t leveraged so much it might have even survived as the positions ultimately turned profitable. The Russian default was the beginning of its troubles. This led to a rise in bonds spreads caused by flight of investments to safer T-bills. Since LTCM bet that the spreads were going to decrease it lost a lot of money on such trades. Also the stock indexes volatility rose as high as 38% thus LTCM again lost tonnes of money on this trade. The nail in the coffin was when the other banks came to know about LTCM's losses and tried to bleed it further to death. Also LTCM had to open its books to Goldman and others as it needed an equity investment. The deal never went through but the whole street came to know of LTCM's various positions. They bled the firm to death.

The firm had built up about $100 billion of assets. It traded with almost every single bank/fund, thus threatening a systemic collapse on its demise. This led to FED orchestrating a rescue plan consisting of 14 banks and $3.65 billion.

All this makes me think even the best can make horrible mistakes out of overconfidence generated by their successes. And my most important take away from this whole story is that “leverage is a dangerous double edge sword”. It can either propel a firm’s returns to stratosphere or push it or the depths of bankruptcy.