When the infamous Long Term Capital Management (LTCM) got into trouble, I was too young to dabble in the financial market. In retrospect, I would love to find out how this mammoth hedge fund got into trouble. Hopefully I can learn their mistakes without paying for them. There was readily a book written by Roger Lowenstein, “When Genius Failed“.
LTCM is a hedge fund that was formed by an all-star team. Spearheaded by John Meriwether, who was already an experienced trader and a bright star in Salomon Brothers. He was assisted by 2 Nobel prize winners and highly acclaimed professors, Myron Scholes and Robert C. Merton. The core group of traders was led by Larry Hilibrand, Victor Haghani, and Eric Rosenfeld, and all of them have the experience and credentials to back them up.
LTCM trading method
Myron Scholes and Robert C. Merton received the 1997 Nobel Prize for Economics for articulating the Options pricing model with mathematical calculations. The fundamental strategy of LTCM trades was mean reversion or to put it simply, their theory states that prices cannot move away from the average price for too long. LTCM started off with bond trades, where they find bonds that are mis-priced. For example, we can look at one of the first trades that LTCM did. The US government issued 30-year bonds and another tranche of 30-year bond 6 months later. However, the initial 30-year bonds became illiquid as more people kept it for the long run. And big institutions are not willing to own the less liquid bonds and preferred to buy the newer 30-year bonds instead. This is not logical to LTCM as the risk between the two is the same. The government is equally likely to redeem the bond in 29.5 years and 30 years. A difference of 6 months is minute. However, the market priced the bonds differently and the interest for the 29.5 year bond yielded 7.36% while the 30 year bond yielded 7.24%. This is where LTCM will buy the cheaper bond and short the dearer bond, to believe both prices would converge to the mean.
The need for high leverage
But there is a problem. There is little money to be earned. “Twelve basis points is a tiny spread; ordinarily, it wouldn’t be worth the trouble. The price difference was only $15.80 for each pair of $1,000 bonds. Even if the spread narrowed two thirds of the way, say a few months’ time, Long-Term would earn only $10, or 1 percent, on those $1,000 bonds.” As such, the only way to earn a decent return was to leverage as much as possible. LTCM was borrowing billions and they were able to negotiate with the banks without putting up any collateral. Usually the collaterals will limit the amount you can borrow, but in this case, LTCM could borrow as much as the banks are willing to.
LTCM did very well in the initial years. In 1995, LTCM earned 59% before fees and 43% after fees. “[A]t the end of 1995, it was leveraged 28 to 1. Take away the leverage, the return is only about 2.45%. But investors would always see the 59% return and the stellar performance attracted more money and banks were more willing to lend LTCM just to build good relations. The all-star team backed by credible theory will not fail in Wall Street’s opinion. As their capital grows, it was harder for the traders to find converging trades. Especially competition from other hedge funds and banks made the converging trades disappear faster than usual. LTCM began to engage in directional trades, buying equities and other asset classes. There is a price for getting too big.
“[T]he professors calculated that Long-Term would lose at least 5 percent of its money 12 percent of the time (that is in twelve of every hundred years). The letter went on to state the precise odds of the fund’s losing at least 10 percent, as well as 15 percent and 20 percent.” The problem is you cannot apply mathematical formula on humans. The pull of gravity and molecules do not change their minds like humans do. That is precisely the wrong footing of trying to quantify the market and assume humans will act rationally all the time. “A rose-coloured world had suddenly gone dark, discoloured by Russia, Japan, even the Clinton-Lewinsky scandal. In every market, investors wanted only the safest bond. In the United States, it had to be the thirty-year Treasury; in Germany, the ten-year Bund. All over the world, people were buying safer (lower-yielding) bonds and selling riskier (higher-yielding) ones, pushing the spreads between such bond pairs ever wider. Minute by Minute, Long-Term was losing millions.” And all of the sudden, what used to be uncorrelated instruments became highly correlated – they fall together. No diversification is safe and LTCM was not spared. All of LTCM trades were losing money. In a single month, Aug 1998, LTCM lost 45% of their capital.
LTCM was in a bad shape that it had to be bailed out. Warren Buffett offered to buy the fund but it was rejected by Meriwether as it was too low, and the latter with his team had to leave the management. The Fed pulled the bankers of Wall Street together in a concerted effort to bailout the fund. The Fed did not want to use public money to save LTCM. The banks, who had stakes and loans to LTCM, feared the huge hedge fund would create a ripple effect to the financial industry if it was allowed to fall. Hence, they reluctantly throw good money after bad to rescue LTCM. The traders felt they were limited by the governance imposed on them. The fund no longer produce the spectacular results it used to have. LTCM closed in 2000. John Meriwether with the same team of traders created a new fund and it crashed the same way it did in the last financial crisis in 2008.
Latest posts by Alvin Chow (see all)
- We lost RM10,146.24, Here’s 2 Lessons You Can Take Away From It - July 15, 2019
- Bitcoin Singapore – Your Complete Guide 2019 [Updated] - July 4, 2019
- What Is BlockChain? 5 Things You Don’t Want To Miss in 2019 - June 23, 2019