Monday, July 9, 2012

The Trillion Dollar Bet: Documentary On LTCM (Long-Term Capital Management)

Watch The Trillion Dollar Bet, a NOVA documentary film on the rise and fall of hedge fund Long-Term Capital Management between 1994-1998. LTCM was founded by John Meriwether, former vice-chairman and head of bond trading at Salomon, and partners Robert Merton and Myron Scholes, the co-authors of the Black-Scholes-Merton model, which was used by the firm to "eliminate risk" entirely on their positions. Merton and Scholes won the Nobel Prize in Economics in 1997. The Black-Scholes model is used by option traders to price options (implied volatility).

LTCM was a huge player in fixed-income and statistical arbitrage, and had a gang of former Salomon arbitrage traders as partners (list). LTCM made big money at first (+40% annualized), but its massively leveraged portfolio ($125 billion in assets/$4.72 billion in equity in 2008 + $1.25 trillion in off balance sheet interest rate derivatives via Wikipedia) collapsed when its models failed to hedge against unforeseen volatility and a "global flight to liquidity" during the 1997 East Asian and 1998 Russian financial crises (via sovereign default). The Fed organized a $3.62 billion rescue of LTCM with large banks that had existing claims against the company because they thought that LTCM was too-big-to-liquidate its positions in the market, which would destabilize the financial system and put bank portfolios at risk (think 2008 as well). Read Myron Scholes' follow up on the bailout below. But first, this is funny. Look who was at LTCM's emergency meeting.

BusinessWeek: September 25, 1998, exactly 10 years before Lehman's big meeting:

"But just now, details of the meeting are getting out. According to one participant, the meeting was held in a big, wood-paneled room with pictures of past Federal Reserve presidents on the wall. The guest list included Wall Street's most powerful leaders. In attendance: CS First Boston CEO Allen Wheat; CEO James Cayne, along with Warren Spector, from Bear Stearns; Morgan Stanley CEO Phillip Purcell; Lehman Brothers CEO Dick Fuld and Tom Russo, chief legal officer; Goldman Sachs CEO Jon Corzine and CFO John Thain. Travelers CEO, Sandy Weill was there in the morning, as well as the co-CEOs of its Salomon Smith Barney unit, Jamie Dimon and Deryck Maughan. President Herb Allison and CEO Dave Komansky from Merrill Lynch were there, too. Their former Merrill colleague, Edson Mitchell, representing Deutsche Bank, was on the phone."

It's like these bank CEOs wanted this to happen again. Unfortunately, we still haven't learned from LTCM or the TBTF bank bailouts.

Crisis and Risk Management

"The increase in volatility (particularly in the equity markets) and the flight to liquidity around the world resulted in an extraordinary reduction in the capital base of the firm that I was associated with, Long-Term Capital Management (LTCM). This reduction in capital culminated in a form of negotiated bankruptcy. A consortium of 14 institutions, with outstanding claims against LTCM, infused new equity capital into LTCM and took over it and the management of its assets. They hired LTCM’s former employees to manage the portfolio under their direct supervision and with sufficient incentives to undertake the task efficiently.

Although the Federal Reserve Bank (FRB) facilitated the takeover, it did not bail out LTCM. Many debtor entities found it in their self-interest not to post the collateral that was owed to LTCM, and other creditor entities claimed to be ahead of others to secure earlier payoffs. Without the FRB acting quickly to mitigate these holdup activities, LTCM would have had to file for bankruptcy—for some, a more efficient outcome, but a far more costly outcome for society. If there was a bailout, it failed: LTCM has been effectively liquidated.

Because of LTCM, the press and others have taken the opportunity to criticize financial modeling, and in particular, the value of option-pricing models. In truth, mathematical models and option-pricing models played only a minor role, if any, in LTCM’s failure. At LTCM, models were used to hedge local risks. LTCM was in the business of supplying liquidity at levels that were determined by its traders. In 1998, LTCM had large positions, concentrated in less liquid assets. As a result of the ļ¬nancial crisis, LTCM was forced to switch from being a large supplier to being a large demander of liquidity, at a cost that eliminated its capital."

Here is Warren Buffett talking about his involvement with LTCM's rescue (part #2). He didn't end up participating.

More reading:

The Forewarning in 1998: Long-Term Capital Management, by Roger Lowenstein who wrote When Genius Failed on LTCM (PBS)

Regulators Need to Focus Greater Attention on Systemic Risk
GGD-00-3, Oct 29, 1999 (

Some Lessons on the Rescue of Long-Term Capital Management (Cleveland Fed, 2007)

BBC coverage I found:

Wall Street rescue for hedge fund (BBC)

Greenspan defends hedge-fund bail-out (BBC)

LTCM partners set for Christmas bonus (BBC)

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