When Genius Failed
Apr 17th, 2008 by Dave
The Rise and Fall of Long-Term Capital Management
An excellent history of the use of derivatives on Wall Street through the spectactular rise and fall of LTCM in four short years - from March 1994 through October 1998. The first modern swap took place in 1981 when David Swensen of Salomon, now managing Yale’s endowment portfolio, came up with the idea of of swapping IBM’s foreign currency exposure of European bond debt with another party (ultimately the World Bank). John Meriwether, a very successful bond arbitrage trader, gathered together some of the rock stars of theoretical finance including Myron Scholes who won a Nobel prize in 1997 for his model for valuing derivatives, and Robert C. Merton who was instrumental in bringing the math and finance models, including the Black-Scholes options pricing model, to Wall Street.
The “Rise” section of the book describes the storm clouds brewing even as LTCM easily surpassed Meriwether’s former employer Salomon Brothers in capital and profits. There are other events in the markets that are eerie forebodings of the current sub-prime mortgage meltdown:
- Banks complicit with customers in “renting out their balance sheets” to customers and circumventing the Regulation T margin requirements - allowing LTCM to put on trades without putting up any collateral.
- Fed Chairman Alan Greenspan pushing for more and more liquidity in the markets (and less oversight for broker dealers, p.106) which kept the economy running hot and the easy money encouraged speculators on Wall Street (derivatives) and Main Street (home buyers bidding up housing prices because money was cheap)
- Treasury Secretary Robert Rubin’s bailout of Mexico which fueled subsequent speculation in Asia (p.112)
The extent of LTCM’s leverage was mind-boggling; where you or I might get 2:1 leverage on stocks or 10:1 leverage buying a relatively stable investment like a home, LTCM got up to 28:1 leverage on much more highly volatile investments and as their portfolio plummeted in the final days leverage went to over 100:1 on the remaining capital. The trades they put on were brilliant for a normally functioning market but the positions were so large that there was no liquidity when other market participants rushed for the exits. LTCM was a huge buyer of volatility; essentially betting that over the long term the spreads between less safe and safe instruments would converge. The phrase was “vacuuming up nickels”. As they ran out of investment opportunities in their area of expertise - fixed income securities - they started investing in riskier situations like merger arbitrage, which is highly information sensitive and started taking on directional bets in foreign markets. Skeptics said they were “picking up nickels in front of a bulldozer.”
This time around, when Russia defaulted on its debt there was to be no bailout. And things only got worse for LTCM; with the spreads widening day by day. An irony of the situation is that if there were 10 LTCMs in the market, and others had been in a position to capitalize, in taking advantage of the situation they would have brought the spreads closer together and improved LTCM’s position. As it was, none of the other market participants were willing or able to step in, and in fact they traded in the other direction, in anticipation of LTCM’s demise.
Great book - read it!