THEORY OF FINANCE

A case study of the LONG TERM CAPITAL MANAGEMENT (LTCM) : Tracking its journey from the zenith to the bottomless pit.

SUBMITTED BY ABHIRUPA DEBROY (QE1102) & ANKITA CHOPRA (QE1108) MSQE II, ISI KOLKATA NOVEMBER 2012

ABSTRACT The investment partnership LongTerm Capital Management was set up in 1993 by John Meriwether, previously a successful bond trader and then senior manager at the US investment bank, Salomon Brothers. Meriwether recruited to LTCM, from Salomon and elsewhere, an impressive team of experienced traders and specialists in mathematical finance. Much of its trading was with leading banks, and it largely avoided risky 'emerging markets', preferring wellestablished ones such as those in government bonds of the leading industrial nations. The fund avoided speculation based on hunches. It built carefully researched mathematical models of the markets in which it traded, and invested in a way designed to achieve insulation from market movements, seeking small pricing anomalies from which it could profit. Although it had to borrow large amounts and commit money on a large scale to make an adequate return from these anomalies, LTCM scrupulously measured and controlled the risks it was taking. In the summer of 1998, when the spreads began to widen much like they had in 1978, the collapse began. During this period, Russia defaulted on its debt, causing a devaluation of many of LTCMs investments. As bits and pieces of LTCMs trading strategy had been discovered, most of Wall Street had actually made similar trades that were also negatively affected by the Russian collapse. As other investors fled toward liquid assets such as shortterm bonds and shied away from longerterm bonds, spreads further increased, causing sharp decreases in the value of LTCMs portfolio. This wouldnt have been a problem if LTCM had an endless supply of cash (like they had access to before Wall Street began to panic). However, the banks increasingly demanded that LTCM give them more information and put up more collateral for their trades. Through Meriwethers personal relationship with other banks, LTCM had managed to borrow much more capital than normally excepted for nearly no collateral, meaning the banks were taking the bulk of the risk should LTCMs trading strategy fail. As the spreads widened, banks began to demand more and more collateral for LTCMs trades collateral they did not have. Since they could not meet all of their cash obligations, the pressure was on to sell off trades and realize losses. Eventually, as LTCM reached the brink of being forced to sell off all of their investments, they were forced to divulge all of the information of their trades and seek help from the other banks. As information became available, others who held similar investments started unwinding their positions or selling them off. At first this was done as an attempt to cut losses, but later this was used as an actual attack on LTCM intended to devalue the fund further and make it an easier acquisition target. The demise of LTCM ended with the intervention of the United States Federal Reserve, who elicited capital from top investment banks to bailout the fund to avoid further blows to the market.

CONTENTS TOPICS NO. MERIWETHER & THE FUND LTCM: EXPECTED TO BE A BREAKTHROUGH TRADING STRATEGIES FLAWS BAILOUT & THE AFTERMATH LESSON LERANT CONCLUSIONS REFERNCE PAGE

MERIWETHER & THE FUND A hedge fund is an investment fund that can undertake a wider range of investment and trading activities than other funds, but which is generally only open to certain types of investors specified by regulators. As a class, hedge funds invest in a diverse range of assets, but they most commonly trade liquid securities on public markets. They also employ a wide variety of investment strategies, and make use of techniques such as short selling and leverage. Hedge funds are left mostly unregulated. In particular, they are exempt under sections 3(c)(1) and 3(c)(7) of the 1940 Investment Company Act if they have either fewer than 100 investors (or partners) or all of their investors meet the eligibility requirements for exemption under section 3(c)(7). Specically, hedge funds may have an unlimited number of investors as long as all fund investors are qualied purchasers at the time of acquisition. Qualied purchasers are individuals with at least $5 million in investments and institutions with at least $5 million under management. As speculative vehicles for high net-worth individuals and institutional investors, hedge funds are free to hold whatever nancial instruments they wish and to pursue whatever investment or trading strategies they choose. The key freedoms that hedge funds have, as opposed to regulated investment companies (mutual funds) and other institutional investors, are that hedge funds are not encumbered by restrictions on leverage or short sales and are free to take concentrated positions in a single rm, industry, or sectorpositions that might be considered imprudent if taken by other institutional fund managers. Their advantage is that they can pursue investment and speculative strategies that are not open to other institutional fund managers, they can avoid the costs associated with regulatory oversight, and they can use whatever fee structure they believe to be optimal. The growth of hedge funds is attributable to two factors viz, the demographics of potential hedge fund investors and the attractive performance of hedge funds. The unregulated nature of hedge funds means that very little is known about their actions. In fact, even the exact number of such funds in operation is unknown. What is known, however, is that there has been an explosive growth in the number of hedge funds. In 1998, there were believed to be approximately 3000 such funds in existence, a number which had ballooned up from less than 1000 at the end of 1992, (In fact in 1968, there were only 215 hedge funds in the world.) of which the LTCM was considered to be the largest at the time.

However, in August 1998, the near-collapse of a single hedge fund, LongTerm Capital Management LP, changed all this. What follows is the story of the LTCM debacle and why the collapse of LTCM has put fear in the hearts of both the nancial community and regulators. Before diving into the set of events that contribute to the rise and fall of LongTerm Capital Management, it is helpful to gain some insight into the backgrounds of the people involved in the process. The most notable figure is founder John Meriwether, an established pioneer of fixed income arbitrage at Salomon Brothers in the early 1980s. During this time, Meriwether recruited some of the most talented economists, mathematicians and physicists to this business who would later become principal founders of LTCM. Amongst these academics were Nobel Laureates in economics Robert Merton and Myron Scholes. At Salomon, Meriwether and his team developed and implemented mathematical models largely based on the assumption of convergence of spreads. For example, he would bet that the different between the price of a 30 year bond and the price of a 29 year bond would converge to a negligible amount as the bonds go to maturity, since they are nearly identical so investors shouldnt pay a premium for one bond over the other. This is the fundamental idea behind the strategy that made Meriwether the reputable star trader at Salomon. Meriwether left the firm in 1991 due to a scandal that involved most of Salomons top executives and established LongTerm Capital Management, taking with him the strategies that had made Salomon so profitable as well as most of the team from the Fixed Income Arbitrage group . Meriwether chose to start a hedge fund to avoid the financial regulation imposed on more traditional investment vehicles, such as mutual funds, as established by the Investment Company Act of 1940funds which accepted stakes from one hundred or fewer individuals with more than one million dollars in net worth each were exempt from most of the regulations that bound other investment companies. Thus was set up : the Long-Term Capital Management (LTCM), a company incorporated in Delaware but based in Greenwich, Connecticut. LTCM managed trades in Long-Term Capital Portfolio LP, a partnership registered in the Cayman Islands. The fund's operation was designed to have extremely low overhead; trades were conducted through a partnership with Bear Stearns and client relations were handled by Merrill Lynch. Clearly, the structure and strategies used by LTCM had their origins long before the funds inception in the early 1990s. In fact, Meriwether and his team carried their trading strategy directly from Salomon to LTCM. His proven track record at Salomon and the assembled all-star team of traders and academicians was expected to profit from the combination of the academics' quantitative models and the traders' market judgment and execution capabilities. These key factors led to enormously successful initial fund raising efforts of LTCM. The bank attracted a wide variety of qualified investors that included other banks, pension funds, international firms as well as high networth individuals. At the end of February

1994, the fund had raised $1.25 billion of capital, the largest startup ever. Once the initial funding was obtained, LTCM needed to set up several trading mechanisms. Their partners included Merrill Lynch, who was primarily responsible for fundraising, Bear Stearns, who executed the majority of the firms trades, and a vast array of investment banks that provided relatively cheap financing. In the process of executing their seemingly successful trading strategy, they developed an extremely complex set of relationships and dependencies.

LTCM : EXPECTED TO BE A BREAKTHROUGH LTCM was a large capital fund comprising of well known people in the traders market and the academic field : John W. Meriwether : Former vice chair and head of bond trading at Salomon Brothers Robert C. Merton : Leading scholar in finance Myron S. Scholes : Co-author of BlackScholes model David W. Mullins Jr. : Vice chairman of the Federal Reserve Eric Rosenfeld : Arbitrage group at Salomon William Krasker : Arbitrage group at Salomon Gregory Hawkins : Arbitrage group at Salomon Larry Hilibrand ; Arbitrage group at Salomon Victor Haghani : Arbitrage group at Salomon

This genius team was highly successful and made LTCM profitable and was widely regarded as the worlds greatest money machine. This led to a social process of imitation; a trading technique that was believed to be successful led to widespread imitation by the market participants. Many other participants believed that LTCM had superior prediction tools to ones they used and so decided to track and replicate LTCMs positions. Such was the impact that LTCM made on the then existing market.

TRADING STRATEGIES: The basic principle of LTCMs trading strategy was that in the long term the price of a security would converge to its fair market value even though there may be

mispricing in the short term. LTCM utilized computer models to find arbitrage opportunities between markets. LTCM's central strategy was to make convergence trades. These trades involved finding securities that were mispriced relative to one another, taking long positions in the cheap ones and short positions in the rich ones. Because these differences in values were tiny, the fund needed to take large and highly leveraged positions in order to make a significant profit. Much of its trading was with leading banks, and it largely avoided risky 'emerging markets', preferring wellestablished ones such as those in government bonds of the leading industrial nations. The fund avoided speculation based on hunches. It built carefully researched mathematical models of the markets in which it traded, and invested in a way designed to achieve insulation from market movements, seeking small pricing anomalies from which it could profit. Although it had to borrow large amounts and commit money on a large scale to make an adequate return from these anomalies, LTCM scrupulously measured and controlled the risks it was taking. The investors who were attracted to LTCMs business strategy reads like a Whos Who of professional and sophisticated investors who knew the risks involved, had committed both equity and loan capital (locked in for perhaps 3 years with various contractual mechanisms to ensure no quick flight of their capital), and, presumably had the approval of the investment committees of their respective institutions. They included: LTCM partners (who invested $100 million); and other whose investment totaled $1 billion; Liechtenstein Global Trust; Bank of Italy; Credit Suisse; UBS; Merrill Lynch (employees' deferred payment plan); Donald Marron, chairman, PaineWebber; Sandy Weill, coCEO, Citigroup; McKinsey executives; Bear Stearns executives; Dresdner Bank; Sumitomo Bank; Prudential Life Corp; Bank Julius Baer (for clients); Republic National Bank; St Johns University endowment fund; and University of Pittsburgh. In total $1.25 billion was raised, and the transparency of their investment was provided by Monthly Net Asset Valuations, Quarterly Balance Sheets, annual financial statements including full disclosure of off balance sheet contractual positions, and periodic presentations to lenders concerning financial condition and portfolio policy. LTCM were strikingly successful from the start of trading: In 1994 it earned 28% after fees in 10 months. In LTCM's first two full years of operation it produced 43% and 41% return on equity and had amassed an investment capital of $7.5 billion. The fund was closed to new investors in 1995. In the last quarter of 1997 LTCM returned $2.7 billion to investors.

Such numbers are quite startling, but not especially so, considering the amount of capital involved, its corresponding leverage, and the probably very high nominal principal amount of each trade chasing perhaps no more than a few basis points per trade. The trading strategies undertaken by the LTCM are :

Convergence trade: LTCM used this term when there was a specifiable future date (usually medium-term fixed maturities) by which convergence of offsetting short and long positions in similar instruments should occur. An example of this strategy consists of buying off-the-run high yield bonds and shorting on-the-run low yield bonds. As soon as the newly issued on-the-run bonds become off-the run, the yields on the two bonds converge and LTCM makes a profit. This is a simple strategy and not necessarily a risky trade since it is very likely that the yields will converge once the on-the-run bonds become off-the-run. Since the yield spread between on- and off-the-run bonds is quite narrow, it is possible to make significant profits only with large positions.

Relative value trade: LTCM used this term when convergence was expected but not guaranteed. Otherwise it was quite similar to convergence trades the held similar instruments in long and short positions and expected them to converge. This often happens when a company has more than one holding company listed in different markets (e.g. Royal Dutch and Shell). The price divergence in these different markets creates profitability. Although the price may not completely converge, but the premium tends to narrow over time. The process is also quite straightforward and does not require complicated model. Directional trades: These where unhedged positions exposed to broad market movements. These types of trades are an unprotected naturally a bet on the movement of the value of a particular instrument, which is quite risky, but can be really profitable if the bet is made in the right direction. Opportunities arose for this strategy when there was a sudden large demand for institutional trades (often due to interest rate change). As long as LTCM was able to obtain reliable information on rate changes or impending institutional trades, the strategy was quite simple and profitable. Fixed rate residential mortgages: It consisted of long positions on FNMA, FHLMC and GNMA pools, hedged with interest rate swaps. The positions themselves are not very complicated, but in order to properly evaluate the fair values of the mortgage pools one needs very sophisticated models. These trades are therefore rather sophisticated and can be very profitable if the investor can properly evaluate the underlying securities. LTCM had exposure as high as $10 million per basis point of spread. This strategy has rather low risk because these mortgage-backed securities are essentially default free (due to its quasigovernmental nature). Japanese government bond swap spread: As in US Treasury bond swap spread, the swap spread is the difference between the fixed rate on swap and

the yield on a similar-duration Treasury bond. The Japanese swap strategy involved long positions in Japanese government bond and in futures on those bonds, hedged by Libor-yen interest rate swaps. The profit of this type of strategy was quite arithmetic, given no initial outflow (bonds was purchase with 100% financing at repo rate), the cash flow of the strategy is : (liborrepo) swap spread. Given that libor > repo and a swap spread at its historical low, the net profit is secured; therefore limiting the risk. However, the net spread is usually in single basis point. LTCM had at most $10 million per basis point exposure to this trade. Yield-curve relative value trades: LTCM constructed a butterfly spread on the yield curve where they thought that bulges and dips in the yield curve where due to investor preferences for specific maturities but not to their expectations. These are rather sophisticated trades where an investor has to calibrate the positions such that the total position has no or minimum exposure to changes in the yield curve. This strategy can be risky due to misevaluation of the yield-curve. LTCM usually constructed these trades such that its exposure was $3 million per basis point Selling volatility: LTCM sold puts and calls when the demand and prices for long term options rose. The rise in option prices arose when there was strong demand for long term downside protection on stock indexes. LTCM therefore sold options with a lot higher implied volatility than both historical and implied volatility on short term options observed in the market. To implement such a strategy properly, an investor needs a good model to evaluate the underlying asset. However, it is quite risky to speculate on options. LTCM had at most $30 million under for 1% change in volatility Risk arbitrage: LTCM did some risk arbitrage. Given the fact that it had no advantage in predicting the outcome of a merger, LTCM preferred non hostile takeovers and stock deals rather than cash deals. Since the fund was able to finance trades very efficiently it could profit on risk arbitrage when others could not. The only risk involved in this strategy is when the M&A deal falls through, but in general, this strategy has rather low risk. At the peak they had a risk arbitrage portfolio of about $5 billion.

Of these there were four main types of trade: Convergence among U.S., Japan, and European sovereign bonds; Convergence among European sovereign bonds; Convergence between on-the-run and off-the-run U.S. government bonds;

Long positions in emerging markets sovereigns, hedged back to dollars. The company used complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades) usually with U.S., Japanese, and European government bonds. Government bonds are a "fixed-term debt obligation", meaning that they will pay a fixed amount at a specified time in the future. Differences in the bonds' present value are minimal, so according to economic theory any difference in price will be eliminated by arbitrage. Unlike differences in share prices of two companies, which could reflect different underlying fundamentals, price differences between a 30 year treasury bond and a 29 and three quarter year old treasury bond should be minimalboth will see a fixed payment roughly 30 years in the future. However, small discrepancies arose between the two bonds because of a difference in liquidity. By a series of financial transactions, essentially amounting to buying the cheaper 'off-the-run' bond (the 29 and three quarter year old bond) and shorting the more expensive, but more liquid, 'on-the-run' bond (the 30 year bond just issued by the Treasury), it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond was issued, i.e., the long the short positions were highly correlated and so the net risk was small. As LTCM's capital base grew, they felt pressed to invest that capital and had run out of good bond-arbitrage bets. This led LTCM to undertake more aggressive trading strategies. Although these trading strategies were market neutral, i.e. they were not dependent on overall interest rates or stock prices going up (or down), they were not convergence trades as such. By 1998, LTCM had extremely large positions in areas such as merger arbitrage (betting whether mergers would be completed or not) and S&P 500 options (net short long-term S&P volatility). LTCM had become a major supplier of S&P 500 vega, which had been in demand by companies seeking to essentially insure equities against future declines. Because these differences in value were minuteespecially for the convergence tradesthe fund needed to take highly-leveraged positions to make a significant profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt to equity ratio of over 25 to 1. It had off-balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.

FLAWS: The chronological list of events that occurred during the span 1997-1998 and lead to the down fall of the LTCM are :

End of 1997: After two years of returns running close to 40%, the fund had approximately $7 billion under management and was achieving only a 27% return comparable with the return on US equities that year. Meriwether returned about $2.7 billion of the fund's capital back to investors because "investment opportunities were not large and attractive enough. Early 1998: The portfolio under LTCM's control amounted to well over $100 billion, while net asset value stood at some $4 billion; its swaps position was valued at some $1.25 trillion notional, equal to 5% of the entire global market. It had become a major supplier of index volatility to investment banks, was active in mortgagebacked securities and was dabbling in emerging markets such as Russia. 17 August 1998: Russia devalued the rouble and declared a moratorium on 281 billion roubles ($13.5 billion) of its Treasury debt. This resulted in a massive "flight to quality", with investors flooding out of any remotely risky market and into the most secure instruments within the already "risk-free" government bond market. Ultimately, this resulted in a liquidity crisis of enormous proportions, dealing a severe blow to LTCM's portfolio. 1 September 1998: LTCM's equity had dropped to $2.3 billion. John Meriwether circulated a letter which disclosed the massive loss and offered the chance to invest in the fund "on special terms". Existing investors were told that they would not be allowed to withdraw more than 12% of their investment, and not until December, that year. 22 September 1998: LTCM's equity had dropped to $600 million. The portfolio had not shrunk significantly, and so its leverage was even higher. Banks began to doubt the fund's ability to meet its margin calls but could not move to liquidate for fear that it would precipitate a crisis that would cause huge losses among the fund's counterparties and potentially lead to a systemic crisis. Thus we see that it all started to go sour in the summer of 1998 because of unusually adverse market conditions. There were, perhaps, five contributory factors, some of which were extreme events, which lead to its down fall. Russia's devaluation of the rouble and partial default on its rouble denominated debt. The Russian default was just such an extreme event, though one that no one had anticipated: the surprise was not that Russia was in economic trouble, but that it defaulted on debts denominated in roubles, rather than simply printing more money, and also that it temporarily blocked some foreign exchange transactions by Russian banks. LTCM itself had only a minor direct exposure to events in Russia, but the precise form of Russia's actions caused significant losses to Western banks. An investment fund called High Risk Opportunities failed, and (quite unfounded) rumors began to circulate that Lehman Brothers, an established investment bank, was also about to do so. Suddenly, market unease turned into selffeeding fear. A

'flight to quality' took place, as a host of institutions sought to liquidate investments that were seen as difficult to sell, and potentially higher risk, replacing them with lower risk, more liquid alternatives. Because LTCM's 'convergence arbitrage' generally involved holding the former, and short selling the latter, the result was a substantial market movement against the fund. Another, perhaps anecdotal, factor was the simple fact that it took place in August, when many European and US traders, and managers, were on holiday and markets tended to be thinner and less liquid than usual. LTCM was by no means the only market participant involved in convergence arbitrage: many of the world's leading banks, notably Wall Street investment banks who were also LTCM investors, had broadly similar large positions. The majority of these banks employed valueatrisk models not just as LTCM did (to gauge the overall risks faced by the fund), but also as a management tool. By allocating valueatrisk limits to individual traders and trading desks, big institutions prevent the accumulation of overrisky positions while giving traders flexibility within those limits. However, if adverse market movements take positions up to or beyond the limits, the traders involved have no alternative but to try to cut their losses and sell, even if it is an extremely disadvantageous time to do so. In August 1998, widespread efforts to liquidate broadly similar positions in roughly the same set of markets seem to have intensified the adverse movements that were the initial problem. Crucially, they also led to greatly enhanced correlations between what historically had been only loosely related markets, across which risk had seemed to be reduced by diversification. LTCMs position, however, was constructed so robustly that, though they caused major losses, these problems were not fatal. In September 1998, though, a social process of a different kind got underway in effect a run on a bank. LTCM's difficulties became public. On 2 September Meriwether sent a private fax to the company's investors, describing its financial situation and seeking to raise further capital to exploit what he described (quite reasonably) as attractive arbitrage opportunities. The fax was posted almost immediately on the Internet and was read as evidence of desperation. The nervousness of the markets crystallized as fear of LTCM's failure. Almost no one could be persuaded to buy, at any reasonable price, an asset that LTCM was known or believed to hold, because of the concern that the markets were about to be saturated by a fire sale of the fund's positions. In its attempt to raise additional capital, LTCM had shown its positions to outsiders, which may have caused leaks on what was held. In addition, LTCM's counterparties the banks and other institutions that had taken the other side of its trades tried to protect themselves as much as possible against LTCM's

failure by a mechanism that seems to have sealed the fund's fate. As good business practice, LTCM had constructed its trades so that solid collateral, typically government bonds, moved backwards and forwards between it and its counterparties as market prices moved in favour of one or the other. Under normal circumstances, when prices were unequivocal (rational), it was an eminently sensible way of controlling risk. But in the fearchilled, illiquid markets of September 1998 (irrational), prices lost their character as clear facts. As was their contractual right, LTCM's counterparties marked against it: that is, they chose prices that were unfavourable to LTCM, seeking to minimize the consequences for their balancesheets of a LTCM's failure by getting hold of as much of the firm's collateral as possible. Fearing the failure, they made it inevitable by draining the firm of its remaining capital. The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude): $1.6 billion in swaps $1.3 billion in equity volatility $430 million in Russia and other emerging markets $371 million in directional trades in developed countries $286 million in equity pairs (such as VW, Shell) $215 million in yield curve arbitrage $203 million in S&P 500 stocks $100 million in junk bond arbitrage no substantial losses in merger arbitrage

BAILOUT & THE AFTERMATH Each US Federal Reserve System Bank has a remit to monitor all the financial institutions within in its geographical preserve, and likewise, each financial institution has an obligation to disclose to its local Fed Bank any untoward circumstances. In early September, 1998, David Mullins, on behalf of the management of LTCM, informed the New York Fed chairman Bill McDonough about the situation at LTCM.

On September 18, 1998, McDonough made "a series of calls to senior Wall Street officials to discuss overall market conditions, everyone I spoke to that day volunteered concern about the serious effect the deteriorating situation of Long Term could have on world markets." Peter Fisher, executive vice president at the NY Fed, decided to take a look at the LTCM portfolio. On Sunday September 20, 1998, he and two Fed colleagues, assistant treasury secretary Gary Gensler, and bankers from Goldman and JP Morgan, visited LTCM's offices at Greenwich, Connecticut. It was now clear that, although LTCM's major counterparties had individually closely monitored their bilateral positions, they now had sight of LTCM's overall total off balance sheet leverage. The off balance sheet contracts were mostly nettable under bilateral ISDA master agreements, and most of them were also collateralized, but unfortunately the value of the collateral had also taken a dive since midAugust. However, from LTCMs perspective these swaps were markedtomarket on daily basis so if more collateral was needed it had to be made available on a daily basis. The next day, Monday 21st September, bankers from Merrill, Goldman and JP Morgan continued to review the problem. It was still hoped that a single buyer for the portfolio could be found the cleanest solution. By this time LTCM's capital base had dwindled to a mere $1,000 million. That evening, Monday 21st September, UBS sent a team to Greenwich to study the portfolio. On Tuesday 22nd September, the Feds Peter Fischer invited those three banks, and UBS, to breakfast at the Fed headquarters the following day. The bankers decided to form working groups to study possible market solutions to the problem, given the absence of a single buyer. Proposals included buying LTCM's fixed income positions, and "lifting" the equity positions (which were a mixture of index spread trades and total return swaps, and some takeover positions). During the day a third option emerged as the most promising: seeking recapitalization of the portfolio by a consortium of creditors. But any action had to be taken swiftly. The danger was a single default by LTCM would trigger crossdefault clauses in its ISDA master agreements precipitating a mass closeout in the overthecounter derivatives markets. Banks terminating their positions with LTCM would have to rebalance any hedge they might have on the other side. The market would quickly get wind of their need to rebalance and move against them. Marktomarket values would descend in a vicious spiral. There was a wider concern that an unknown number of market players had convergence positions similar or identical to those of LTCM. In such a oneway market there could be a panic rush for the door. There is also the market mechanics of unwinding these positions in a bankruptcy situation. For example, if LTCM had a trade long the 29 year bond and short the 30 year bond that had very

little risk. They had used leverage to bring that risk more into line with normal market risk. At inception, each side of the trade had been done with a different counterparty, for two reasons. First, for proprietary reasons LTCM probably did not want their counterparties to see the exact trade for fear that that might copy it; and Second, LTCM received better financing terms when they separated the legs of their trades.

But if in the event that LTCM filed for bankruptcy, these trades would no longer be paired together as the counterparties looked to unwind them quickly. To illustrate, if JP Morgan was financing the LTCM long position in the 29 year bond via a repo, then J P Morgan had lent LTCM cash against holding the 29 year bond as a collateral. In bankruptcy J P Morgan would look to sell out their collateral as quickly as possible and if there was a shortfall they would send LTCM a bill. On the short side LTCM might have borrowed the 30 year bond from Citibank and posted cash as collateral. In bankruptcy, Citibank would buy back the bond quickly in the open market. The paired trade had very little risk, but in bankruptcy each side had enormous risk. In this sense LTCM acted almost as a clearinghouse so that when it was a going concern there would be a small amount of risk, but in bankruptcy each of the individual legs of the trades could have a substantial amount of risk. A meltdown in developed markets on top of the panic in emerging markets seemed a real possibility. In addition, LTCM's clearing agent Bear Stearns was threatening to foreclose the following day if it didn't receive an additional $500 million in collateral. Until now, LTCM had resisted the temptation to draw on a $900 million standby facility that had been syndicated by Chase Manhattan Bank, because it knew that the action would panic its counterparties. But the situation was now desperate. LTCM asked Chase for $500 million. It received only $470 million since two syndicate members refused to chip in. To take the consortium plan further, the biggest banks either big creditors to LTCM, or big players in the overthecounter markets were asked to a meeting that evening. The plan was to get 16 of them to chip in $250 million each to recapitalize LTCM at $4 billion. The four core banks met at 7pm Monday 21st September and reviewed a term sheet which had been drafted by Merrill Lynch. Then at 8.30 bankers from nine more institutions showed. They represented: Bankers Trust, Barclays, Bear Stearns, Chase, Credit Suisse First Boston, Deutsche Bank, Lehman Brothers, Morgan Stanley, Credit Agricole, Banque Paribas, Salomon Smith Barney, Societe Generale. David Pflug, head of global credit risk at Chase warned that nothing would be gained a) by raking over the mistakes that had got them in this room, and b) by arguing about who had the biggest exposure: they were all in this equally and together. The meeting resumed at 9.30 on Wednesday 23rd September. Goldman Sachs had a surprise: its client, Warren Buffett, was offering to buy the LTCM portfolio for $250 million, and recapitalize it with $3 billion from his Berkshire

Hathaway group, $700 million from AIG and $300 million from Goldman. The conditions included a) there would be no management role for Meriwether and his team; b) none of LTCM's existing liabilities would be picked up; and c) all current financing had to stay in place. Meriwether had until 12.30 that day to decide. By 1pm it was clear that Meriwether and LTCM could not accept the offer for various reasons, which included a) he couldn't do so without consulting his investors, which would have taken him over the deadline; and b) more importantly to keep the current financing in place including term maturities and no haircuts etc would require the dealers, and other counterparts and debt holders, to agree. LTCM had 15,000 outstanding trades and each one was a credit counterparty trade (like a repo or a swap). Each one would need the approval of the other counterparty to transfer it to the Buffet group. Of course every counterparty would have preferred to have had Buffet on the other side as opposed to an abouttobebankrupt hedge fund but LTCM had 1 hour to obtain all these approvals and many of the counterparties (in Japan) were already closed for the day. So it didnt happen. (Anecdotally, in a Buffett biography, he does discuss his version of what happened, and discloses that he would have liked the transaction to have gone through.) But more importantly, the message to the market was that there would be no firesale of assets. The LTCM portfolio would be managed as a going concern. On September 23, a consortium of 14 leading investment and commercial banks agreed in principle to invest $3.625 billion in the fund. The investment was consummated on September 28. The consortium investment consisted entirely of private sector capital. By midDecember, 1998 the fund was reporting a profit of $400 million, net of fees to LTCM partners and staff. By June 30, 1999 the fund was up 14.1%, net of fees, from the previous September. Meriwether's plan, approved by the consortium, was to redeem the fund, then valued at around $4.7 billion, and to start another fund concentrating on buyouts and mortgages. On July 6, 1999, LTCM repaid $300 million to its original investors who had a residual stake in the fund of around 9%. It also paid out $1 billion to the 14 consortium members.

LESSONS LEARNT Stress Testing of Liquidity Risk : Despite the $900 million Standby Letter of Credit, and over a $1 billion in working capital, LTCM still required a rescue. No matter how extreme they may appear, worstcase scenarios do, and will, happen. Hedging the tail of a VaR may seem like an expensive capital raising insurance but could also limit potential losses in adverse market conditions. But also bear in mind that there will always be events, or compound or correlated events, which will not be anticipated. And no stress testing model (economic, proprietary, accounting or regulatory) is a complete descriptor of the complex reality. There will always be missing elements from

any prior analysis, and thus as part of risk management design one must have procedures in place to deal with managing crises (defined as events not anticipated in any fashion beforehand), which cannot be known in advance. (LTCM did to the extent it had a team of senior management who had dealt with crises of the past (1987 Crash; S&L crisis), nevertheless it was not able to prevent the events described in this Case Study) Market Risk : When markets become illiquid, for whatever reason, bid / offer spreads will diverge dramatically, and selfinterest and selfpreservation will drive market prices. As in liquidity risk, worstcase scenarios do, and will, happen. Credit Risk : There is no substitute for good, and enforceable, credit policies. Any deviations must require approval and signoff at the highest level Governance Risk : The responsibility for good governance starts at home, and cannot be abrogated to regulatory bodies. Operational Risk : i) Always guard against the event of any private, internal documents and memorandum becoming public. In the domain of the uninitiated, they can be taken out of context and cause material, reputational, and financial, damage ii) Seemingly small mistakes (e.g. the design and feasibility of the Buffett offer) leading to major problems (imagine if the Buffett deal had gone through, there would probably have been only a very small story about LTCM) Reputational Risk : The markets perception, including that all your customers and counterparties, of your risk appetite and profile, must be assiduously managed. Processes and processes must be in place (and stress tested) and capital allocated, to protect shareholder, stakeholder, and investor capital in the event of adverse publicity.

CONCLUSIONS It is hard to imagine a greater misnomer than hedge fund since hedge funds, typically, do just the opposite of what their name implies: they speculate. Although LTCM attempted to limit its susceptibility to performance-based liquidations by limiting the ability of its investors to remove their money from the fund, its high degree of leverage eventually caused these liquidation pressures to arise from debtholders. The sharp movement of securities away from the relative direction in which LTCM had predicted they would move caused tremendous losses for the fund. These losses, combined with the funds tremendous leverage, nearly caused the

bankruptcy and liquidation of LTCMs assets. Unfortunately for LTCM, it didnt have the liquidity to take on such trades. As J.M. Keynes correctly said: The market can stay irrational longer than you can stay solvent This inability of performance-based arbitrage vehicles to move the markets towards efficiency when they are needed the most gives an empirical basis for the hypothesis that arbitrage funds are not highly effective at creating market efficiency. The LTCM debacle also points to the need for a greater role for game theory in trading models. Long-Term Capital appears to have believed too fervently in its models of rational markets and options pricing. What these models did not account for, apparently, was that trading is, in part, a game against rational agents. LTCMs models seemed to have ignored the possibility that it could be perfectly rational for another trader, such as AIG, to trade against LTCM in order to weaken Long-Terms position. While in the short-term, such actions may move prices away from their rational levels this may be a more profitable strategy than waiting for the return to the long-run equilibrium price. LTCMs initial performance was exceptional. Keynes had stated that in the long run we are all dead, LTCM showed that the proposition also held in the short run. In fact, they demonstrated that it is possible to self destruct in a surprisingly short time. LTCM is a story of the confluence of many divergent trends - quantitative finance, risk modeling and derivatives trading. Naturally, it is also about the staples of financial markets fear and greed.

REFERNCE www.investopedia.com www.jstor.org www.wikipedia.com Franklin R. Edwards: Hedge Funds and the Collapse of Long-Term Capital Management When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein