Beginning in 1995, LTCM traded every financial instrument imaginable: arbitrage between Japanese options and stocks, bets that shares of the same company sold in different markets would converge in price, bets that the price difference between French and German government bonds would diverge, bets that interest rates of U.S. swaps were too high compared to interest rates on U.S. Treasury bonds, and even a bet on long-dated British government bonds that, because it was made using over-the-counter derivatives, actually exceeded the size of the entire market. LTCM’s trades frequently were in the range of $10 billion to $25 billion81—ten times the size of Andy Krieger’s trades at Bankers Trust.
LTCM’s bets were astute, but the fund often got lucky, too. For example, when LTCM followed the earlier Salomon Brothers strategy of buying cheap options embedded in Japanese convertible bonds, it had expected to make small amounts of money over a long period of time, as the bonds matured. Instead, the options skyrocketed in value when the Kobe, Japan, earthquake hit in January 1995, causing volatility to increase 50 percent.82 (This was the same earthquake that had decimated Nick Leeson’s bets on Japanese stocks.) With a combination of skill and luck, the fund made 59 percent in 1995.
Over time, LTCM began taking on the complex risks that other banks shunned. As horror stories spread about how Bankers Trust, and then Salomon Brothers, had been unable to evaluate their complex portfolios, the top managers at many banks instructed their traders to unload such positions.83 LTCM bought them, betting that its finance specialists could manage the risks better than anyone else. Banks continued to sell complex derivatives deals to clients, but instead of keeping all of the fees, they often paid LTCM to take on the more esoteric risks. In other words, the successors to Gibson Greetings were unknowingly buying their trades from LTCM, with the major Wall Street banks acting merely as an intermediary.
But LTCM’s most lucrative trades weren’t from skill or luck but, instead, from its cozy relationships with central bankers and government officials, which provided the opportunity for the fund to learn about regulatory arbitrage trades—essentially, buying and selling to profit from mispricings due to various countries’ legal rules and regulations. These strategies hardly required a Ph.D. in finance. For example, the fund took advantage of a quirk in British tax law that treated high-coupon and low-coupon government bonds differently, even though they were economically similar. It also used its connections in Japan to short bonds, even though the Bank of Japan had rules discouraging such practices.84 These strategies were a few of the small number of trades David Mullins had described as requiring so much research and time.
Much of LTCM’s activity was in Italy, where it had extraordinary connections. Not only did LTCM employ the former Italian treasury official responsible for debt management, but the Bank of Italy, the country’s central bank, had invested $100 million with LTCM. (This investment was highly unusual; imagine if Alan Greenspan invested the Fed’s money in a foreign hedge fund.) Meriwether and Mullins also had connections in Italy, and Merton was a near-deity there.
It was no coincidence, then, that in one trade LTCM purchased an estimated $50 billion of Italian government bonds—a bet bigger than any previously described in this book, including Joseph Jett’s trading in STRIPS. LTCM owned 25 percent of one segment of the Italian government-bond market. In other trades, LTCM benefited from an Italian tax loophole for foreign investors, and from the prospect of Italy’s entry into the European monetary system, about which it had very good information.
LTCM even found regulatory advantages in its trading with clients. When Union Bank of Switzerland, known as UBS, expressed an interest in buying a stake in LTCM in 1996, long after the fund had closed to new investors, Myron Scholes designed an over-the-counter options deal that enabled the Swiss bank to invest while reducing the taxes of LTCM’s partners. UBS bought shares in LTCM, but sold a seven-year option to LTCM’s partners. When LTCM’s partners eventually exercised the option, they would pay tax at the low, long-term-capital-gains rate, instead of the high, personal-income-tax rate.85
In all, 1996 was another fantastic year, and the fund made 44 percent. Investors already had doubled their money, with little apparent risk. Fund managers were often measured by the Sharpe ratio—essentially, the fund’s average returns divided by its risks. For a good fund manager, the relevant percentages of returns and risks might be about the same, so that the Sharpe ratio was 1.0. A Sharpe ratio of 2.0 was excellent, and probably not sustainable for long. LTCM’s Sharpe ratio, in its first three years, was an astronomical 4.35.86
There were some signs of trouble in 1997. The fund paid investors just 17 percent, after fees. By this time, LTCM employed 25 Ph.D.s,87 but even with this brainpower, the fund had moved from highly quantitative arbitrage trades to outright gambling on currencies and stocks. Myron Scholes questioned whether LTCM really had an advantage in such areas, and wondered whether the fund was assessing its risks properly. The partners agreed that they would reduce the size of the fund by about $3 billion, because of concern that they might not be able to find enough good investments, given the limited number of regulatory-arbitrage opportunities. By the end of 1997, LTCM had about $4.7 billion of equity, which it used to borrow $125 billion and enter into another $1.25 trillion of derivatives. LTCM’s ratio of debt-to-equity, an important measure of the riskiness of a firm, was almost 27 times ($125 billion of debt divided by $4.7 billion of equity). Firms with a high debt-to-equity ratio were said to have greater leverage, and were more likely to have trouble repaying their debts.
Some investors whose money was returned were upset to lose the cachet of LTCM. But anyone who thought carefully about what LTCM was doing would have spotted the danger signs; and, indeed, a few investors called the fund to express concerns. The number of hedge funds had grown by about 20 percent every year since 1988; and, by 1996, there were almost 5,000 of them, with $300 billion under management. 88 The markets had become so competitive that even the most sophisticated hedge-fund operators were questioning whether it still was possible to find the tiny arbitrage-profit opportunities that remained.
David Shaw, a computer scientist, who had founded a hedge fund called D. E. Shaw in 1988 and had generated 18 percent annual returns, with low volatility, for eight years, said the markets were so competitive that if he were considering starting up a hedge fund in 1996, he’d “probably stay out of the business altogether.”89 Victor Niederhoffer, a peculiar hedge-fund manager, who was frequently barefooted or reading obscure philosophy tracts, and who had a track record of 30 percent annual returns for fifteen years, lost all of his investors’ money—more than $100 million—in 1997. First, Niederhoffer lost $50 million in the East Asia crisis. Then, he “doubled down” by selling put options on U.S. stocks, betting that the market would not go down. When U.S. stocks fell seven percent on October 27, he lost everything that day.90
Investors in these hedge funds hadn’t known about their risks, because the funds did not disclose details. LTCM, D. E. Shaw, and similar funds said they needed to keep their strategies secret or other investors would mimic them, thereby eroding the profit opportunities. Many investors could not understand these complex strategies, anyway. One of David Shaw’s investors said, “With most of the investments I have, I understand exactly what’s going on. I don’t with David.”91
The same was true of LTCM. LTCM split its trades among numerous banks, so that no one would be able to see its trading strategies. It might do one side of a trade with one bank, and another with a different bank. It told its investors very little about its strategies, and never released the details of specific trades.
The President’s Working Group on Financial Markets later concluded that “financial firms did not fully understand LTCM’s risk profile and that some may not have adequately contemplated the market and liquidity risks that would have arisen if LTCM had defaulted. As the complexity, volume, interrelationship, and, in some cases, the leverage of transactions increased, the existing risk man
agement procedures underestimated the probability of severe losses.”92 But during the months before LTCM collapsed, most regulators were more hostile to regulation. After the Commodity Futures Trading Commission considered issuing a “concept release,” addressing the regulation of the over-the-counter derivatives LTCM and various banks traded, the President’s Working Group on Financial Markets held a meeting at which Treasury Secretary Robert Rubin discouraged the CFTC from issuing any release, arguing that the “CFTC was utterly without jurisdiction over the over-the-counter derivatives market.” Arthur Levitt meekly agreed. When pressed for an explanation of why the federal law granting authority for regulating derivatives to the CFTC did not apply, neither Rubin nor his general counsel could offer any legal analysis supporting their position. The CFTC boldly decided to issue the concept release anyway, against the objections of Greenspan and Rubin, and when one Treasury official discovered the CFTC’s plans, his reaction was, “Oh, no. The big banks won’t like that.”
In theory, investors didn’t need legal rules for protection, so long as they could trust LTCM’s traders to manage their risks appropriately. In early 1998, LTCM’s traders carefully checked the fund’s risk exposures by using its Value-At-Risk computer models, which estimated the maximum daily loss the fund would suffer with a 95 percent level of confidence, based on historical data. After crunching the numbers, the traders concluded that the fund’s VAR was $45 million—less than one percent of its capital. The models said that it would take LTCM several billion times the life of the universe before it would lose all of its capital on just one day.93
Unfortunately, the VAR models were wrong, and became even less accurate as LTCM lost money on bets in foreign bond and currency markets during May and June 1998. The fund lost 16 percent during that time—the first time it lost money in consecutive months.94 The traders decided to reduce their one-day exposure, based on their VAR models, from $45 million to $35 million, just to be safe. However, when they sold off some of their less attractive positions, and rechecked the models, the VAR measures had gone up, to over $100 million. The firm’s computer models were going haywire. It seemed that the traders had not properly accounted for liquidity risk—the risk that their bets would become more difficult to sell as trading dried up. Illiquid markets moved down much more quickly than liquid ones—think of trying to sell a million-dollar home when no one is buying—and LTCM’s sophisticated experts had not correctly modeled that risk.
In July 1998, Salomon Brothers decided it had become too difficult for its Arbitrage Group to make money, and shut its remaining traders down. Meanwhile, LTCM not only remained open, but pursued trades far removed from the Arbitrage Group’s original strategies, which had become less profitable as other traders learned of and implemented them. For example, LTCM had begun betting on whether particular corporate takeovers would be completed. The rationale was that after a company announced it was taking over another company, but before the takeover was completed, there was a small gap between the price of the shares of the target company and the value the target shareholders would receive at the time of the takeover. LTCM could buy shares of the target, sell shares of the acquirer, and wait for the values to converge.
In reality, it was more like praying for the values to converge than merely waiting. The reason for the price gap was that the companies might abandon the merger, and if they did, the value of the target shares would plunge. That was why the target’s shares would trade for $99 per share even after the acquirer had announced that it was planning to buy those shares for $100. The strategy of buying for $99 with the hope of getting $100 was sometimes labeled risk arbitrage—the ultimate finance oxymoron, for true arbitrage did not involve risk.
Nevertheless, LTCM embraced the strategy. It lost and then recouped $100 million on the takeover of MCI Communications: first betting that British Telecommunications would succeed as an acquirer, and then—when that takeover failed—betting that WorldCom would buy MCI.95 In August 1998, LTCM had made a large bet that Tellabs would complete its takeover of Ciena, and was “waiting” for the values to converge.
A glance at LTCM’s trades showed how much the firm had changed. It was no longer simply betting on the convergence of different financial assets to their historical levels; it also had begun speculating, not only on corporate takeovers, but in various international markets. It bet on bonds in so-called emerging markets, including Russia. It sold options on various European stock indices, making essentially the same outright gamble in Europe that Nick Leeson had made in Japan.
Selling options was a highly risky, but relatively simple strategy. The seller received cash today and kept the cash so long as markets did not move much. But if the markets were volatile, the seller’s potential losses were unlimited. It was the same desperate trading strategy Victor Niederhoffer—and before him, Nick Leeson of Barings—had tried. Selling options was far from the kind of complex, quantitative strategies that had earned Meriwether and his traders their reputations. Myron Scholes owed an apology to Andrew Chow, the derivatives manager from Conseco who had questioned whether LTCM could continue to find arbitrage opportunities. It could not.
In mid-August, Russia defaulted on some of its debts and devalued its currency, just as Mexico had in 1994, and Thailand had in 1997. Numerous hedge funds lost billions of dollars in total. George Soros’s fund was the big loser, at $2 billion.96 LTCM’s Russian losses were smaller.
The Russian collapse quickly infected other markets, as various hedge funds, banks, and other financial institutions that had borrowed to buy Russian bonds were forced to sell other investments to raise cash. Unfortunately, many of the institutions that owned Russian bonds also owned essentially the same other instruments: stocks and bonds in Latin America, Eastern Europe, and—again—East Asia. Once again, everyone had made the same bet on the financial roulette wheel. Just as investors in the early 1990s had bet in unison that interest rates would stay low, various institutions in 1998 had gambled on emerging markets. Memories of losses from the crisis in East Asia had barely lasted a year.
Banks worried that hedge funds might not be able to repay their debts, so they refused to lend them more money, forcing the funds to sell even more investments. Half of the two dozen so-called emerging markets were down by more than 35 percent in 1998, through August. Interest rates shot up as high as 40 to 80 percent in Brazil, Mexico, and Venezuela, countries that still did not have long-term bond markets and therefore were vulnerable to short-term investment outflows.97 The Mexican peso—which had stabilized around eight pesos per dollar (less than half its 1994 value)—fell to below ten pesos per dollar. The Malaysian government imposed controls on currency trading, to try to avoid another collapse. The Republic of Korea restricted the amount of money its large conglomerates—Chaebols—could borrow. Markets in Hungary, Poland, and the Czech Republic collapsed. The Economist magazine announced, “A contagious disease continues to spread through emerging markets,” and labeled the disease “Emerging-Market Measles.”98
LTCM had a diversified portfolio of investments, and its computer models had calculated that losses in some of these investments would be offset by gains in others. However, as investors bailed out of various risky assets, almost every market—except the most liquid U.S. Treasury bonds—went down in lockstep. Meriwether’s traders hadn’t anticipated this correlation. They had believed their portfolios were sufficiently diversified to survive even if the ball on the roulette wheel landed on black several times in a row. But now, all of LTCM’s supposedly uncorrelated bets were going down, at the same time. The ball was landing on black, over and over again.
In mid-August, LTCM lost money on bond investments in various emerging markets. On August 20, LTCM lost $100 million on its bet on the Tellabs-Ciena takeover, when analysts speculated the merger might be canceled. On August 21, LTCM lost $550 million on its basic convergence bets, as investors bailed out of relatively safe plain-vanilla interest-rate swaps, seeking the ultimate security of U.S.
Treasury bonds. Suddenly, the fund had lost 44 percent for the year.99
LTCM was down to about $2 billion of capital, and it still had $100 billion of debt. That debt had been manageable when the fund had $4 billion of capital. But now its leverage ratio was up to 50-to-1. Such leverage made LTCM’s returns hair-trigger sensitive to small changes in markets. Earlier, LTCM’s predicament had been analogous to trying to sell a million-dollar home when no one was buying; now, it was like trying to sell the same home with a mortgage of $980,000. How long could LTCM’s sliver of capital last? John Meriwether tried to refinance LTCM’s positions, to reduce the fund’s leverage ratio, but at this point no one was interested in giving LTCM any more money. He hurriedly sent a letter to investors blaming the collapse in Russia for the liquidity crisis, and assuring investors that LTCM was still alive.
Other traders smelled blood at LTCM, and began betting against the hedge fund, trying to weaken its positions, just as Andy Krieger had traded against the central bank of New Zealand. LTCM was known as the “central bank of volatility,” and it began experiencing a classic run on the bank. John Meriwether, who rarely gave interviews, told reporter Michael Lewis, “It was the trades that the market knew we had on that caused us trouble.”100 Although the firm’s investors were locked in and couldn’t withdraw their money, LTCM’s once-starstruck lenders were finally considering whether they should call in their billions of dollars of loans.
The final blow came in September, when volatility in nearly every market spiked upward, and LTCM sustained massive losses from its sales of long-dated stock options, mostly on the French and German stock indices. All the world’s markets were moving in lockstep, and LTCM was losing on nearly all of its trades. On September 21, the firm’s trades were worth less than $1 billion, and with leverage of more than 100-to-1, it would go under if the market even flinched.
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