Chuzz & All... talk about leverage! BW article on LTCM
HOW THE GAME WAS
PLAYED--AND WHY
LONG-TERM LOST
Its computer models didn't foresee how bad bad could be
The rocket scientists at Long-Term Capital Management wrote the book on
how to use derivatives. Now, they can write the sequel on how to misuse
them.
Long-Term didn't make money the old-fashioned way, by searching out
assets whose inherent value was not reflected in the market. Instead, it bet on
the interior dynamics of the markets themselves: exploiting anomalies in the
price difference between, say, two bonds with different credit ratings or
between shares of merging companies. Instead of using derivatives to hedge
against risk, Long-Term mainly used them as enhancers--amplifying its
gambles and ultimately amplifying its losses when bets proved wrong.
As it pursued this strategy, the hedge fund in Greenwich, Conn., was able to
make bets on the markets entirely out of proportion with its financial
resources. And now the bailout of the fund is being hampered by the difficulty
of unwinding these complicated investment plays that consist, mainly, of
bundle upon bundle of these investment products known as derivatives--the
squishy value of which is based on the worth of underlying securities.
What's shocking about the screwup is thAt no one should have understood
derivatives better than LTCM. Partners Myron S. Scholes and Robert C.
Merton shared a 1997 Nobel Prize in economics for options-pricing theory,
the basis of the derivatives business.
To be sure, the exact positions that Long-Term Capital holds remain secret.
(Anyone who knows what the new owners plan to liquidate could profit by
betting the other way.) Still, the general outlines of Long-Term's strategy are
known. Here, in a nutshell, is how it played the game--and how it was able to
pile up such huge stakes that Wall Street and the Federal Reserve ultimateLy
decided it was too big to fail.
Long-Term's favorite bet was on the difference in the yield, or rate of return,
between two debt instruments. Let's say that five-year junk bonds rated BB3
usually yield about two percentage points more than five-year Treasuries
because of their higher risk. Long-Term's strategists might bet that if the yield
spread ever got much wider than two percentage points, it was likely to
narrow again soon.
Computer models would show that's a smart bet. But with the global economy
in turmoil, investors lost their appetite for risk. Starting in July, they fled junk
bonds and poured money into Treasuries. That pushed yields higher on junk
bonds and lower on Treasuries. By late September, the yield spread had
widened to a punishing 2.8 percentage points (chart). Instead of converging,
the yields diverged.
NO ONE KNOWS. Long-Term Capital made matters worse by using
derivatives to increase the size of its bets without borrowing. For instance, it
could have made a bet such as the one above without putting up a penny.
Instead of spending $100 million for a portfolio of junk bonds and shorting a
like-size T-bond portfolio, Long-Term may have used a popular derivative
known as a swap. In a swap, no money changes hands initially because
typically the two parties start out by paying each other equal amounts.
Long-Term would agree to pay the current yield on $100 million of junk bonds
and would receive in turn the current yield on $100 million of Treasuries (plus
some fixed percentage markup to make it a fair trade). The $100 million is
called a ''notional amount'' since neither party owns the underlying securities.
How much did Long-Term Capital risk? By some estimates, it had bets with
''notional amounts'' of $1 trillion or more. But that overstates risks, since many
of its positions essentially offset each other. While its balance sheet showed
about $100 billion in assets on a capital base of less than $4 billion, its true
risk came from derivative deals that don't appear on the balance sheet at all.
The firms that took it over are still sorting out what they've inherited.
The beauty of a swap is that if the spread moves in your favor, you can make
enormous profits without tying up any of your own money--in essence, your
leverage is infinite. If the spread moves against you, though, you have to
come up with correspondingly large amounts of collateral. Prudent firms won't
enter huge swap deals unless they have capital adequate to withstand severe
moves against them. Long-Term Capital's partners and its lenders apparently
ignored that principle--or seriously underestimated how bad bad could be.
Risk-assessment computer models ''tend to ignore low-probability
catastrophic events,'' says Henry T.C. Hu, a law professor and derivatives
expert at the University of Texas.
Still, how could one small firm's bad bets threaten the entire U.S. financial
system, to the point where the Federal Reserve Bank of New York brought
together 14 major financial institutions to bail it out? Simple: Not knowing how
much aggregate risk Long-Term Capital was taking on, these same firms
extended enormous amounts of credit because Long-Term had always paid
off in the past. ''It's a bit like a junkie with crack. You gotta have more of this
stuff,'' says a banking industry consultant. By mid-September, Long-Term
owed so much money that its failure might have set off a worldwide chain
reaction of creditors cutting off credit. In other words, a liquidity crisis.
Keeping Long-Term Capital on life support became even more important,
since most derivatives aren't readily salable. One bet might employ half a
dozen derivatives to hedge out various unwanted risks. Like the twigs in a
bird's nest, each derivative is worth less alone than as part of a carefully built
whole.
SHOT IN THE ARM. The injection of $3.6 billion in fresh capital into LTCM will
allow it to meet its margin calls, easing fears of a ripple effect. And Long-Term
Capital's new owners will be able to keep many of the firm's core bets in place
with hopes that convergence will ultimately make the bets pay off.
On the other hand, some important spreads have actually widened in recent
weeks. The Federal Reserve's Sept. 29 rate cut should help. But if new
margin calls and money-losing asset sales eat away too much of its current
rescue package, Long-Term Capital might need to be bailed out all over
again.
By Peter Coy in New York
RELATED ITEMS
CHART: Diverging Yields
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