For those wondering why the most brilliant minds on Wall Street collapsed Long Term Capital Management; please read on.*************
"This is exactly what the firm "headlined" in the news, Long -Term Capital Management (LTCM), did. John Meriwether (formerly the head of bond trading at Salomon Bros.) formed the company in Greenwich, Conn. in 1994, joined by two Nobel Prize winners in Economics, Merton Miller and Myron Scholes. LTCM "shorted" the U.S. government Treasury bond while buying higher-yielding corporate securities.
Their theory was that the "yield spread" between these two instruments, which had been widening during these times of financial stress, would return to normal yield differences. If it did, they would make a great deal of money. Well it didn't, and it hasn't. As an example, normal yield spreads of 6 percent widened at the peak of the recent crisis to 17 percent, and have only recently come down to 12 percent. LTCC is still losing money.
However, the problem with Long-Term Capital is not that it is losing money (it may lose only about $3-4 billion of shareholder money), but that to achieve its returns, company officials were able to borrow hundreds of billions of dollars from banks and brokerages to "place their bets." Small changes in interest-rate differentials could wipe out their collateral - and they did.
Now the banks and brokers own the assets of Long-Term Capital and Long-term investing is not easy.
they will continue to place collateral into the company until they can "unwind" the bets at a profit. This may take a year or more. Fourteen institutions ponied up capital to save Long -Term Capital Corp. and now own 90 percent of the company.
The new Magnificent Six.
Six "magnificent" individuals were chosen to oversee the daily operations. They are: the best "block trader" from Goldman Sachs, the co-head of global debt markets at Merrill Lynch, the head of fixed income's risk management unit at Morgan Stanley, the head of risk control at UBS, Morgan Guaranty's head of global fixed income (including derivatives), and the head of global fixed income/derivatives at Traveler's/Smith Barney.
As many of you probably noticed, the Federal Reserve got involved in this case. Its interest was in making sure that Long-Term Capital did not "unwind" its vast assets at distress prices. The very size of the company was the problem. Quick margin-call sales would roil the capital markets above and beyond anything fundamentally related to the general capital markets.
To further complicate matters and put the problem into a different perspective, the American Stock Exchange Broker/Dealer Index fell 45 percent from July 17 to Oct. 2, 1998. On Oct. 3, the same index rose 4 percent as investors anticipated the Group of Seven meeting in Washington, D.C. (Seven major industrial nations). The S&P 500 Index for the above dates fell 16.9 percent and then rose 2 percent on Friday, Oct. 3.
The reason for the sizable decline in the AMEX Broker/Dealer Index is that Wall Street's proprietary trading desks do much of the same thing as LTCM! As of Sept. 2, Wall Street firms were "short" $60 billion of U.S. Treasuries and "long" $63 billion of other similar, but higher-yielding, securities. The Federal Reserve has its work cut out for it in restoring "normalcy" back to the markets.
Our investment position
As you can see from the foregoing discussion, we live We have found that for every poor year there are three good ones.
in interesting times. We did not and could not have predicted the emergence and effect of Long-Term Capital Management on the U.S. and European scene. However, every major financial crisis of the last 40 years has produced an improvement in understanding by financial authorities and a new set of policies and regulations. We expect nothing less in this situation.
All the major financial policymakers are meeting in early October. We expect a lot of new discussions and changes in how capital around the world is managed. For example, we expect to see some kind of capital "controls" for emerging countries. We expect to see more pro-growth policies from the IMF's lending. We expect to see more regulation by banks of "hedge" funds. And we expect to see much lower interest rates in the U.S. and Europe.
As a matter of practice, we do not invest in "derivatives" or low-quality stocks or bonds. Our bond choices primarily are U.S. government securities and high-quality U.S. stocks. Some of our investments have been hurt this year in our currently hypersensitive psychological market. As companies experience a slowdown in orders due to the uncertainty of global issues, investors are "selling first; asking questions later." The good often is going down with the bad. We feel fortunate that we didn't invest offshore this year or in the smaller stocks. Table One reveals the range of performance produced this year by various asset classes.
Long-term investing is not easy. Each client has chosen to take the risks and volatility in trade for higher average returns over a time period beyond five years. The alternative is keeping money safe in bank CDs or money-market funds, whose returns over time have covered purchasing power or enhanced wealth positions.
One never knows when the markets will move one way or the other. We must rely on educated guesses. This why we are never really out of the market all together or invested fully at 100 percent.
We would like to remind readers and ourselves on a regular basis of a study done a few years ago. Cambridge Associates examined returns from 1982 to 1990. The S&P 500 averaged an 18 percent return. If you take out the 10 biggest days, the average return drops to 12 percent. Without the 20 biggest advances, the returns average 8 percent and without 30 days, the return drops to only 5 percent. At this point, you are better off to be in Treasury Bills.
With about 250 trading days per year over nine years, that's 2,250 treading days. Can you tell the right 10 or 20 days (less than 1 percent of the time) to be in the market? We can't and we have been in the business over 30 years. Since 1926, stocks returned an average of 11 percent, long-term bonds 5 percent and short-term assets 3.5 percent. During that time inflation was running at 3.2 percent and Real GNP was up 3.2 percent.
This is the logical reason to stay in the markets and accept the unnerving swings: for the hope of higher returns and increased wealth over inflation. All of our clients have a long- term horizon. Our actuarial life expectancy is 85 years old. At 45 years old, you have another 40 years, and at 65 that's another 20 years to let things work out. Stock prices follow growth in profits and growth in the economy. We have found that for every poor year there are three good ones. We expect this relationship to continue."
I have to add my two cents;;;;; LTCM sold short treasuries and we know what happened, the price of treasuries went very high. They bought high yield corporates and the price of junk bonds have decreased. Jane on this thread mentioned about the possibility of buying high yield corporates in August. I feel that now is the time and the much awaited yield narrowing of the spread between treasuries and high yields will occur over the next year. So for this reason sell the treasuries, take profits off the table and buy the junk.
Also the bigger picture. As God's people please do not leverage as LYCM did. Don't borrow against the house to buy stocks. Don't go on margin. Buy the stocks and forget the options. Free up your mind and emotions to let the Lord bless you and when we are out there winning souls into the kingdom let the Lord send his angels to look after your investments. In Christ.gregor
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