HOW LONG-TERM CAPITAL ROCKED STOCKS, TOO (BW Nov. 09, 1998)
It wasn't just the bond market that LTCM endangered
It's widely believed that Long-Term Capital Management nearly collapsed because of huge bond trades. But that's only part of the story. Equally important were its gargantuan equity positions. What really shocked and alarmed Wall Street banks and brokerages was the havoc that an LTCM collapse would wreak in the stock market. ''We were most concerned about the equity book,'' says Jon S. Corzine, chairman, Goldman, Sachs & Co., referring to LTCM's equity holdings.
Wall Street execs who attended meetings at the New York Federal Reserve before the Sept. 23 bailout were startled at the enormous size of many of LTCM's equity positions. While each firm that traded with LTCM knew about its own positions, it was unaware of the extent of LTCM's trading with others. ''We knew about the fixed-income positions. We had no idea about the equity,'' says another banker involved in the $3.6 billion bailout. ''That's what scared Wall Street.'' Another top banker put it this way: ''It was a hand grenade ready to explode.''
The hedge fund was deeply involved in three types of equity trading: ''pairs'' trading, risk arbitrage, and bets on overall market volatility. A major Wall Street firm says that LTCM's arbitrage positions in merger stocks alone, called risk arbitrage, reached $6.5 billion, and LTCM's positions in individual takeover stocks were 5 to 10 times as large as this Wall Street firm's own arbitrage positions. Some pairs-trading positions were even larger.
Of most concern was a massive $2.3 billion position in Royal Dutch Petroleum and Shell Transport, two closely related stocks. This position is called a pairs trade, or an arbitrage between two stocks, often in the same industry, that usually move closely together but sometimes diverge. Shell Transport owns 40% of Royal Dutch/Shell Group, while Royal Dutch Petroleum (RD) owns 60% of Royal Dutch/Shell Group. Both get their income from dividends from Royal Dutch/Shell Group.
Historically, Shell had sold at an 18% discount to Royal Dutch. When the discount rose above that, LTCM bet that Shell was cheap compared to Royal Dutch. So LTCM effectively bought shares of Shell Transport and simultaneously sold shares of Royal Dutch. The idea: If oil stocks moved up, Shell would rise more than Royal Dutch, and if oil stocks moved down, Shell would fall less than Royal Dutch. Instead, the stocks diverged even further.
FORCED SELL. David H. Komansky, chief executive of Merrill Lynch & Co. (MER), feared that if LTCM had to liquidate its huge Shell position as well as its other equity positions, it would roil the prices of the two oil-company stocks as well as the overall stock market. Says Komansky: ''That whole potential scenario of unwinding their equity portfolio under a forced environment could have had extremely negative
consequences on the [overall] market.''
The dangers to the market were exaggerated by the way LTCM executed its positions. Rather than going the traditional route--buying stocks and selling stocks short--LTCM entered into total-return swaps with the Wall Street firms. This did two things: It allowed LTCM to pump
up its positions using leverage, and it shifted much of the risk from
LTCM to its trading partners--the Wall Street banks and brokerages.
Here's how a total-return swap works in risk arbitrage: LTCM wanted to
capitalize on the discrepancy between the prices of two companies that
had announced a merger, say, Citicorp (CCI) and Travelers (TRV) (table). Based on the merger terms, Citicorp is underpriced relative to Travelers. Rather than buying Citicorp, LTCM buys a total-return swap from a bank. The bank agrees to pay LTCM the total return on Citicorp stock--the stock appreciation and the dividend. If Citicorp declines, LTCM must pay the bank the decline in the stock price.
In effect, this allows LTCM to own the stock without putting up a penny in margin. But the bank that sold the swap must buy Citicorp stock to hedge itself against a rise in the stock price. If the price falls, the bank goes back to LTCM and asks for its money. The problem was that LTCM was fast running out of money. The bank was left with positions that were hard to unwind.
BAD BET. Since LTCM had its near-death experience, it has liquidated much of its risk-arbitrage portfolio, says a source close to LTCM, though it still has some of its pairs trades. But Wall Street remains troubled by the bets LTCM still has on market volatility, the third string in LTCM's equity-trading bow.
LTCM was wagering that the swings in the stock market, which had become very wide, would revert to a more normal, calmer pattern. How
does one make that bet? Generally, the more volatile a stock, the more expensive the puts (bets on a price decline) and calls (bets on a price increase). Similarly, the more volatile the overall stock market, the higher the prices of the puts and calls on the stock indexes.
Early this year, LTCM was convinced that volatility was abnormally high. To LTCM, that meant that the puts and calls on the indexes were
overpriced. The firm sold puts and calls on stock indexes to Wall Street firms, betting that volatility would decline and so, too, would the prices of these options. In the lingo of the Street, LTCM was ''short volatility.'' But the opposite happened: Instead of volatility declining, it reached record levels. And LTCM had to put up more collateral to cover its losses and maintain its put and call positions.
LTCM's foray into U.S. equity arbitrage began in 1995, only a year after the firm was started. LTCM's partners believed their bond expertise was transferable to stocks. ''They didn't think of themselves as just fixed-income people,'' says someone close to LTCM. The partners thought they could earn attractive returns and that such a move would proviDe diversification. And conceptually, stock arbitrage was similar to what the firm was already doing in bonds. LTCM would go long one bond and short another bond in the expectation that the spread between the two bonds would converge to its historical relationship.
LTCM never hired an experienced equity arbitrager, say sources close
to the firm. Instead, LTCM partner Lawrence E. Hilibrand headed the
hedge fund's move into equity arbitrage. Hilibrand made his name as a
quantitative expert on mortgage-backed securities as head of Salomon
Brothers Inc.'s bond-arbitrage group. LTCM was soon doing complicated trades, such as going long a basket of 30 stocks of target companies and short a basket of the 30 companies that were expected to acquire them. Stock arbitragers gradually became aware of the new 800-pound gorilla on the bloCk. ''Their whole m.o. was to take a relatively risk-free deal and lever it up,'' says one arbitrager.
For several years, risk arbitrage was profitable for LTCM, as was pairs trading and volatility. But in 1998, the world changed. In August, the firm got hit with massive losses in its fixed-income positions and in its various equity positions. LTCM was forced to liquidate its risk-arbitrage positions to meet margin calls. It's still holding its Shell position and its volatility trades, which are more difficult to unwind. That's why Goldman Sachs, one of six main firms managing the bailout, chose J. David Rogers, the head of its global equities trading, instead of a debt specialist, to sit on LTCM's oversight committee.
Since the bailout, equity markets have improved, and prices are less volatile than in August and September. This may have helped LTCM,
even though on Oct. 27, it laid off one-fifth of its staff. But if the markets convulse again, LTCM will have to come back to Wall Street for another transfusion.
By Leah Nathans Spiro, with Jeffrey M. Laderman, in New York
Copyright 1998, by The McGraw-Hill Companies Inc. All rights reserved. |
