Why Total-Return Swaps Scare Wall Street (...BW Nov. 09, 1998)
This example demonstrates how banks and brokerages would have faced huge equity losses if LTCM had defaulted
THE DEAL
Under the proposed merger of Citicorp and Travelers, each Citicorp share will be exchanged for 2.5 shares of Travelers. But on June 1, for example, Citicorp stock was selling for $153 a share, while Travelers traded at $63, a ratio of 2.43 to 1. Each Citicorp share should be selling for $157.50.
THE PLAY
To capture this 3% premium, LTCM could buy, say, 1 million shares of Citi at $153 and shorts 2.43 million shares of Travelers. Instead of buying Citicorp stock, LTCM buys a total-return swap from Firm X. In this swap, Firm X agrees to pay LTCM the total return on Citicorp stock. LTCM agrees to pay Firm X a fixed interest rate in exchange. And LTCM shorts Travelers not at Firm X but through its account at Firm Y.
THE BLOWUP
By Sept. 23, Citi's stock has declined to $95 a share. Under its swap
arrangement, LTCM posts $58 million with Firm X to cover the losses.
But if LTCM defaults, Firm X is left with its Citi stock and no offsetting short position in Travelers stock since LTCM did the short trade with Firm Y. Firm X would be forced to dump Citi stock in a declining market.
THE SAFETY NET
Firm X hedges itself by buying 1 million shares of Citicorp stock at $153. This way, if Citi goes up, Firm X's profits on its Citi shares offset its payments to LTCM. If Citi declines, Firm X's share losses are offset by payments from LTCM (since Citi's total return is negative).
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