NEAR-TERM PAYOFF AT LONG-TERM CAPITAL? (BW Nov. 16, 1998)
The markets start to benefit the hedge fund's new owners
It's too soon to say for sure, but there are signs that the worst may be over for Long-Term Capital Management, the Greenwich (Conn.) hedge fund that got creamed by bad guesses on the markets in August and September. Volatility in stock and bond trading has declined, and the spreads between safe and risky securities have narrowed. If those trends continue, Long-Term's bets will begin to pay off, and the companies that took over the fund in September will have a profitable investment on their hands.
Long-Term Capital's executives won't comment for the record on how well the fund is doing or divulge precisely what's in its portfolio, so any assessment of where it stands necessarily involves some guesswork. Although it's unlikely, it could be that the fund is sitting on some undisclosed positions that continue to deteriorate. It's also possible that the world's financial markets will once again sink into crisis. Indeed, a source close to the fund says, ''I wouldn't be quick to hoist up the flag that the fund is out of the woods.''
''BETTER SHAPE.'' But this same source says that the fund is in ''a lot better shape'' than it was in a few weeks ago. And the available evidence supports that contention. The markets have finally begun moving in a direction that plays into Long-Term Capital's core strategy. While the fund tries to keep its specific investments secret, some of its holdings have leaked out. What's more, its broad strategy is public knowledge. Its managers have said in letters to shareholders and in public statements that they were betting on, in essence, an improvement in the health of markets. Thatis, they made long-term bets that price fluctuations would shrink; that confident investors would increase their appetite for relatively risky securities; and that markets would be liquid--that is, there would be plenty of bidders around whenever someone wanted to sell.
For a while, those bets went disastrously awry--so much so that the original owners of Long-Term Capital Management ran out of money to meet all the margin calls and demands for collateral they were faced with. On Sept. 23, under the auspices of the Federal ReservE Bank of New York, 14 big banks and brokerage firms injected $3.6 billion to keep Long-Term Capital afloat and received 90% of the partnership's equity in return. But even that didn't stop the bleeding. Things continued to get worse after the takeover. Spreads got wider and volatility increased.
But more recently, things have begun to turn the other way (charts). For instance, it's believed that Long-Term Capital privately sold large numbers of options in the debt and equity markets, figuring that it could buy them back cheaper and close out its position at a profit. The assumption was that option prices would fall because market volatility would decrease. Bad guess: As markets went crazy, option prices shot up to historic levels. More recently, though, volatility has begun to recede in the bond market (left chart) as well as in the stock market (page 188).
Market participants say Long-Term also bought commercial mortgage-backed securities and shorted Treasury bonds, betting on a narrowing of the spreads between them. Instead, the spreads more than
doubled. Since mid-October, the spreads have narrowed, but only slightly (middle chart). The situation in commercial mortgage-backed securities is still worse than when the new owners took over the fund. It's not clear how much of the portfolio Long-Term dumped at fire-sale prices.
Another gamble that went bad for Long-Term: a bet on the convergence of short-term interest rates in Europe before the Jan. 1 move to a common currency, the euro (page 186, right chart). Italian and German three-month Treasury rates, which had been slowly converging, diverged dramatically at the end of August. Since then, they have returned to the differential of midsummer.
Several other indicators seem to signal better days ahead for Long-Term Capital. Liquidity is coming back, narrowing the unusually wide yield differentials between new 30-year Treasury bonds and older, less traded, issues. (Long-Term had bet on a narrowing of those spreads and was hurt when they widened.) Prices are returning toward their typical alignments. ''Slowly but surely, we're seeing the notion of relative value return to the market,'' says a risk manager at a Wall Street firm that's not part of the LTCM ownership consortium. Indeed, it's hard to find a single market that's continuing to go in the wrong direction from Long-Term's perspective.
The new owners appear to be in better shape than the original owners in two ways: They bought into Long-Term's positions cheaply, and they had deep enough pockets to ride out a month in which things got worse.
Indeed, the biggest problem of Long-Term Capital's original owners was that they built their massive positions primarily on borrowed money and didn't have the financial staying power--the deep pockets--to live up to their moniker's promise of hanging in for the long term. The new owners, some of the world's biggest financial institutions, look as though they'll be able to keep Long-Term Capital's bets in place. And if the markets keep going in the right direction, the payoff could be sweet.
By Peter Coy in New York
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