LTCM may prove turning point for markets-economist
By Isabelle Clary
ANNANDALE-ON-HUDSON, N.Y., April 23 (Reuters) - The near-default of U.S. hedge fund Long-Term Capital Management (LTCM) may prove a turning point for financial markets because it showed liquidity and not asset pricing theories is key for trading strategies, a senior economist said on Friday.
''History will write about LTCM as an experience where modern finance was pushed as far as it could by its creators and came up short,'' Perry Mehrling, a Columbia University professor of economics who authored a paper on LTCM, told Reuters.
''The theory of modern finance assumes liquidity is a free good and it assumes perfect liquidity of markets, that all assets are equally and completely liquid,'' said Mehrling, a panelist at the Jerome Levy Economics Institute's conference on the global financial crisis.
''LTCM had made one bet and one bet only, that spreads would narrow, and they lost because they were unable to refinance when spreads widened instead,'' Mehrling said.
LTCM's strategy was based on arbitrage or the play benefiting from small changes in the yield spreads between two debt instruments, such as U.S. and Russian government securities, or mortgage-backed and Treasuries. The strategy was expected to yield large profits -- provided trading involved large volume resulting from high leverage and enjoyed a long time horizon.
But LTCM's arbitrage was essentially in one direction -- betting that all spreads will eventually converge.
''Arbitrage turned out not to create liquidity but rather only to stretch what liquidity there was across different markets,'' said Mehrling. ''LTCM bought illiquid assets and sold liquid assets, behaving as a market-maker far out on the illiquid margin of markets where dealers feared to tread.''
Mehrling said one problem well known to traders, but that believers in the modern finance theory ignore, is that liquidity is not always a readily available commodity.
''LTCM's founders, Nobel Prize winners Robert Merton and Myron Scholes among others, did not imagine they were doing anything terribly risky,'' he added. ''They were betting spreads would narrow over time. But the Asian crisis and then the Russian crisis caused spreads to widen instead.''
Merton and Scholes won the Nobel Prize for their work on financial asset pricing.
The Jerome Levy Economics Institute said the work of late U.S. economist Hyman Minsky provided the framework for its conference on financial crises.
Minsky, a professor of economics at Washington University, held the view that ''capitalism is essentially a financial system,'' because every activity -- from households' spendings to dealers' trading -- rests on the ability to finance and refinance private or business activities.
Unlike the followers of the modern finance theory, Minsky did not assume liquidity is a freely available good.
''From a 'Minskian' point of view, the problem that brought down LTCM was essentially a problem of refinance.''
Mehrling also justified the role the Federal Reserve played in the LTCM rescue, saying a default by the hedge fund would have taken down a clearinghouse handling U.S. Treasury bills futures which would have prompted ''defaults on Treasury bill futures... a threat to the very foundation of the (financial) system.''
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