The Bull Market part 2
Most of LTCM's bets had been variations on the same theme, convergence between liquid treasuries and more complex instruments that commanded a credit or liquidity premium. Unfortunately convergence turned into dramatic divergence.
LTCM's counterparties, marking their LTCM exposure to market at least once a day, began to call for more collateral to cover the divergence. On one single day, August 21, the LTCM portfolio lost $550 million, writes Lewis. Meriwether and his team, still convinced of the logic behind their trades, believed all they needed was more capital to see them through a distorted market.
Perhaps they were right. But several factors were against LTCM.
Who could predict the time-frame within which rates would converge again?
Counterparties had lost confidence in themselves and LTCM.
Many counterparties had put on the same convergence trades, some of them as disciples of LTCM.
Some counterparties saw an opportunity to trade against LTCM's known or imagined positions.
In these circumstances, leverage is not welcome. LTCM was being forced to liquidate to meet margin calls.
On September 2, 1998 Meriwether sent a letter to his investors saying that the fund had lost $2.5 billion or 52% of its value that year, $2.1 billion in August alone. Its capital base had shrunk to $2.3 billion. Meriwether was looking for fresh investment of around $1.5 billion to carry the fund through. He approached those known to have such investible capital, including George Soros, Julian Robertson and Warren Buffett, chairman of Berkshire Hathaway and previously an investor in Salomon Brothers [LTCM incidentally had a $14 million equity stake in Berkshire Hathaway], and Jon Corzine, then co-chairman and co-chief executive officer at Goldman Sachs, an erstwhile classmate at the University of Chicago. Goldman and JP Morgan were also asked to scour the market for capital.
But offers of new capital weren't forthcoming. Perhaps these big players were waiting for the price of an equity stake in LTCM to fall further. Or they were making money just trading against LTCM's positions. Under these circumstances, if true, it was difficult and dangerous for LTCM to show potential buyers more details of its portfolio. Two Merrill executives visited LTCM headquarters on September 9, 1998for a "due diligence meeting", according to a later Financial Times report (on October 30, 1998). They were provided with "general information about the fund's portfolio, its strategies, the losses to date and the intention to reduce risk". But LTCM didn't disclose its trading positions, books or documents of any kind, Merrill is quoted as saying.
The US Federal Reserve system, particularly the New York Fed which is closest to Wall Street, began to hear concerns about LTCM from its constituent banks. In the third week of September, Bear Stearns, which was LTCM's clearing agent, said it wanted another $500 million in collateral to continue clearing LTCM's trades. On Friday September 18, 1998, New York Fed chairman Bill McDonough made "a series of calls to senior Wall Street officials to discuss overall market conditions", he told the House Committee on Banking and Financial Services on October 1. "Everyone I spoke to that day volunteered concern about the serious effect the deteriorating situation of Long-Term could have on world markets."
Peter Fisher, executive vice president at the NY Fed, decided to take a look at the LTCM portfolio. On Sunday September 20, 1998, he and two Fed colleagues, assistant treasury secretary Gary Gensler, and bankers from Goldman and JP Morgan, visited LTCM's offices at Greenwich, Connecticut. They were all surprised by what they saw. It was clear that, although LTCM's major counterparties had closely monitored their bilateral positions, they had no inkling of LTCM's total off balance sheet leverage. LTCM had done swap upon swap with 36 different counterparties. In many cases it had put on a new swap to reverse a position rather than unwind the first swap, which would have required a mark-to-market cash payment in one direction or the other. LTCM's on balance sheet assets totalled around $125 billion, on a capital base of $4 billion, a leverage of about 30 times. But that leverage was increased tenfold by LTCM's off balance sheet business whose notional principal ran to around $1 trillion.
The off balance sheet contracts were mostly nettable under bilateral Isda (International Swaps & Derivatives Association) master agreements. Most of them were also collateralized. Unfortunately the value of the collateral had taken a dive since August 17.
Surely LTCM, with two of the original masters of derivatives and option valuation among its partners, would have put its portfolio through stress tests to match recent market turmoil. But, like many other value-at-risk (Var) modellers on the street, their worst-case scenarios had been outplayed by the horribly correlated behaviour of the market since August 17. Such a flight to quality hadn't been predicted, probably because it was so clearly irrational.
According to LTCM managers their stress tests had involved looking at the 12 biggest deals with each of their top 20 counterparties. That produced a worst-case loss of around $3 billion. But on that Sunday evening it seemed the mark-to-market loss, just on those 240-or-so deals, might reach $5 billion. And that was ignoring all the other trades, some of them in highly speculative and illiquid instruments.
The next day, Monday September 21, 1998, bankers from Merrill, Goldman and JP Morgan continued to review the problem. It was still hoped that a single buyer for the portfolio could be found - the cleanest solution.
According to Lewis's article LTCM's portfolio had its second biggest loss that day, of $500 million. Half of that, says Lewis, was lost on a short position in five-year equity options. Lewis records brokers' opinion that AIG had intervened in thin markets to drive up the option price to profit from LTCM's weakness. At that time, as was learned later, AIG was part of a consortium negotiating to buy LTCM's portfolio. By this time LTCM's capital base had dwindled to a mere $600 million. That evening, UBS, with its particular exposure on a $800 million credit, with $266 million invested as a hedge, sent a team to Greenwich to study the portfolio.
The Fed's Peter Fischer invited those three banks and UBS to breakfast at the Fed headquarters in Liberty Street the following day. The bankers decided to form working groups to study possible market solutions to the problem, given the absence of a single buyer. Proposals included buying LTCM's fixed income positions, and "lifting" the equity positions (which were a mixture of index spread trades and total return swaps, and the takeover bets). During the day a third option emerged as the most promising: seeking recapitalization of the portfolio by a consortium of creditors.
But any action had to be taken swiftly. The danger was a single default by LTCM would trigger cross-default clauses in its Isda master agreements precipitating a mass close-out in the over-the-counter derivatives markets. Banks terminating their positions with LTCM would have to rebalance any hedge they might have on the other side. The market would quickly get wind of their need to rebalance and move against them. Mark-to-market values would descend in a vicious spiral. In the case of the French equity index, the CAC 40, LTCM had apparently sold short up to 30% of the volatility of the entire underlying market. The Banque de France was worried that a rapid close-out would severely hit French equities. There was a wider concern that an unknown number of market players had convergence positions similar or identical to those of LTCM. In such a one-way market there could be a panic rush for the door.
A meltdown of developed markets on top of the panic in emerging markets seemed a real possibility. LTCM's clearing agent Bear Stearns was threatening to foreclose the next day if it didn't see $500 million more collateral. Until now, LTCM had resisted the temptation to draw on a $900 million standby facility that had been syndicated by Chase Manhattan Bank, because it knew that the action would panic its counterparties. But the situation was now desperate. LTCM asked Chase for $500 million. It received only $470 million since two syndicate members refused to chip in.
To take the consortium plan further, the biggest banks, either big creditors to LTCM, or big players in the over-the-counter markets, were asked to a meeting at the Fed that evening. The plan was to get 16 of them to chip in $250 million each to recapitalize LTCM at $4 billion. |
