The Bull Market part 5
Post Mortem
The LTCM fiasco naturally inspired a hunt for scapegoats:
First in line were Meriwether and his crew of market professors.
Second were the banks which conspired to give LTCM far more credit, in aggregate, than they'd give a medium-size developing country. Particularly distasteful was the combination of credit exposure by the institutions themselves, and personal investment exposure by the individuals who ran them. Merrill Lynch protested that a $22 million investment on behalf of its employees was not sinister. LTCM was one of four investment vehicles which employees could opt to have their deferred payments invested in. Nevertheless, that rather cosy relationship may have made it more difficult for credit officers to ask tough questions of LTCM. There were accusations of "croney capitalism" as Wall Street firms undertook to bail out, with shareholders' money, a firm in which their officers had invested, or were thought to have invested, part of their personal wealth.
Third in line was the US Federal Reserve system. Although no public money was spent - apart from hosting the odd breakfast - there was the implication that the Fed was standing behind the banks, ready to provide liquidity until the markets became less jittery and more rational. Wouldn't this simply encourage other hedge funds and lenders to hedge funds to be as reckless in future?
Fourth culprit was poor information. Scant disclosure of its activities and exposures, by LTCM, as with many hedge funds, was a major factor in allowing it to put on such leverage. There was also no mechanism whereby counterparties could learn how far LTCM was exposed to other counterparties.
Fifth was sloppy market practice, such as allowing a non-bank counterparty to write swaps and pledge collateral for no initial margin as if it were part of a peer-group top-tier banks.
1. LTCM's risk management.
Despite the presence of Nobel laureates closely identified with option theory it seems LTCM relied too much on theoretical market-risk models and not enough on stress-testing, gap risk and liquidity risk. There was an assumption that the portfolio was sufficiently diversified across world markets to produce low correlation. But in most markets LTCM was replicating basically the same credit spread trade. In August and September 1998 credit spreads widened in practically every market at the same time.
LTCM risk managers kidded themselves that the resultant net position of
LTCM's derivatives transactions bore no relations to the billions of dollars of notional underlying instruments. Each of those instruments and its derivative has a market price which can shift independently, each is subject to liquidity risk.
LTCM sources apparently complain that the market started trading against its known positions. That seems like special pleading. Meriwether et al must have been in the markets long enough to know they are merciless, and to have been just as merciless themselves. "All they that take the sword shall perish with the sword." [Matthew, xxvi, 52]
2. Risk management by LTCM counterparties
Practically the whole street had a blind spot when it came to LTCM. They forgot the useful discipline of charging non-bank counterparties initial margin on swap and repo transactions. Collectively they were responsible for allowing LTCM to build up layer upon layer of swap and repo positions.
They believed that the first-class collateral they held was sufficient to mitigate their loss if LTCM disappeared. It may have been over time, but their margin calls to top up deteriorating positions simply pushed LTCM further towards the brink.
Their credit assessment of LTCM didn't include a global view of its leverage and its relationship with other counterparties.
A working group on highly leveraged institutions set up by the Basle Committee on Banking Supervision reported its findings in January, 1999 drawing many lessons from the LTCM case. It criticized the banks for building up such exposures to such an opaque institution. They had placed a "heavy reliance on collateralization of direct mark-to-market exposures" the report said. "This in turn made it possible for banks to compromise other critical elements of effective credit risk management, including upfront due diligence, exposure measurement methodologies, the limit setting process, and ongoing monitoring of counterparty exposure, especially concentrations and leverage."
The working group also noted that banks' "covenants with LTCM did not require the posting of, or increase in, initial margin as the risk profile of the counterparty changed, for instance as leverage increased". (For full reports, see "Sound Practices for Banks' Interactions with Highly Leveraged Institutions," and "Banks' Interactions with Highly Leveraged Institutions".) Another report in June, 1999 by the Counterparty Risk Management Policy Group, a group of 12 leading investment banks, suggested many ways in which information-sharing and transparency could be improved. It noted the importance of measuring liquidity risk, and improving market conventions and market practices, such as charging initial margin.
3. Supervision
Supervisors themselves showed a certain blinkered view when it came to banks' and securities firms' relationships with hedge funds, and a huge fund like LTCM in particular. The US Securities & Exchange Commission (SEC) appears to assess the risk run by individual broker dealers, without having enough regard for what is happening in the sector as a whole, or in the firms' unregulated subsidiaries.
In testimony to the House Committee on Banking and Financial Services on October 1, 1998, Richard Lindsey, director of the SEC's market regulation division recalled the following: "When the commission learned of LTCM's financial difficulties in August, the commission staff and the New York Stock Exchange surveyed major broker-dealers known to have credit exposure to one or more large hedge funds. The results of our initial survey indicated that no individual broker-dealer had exposure to LTCM that jeopardized its required regulatory capital or its financial stability.
"As the situation at LTCM continued to deteriorate, we learned that although significant amounts of credit were extended to LTCM by US securities firms, this lending was on a secured basis, with collateral collected and marked-to-the-market daily. Thus, broker-dealers' lending to LTCM was done in a manner that was consistent with the firms' normal lending activity. The collateral collected from LTCM consisted primarily of highly liquid asseets, such as US treasury securities or G-7 country sovereign debt. Any shortfalls in collateral were met by margin calls to LTCM. As of the date of the rescue plan, it appears that LTCM had met all of its margin calls by US securities firms. Moreover, our review of the risk assessment information submitted to the commission suggests that any exposure to LTCM existed outside the US broker-dealer, either in the holding company or its unregistered affiliates."
The sad truth revealed by this testimony is that the SEC and the NYSE were concerned only with the risk ratios of their registered firms and were ignorant and unconcerned, as were the firms themselves, about the market's aggregate exposure to LTCM.
Bank of England experts note the absence of any covenant between LTCM and its counterparties that would have obliged LTCM to disclose its overall gearing. UK banks have long been in the habit of demanding covenants from non-bank counterparties concerning their overall gearing, the Bank of England says. |
