Interesting reading why Allen G. panicked, to save his friends who are reckless gamblers.
After reading this article I got even more angry.
In a nutshell if there are laws against gambling in the banking system why nobody is punished??
Why banks who are FDIC insured must deal in such swap deals??
We will end paying for the fat cats gambling losses!!
In this week Business Week
HOW LONG-TERM CAPITAL ROCKED STOCKS, TOO
It wasn't just the bond market that LTCM endangered
It's widely believed that Long-Term Capital Management
nearly collapsed because of huge bond trades. But that's only
part of the story. Equally important were its gargantuan equity
positions. What really shocked and alarmed Wall Street
banks and brokerages was the havoc that an LTCM collapse
would wreak in the stock market. ''We were most concerned
about the equity book,'' says Jon S. Corzine, chairman,
Goldman, Sachs & Co., referring to LTCM's equity holdings.
Wall Street execs who attended meetings at the New York
Federal Reserve before the Sept. 23 bailout were startled at
the enormous size of many of LTCM's equity positions. While
each firm that traded with LTCM knew about its own
positions, it was unaware of the extent of LTCM's trading with
others. ''We knew about the fixed-income positions. We had
no idea about the equity,'' says another banker involved in
the $3.6 billion bailout. ''That's what scared Wall Street.''
Another top banker put it this way: ''It was a hand grenade
ready to explode.''
The hedge fund was deeply involved in three types of equity
trading: ''pairs'' trading, risk arbitrage, and bets on overall
market volatility. A major Wall Street firm says that LTCM's
arbitrage positions in merger stocks alone, called risk
arbitrage, reached $6.5 billion, and LTCM's positions in
individual takeover stocks were 5 to 10 times as large as this
Wall Street firm's own arbitrage positions. Some pairs-trading
positions were even larger.
Of most concern was a massive $2.3 billion position in Royal
Dutch Petroleum and Shell Transport, two closely related
stocks. This position is called a pairs trade, or an arbitrage
between two stocks, often in the same industry, that usually
move closely together but sometimes diverge. Shell
Transport owns 40% of Royal Dutch/Shell Group, while
Royal Dutch Petroleum (RD) owns 60% of Royal Dutch/Shell
Group. Both get their income from dividends from Royal
Dutch/Shell Group.
Historically, Shell had sold at an 18% discount to Royal
Dutch. When the discount rose above that, LTCM bet that
Shell was cheap compared to Royal Dutch. So LTCM
effectively bought shares of Shell Transport and
simultaneously sold shares of Royal Dutch. The idea: If oil
stocks moved up, Shell would rise more than Royal Dutch,
and if oil stocks moved down, Shell would fall less than Royal
Dutch. Instead, the stocks diverged even further.
FORCED SELL. David H. Komansky, chief executive of
Merrill Lynch & Co. (MER), feared that if LTCM had to
liquidate its huge Shell position as well as its other equity
positions, it would roil the prices of the two oil-company
stocks as well as the overall stock market. Says Komansky:
''That whole potential scenario of unwinding their equity
portfolio under a forced environment could have had
extremely negative consequences on the [overall] market.''
The dangers to the market were exaggerated by the way
LTCM executed its positions. Rather than going the
traditional route--buying stocks and selling stocks
short--LTCM entered into total-return swaps with the Wall
Street firms. This did two things: It allowed LTCM to pump up
its positions using leverage, and it shifted much of the risk
from LTCM to its trading partners--the Wall Street banks and
brokerages.
Here's how a total-return swap works in risk arbitrage: LTCM
wanted to capitalize on the discrepancy between the prices of
two companies that had announced a merger, say, Citicorp
(CCI) and Travelers (TRV) (table). Based on the merger
terms, Citicorp is underpriced relative to Travelers. Rather
than buying Citicorp, LTCM buys a total-return swap from a
bank. The bank agrees to pay LTCM the total return on
Citicorp stock--the stock appreciation and the dividend. If
Citicorp declines, LTCM must pay the bank the decline in the
stock price.
In effect, this allows LTCM to own the stock without putting
up a penny in margin. But the bank that sold the swap must
buy Citicorp stock to hedge itself against a rise in the stock
price. If the price falls, the bank goes back to LTCM and asks
for its money. The problem was that LTCM was fast running
out of money. The bank was left with positions that were hard
to unwind.
BAD BET. Since LTCM had its near-death experience, it has
liquidated much of its risk-arbitrage portfolio, says a source
close to LTCM, though it still has some of its pairs trades. But
Wall Street remains troubled by the bets LTCM still has on
market volatility, the third string in LTCM's equity-trading bow.
LTCM was wagering that the swings in the stock market,
which had become very wide, would revert to a more normal,
calmer pattern. How does one make that bet? Generally, the
more volatile a stock, the more expensive the puts (bets on a
price decline) and calls (bets on a price increase). Similarly,
the more volatile the overall stock market, the higher the
prices of the puts and calls on the stock indexes.
Early this year, LTCM was convinced that volatility was
abnormally high. To LTCM, that meant that the puts and calls
on the indexes were overpriced. The firm sold puts and calls
on stock indexes to Wall Street firms, betting that volatility
would decline and so, too, would the prices of these options.
In the lingo of the Street, LTCM was ''short volatility.'' But the
opposite happened: Instead of volatility declining, it reached
record levels. And LTCM had to put up more collateral to
cover its losses and maintain its put and call positions.
LTCM's foray into U.S. equity arbitrage began in 1995, only a
year after the firm was started. LTCM's partners believed
their bond expertise was transferable to stocks. ''They didn't
think of themselves as just fixed-income people,'' says
someone close to LTCM. The partners thought they could
earn attractive returns and that such a move would proviDe
diversification. And conceptually, stock arbitrage was similar
to what the firm was already doing in bonds. LTCM would go
long one bond and short another bond in the expectation that
the spread between the two bonds would converge to its
historical relationship.
LTCM never hired an experienced equity arbitrager, say
sources close to the firm. Instead, LTCM partner Lawrence E.
Hilibrand headed the hedge fund's move into equity arbitrage.
Hilibrand made his name as a quantitative expert on
mortgage-backed securities as head of Salomon Brothers
Inc.'s bond-arbitrage group. LTCM was soon doing
complicated trades, such as going long a basket of 30 stocks
of target companies and short a basket of the 30 companies
that were expected to acquire them. Stock arbitragers
gradually became aware of the new 800-pound gorilla on the
bloCk. ''Their whole m.o. was to take a relatively risk-free
deal and lever it up,'' says one arbitrager.
For several years, risk arbitrage was profitable for LTCM, as
was pairs trading and volatility. But in 1998, the world
changed. In August, the firm got hit with massive losses in its
fixed-income positions and in its various equity positions.
LTCM was forced to liquidate its risk-arbitrage positions to
meet margin calls. It's still holding its Shell position and its
volatility trades, which are more difficult to unwind. That's why
Goldman Sachs, one of six main firms managing the bailout,
chose J. David Rogers, the head of its global equities trading,
instead of a debt specialist, to sit on LTCM's oversight
committee.
Since the bailout, equity markets have improved, and prices
are less volatile than in August and September. This may
have helped LTCM, even though on Oct. 27, it laid off
one-fifth of its staff. But if the markets convulse again, LTCM
will have to come back to Wall Street for another transfusion.
By Leah Nathans Spiro, with Jeffrey M. Laderman, in New York |
