WHEN GENIUS FAILED

THE RISE AND FALL OF LONG-TERM CAPITAL MANAGEMENT

Agenda
INTRODUCTION: Rise and fall of LTCM
-Background- LIU SHUANG -Example of trade- ZHANG ZHENGZHOU -Size & liquidity- DAVID CHLEBECEK -The unfavorable events- ZHANG XI & ELINA KOZMENKO -Rescue of LTCM- WANG YAO

ANALYSIS: What went wrong?

-Risk factors- TANG LEI & MIAO LIQIANG -VAR- YANG JIE

DISCUSSION: How should LTCM avoid failure?

-How should LTCM avoid failure- WU XIN

Background of LTCM

Background of LTCM
The Constellation of Elite
John Meriwether -MBA in Chicago University. -The founder of arbitrage group in Salomon 1980s -Brought the nerds to the trading floor Eric Rosenfeld -MIT Ph.D., HBS professor Victor Haghani -Master in LSE, joined Salomon in his twenties. Larry Hilibrand -Ph.D., MIT Gregory Hawkins -MIT Ph.D., Pupil of Merton. William Krasker -MIT Ph.D. Robert C. Merton Myron Scholes -The BSM model and Nobel Laureates David W. Mullins -The vice chairman of the US Federal Reserve

Fund Development
$1.2 3BLN

$3 BLN

$6.7 BLN

- 1994: LTCM launching campaign raised $1.23 billion - 1994: LTCM raised additional $2 billion - 1997: LTCMs net capital reached $6.7 billion
Source: LTCM

- Monthly return volatility: -3% to 8% - Return creation slows down in 1997 - The accumulation of net performance index slows down in 1997

Trading Strategy & Financing

Hallmark Strategy
- Relative value Long convertible bond, short equity - Convergence trade Long off-the-run Treasury bond, short on-the-run Treasury bond Other Strategy - Directional trade Unhedged long position in French Government bonds Long-term Financing

- Stringent 3-year lockup period - $230 million unsecured loan and $700 million unsecured revolving line of credit - 6 to 12 month maturity repo

Source: LTCM, L.P. (A)

LTCM Structure & Role

LTCM Performance
Year Feb to Dec, 1994 1995 1996 Jan to Aug, 1997 Return 19.9% (unannualized) 42.8% 40.8% 11.1% (unannualized)

Protection Seller

- Counterparty to hedger and work directly with end clients - Provide liquidity to the market
- Major competitor are bulge bracket trading floor instead of other hedge funds

LTCM Fee Structure

Management fee 2% p.a. Performance fee 25% p.a.

Hedge Fund Fee Structure

Management fee 1% p.a. Performance fee 20% p.a.

Source: LTCM, L.P. (A)

Risk Management & Leverage

Risk Management
Method Return

Leverage
Company LTCM Salmon Inc. Morgan Stanley Lehman Brothers Banker Trust Chase Manhattan D/A* 22.5 42.5 26.5 33.2 21.9 15.6

VaR Economic stress test

Correlation test

Scenario Analysis
The correlation of profits across positions

Risk over horizon

Different consideration over horizon

Correlation test - LTCMs leverage is lower than what figure indicates.

Source: LTCM Note: *average ratio for LTCM from Jun 94 to Aug 97. Banks ratio is for 1996.

Agenda
INTRODUCTION: Rise and fall of LTCM
-Background -Example of trade -Size & liquidity -The unfavorable events -Rescue of LTCM

ANALYSIS: What went wrong?

-Risk factors -VAR

DISCUSSION: How should LTCM avoid failure?

-How should LTCM avoid failure

Treasury Bond-Swap spread trade

- Long the spread
The swap rate (measure of macro economy)>TB yield (risk free)

Buy the bond through repo market

LTCM
B0 B0 bonds

Collateral B0 bonds

Bank

Loan B0-haircut

LTCM needs to fund the haircut with its working capital

Enter the swap as the fixed rate payer

- When spread is very small, LTCM can get positive cost of carrypure arbitrage. - LTCM can hold to maturity. Not an optimal situation for LTCM. - As long as swap spread is considered to be small compared to historical range LTCM would take this trade. Scenarios: - Swap spread remains constant: no effect. - Swap spread decrease: value of bond decreases relative to the value of swap LTCM loses money. - Swap spread increase: value of bond increases relative to the value of swap LTCM makes money. So LTCM looks forward to a widening spread, hoping bond yield decreases relative to the fixed swap rate.

Closing position
- Sell the bond in the repo market
Return Collateral B0 bonds

LTCM
Loan B0-haircut + repo cost B1 Sell B1 bonds

Bank

Terminate the swap position by offsetting.

Short the spread

- Short the bond through reverse repo
Borrow B0 bonds

LTCM
B0 Sell B0 bonds

Bank

Loan B0-haircut

Enter the swap as fixed rate receiver, short the swap spread.

Enter the swap as fixed rate receiver

- When the spread is very large, LTCM can get positive cost of carry. Scenarios: - Swap spread remains constant: no effect - Swap spread decrease: value of bond decreases relative to the value of swap LTCM makes money. - Swap spread increase: value of bond increases relative to the value of swap LTCM loses money. So LTCM looks forward to shortening spread, hoping bond yield increase relative to the fixed swap rate.

Agenda
INTRODUCTION: Rise and fall of LTCM
-Background -Example of trade -Size & liquidity -The unfavorable events -Rescue of LTCM

ANALYSIS: What went wrong?

-Risk factors -VAR

DISCUSSION: How should LTCM avoid failure?

-How should LTCM avoid failure

Size
1997: 6.7 billion USD, borrowed up to 125 billion

100 different strategies, 7600 positions,

Became too big

Wanted to redeem at least part of the investors to lower the size

Danger-people knew what the fund was doing-couldnt hide-taking opposite positions Leverage ratio 19:1 (up to 31:1)

Liquidity-financing
- Two way mark to market - Secured financing might become difficult to obtain or too expensive

- Institution wanted to lend them money-favorable terms

Liquidity-market
- Underestimated liquidity as a risk factor
- During crises, flight to liquidity=buy US, sell emerging, shift in liquidity (LTCM too big, when they sell the price drops even more, they loose even more)

- Problems with liquidating their big positions, sharp drops in prices, liquidation slow

Agenda
INTRODUCTION: Rise and fall of LTCM
-Background -Example of trade -Size & liquidity -The unfavorable events -Rescue of LTCM

ANALYSIS: What went wrong?

-Risk factors -VAR

DISCUSSION: How should LTCM avoid failure?

-How should LTCM avoid failure

Russia Default

3.5 weeks later of bond issue

Rather than simple printing money

Default on rouble

Blocked foreign transaction by Russia banks.

Increasing spread btw Eur mkt and emerging mkt bond

LTCM bet on narrow spread

[18 Aug 1998] Russia Default its gov. debt

Tellabs canceled acquisition

Tellabs abruptly canceled the acquisition of Ciena Corp

Widening Spread
Spread between the two firms stock prices widened dramatically.

LTCM suffered a significant loss in a risk arbitrage position

No Acquisition

Loss

Widespread efforts to liquidate similar positions in August 1998

- Many of the world leading banks had put on the same convergence trades. - In adverse market movements taking positions up to or beyond the risk limits, the traders have to try to cut their losses and sell.

- In August 1998, widespread efforts to liquidate broadly similar positions in roughly the same markets had intensified the adverse movements.
- Correlations between historically only loosely related markets were enhanced.

LTCMs difficulties became public

- On 2 September Meriwether sent a letter to the companys investors, describing its financial situation and seeking to raise further capital. - Letter was read as evidence of desperation. - No one could be persuaded to buy an asset that LTCM was known or believed to hold. - Some counterparties saw an opportunity to trade against LTCMs known positions.

Agenda
INTRODUCTION: Rise and fall of LTCM
-Background -Example of trade -Size & liquidity -The unfavorable events -Rescue of LTCM

ANALYSIS: What went wrong?

-Risk factors -VAR

DISCUSSION: How should LTCM avoid failure?

-How should LTCM avoid failure

Rescue LTCM
- September 1998, LTCM avoided bankruptcy.
- Not to protect LTCMs investors, creditors, or manager from loss, but to avoid the distortion to market processes caused by a fire-sale liquidation and the consequent spending of those distortions through contagion. ----Alan Greenspan

Rescue LTCM
- The participating banks got 90% share in the fund and a promise the a supervisory board would be established.
$300 million: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P.Morgan, Morgan Stanley, Salomon Smith Barney, UBS $125 million: Soci tG n rale $100 million: Lehman Brothers, Paribas Bear Stearns declined to participate.

- LTCMs partners received a 10% stake, still worth about $400million, but this money was complete consumed by their debts.

Alternatives to the Restructuring

- The Buffet offer
- Berkshire Hathaway, AIG, and Goldman Sachs would be willing to buy the fund for $250 million. - LTCM partners with no stake in the firm - The management of LTCM rejected the offer, and one can only presume that they did so because they were confident of getting a better deal from the Fed. - The bid was formally structured to purchase the assets of LTCM which did not include the portfolio.
Source: Dowd, Kevin. 1999. Hedge Funds and the collapse of Long-Term Capital Management, Journal of Economic Perspectives.

Agenda
INTRODUCTION: Rise and fall of LTCM
-Background -Example of trade -Size & liquidity -The unfavorable events -Rescue of LTCM

ANALYSIS: What went wrong?

-Risk factors -VAR

DISCUSSION: How should LTCM avoid failure?

-How should LTCM avoid failure

What went wrong?

- Cocktail risks

Excess leverage

- In 1997, LTCM believed that - In 1998, LTCMs capital base investment opportunities were not shrank significantly and leverage large and attractive enough. went up as high as 55. - LTCM chose to return 2.7 billion of - LTCM faced difficulty to meet capital to investor. margin calls. - As a result , the leverage went up to 28.

Excess leverage

- The ability of withstanding unfavorable market movements is compromised when using dramatic leverage.
- The failure of LTCM does not mean use of leverage is bad, but it is very dangerous if excessive leverage is present.

Liquidity Issue
- LTCM underestimated the probability of a market crisis and potential for a flight to liquidity. - Globalization and time compression: High sigma events are more likely to occur. - Poor liquidity management in 1998. - LTCM was a big player and liquidity of its positions dried up in a liquidity crisis.

Too concentrated
- LTCMs positions were too concentrated on related risk factors, and were singularly undiversified . - Large positions that were exposed to liquidity, credit and volatility spreads. - Swap spread trade - Equity volatility trade

Complex Adaptive System

- The spread convergence trades were fundamentally sound in the long term.

- The real world is a complex adaptive system.

- Whether the spread would widen or narrow depended on actions of other players. - LTCM was very large, but no player is larger than the market.

Agenda
INTRODUCTION: Rise and fall of LTCM
-Background -Example of trade -Size & liquidity -The unfavorable events -Rescue of LTCM

ANALYSIS: What went wrong?

-Risk factors -VAR

DISCUSSION: How should LTCM avoid failure?

-How should LTCM avoid failure

VAR
Basic understanding

VAR should be viewed as a measure of risk capital necessary to support a financial activity.

How to calculate capital needs

Assumptions Daily Std (market risk) $100 million

Time Horizon 1 year

Trading Days (within 1 yr) 252 days

Default Probability 0.022%

Calculation Annual Std Normal Distribution $5.6 billion

$1.6 billion
-

LTCM stated that its target daily volatility was $45 million around May 1998 (based on 4.7 billion capital). However, the actual daily volatility was closer to $100 million.

Weak Assumptions in VAR

1. In reality, hedge funds return distribution is asymmetric: skewness and kurtosis should be taken into account.

Merton: long positions in credit-sensitive instruments can be interpreted as short positions in options, which have limited upside potential and large downside risks.

How to calculate capital needs

Assumptions Daily Std (market Time Horizon risk) $100 million 1 year Trading Days (within 1 yr) 252 days Default Probability 0.022%

Calculation Annual Std $1.6 billion

Normal Distribution
$5.6 billion

Student tDistribution (6 degree) $12.6 billion

Student tDistribution (4 degree) $20.4 billion

LTCMs capital (after distributing 2.7 billion to its investors): $4.7 billion

Weak Assumptions in VAR

2. Volatility is changing over time.
The assumption of constant volatility is mistaken, which in fact can easily double in turbulent times.

Weak Assumptions in VAR

3. Actual correlation may change over time.
The correlation between highly-correlated assets may drop especially when the assets are credit-sensitive. E.g. corporate bonds V.S. Treasury.

4. Time compressionDanger of measuring event risks based on the very recent data.
Estimating risk based on the recent history, LTCM assigned a low predicted exposure to events such as sovereign defaults and market disruptions.

5. Price-taker assumption is inappropriate.

The size of the fund is large enough to affect the price. The very size made it impossible to maneuverer once it had loss $2.3 billion.

Agenda
INTRODUCTION: Rise and fall of LTCM
-Background -Example of trade -Size & liquidity -The unfavorable events -Rescue of LTCM

ANALYSIS: What went wrong?

-Risk factors -VAR

DISCUSSION: How should LTCM avoid failure?

-How should LTCM avoid failure

How should LTCM avoid failure

Shall LTCM take this risky strategy - Mainly bet on the convergence - Totally independent of the trend of market - Highly possible to huge loss in volatility market. High leverage to accumulate the tiny profit

Fall of LTCM
May 1998 June 1998 End of June 1998 -6.7% -10.1% The principal found the loss could be quite surprising Decrease some relative value position Trimmed directional reads Increase the most profitable position 7 July 1998 22 July 1998 August 17 August 21 August 23 august Disband the bond team Market move adversely Cut 5% position where possible Small loss from Russian default , 10% U.S \U.K T swap spread widened

Event driven position loss

Other market participants shrink their position Market trade volume declined

How should LTCM avoid failure

Know yourself and beat yourself - Know your strength and why you success. - Never fight the market. - Never be a price maker.

How should LTCM avoid failure

Know the market - A significant volatility is always followed by aftershocks. - Full dynamic hedging must be proceeded when black swan event happens. - Monitor the assumptions of your model. - Market participants reaction.

How should LTCM avoid failure

Know your position - Base all risk management on the payoff of certain position.

- Do not take the positions you do not know where the loss comes from.