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January 20 - February 16, 2020
This one obscure arbitrage fund had amassed an amazing $100 billion in assets, virtually all of it borrowed—borrowed, that is, from the bankers at McDonough’s table. As monstrous as this indebtedness was, it was by no means the worst of Long-Term’s problems. The fund had entered into thousands of derivative contracts, which had endlessly intertwined it with every bank on Wall Street. These contracts, essentially side bets on market prices, covered an astronomical sum—more than $1 trillion worth of exposure.
I love a hedge, sir. —HENRY FIELDING, 1736 Prophesy as much as you like, but always hedge. —OLIVER WENDELL HOLMES, 1861
As far as securities law is concerned, there is no such thing as a hedge fund. In practice, the term refers to a limited partnership, at least a small number of which have operated since the 1920s. Benjamin Graham, known as the father of value investing, ran what was perhaps the first. Unlike mutual funds, their more common cousins, these partnerships operate in Wall Street’s shadows; they are private and largely unregulated investment pools for the rich. They need not register with the Securities and Exchange Commission, though some must make limited filings to another Washington agency, the
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The implicit logic is that if a fund is open to only a small group of millionaires and institutions, agencies such as the SEC need not trouble to monitor it. Presumably, millionaires know what they are doing; if not, their losses are nobody’s business but their own.
The term “hedge fund” is a colloquialism derived from the expression “to hedge one’s bets,” meaning to limit the possibility of loss on a speculation by betting on the other side. This usage evolved from the notion of the common garden hedge as a boundary or limit and was used by Shakespeare (“England hedg’d in with the maine”³).
investing in a hedge fund denoted a certain status, an inclusion among Wall Street’s smartest and savviest.
Similarly, Long-Term Capital would “borrow” by selling one group of bonds and lend by purchasing another—presumably bonds that were slightly less in demand and that therefore yielded slightly higher interest rates. Thus, the fund would earn a spread, just like a bank. Though this description is highly simplified, Long-Term, by investing in the riskier (meaning higher-yielding) bonds, would be in the business of “providing liquidity” to markets. And what did a bank do but provide liquidity? Thanks to Merton, the nascent hedge fund began to think of itself in grander terms.
Indeed, by snaring a central banker, Long-Term gained unparalleled access for a private fund to the pots of money in quasi-governmental accounts around the world. Soon, Long-Term won commitments from the Hong Kong Land & Development Authority, the Government of Singapore Investment Corporation, the Bank of Taiwan, the Bank of Bangkok, and the Kuwaiti state-run pension fund.
They [Long-Term] are in effect the best finance faculty in the world. —INSTITUTIONAL INVESTOR
On Wall Street, the older bond, which has about 29 ½ years left to mature, is known as off the run; the shiny new model is on the run. Being less liquid, the off-the-run bond is considered less desirable. It begins to trade at a slight discount (that is, you can purchase it for a little less, or at what amounts to a slightly higher interest yield). As arbitrageurs would say, a spread opens.
Imagine, by illustration, that a Red Sox fan and a Yankees fan agree before the season that each will pay the other $1,000 for every run scored by his rival’s team. Long-Term’s derivative contracts were not dissimilar, except that the payoffs were tied to movements in bonds, stocks, and so forth rather than balls and strikes.
banks saw the fund not as a credit-hungry start-up but as a luminous firm of celebrated scholars and brilliant traders, something like that New Age “financial intermediary” conjured up by Merton.
True, many other firms had done the same kind of trade. “But we could finance better,” an employee of Long-Term noted. “LTCM was really a financing house.”
Despite appearances, finding these “nickels” was anything but easy. Long-Term was searching for pairs of trades—or often, multiple pairs—that were “balanced” enough to be safe but unbalanced in one or two very particular aspects, so as to offer a potential for profit.
Klarman was perturbed by a seemingly reckless trend on Wall Street. Investment banks possessed of the equivalent of financial Veg-O-Matics were slicing and dicing financial assets into potent, newfangled securities—IOs and POs—that investors were scooping up with reckless élan.
Peter Rosenthal, Long-Term’s press spokesman, glibly explained, “Risk is a function of volatility. These things are quantifiable.”
The differential equations used to solve the Black-Scholes formula were adapted from physics equations that describe, among other phenomena in the physical world, the way cream spreads through a cup of coffee.4
If the population of price changes is strictly normal, on the average for any stock . . . an observation more than five standard deviations from the mean should be observed about once every 7,000 years. In fact such observations seem to occur about once every three to four years.9
David DeRosa, a currency trader who teaches at Yale, dubbed Value-at-Risk “a lighthouse for the soon-to-be-shipwrecked.”
During its first two years, in which Long-Term had earned a remarkable $1.6 billion, Italy contributed an estimated $600 million in profits. All told, it was the fastest, most impressive start by any fund ever.
Taking its derivative trades into account, its cash-on-cash return was probably less than 1 percent.24 The exact number is unimportant. The point is that almost all of its heady 59 percent return was due to the remarkable power of leverage.
By the spring of 1996, Long-Term had an astounding $140 billion in assets, thirty times its underlying capital. Though still unknown to 99 percent of Americans, Long-Term was two and a half times as big as Fidelity Magellan, the largest mutual fund, and four times the size of the next largest hedge fund.¹
Their total profits in 1996 were an astounding $2.1 billion.15 To put this number into perspective, this small band of traders, analysts, and researchers, unknown to the general public and employed in the most arcane and esoteric of businesses, earned more that year than McDonald’s did selling hamburgers all over the world, more than Merrill Lynch, Disney, Xerox, American Express, Sears, Nike, Lucent, or Gillette—among the best-run companies and best-known brands in American business.
Tisch left feeling that Long-Term didn’t know what it was doing. It was both inexperienced and highly leveraged—a potentially explosive combination.
Then, part of the deal was shifted to the bank’s treasury department, which paid a 5 percent premium.
Markets can remain irrational longer than you can remain solvent. —JOHN MAYNARD KEYNES
“We misread the haircuts that we needed to be protected,” Dunn admitted. “It wasn’t a mistake we made singly for Long-Term. The whole market was pressuring us. To suffer the organization telling you that you are losing business—it takes a tremendous amount [of courage] to stand up and say, ‘I’m not going to do it.’ The Street all got that collectively wrong.”
Writing to investors, J.M. reported that “future expected returns are good.”
On July 30, testifying before the Senate Committee on Agriculture, Nutrition, and Forestry, Greenspan declared that derivative traders “have managed credit risks quite effectively through careful evaluation of counterparties.”
The question . . . is whether the LTCM disaster was merely a unique and isolated event, a bad drawing from nature’s urn; or whether such disasters are the inevitable consequence of the Black-Scholes formula itself and the illusion it may give that all market participants can hedge away all their risk at the same time.
The professors hadn’t modeled this. They had programmed the market for a cold predictability that it had never had; they had forgotten the predatory, acquisitive, and overwhelmingly protective instincts that govern real-life traders. They had forgotten the human factor.
“We had no idea they would have trouble—these people were known for risk management. They had taught it; they designed it,” reflected Dan Napoli, the Merrill risk manager who had so enjoyed golfing with the partners in Ireland. “God knows, we were dealing with Nobel Prize winners!” Ironically, only a very intelligent gang could have put Wall Street in such peril. Lesser men wouldn’t have gotten the financing or attracted the following that resulted in such a bubble.
Fisher’s overall view of hedge funds was not dissimilar to Merton’s notion that Long-Term was essentially a bank.
However, Long-Term was not a bank, and the Fed does not have authority over hedge funds. Had Fisher demanded to see Long-Term’s books—or any hedge fund’s—it could in theory have refused. But in practice, Fisher routinely talked to traders at hedge funds, some of whom freely shared their opinions on the market and all of whom tacitly recognized the Fed’s authority.
Long-Term’s trades were linked—they had been correlated before the fact. “They had the same spread trade everywhere in the world,” Fisher thought. Gensler had a related thought: During a crisis, the correlations always go to one. When a quake hits, all markets tremble. Why was Long-Term so surprised by that?
Most of Long-Term’s outside investors came out ahead—saved, ironically, by the forced repatriation of their capital at the end of 1997. Some thirty-eight investors who had been lucky enough to invest at the inception and to have been mostly cashed out in 1997 finished with an average return of 18 percent a year—not quite as high as the major stock averages over the same span but very good all the same.
The mixed results of the outside investors in no way diminished the magnitude of Long-Term’s failure. Even with the headwind of its first four highly successful years, Long-Term’s final, cumulative loss was staggering. Through April 1998, the value of a dollar invested in Long-Term quadrupled to $4.11. By the time of the bailout, only five months later, precisely 33 cents of that total remained.
Will investors in the next problem-child-to-be, having been lulled by the soft landing engineered for Long-Term, be counting on the Fed, too? On balance, the Fed’s decision to get involved—though understandable given the panicky conditions of September 1998—regrettably squandered a choice opportunity to send the markets a needed dose of discipline.
The Fed’s two-headed policy—head in the sand before a crisis, intervention after the fact—is more misguided when viewed as one single policy. The government’s emphasis should always be on prevention, not on active intervention. It is altogether proper that the government set rules in advance for regulated bodies such as banks; crisis intervention on behalf of unregulated hedge funds is another matter.
The professors’ conceit was to think that models could forecast the limits of behavior. In fact, the models could tell them what was reasonable or what was predictable based on the past. The professors overlooked the fact that people, traders included, are not always reasonable. This is the true lesson of Long-Term’s demise. No matter what the models say, traders are not machines guided by silicon chips; they are impressionable and imitative; they run in flocks and retreat in hordes.
