By David Shirreff
Barings, the Russian meltdown, Metallgesellschaft, Procter & Gamble, LTCM. These are all events in the financial markets which have become marker buoys to show us where we went wrong, in the hope that we won't allow quite the same thing to happen again. The common weakness, in these cases, was themisguided assumption that ‘our counterparty and the market it was operating in, were performing within manageable limits.’ But once those limits were crossed for whatever reason, disaster was difficult to head off.
The LTCM fiasco is full of lessons about:
1. Model risk
2. Unexpected correlation or the breakdown of historical correlations
3. The need for stress-testing
4. The value of disclosureand transparency
5. The danger of over-generous extension of trading credit
6. The woes of investing in star quality
7. And investing too little in game theory.
The latter because LTCM's partners were playing a game up to hilt.
John Meriwether, who founded Long-Term Capital Partners in 1993, had been head of fixed income trading at Salomon Brothers. Even when forced to leave Salomon in1991, in the wake of the firm's treasury auction rigging scandal (another marker buoy), Meriwether continued to command huge loyalty from a team of highly cerebral relative-value fixed income traders, and considerable respect from the street.
Teamed up with a handful of these traders, two Nobel laureates, Robert Merton and Myron Scholes, and former regulator David Mullins, Meriwether and LTCM hadmore credibility than the average broker/dealer on Wall Street.
It was a game, in that LTCM was unregulated, free to operate in any market, without capital charges and only light reporting requirements to the US Securities & Exchange Commission (SEC). It traded on its good name with many respectable counterparties as if it was a member of the same club. That meant an ability to put on interestrate swaps at the market rate for no initial margin - an essential part of its strategy. It meant being able to borrow 100% of the value of any top-grade collateral, and with that cash to buy more securities and post them as collateral for further borrowing: in theory it could leverage itself to infinity. In LTCM's first two full years of operation it produced 43% and 41% return on equity and hadamassed an investment capital of $7 billion.
Meriwether was renowned as a relative-value trader. Relative value means (in theory) taking little outright market risk, since a long position in one instrument is offset by a short position in a similar instrument or its derivative. It means betting on small price differences which are likely to converge over time as the arbitrage is spotted by therest of the market and eroded. Trades typical of early LTCM were, for example, to buy Italian government bonds and sell German Bund futures; to buy theoretically underpriced off-the-run US treasury bonds (because they are less liquid) and go short on-the-run (more liquid) treasuries. It played the same arbitrage in the interest-rate swap market, betting that the spread between swap rates and themost liquid treasury bonds would narrow. It played long-dated callable Bunds against Dm swaptions. It was one of the biggest players on the world's futures exchanges, not only in debt but also equity products.
To make 40% return on capital, however, leverage had to be applied. In theory, market risk isn't increased by stepping up volume, provided you stick to liquid instruments and don't get sobig that you yourself become the market.
Some of the big macro hedge funds had encountered this problem and reduced their size by giving money back to their investors. When, in the last quarter of 1997 LTCM returned $2.7 billion to investors, it was assumed to be for the same reason: a prudent reduction in its positions relative to the market.
But it seems the positions weren't reduced...