Rumors spread that LTCM had weakened. LTCM believe that other companies used their weakness as an opportunity to strengthen. Wall Street firms began to duplicate LTCMs investment strategies, which weakened LTCMs market position. The institution was weak and owned a huge portion of the market. Of course, other companies would want to destroy LTCM to strengthen their own positions. Another suggested contributor to the near collapse of LTCM is as follows.
A large number of positions in the LTCM portfolio depended on a narrowing of the spread between two related securities (i.e. hedging two securities). This means that investors take a long position (i.e. buy) the higher yielding security, and take a short position (i.e.
sell) the lower yielding security and hope the spread will narrow. When substantial leverage is used, the spread can be extremely profitable if the spread relationship remains constant or narrows. In fact, betting on volatility in markets this way leads to a “catch-22” situation. A firm is betting on markets to be volatile, and will profit when they are, but buying derivative securities such as volatility swaps and straddles is a zero-sum game.
When the firm profits, its counterparty loses, which makes the firm less likely to collect their money because the loss could put the counterparty into bankruptcy. This is called “counterparty risk”, and LTCM was certainly affected by it when the liquidity in Russian and Asian markets dried up. If the liquidity had been available, LTCM might have been able to survive. Therefore, the problem was not necessarily the leverage LTCM employed; the lack of market liquidity might have been a more direct cause of the funds failure.
Other companies with similar trades were trying to narrow these spreads at the same time. This caused spreads to widen, resulting in big losses by banks and highly leveraged hedge funds such as LTCM.13 LTCM lost money at unprecedented rates. After returning over 40% for three consecutive years, the fund lost US$500 million, on two consecutive days.14 Very few firms, if any, have the liquidity not to be overwhelmed by a US$1 billion loss in a period of 48 hours. LTCM became insolvent very suddenly, and the portfolios value continued to plummet due to psychological market reactions (i.e.
loss of confidence, changed credit ratings). Over a six-week period in August/September 1998, LTCM lost approximately US$4.4 billion, and would have declared bankruptcy had it not been for the FRBNYs intervention. ? How The Fed Saved LTCM and Why They Did So The FRBNY saved LTCM from bankruptcy by consolidating fourteen American investment banks and securities firms to collectively bail out LTCM for $3.625 billion in September 1998. The company still exists, and John Meriwether is now involved in slowly reimbursing many of the funds initial investors for what Myron Scholes calls a “non-fault bankruptcy.”15 Why did the Fed go to such trouble to rescue this particular company? What did it stand to gain by doing so? What was it trying to accomplish or avoid? The answer is that after conducting an audit of LTCMs books, the FRBNY recognized the strategic importance of this firms international financial position. The FRBNY was concerned that LTCMs default could pose great danger to the entire international financial system due to the size, nature and complexity of the wealth they had spread around the globe. The international significance of LTCMs investments is discussed in the following section.
LTCMs International Significance LTCM had spread its investment position into 75 different nations, in order to avoid concentrating risk in any one given area.16 This ultimately worked to the funds detriment, as its position nearly created an international catastrophe. However, it also worked to LTCMs benefit, as the Fed would not have saved them were they not so extensively diversified and internationally important. However, the financial well being of LTCM was of no direct concern to the supervisory authorities of the United States. Rather, the FRBNY saved LTCM to prevent the potential direct and indirect effects of LTCMs failure on other financial markets and institutions around the world.17 Direct losses, such as those to credit positions and owners of LTCMs capital, would likely have been controllable, but were not the concern of the FRBNY anyway. However, the Fed was concerned about the consequences of LTCMs default on the functioning of the financial system, i.e.
the systematic effects associated with the global market resulting from LTCM. Potentially, the default could have affected liquidity to the degree that markets would have been unable to function properly. This might have had serious negative effects on the positions and soundness of financial intermediaries, including even those institutions that had no direct trading with LTCM. In addition, the FRBNY feared that loss of confidence in the functioning of credit markets would lead to extreme risk aversion, thereby threatening the viability of debt markets and ultimately the ability of businesses to borrow and invest. For these reasons, the FRBNY was motivated to keep LTCM liquid enough so as to avoid this calamity. Central banks and supervisory authorities have recognized the importance of maintaining financial stability in the past few decades.
The increased interaction between large institutions has increased the rapid spread of financial problems across institutions and markets. Financial problems, such as sharp reduction of financial resources, may have negative consequences on production, welfare and employment. Since the supervision of registered investment institutions does not protect against investment risks, a large equity base and trading position hedge fund, such as LTCM, may pose a threat to financial stability. In this context, supervisory authorities were worried about the size of trading positions, the potentially high leverage and the lack of disclosure by these institutions.
It leads one to ask; was LTCM an isolated incident? Could another firm pose this sort of danger again? In national forums and in an international context, authorities are discussing the improvement of disclosure of financial data by unregulated participants in financial markets. This can be done on a voluntary basis with initiatives towards self-regulation of groups of institutions or by internationally coordinating regulations. Supervisory authorities support this idea, but doubt whether increased disclosure is enough to fix the potential problems large hedge funds, such as LTCM, can create.18 ? Lessons Learned LTCMs near default has caused banks to become more aware of the risks associated with investing in hedge funds. The difficulty of analyzing and monitoring a hedge fund contributes to the risk.
Also, since hedge funds are not limited by regulations, institutions operating hedge funds can assume more leverage. Another factor contributing to risk is a hedge fund’s reliance on properly functioning financial markets and models, making systematic risk very prominent. To avoid another such a number of banks have tightened their lending policy to such institutions. Advantages of hedge funds include an improvement of market liquidity (under normal circumstances) and an improvement of market efficiency through value-at-risk (VAR) trading. Disadvantages may be periodic increases in volatility, which the LTCM case exemplified, and a concentration of risks in unregulated markets. If banks and securities firms are more careful in their use of hedge funds, the systematic risks associated with the use of hedge funds could be reduced.
This is because the size of positions taken by hedge funds increases the systematic risk in those markets. The LTCM case brought to light a number of important issues. The Committee of G-10 banking supervisors made recommendations to help improve banks’ risk management. A paper on sound practices is geared towards guiding banks and supervisory authorities when considering a credit relationship with hedge funds or other highly levered institutions. The first recommendation is that organizations should only invest in institutions with a sound lending strategy.
In other words, the organization must consider the institutions’ desired risk/return ratio, diversification objectives, and risk management framework. The second recommendation is that if a bank does decide to do business with highly leveraged institutions, it should conduct a thorough and frequent analysis of the credit-worthiness of the institution, i.e the risk profile and risk management of the institution. Finally, banks should concentrate on risk measurement of derivative positions, collateral management and the use of attendant covenants.19 Summary Ultimately, the cause of LTCMs near default was a combination of its excessive use of leverage, the inefficiency of the Black-Scholes model under extreme market conditions, the drying-up of liquidity in financial assets, social and psychological investment factors, and global systematic risk. The Fed did not underestimate the importance of LTCM to the international financial system, as shown by the FRBNYs US$3.625 billion intervention. The most frightening aspect of the whole ordeal was how quickly and efficiently one American firm, a hedge fund, was able to position itself as a real potential threat to the global economy.
It is difficult to believe that LTCM was actually so special as to be the only firm that could ever accomplish such an obscene feat. The private mutual funds industry may need to be further regulated, or at least controlled, in order to avoid a reoccurrence. Banks and financial institutions learned a valuable lesson from the LTCM fiasco, as these institutions will now be more cautious in doing business with hedge funds.
