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1998

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I have described several episodes where excess systematic leverage has exacerbated volatility. Perhaps the most profound example was in 1998 when the turmoil that first struck the currency markets spilled over into other markets courtesy of Long Term Capital Management (for a great read and more detail on this pick up "When Genius Failed" by Roger Lowenstein).

In the spring of 1998 I was two years into running the trading and risk of equity derivatives for Lehman Brothers. Our business model was predicated on running a large customer facilitation business linked to a large proprietary book. I had some great traders working for me, people that really understood risk. This is why we ran into trouble with one of our customers, LTCM. We refused to do their trades.

LTCM was the brainchild of John Merriwether, the infamous bond trader formerly of Salomon Brothers. Salomon was a trading powerhouse known for taking risks others would not, that is until they took one risk too many. They were bought by Smith Barney, which was eventually bought by Citicorp. Mr. Merriwether took his hubris, a lot of brainpower, and a lot of capital and started a hedge fund based on many of the strategies that he had employed at Salomon, strategies that used very heavy leverage.

There are really only two types of strategies in investing and trading at the extremes (with all types of flavors in-between): high risk-high return strategies that employ no leverage and low risk-low return strategies that "leverage" those trades up to earn a reasonable return.

An example of a high risk-high return strategy might be betting on the lottery. There is a very low probability of winning, but a very high return if you do. Most people would understand that you should not borrow money to play the lottery; even if anyone was willing to lend you money for this purpose, which I doubt, you would quickly lose all the borrowed funds and go bankrupt.

An example of a low risk-low return strategy would be buying AAA municipal bonds. Now most people have a mortgage, so whether they realize it or not, in this situation they are borrowing money (using leverage) to earn a low rate of return on a low risk investment. Current thirty year mortgage rates are around 6.05% and AAA municipal bond rates are around 5.75%. If a person is in the 30% tax bracket, the after-tax cost of that borrowed money is 6.05% x .75 ((1-.3) = .6 but then you must adjust this up because of the alternative minimum tax) is 4.53%. So a person that borrows money in the mortgage market and uses that money to buy municipal bonds is earning 5.75% - 4.53 % = 1.22% net after tax. This is called a carry trade.

In this low return-low risk strategy, although it looks like there is little risk, there are things that can go wrong. What if the government changed the tax laws so that mortgage interest is no longer deductible? The small positive "spread" that you were earning would turn into a loss. Since you are locked into your mortgage and municipal bonds for a long period of time this loss would be catastrophic: it would eat away any small capital you have because it is based on borrowed funds. Why not just unwind the trade you ask? Because the prices of the mortgage and bonds would immediately reflect the new rules (because almost everyone has this trade on whether they realize it or not) and any unwinding would be at a loss that would equal the present value of the losses over thirty years.

LTCM specialized in this strategy, using obtuse trades that were supposedly low return and low risk and levered these trades to earn a return. The problem is that they did not use the two to one or four to one leverage described in our mortgage example; they were using 60 to 70 times leverage to gross the returns up to 40 to 50%. Their business model was based on statistically figuring out the probability of the spreads going wrong and to what degree and placing bets accordingly. They made two mistakes. First, they underestimated the higher than normal correlation exhibited by assets when there is a large move in a macro variable, like currency rates. Second, they glossed over the part of probability theory illustrated time and time again in our universe: even the statistically very improbable becomes almost certain over long periods of time. They unfortunately didn't have to wait eons for this to occur.

In late summer of 1998 the currency markets became extremely volatile as systematic leverage of another sort forced the exporting Asian economies to devalue their currencies. Normal correlations broke down and the high probability levered trades that LTCM had on in this market imploded.

But LTCM was making the same types of bets in many markets, including the equity market, and using derivatives to attain the leverage necessary to gross up returns. One favorite strategy that they were using was called a performance swap, a way to get around Regulation T of the Federal Reserve (which requires a customer to put up at least 50%, two to one leverage, when buying or selling a stock).

For example, let's say that LTCM wanted to be long 100,000 shares Apple Computer at $22.50 and short 100,000 shares Dell Computer at $33.50. Instead of buying and shorting these stocks at only two to one leverage, they would make an agreement (over the counter derivative) with a broker to pay or receive an amount based on the difference between the stock prices at the end of a certain period, say six months. A strike price is set on 100,000 at the beginning of the agreement equal to $33.50 - $22.50 = $11. At the end of the period if the difference between the stock prices is $15 LTCM owes the broker $400,000; if the difference is - $4 (AAPL goes to $30 and DELL goes to $26) the broker owes LTCM $1.5 million. This trade is not subject to Reg. T, so the broker is not required to ask for collateral (good faith money to secure the settlement of the trade). In 99% of theses trades, brokers did not ask for collateral. LTCM simply paid them a small fee and Wall Street assumed this big hedge fund run by brilliant people would always settle their trades.

And in fact they didn't. Their problems in the currency markets turned into problems in the bond market. Volatility began to pick up as LTCM attempted to unwind trades in one market as losses built in another. But LTCM simply did not have the capital to support all of the swaps done on heavy margin and quickly unraveled. The brokers with equity performance swaps were left with their hedges (in order to hedge their risk of being short AAPL and long DELL to LTCM through the swap, they had gone out in the stock market and actually bought AAPL and shorted DELL). Essentially what happened is that the brokers, who are not subject to Reg. T (because the government trusts them to understand and control leverage) had passed this exemption on to LTCM.

Even though all markets are in some way connected, LTCM through their vastness and heavy use of leverage, exacerbated this connection, which exacerbated volatility. Broker dealers, who have little capital themselves and were exposed to trades they had no way to control, drew near the brink of collapse. The Federal Reserve had to step in to avoid a meltdown by aggressively providing liquidity and I believe, even targeted a higher stock market (many of these swaps actually were leaning long the market).

I will never forget the day that for maximum effect, they lowered rates unexpectedly 50 basis points at 3:12 in the afternoon (after bonds closed), the day before a bond expiration and an option expiration. All those broker dealers who were long swaps, and consequently I believe, long stock, were able to sell into the rally and recoup their losses.


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