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A Panicky Trip Down Memory Lane: Long Term Capital Management


Ten-year-old lessons went unlearned.

Editor's note: The following originally appeared on September 12, 2003 and in light of current events has been reprinted here for the benefit of the Minyanville community.

I have previously 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, LTCM (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 Citigroup (C). 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 he'd employed at Salomon: strategies that used very heavy leverage.

Minyanville's Why Wall Street Will Never Be the Same 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.

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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 30-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 30 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 it didn't use the 2 to 1 or 4 to 1 leverage described in our mortgage example: It was using 60 to 70 times leverage to gross the returns up to 40 to 50%.

Its business model was based on statistically figuring out the probability of the spreads going wrong and to what degree and placing bets accordingly. It made two mistakes. First, it underestimated the higher than normal correlation exhibited by assets when there is a large move in a macro variable, like currency rates. Second, it 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.

Unfortunately, it didn't have to wait eons for this to occur.

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