heavily that those instruments would return to normal levels. Because of its early success and the pedigrees of its principalsâincluding former Salomon Brothers bond chief John Meriwether and Nobel Prize-winning economists Myron Scholes and Robert MertonâLTCM was able to use leverage to amplify its bets many times.
Thanks to leverage, LTCMâs exposure was greater than $100 billion. Furthermore, the fund was able to negotiate cut-rate prices for financing from many Wall Street firms, who were enamored of and infatuated by the fundâs mysterious nature. So great was the allure of LTCM that many of its financiers mimicked the fundâs trades (see Figure 6.1 ).
Thus, many big Wall Street firms were exposed to similar risk throughout 1998. When Russia defaulted on its debt in August of that year, spreads on emerging market bonds not only didnât revert to normal levels, but continued to widen. The widening credit spreads were taking an unhealthy bite out of LTCMâs portfolio. In less than four months, the fund lost nearly $5 billion.
As LTCMâs losses began to accumulate, the fund had no choice but to liquidate whatever it could to stay afloat. Markets had been digesting its gains since April, but speculation about LTCMâs troubles was starting to make the rounds. As rumors of the fundâs losses spread, the Dow fell from its high near 8,700 in mid-August 1998 to as low as 7,400 in early Septemberâa rapid-fire 15 percent decline.
The Asian flu took place halfway across the world, and required little in the way of a Fed response. LTCM, by contrast, was in Greenwich, Connecticutâmuch closer to home. Most of the 19 primary dealersâbanks and brokerages that directly trade government securities with the Federal Reserveâwere involved. They all had lent LTCM much of its leverage, and stood to lose $100 billion if the firm collapsed.
Figure 6.1 1997 Asian Flu, 1998 LTCM
Too Smart for Their Own Good
Long-Term Capital Management (LTCM) used sophisticated trading techniques, but its business model was fairly simple. Using proprietary software, the traders identified price spreads that were wrong according to the quantsâ models. However, these price discrepancies were very small on a percentage basis. In order to make money doing this, they had to use leverage to make the price differentials add up to anything significant. This meant LTCM borrowed lots and lots of money against their investorsâ cash, and then put that to work following the computerâs algorithms.
Since the bond market is so deeply tradedâmillions of traders trade trillions of dollarsâ worth every dayâeven with the leverage, their choices were limited. So they took the road less traveled, or in LTCMâs case, the bond less traded. Ordinary Treasuries could not satisfy their itch; instead, their proprietary models found ever rarer and more exotic fixed-income instruments. These were not well followed or understood, nor were they deeply traded. The quants at LTCM thought this gave them an advantage, as they understood these instruments better than many, indeed most. Off they went in search of lesser-known markets. Leaving the main river, they soon found themselves in unknown eddies, trading exotic fixed-income marketsâlike those soon-to-be defaulting Russian bonds.
This worked well, so long as prices were behaving as the models forecast. Wide spreads were supposed to tighten, and rising prices were supposed to keep rising. Once prices stopped behaving as the models forecast, however, trouble soon followed.
The leverage that so enhanced returns on the way up began to slaughter capital on the way down. For those trading their capital without leverage, a 10 percent loss is a relatively minor inconvenience. If you are leveraged 10 to 1, however, a 10 percent loss wipes you out totally.
And if youâre leveraged 100 to 1 like LTCM was, well, then youâre just begging for
Thanks to leverage, LTCMâs exposure was greater than $100 billion. Furthermore, the fund was able to negotiate cut-rate prices for financing from many Wall Street firms, who were enamored of and infatuated by the fundâs mysterious nature. So great was the allure of LTCM that many of its financiers mimicked the fundâs trades (see Figure 6.1 ).
Thus, many big Wall Street firms were exposed to similar risk throughout 1998. When Russia defaulted on its debt in August of that year, spreads on emerging market bonds not only didnât revert to normal levels, but continued to widen. The widening credit spreads were taking an unhealthy bite out of LTCMâs portfolio. In less than four months, the fund lost nearly $5 billion.
As LTCMâs losses began to accumulate, the fund had no choice but to liquidate whatever it could to stay afloat. Markets had been digesting its gains since April, but speculation about LTCMâs troubles was starting to make the rounds. As rumors of the fundâs losses spread, the Dow fell from its high near 8,700 in mid-August 1998 to as low as 7,400 in early Septemberâa rapid-fire 15 percent decline.
The Asian flu took place halfway across the world, and required little in the way of a Fed response. LTCM, by contrast, was in Greenwich, Connecticutâmuch closer to home. Most of the 19 primary dealersâbanks and brokerages that directly trade government securities with the Federal Reserveâwere involved. They all had lent LTCM much of its leverage, and stood to lose $100 billion if the firm collapsed.
Figure 6.1 1997 Asian Flu, 1998 LTCM
Too Smart for Their Own Good
Long-Term Capital Management (LTCM) used sophisticated trading techniques, but its business model was fairly simple. Using proprietary software, the traders identified price spreads that were wrong according to the quantsâ models. However, these price discrepancies were very small on a percentage basis. In order to make money doing this, they had to use leverage to make the price differentials add up to anything significant. This meant LTCM borrowed lots and lots of money against their investorsâ cash, and then put that to work following the computerâs algorithms.
Since the bond market is so deeply tradedâmillions of traders trade trillions of dollarsâ worth every dayâeven with the leverage, their choices were limited. So they took the road less traveled, or in LTCMâs case, the bond less traded. Ordinary Treasuries could not satisfy their itch; instead, their proprietary models found ever rarer and more exotic fixed-income instruments. These were not well followed or understood, nor were they deeply traded. The quants at LTCM thought this gave them an advantage, as they understood these instruments better than many, indeed most. Off they went in search of lesser-known markets. Leaving the main river, they soon found themselves in unknown eddies, trading exotic fixed-income marketsâlike those soon-to-be defaulting Russian bonds.
This worked well, so long as prices were behaving as the models forecast. Wide spreads were supposed to tighten, and rising prices were supposed to keep rising. Once prices stopped behaving as the models forecast, however, trouble soon followed.
The leverage that so enhanced returns on the way up began to slaughter capital on the way down. For those trading their capital without leverage, a 10 percent loss is a relatively minor inconvenience. If you are leveraged 10 to 1, however, a 10 percent loss wipes you out totally.
And if youâre leveraged 100 to 1 like LTCM was, well, then youâre just begging for
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