Episode 6: Long Term Capital Management

 Jim Grenn:  1996 was a banner year for many large blue-chip corporations like Disney, Dell, and Nike.  And on a personal note, I learned how to walk.  Disney released their blockbuster movie ‘Toy Story’ on VHS. 101 Dalmatians enjoyed success at the box office.  They acquired the media giant ABC, and even reached an agreement to purchase a stake in the Anaheim Angels.  Disney also set a record for amusement park attendance in 1996.  In total, Disney employed more than 100,000 people and recorded $1.2 billion in net income.    

Dell Computers launched their new website; Dell.com, the company was averaging $1 million in sales per day.  Their share price tripled over the course of the year. 

Meanwhile, Nike signing an amateur golf prodigy named Tiger Woods to a large endorsement deal and the company’s poster boy, Michael Jordan led the Chicago Bulls to another championship and the best record in NBA history.  Air Jordan’s flew off the shelves.  Across the board, corporate profits soared and the stock roared to new highs.

Meanwhile, in Greenwich, Connecticut, a world away from all that action, a small hedge fund with less than 100 employees made more money than Disney, Nike and Dell in 1996…Combined.  

This is Domino.  A podcast that explore a historic event that had a ripple effect on the global economy.

Hi, this is Jim Grenn and I’m your host.  We are examining the story of Long Term Capital Management – the most successful and talked about hedge fund at the time and how things quickly went so wrong that it threatened the fabric of the financial system and give rise to a new term “too big to fail” 

Kent Oliver:  The origins of Long Term Capital Management begins in the 1980s with a guy named John Meriwether.    

Jim Grenn: that’s Kent Oliver.  Our big picture guy.

Kent Oliver:  John W. Meriwether made a name for himself heading up the bond arbitrage desk for Solomon Brothers in the 1980s.  He became somewhat infamous in 1991 when he was fined $50,000 by the SEC for a scandal involving Treasury bonds…. Meriwether survived the scandal, but many didn’t.  Warren Buffett- a large shareholder in Salomon actually became the company’s chairman and CEO briefly.

Jim Grenn: Interesting.

Kent Oliver:  But most folks would know Meriwether best from his role in Michael Lewis’ book Liar’s Poker in which Meriwether reportedly bet $10mil on a single bet during a popular game that involved bluffing about serial numbers on dollar bills.

Jim Grenn:  I read that – it was a pretty solid book.

Kent Oliver:  Anyway, Meriwether’s bond arbitrage desk was a relatively obscure division within the investment firm, but it was highly profitable.  Few outside of the division truly understood what the traders actually did.  Even fewer knew the inner-workings like Meriwether. 

Jim Grenn: can you give our listeners a detailed explanation of bond arbitrage.

Kent Oliver: No… But Meriwether was confident that few could replicate the strategy.  Having overseen the division for years, Meriwether felt confident that he could create his own firm and replicate the strategies without having to share profits with the rest of the firm.  In 1993, he decided to put his strategy to the test and founded Long Term Capital Management (LTCM). 

Brady Raanes:  Meriwether offered key positions to his most talented bond traders at Solomon Brothers and attracted academics with PhDs from MIT and Harvard as partners.  His new firm was even able to boast of having two Nobel Prize winning economists on their staff, Myron Scholes and Robert Merton.

Jim Grenn: That’s Brady Raanes, you probably know him by now.

Brady Raanes:  Scholes and Merton were big names.  They are credited for inventing the option pricing model used on Wall Street today.  I mean, these guys carried weight in the financial world.

Jim Grenn: Ok, so these smart guys come together to form a new investment firm… and it’s structured as a hedge fund.  let’s discuss hedge funds.  What is a Hedge Fund?

Brady Raanes: So, a hedge fund is an unregulated investment vehicle charged with investing money for institutions and the ultra-wealthy investors.  It’s unregulated so they are free to invest any way it sees fit without oversight from a government regulatory body.  They could also use as much leverage as they could borrow to fund their investments.

Kent Oliver:  Long Term Capital Management chose this approach because they were going to be using some pretty exotic stuff, and leverage was a big part of their strategy.  They used a handful of different strategies to generate their returns, but one unique trait was central to most strategies; Long Term Capital Management didn’t actually own anything. 

Jim Grenn:  Please explain.

Kent Oliver:  Rather than purchase individual stocks and bonds like most investors, Long Term Capital chose to use investments known as swaps and futures contracts, essentially placing side bets on price movement without actually owning anything. 

Jim Grenn:  Ok, we need to get a little deeper with that…   

Brady Raanes:  That may be a bit much.  Ok, so imagine if a gambler wished to profit from the outcome of a professional basketball game he wouldn’t need to own the team, he could simply place a bet on the outcome of the game.  If team A wins, for example, the gambler collects money.  If team A losses, the gambler loses his wager.

However, rather than simply betting on a win or a loss which would result in a 100% gain or 100% loss, a savvy gambler may enter into an agreement with a fan of the opposing team to swap money for every point scored.  Under that hypothetical bet, the investor may choose to pay $1 for every point scored by team A and collect $1 for every point scored by the opposing team.   A quick look back at past NBA games may reveal that the average margin of victory is 4 points.  Therefore, on average, the gambler could safely assume that $4 will be the average amount to change hands at the end of a typical game. 

Kent Oliver:  Such a strategy may even allow the gambler to wait until the game was in process before entering into a bet.  The gambler may wait until one team trailed by a large amount, say 30 points, before agreeing to swap dollars for points on the belief that the trailing team will eventually rally and close the gap in points.    

Brady Raanes:  Margins of victory can vary greatly.  Sometimes teams win by 20 points, or 40 points… but rarely does a team win by 60 points.  In fact, some fun trivia for you… the largest loss in NBA history is 68 points (Cavs beat the Heat 148-80 on Dec 17, 1991). 

Jim Grenn: Great trivia there… is that common knowledge for you?

Brady Raanes: Yes.

Anyway, by structuring bets in this manner, a gambler may be relatively confident that losses or gains will rarely exceed past extremes.   This was Long Term Capital Management’s playbook: wait until an extreme divergence from the usual, then make a large bet that the gap would close.  The technical term for this strategy is called ‘reversion to the mean.’   

Jim Grenn: So what method did they use to place these bets if they didn’t own anything?

Brady Raanes: They used something called “swaps” where two investors agreed to “swap” the returns of one asset for the returns on another asset.  Much like the $1 per point in the basketball analogy.

Kent Oliver:  A typical swap for Long Term Capital may involve swapping the return on Italian bonds in return for the return on French bonds over a certain period of time.  In such an agreement, Long Term Capital would profit so long as Italian bonds outperformed French bonds.  It didn’t matter if both bonds both went up, or both bonds went down so long as the Italian bonds went up more or down less than the French bonds. 

Brady Raanes:  In other words, to come back to the basketball analogy didn’t matter if the final was 150-149 or 79-78 – either way someone won by 1 point…

Kent Oliver:  Right.  So. Anyway, using historical norms as their guide, Long Term Capital would study probabilities based on computer models to indicate abnormalities relative to the past. 

Brady Raanes:  Long Term Capital employed this logic to structure dozens of low risk / high probability / low return bets with varying degrees of complexity.  In order to increase returns, LTCM employed leverage of as much as 30:1, meaning they invested $30 into an investment despite having only $1 of actual cash.  The rest why borrowed from banks.  By placing several different low risk bets at once, LTCM felt comfortable that all bets wouldn’t go wrong at the same time.  However, with leverage of that magnitude, a mere 3% loss would completely wipe the equity in the entire fund. 

Jim Grenn: But how was LTCM able to borrow so much money?  And was that even legal?

Brady Raanes:  As an unregulated investment vehicles hedge funds are not required to disclose any details about their strategy, holdings, or leverage.  Long Term Capital relished this fact, and proudly shrouding their strategy in mystery.  No one had to know how much LTCM was borrowing.  This also allowed them to employ massive amounts of leverage with a variety of different Wall Street banks, each of whom happily extended billions of dollars in credit with little to no collateral, largely unaware that multiples other banks were extending the same credit. 

Jim Grenn: Ok, interesting. 

Kent Oliver:  Another thing to know about hedge funds – they charge pretty hefty fees.  LTCM would charge 25 percent of profits each year, plus two percent of however they managed.  And investors were required to keep their money with LTCM for a minimum of three years. These standards were incredibly uncommon, even for a hedge fund in the 1990s.

Jim Grenn: Good lord, who would agree to that?

Kent Oliver: Well, that’s why they needed all those smart guys on staff – to convince the investors that they had a strategy that couldn’t be replicated. 

Brady Raanes:  Long Term Capital enjoyed success right out of the gate, posted a 40% gain in 1994, their first official year of operation.  Just 9 months into operation, Businessweek wrote an article introducing the investment world to the “Dream Team.”   LTCM followed up their stellar year by earning 55% in 1995, and a staggering 71% in 1996.  Early investors, thrilled with their returns, happily doubled down, adding as much as they could. 

Jim Green:  So obviously their strategies are working?

Brady Raanes:  Yeah, the numbers were phenomenal.  By 1996, the firm had over 100 employees and $140 billion in assets. That year they brought in total profits of $2.1 billion.

Kent Oliver:  But this is where the partners begin to make fatal mistakes.  They really have more money than they know what to do with and they begin to venture into other investments outside their areas of expertise. 

Jim Grenn:  Like what? 

Kent Oliver:  Well, perhaps not outside their expertise, but at least outside of their computer models.  They began investing in individual stocks and bonds.  Things like Brazilian bonds, Russian bonds, and Danish mortgages.

Brady Raanes:  And… the numbers are so great they decided to start getting a little selfish.  The partners reasoned that if they started giving investors their money back, the partners would personally own a larger portion of the fund, and thus, could keep more of the profits.  They returned 2.7 Billion to investors.  The partners bought in even more, and by the end of 1996 each had invested a substantial amount of their personal net worth into the fund. 

Jim Grenn:  So, in the last episode we discussed Thailand’s currency meltdown that started in 1997 and spread throughout the region and even impacted US markets.  Was LTCM able to navigate than landmine? 

Kent Oliver:  A great episode by the way.  If you aren’t familiar, you should take 30 minutes and go listen to it. 

Brady Raanes: LTCM was able to navigate and hedge themselves really well.  The numbers were great again in 1997.  The fund returned 17%.  But as fate would have it, in 1998 the world stopped reverting to the mean. 

Kent Oliver:  In 1998, the focus turned to Russia, whose currency, the ruble was also pegged to the dollar.  Similar to Thailand and Mexico, exports were also a main driver behind Russia’s economy, but unlike East Asia, oil was the primary driver. 

Kent Oliver: Investors began pulling money out of Russia – which as we’ve discussed, hurts the currency value - the Russian ruble.  At about the same time the price of oil begins to fall – which is Russia’s biggest export.  Anyway, suddenly Russia had a problem – they have a weak currency and a falling export base.

Brady Raanes: Yeah, and unfortunately for Russia, oil prices fell by more than 50% from the beginning of 1997 to the end of 1998; resulting in a dramatic decline in tax revenue for the country. 

Jim Grenn: This is like déjà vu.

Brady Raanes: Agreed.  As the financial situation worsened for the Russian government, the country was forced to increase interest rates to attract investors who demanded a higher return on government bonds for fear that the government wouldn’t be able to meet their liabilities.  As interest rates surpassed 30% Russia was faced with a difficult decision.  Should they continue to raise rates and borrow money to finance the deficit, or do they print more rubles causing dramatic inflation?  

Jim Green: This is the same decision faced by Mexico in the 1980s.

Brady Raanes: And, like Mexico, Russia opted to continue to increase interest rates.  Borrowing costs surpassed 50% in May of 1998.  

Jim Grenn:  What’s going on with Long Term Capital Management at this point?

Kent Oliver:  LTCM were keenly aware of the Russian bond yields.  Their computers suggested that Russia would likely to “revert to the mean” and normalize at some point, so LTCM began investing in Russian bonds. 

Brady Raanes: Behind the scenes, the Central Bank of Russia worked feverishly to maintain the peg between the value of the ruble and the dollar, buying rubles on the open on the open market with the dollars they held in reserve as investors pulled money from Russia.  The central bank’s currency reserves dwindled to only $8 billion by August of 1998, down from $20 billion the previous summer.  Sound familiar? 

Jim Grenn:  It’s like the same story with different countries. 

Kent Oliver:  I know.  Pretty wild.  Anyway, it was becoming increasingly clear that Russia would be unable to hold the peg and ultimately decided to let their currency float freely.  The ruble declined by more than 80% over the next 18 months.  Also, strapped with unbearable debt and high interest rates, Russia defaulted on a portion of their government bonds.

Jim Grenn: That’s wild.  Seemingly mispriced assets became even more mispriced.  The default on Russian bonds was something that their computer models didn’t pick up on.  What about US markets?

Brady Raanes: The stock market in the US muddled along through the summer of 1998, falling more than 20% briefly.  But… although we didn’t know it at the time, this was the dot.com bubble and there were plenty of other things to take investors’ attention away from Russia. 

Kent Oliver:  Yeah, e-Bay went public in late September of 1998 and jumped 163% on their first day of trading.  A Social networking site, TheGlobe.com began trading publicly on Nov. 13, 1998, and jumped 900% despite have no profits.  After all, it was the 1990s! 

Jim Grenn: LTCM should have just bought tech stocks.

Kent Oliver: Yeah, that would have been way easier than trying to play the spread on Russian bonds.

Brady Raanes: You know, the weird part about the Russian bonds, and the part that the Long Term Capital computer models keyed on was that Russia’s debt was due in their own currency, the ruble.  In theory, Russia could have simply printed more rubles rather than default, but Russia chose not to.  Faced with two unappealing options, Russia decided to avoid further inflation and chose to default on government bonds.  Long Term Capital Management hadn’t anticipated the outcome.  The default was a choice, not a necessity.  Their computer models hadn’t picked up on the human element – only the economic viability and signaled an excellent opportunity for Russian bond prices to revert to their mean.

Jim Grenn: Oh interesting.

Kent Oliver: Yeah, as bond prices weakened, Long Term Capital had continued adding to their position seeing it as even better opportunity than before. 

Brady Raanes: At the beginning of 1998, Long Term Capital had $4.6 billion in actual investor capital backing more than $100 billion of bets. 

Jim Grenn:  Oh wow – those are big numbers – that’s massive leverage.

Brady Raanes:  Yeah, it really is.  And by September of 1998, the value of Long Term Capital Management’s holdings had declined by nearly $4 billion, erasing nearly all of the firm’s equity.  With such a small amount of capital backing nearly $100 billion of the strange bets, LTCM was leveraged at well more than 100:1. 

Jim Grenn:  Wait say that again.  So, they had $4.5 billion at the start of the year in actual money and $100 billion in bets.  The bets fell in fell by roughly 4% total…

Brady Raanes:  Yeah, so they only really had a 4% drawdown on the asset values, but because of the crazy leverage it erased almost all their actual capital.

Jim Grenn:  Oh wow.

Brady Raanes: The real losers were the partners.  Remember, they had returned a ton of shareholder money so that they would personally own a larger share of the fund.

Kent Oliver: More concerning for the overall economy, the bets, known as derivatives, were spread across the banking system.  If Long Term Capital went under who would be on the hook for the other side of the swaps?  As the situation worsened, LTCM was afraid they wouldn’t be able to make good on their end of the swap contracts. 

Jim Grenn:  So, if LTCM went under, your saying their bets would still be active.

Brady Raanes:  Yeah, so back to the basketball analogy – let’s say I bet $100 on a game with you… if you die suddenly how will I get paid. 

Kent Oliver:  That’s a morbid analogy and I’m not even sure if that’s accurate.

Brady Raanes:  Nevertheless, concern grew that an LTCM bankruptcy could dramatically destabilize markets and threaten the solvency of the US banking system.  The fear of such a chain reaction was likely unfounded and overblown, but the Fed decided to intervene regardless. 

Jim Grenn: So, the Federal Reserve knew about Long Term Capital’s massive leverage?  

Brady Raanes:  They were made aware as the crisis mounted. 

Kent Oliver: The New York branch of the Federal Reserve summoned sixteen prominent financial institutions to meet and discuss a plan for rescuing Long Term Capital in hopes of avoiding a banking crisis.  Each of the sixteen bank’s executives crowded around a table at the Federal Reserve offices in New York.  When the dust settled, fourteen of them agreed to support a bailout effort, raising $3.6 billion collectively. 

Jim Grenn: Only 14? 

Kent Oliver: Yep, two banks declined to offered aid to their Wall-Street counterparts…

Brady Raanes: Wait for it.  

Kent Oliver: Bear Sterns and Lehman Brothers. The decision didn’t earn either many friends on Wall Street. 

Jim Grenn:  Remember those names – they will come back up in future episodes.

Kent Oliver:  Anyway, with a little help from Wall Street, Long Term Capital was allowed to survive long enough to unwind their bets.  The firm was eventually dissolved without further incident.

Jim Grenn:  What happened to the LTCM partners?  Did they get their money back?

Kent Oliver:  No, they lost a huge portion of their investment. 

Jim Grenn:  So where are they now?

Brady Raanes: John Meriwether, the guy who started LTCM was able to start another hedge fund, known as JWM Partners in 1999.  The new fund lasted 10 years, but shut down in July 2009 after large losses during the financial crisis.

Robert Merton continued as a professor at Harvard and is now a professor at neighboring MIT.

Myron Scholes currently teaches an annual course at the Stanford Graduate School of Business: The “Evolution of Finance” and another titled “Managing Under Uncertainty.”  He also serves as Chief Investment Strategist at Janus Henderson Investors where he contributes analysis specific to hedging, and risk management.

Jim Grenn:  That’s a little ironic.  As it turned out, the real genius behind Long Term Capital Management was getting the investment world to believe they were geniuses.  Wall Street was rewarded for its bailout and an important lesson was learned.  Some intuitions were simply “too big to fail”.  A new phrase was born on Wall Street.