The Classis Case of “LTCM”

#Post Graduate Program in Securities Markets(PGPSM)@National Institute of Securities Markets(NISM)

Vashi, Navi Mumbai

In the long run…

John Meriwether

Mythology

Stock market crash 1987

Traditional trade or Quantitative and research-driven trade

Modus operandi

• The presence of Merton, Scholes and Mullins

• $4000 million

• 2% management fee and 25% incentive fee

Secret trader’s business

• The buzz words were ‘relative value’ and ‘convergence’ trading

• Small pricing discrepancies between securities• Long run equilibrium values• Leverage up to 25 times• Myron Scholes explained “Think of us(LTCM)

as a gigantic vacuum cleaner sucking up nickels from all over the word”

Let the good times roll

Extending to credit spread trading, volatility trading etc.

43%pa in 1995 and 41% in 1996

The perfect Storm

• By September, LTCM had lost 92% of its capital

• Leverage had increased to over 100 times

Origins

• The 1998 crisis had its origins in the Asian monetary crisis

• LTCM perceived the increase in volatility levels and credit spread as a trading opportunity

• Placed a massive bet on credit spread and stock volatility

Credit spread

• LTCM believed that, although yield difference between risky and riskless fixed-income instruments varied over time, the risk premium tended to revert to average historical levels.

• Entered into mortgage spreads and international high-yield bond spreads

Equity volatility

• Assumed that volatility on equity options tended to revert to long-term average levels

• LTCM “sold volatility” until it regressed to normal levels

Crisis development

• In May/June 1998, a big loss in mortgage backed securities.

• In August, Russia defaulted on its debt• Credit spread increased- Large losses on credit

spread positions• $550 million on 21 August alone• On 2 September 1998, John Meiwether issued a

letter to investors that revealed LTCM had lost 52% of its value.

Recapitalization

• On 18 Sep 1998, Bear Stearns was rumoured to have frozen the fund’s cash account following a large margin call

• On 23 Sep 1998, AIG, Goldman Sachs, Warren Buffett made an offer to buyout LTCM

• 14 banks invested $3.6 billion in return for 90% of LTCM

Weather forecast

• At beginning of 1998, LTCM VaR was $45 million at 99% confidence level

• In Sep, LTCM’s profit and loss was moving $100-$200 million daily

• LTCM’s models assumed that it would be possible to reduce positions across the entire portfolio rapidly, but not all position were liquid

Copy Cats

• Many dealers established internal hedge fund

• When storm hit, everybody had put on same trades

Hubris

Endgame

• John Meriwether established a new hedge fund (JWM Associates)

• Scholes set up a separate hedge fund• Scholes promoted a new product – liquidity

options