Case Study

Outlines Part One: A New Era
Founding Performance P f Trading strategy Mutual Fund & Hedge Fund u ua u d edge u d

Part Two: When Genius Failed
Downturn: 1998 Russian Financial Crisis Chain Reaction In the end: Bailout & Characters

Part Three: Enemies are ourselves
Risk Measurement Diligence, Ethics and Honesty Dili Ethi dH t

Part One: A NEW ERA

Founding of LTCM
LTCM was founded in 1994 by John Meriwether, the former vice‐ chairman and head of bond trading at Salomon Brothers t di tS l B th LTCM was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute‐ h l d b l return trading strategies combined with high leverage. The fund's operation was designed to have extremely low overhead; trades were conducted through a partnership with Bear Stearns and hi i h B S d client relations were handled by Merrill Lynch.
LTCM Partners
John Meriwether Former vice chair and head of bond trading at Solomon Brothers; MBA, University of Chicago Leading scholar in finance; Prof. at Harvard Co-author of Black-Scholes model; Prof. at Stanford St f d Vice chairman of the Fed; Prof. at Harvard; Arbitrage g p at Salomon; former Harvard g group ; Prof. Arbitrage group at Salomon; former Harvard Prof. Arbitrage group at Salomon; Ph D MIT Ph.D. Arbitrage group at Salomon; Ph.D. MIT Bond trader B dt d Executive at Salomon Arbitrage group at Salomon; Master in Finance, LSE

Robert C. Merton Myron Scholes David W. Mullins Eric Rosenfeld William Krasker Gregory Hawkins Larry Hilibrand James M E t J McEntee Dick Leahy Victor Haghani

Performance
Year Return* 1994 19.9% 1995 42.8% 1996 40.8% 1997 17.1% 1998 -98.3%

LTCM earned $2.1bn in 1996 while Morgan Stanley 1bn Stanley 1bn LTCM charged management fees @2% and performance fees d f f @25%, higher than average respectively ROA is only 2.45% in ROA i l 2 45% i 1995

*Returns are adjusted after fees

Performance
High‐leverage
To significantly profit from small discrepancies between bonds, high‐leverage is required Principal is not fully contributed from those partners. They also leveraged on their friends and families As LTCM s capital base grew, they felt pressed to invest that capital and had run As LTCM's capital base grew, they felt pressed to invest that capital and had run out of good bond‐arbitrage bets. This led LTCM to undertake more aggressive trading strategies In 1997, LTCM paid back $2.7bn, 1/3 of its equity to the outside investors In 1997 LTCM paid back $2 7bn 1/3 of its equity to the outside investors As LTCM partners are well recognized and associated with the industry, there was almost no restriction on LTCM’s financing from large banks At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed At th b i i f 1998 th fi h d it f $4 72 billi dh db d over $124.5 billion with assets of around $129 billion, for a debt to equity ratio of over 25 to 1 It had ff b l It h d off‐balance sheet d i ti h t derivative positions with a notional value of iti ith ti l l f approximately $1.25 trillion

Performance
VaR
a threshold value such that the probability that the loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level For example, if a portfolio of stocks has a one‐day 5% VaR of $1 million, there is a 0.05 probability that the portfolio will fall in value by more than $1 million p y p y over a one day period if there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day in 20

Copulas: a copula can be use to describe the dependence between random variables.

Trading strategy
Arbitrages make positive return with almost no costs and no risks Strategies: Non‐market Directional
Convergence trade (on the run & off the run treasury bond) Convergence trade (on‐the run & off‐the‐run treasury bond) Yield spread (Emerging markets & US. sovereign debt) Tax regulation (Italian bond, 35% profit in 1995) Real estate bond trading Real estate bond trading Merger arbitrage Dual‐listed company arbitrage (Royal Dutch Shell premium) Long term S&P volatility net short Long term S&P volatility net short

LTCM’s strategies required
The market to be efficient A long time for the return to be realized l f h b l d

“Market can stay irrational longer than you are solvent”

Mutual Fund Definition
No legal definition of mutual fund Broadly: a type of professionally‐managed type collective investment scheme that pools money from many investors many investors Narrowly (most commonly): only those collective investment schemes that are regulated, available to the general public and open‐ended in nature Note: hedge funds are not considered a type of mutual fund

Structure
Registered with SEC Overseen by a board of directors (if organized as a corporation) or board of trustees (if organized as a trust) Ensures that the fund is managed in the best interests of the fund's investors Hires the fund manager and other service providers to the fund Hi th f d d th i id t th f d Managed by the fund manager (the fund sponsor or fund management company) Trades (buys and sells) the fund's investments in accordance with the fund's investment objective Must be a registered investment advisor Fund family / fund complex: Funds that are managed by the same fund manager and that have the same brand name

Mutual Fund
3 types established by the Investment Company Act of 1940 open‐end funds unit investment trusts (UITs) closed‐end funds l d df d Exchange‐traded funds (ETFs): open‐end funds or unit investment trusts that trade on an exchange

4 categories classified by principal investments 4 categories classified by principal investments
Money market funds Bond or fixed income funds Stock or equity funds: q y may be subclassified along two dimensions: (1) market capitalization: micro cap, small cap, mid cap, large cap (2) investment style: growth, blend/core, value Hybrid funds

2 categories classified by investment concepts
Index funds (passively‐managed funds): seek to match the performance of a market index Actively‐managed funds: seek to outperform a relevant index through superior security selection.

Mutual Fund
Expenses
Distribution charges (sales loads and 12b‐1 fees) Paid for marketing, distribution of the fund's shares, services to investors Operating expenses O ti Management fee Other fund expenses S a e o de t a sact o ees Shareholder transaction fees Paid for certain transactions by shareholders Securities transaction fees expenses and taxes related to buying or selling the securities in its portfolio

Hedge Fund
Definition D fi i i
An investment fund that can undertake a wider range of investment and trading activities than other funds, but which is only open for investment from particular types of investors specified by regulators

Investors
Institutions, such as pension funds, university endowments and foundations High net worth individuals

Invested assets
Diverse range Most common: liquid securities on public markets

Techniques
Short selling Short selling Leverage

Fees
Management fees g Calculated as a percentage of the fund's net asset value Typically from 1% to 4% per annum, with 2% being standard Designed to cover the operating costs of the manager, whereas the performance fee provides the manager s profits manager's profits Performance fees Calculated as a percentage of the fund's profits Typically from 10% to 50% per annum, with 20% being standard Intended to provide an incentive for a manager to generate profits d d d f f

Mutual Fund Advantages (Why do people buy mf)
Increased diversification Daily liquidity Professional investment management f l Ability to participate in investments that may be available only to larger investors Service and convenience Government oversight Government oversight Ease of comparison

Disadvantages
Fees Less control over timing of recognition of gains Less predictable income No opportunity to customize

Hedge Fund Elements
The hedge fund's approach to the market The particular instrument used The market sector the fund specializes in (e.g. healthcare) h k h f d l ( h lh ) The method used to select investments The amount of diversification within the fund

Asset classes A t l
Equity, fixed income, commodity and currency

Instruments
Equities, fixed income, futures, options and swaps

4 main categories distinguished by investment style
Global macro (Directional)
Investing strategy take sizable positions in share, bond or currency markets in anticipation of global macroeconomic events in order to generate a risk‐adjusted return

Long short (Directional)
Utilizing market movements, trends, or inconsistencies when picking stocks across a variety of markets

Event‐driven
Concerning situations in which the underlying investment opportunity and risk are associated with an event

Market Neutral (arbitrage)
Taking advantage of relative discrepancies in price between securities Taking advantage of relative discrepancies in price between securities

Part Two: WHEN GENIUS FAILED

Downturn: 1998 Russian Financial Crisis
Reasons Behind
Over‐spending & chronic fiscal deficit : excessive public investments; social welfare; first war in Chechnya. Artificially high fixed exchange rate: Russian Central Bank committed to maintain a band of 5.3 to 7.1 RUR/USD. This forced the Central Bank to spend its foreign reserves to defend the ruble, which in turn further eroded investor confidence and undermined the ruble. It is estimated that between 1 October 1997 and 17 August 1998, the Central Bank expended approximately $27 billion of its U.S. dollar reserves to maintain the floating peg. Political unrest: Boris Yeltsin suddenly dismissed Prime Minister Viktor Chernomyrdin and his entire cabinet on 23 March, 1998. Yeltsin named Energy Minister Sergei Kiriyenko, aged 35, as acting prime minister. On 29 May, Yeltsin appointed Boris Fyodorov Head of the State Tax Service. Narrowed tax income: 1998 Asian Financial Crisis struck the economy. Oil price dropped dramatically. Economy shrunk. The authority are unable to meet the budget needs y y y g through taxation. The growth of internal loans could only be provided at the expense of the inflow of foreign speculative capital, which was attracted by very high interest rates. In June Kiriyenko hiked GKO (Russian short‐term zero‐coupon bond) interest rates to 150%.

Downturn: 1998 Russian Financial Crisis
Process of the crisis
13 July: A $22.6 billion IMF and World Bank financial package was approved to support reforms and stabilize the Russian market by swapping out an enormous volume of the quickly maturing GKO short‐term bills into long‐term Eurobonds. In July 1998, monthly interest payments on Russia’s debt rose to a figure 40 percent g greater than its monthly tax collections. y 13 August: the Russian stock, bond, and currency markets collapsed as a result of investor fears that the government would devalue the ruble, default on domestic debt, or both. Annual yields on GKO were more than 200 percent. The stock market had to be y p closed for 35 minutes as prices plummeted. From January to August the stock market had lost more than 75 percent of its value. 17 August: the Russian government devalued the ruble from [5.3, 7.1] to [6.0, 9.5], 17 August: the Russian government devalued the ruble from [5.3, 7.1] to [6.0, 9.5], defaulted on domestic debt, and declared a moratorium on payment to foreign creditors. The government declared that the government securities (GKOs and OFZs) with due dates through December 31, 1999, would be rescheduled into new securities. g , , 2 September: Russian Central Bank decided to abandon the "floating peg" policy and float the ruble freely. By 21 September the exchange rate had reached 21 rubles to the US dollar, meaning it had lost two thirds of its value of less than a month earlier. , g

Chain Reaction
LTCM played a role as long Russian and emerging market bonds and short US. and Germany bonds Profits supposed to occur when the value of these bonds converged Profits supposed to occur when the value of these bonds converged Yet, they diverged because of risk aversion sentiment By the end of August 1998, LTCM lost $1.85 billion LTCM had to liquidate its positions in other portfolios and suffer further losses Eg. Royal Dutch Shell premium rose to 22% from 8% Eg Royal Dutch Shell premium rose to 22% from 8% S&P volatility rose to 19% to 26% LTCM’s equity tumble from 2.3bn at the start of Sept. to just 400mil by Sept. 25 With over $100bn liabilities, its leverage ratio was more than 250‐to‐1

The Bailout Warren Buffett’s offer
Buy out LTCM’s asset portfolio with 250 million from Berkshire Hathaway, AIG and Goldman Sachs and Goldman Sachs Failed at last: too short the respond time; too cheap; too simple

Final solution
The entire banking industry came out to help themselves $300 million: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill lynch, J. , , , y , P. Morgan, Morgan Stanley, Salomon Smith Barney, UBS $125 million: Societe Generale $100 million: Lehman Brothers, $100 million: Lehman Brothers Paribas Bear Stearns declined to participate.

Are they friends? No! y
There are no friends in wall street. Every bank who knew LTCM’s portfolio detail shorted those assets that LTCM holds to profit from the crisis. Which actually worsened the situation. holds to profit from the crisis Which actually worsened the situation

Characters
Robert C. Merton
He worried a lot about his academic reputation. Soon he started to work on more complicated models.

Myron Scholes
One week after LTCM’s shutdown, he married a lawyer from San Francisco at Pierre Palace New York. This is his second marriage. On his wedding ceremony, he said he prefer to follow his wife’s surname.

Eric Rosenfeld
He auctioned all his wine collection, most of which were bought by Conrad Waldstatt from He auctioned all his wine collection, most of which were bought by Conrad Waldstatt from Merrill Lynch, who tookover LTCM’s portfolio as well. His wife’s relatives’ investments also vanished. Once his ex‐workmate called him and asked what he needed for help. p He said: ONLY MONEY!

Larry Hilibrand
Once he possessed assets over 500 million in total. Once he possessed assets over 500 million in total After the bailout, he beg for Societe Generale’s mercy for not declaring his bankrupcy and lived on his wife’s income.

Characters
David W. Mullins
Once considered a possible successor to Alan Greenspan, saw his future with the Reserve dashed.

John Meriwether
After the bailout, Long‐Term Capital Management continued operations. In the year following the bailout, it earned 10%. By early 2000, the fund had been liquidated, and the consortium of banks that financed the bailout had been paid back. After helping unwind LTCM, Meriwether launched JWM Partners. Haghani, Hilibrand, Leahy, and Rosenfeld all signed up as principals of the new firm. By December 1999, they had raised $250 million for a fund that would continue many of LTCM's strategies—this time, using less $250 million for a fund that would continue many of LTCM's strategies this time using less leverage. With the Credit Crisis, JWM Partners LLC was hit with 44% loss from September 2007 to February 2009 in its Relative Value Opportunity II fund. As such, JWM Hedge Fund was shut down in July 2009 y

Part Three: ENEMIES ARE OURSELVES

Risk Measurement Risk
Market risk Liquidity risk Li idit i k Credit risk Ope a o a s Operational risk …

Measurement
VaR UPM Copulas …

Risk Measurement
LTCM had a good command of risk management and expertise in financial engineering A progress in finance history A progress in finance history Black Swan vs. VaR Subprime Crisis vs. Copulas “Don’t rely on formulas too much” Essentially, leverage ratio is the most important risk measurement

Work Ethics
Partnership Diligence in the bailout Honesty JWM Partners

Reference
Lowenstein, Roger (2000). When Genius Failed: The Rise and Fall of Long­Term Capital Management. Random House. ISBN 0‐375‐50317‐X