Jan

31

Long Term Capital Management and the Hedge Fund Environment (1998)

January 31, 1998 | Leave a Comment

Every three or four years, the hedge fund industry just seems to find itself in trouble. It happened back in 1987, then in 1990, in 1994, and again in 1998. The major causes have been: the US stock market crash in 1987; the high yield crash in 1990; and the Fed’s interest rate hike in 1994. This year, the problem areas are more comprehensive:     

* a general emerging markets crisis (Asian flu, Russian default, liquidity problems in Brazil)      

* the drawdown of the US, European and Japanese stock markets      

* a general flight to quality, resulting in widening spreads for US high yield bonds, emerging markets debt, and government bonds of some EMU participants      

* a deflationary environment with low oil and general commodity prices      

* unexpectedly high US mortgage prepayment levels due to low interest rates      

* cancellation of several important takeover deals (Lockheed/Northrop and Ciena/Tellabs)      

* extraordinarily high volatility across all markets.      

August has seen most hedge fund strategies returning negative figures. CTAs, short-biased equity funds and market neutral long/short equity funds were the general exception. Typical fund of funds returned between –1% and –12%, depending on their mandate and portfolio. Not only macro and equity hedge funds suffered but also strategies which depend on liquidity, ie fixed income arbitrage, mortgage-backed securities arbitrage, emerging markets debt strategies, high yield strategies, and, to a lesser extent, convertible bond arbitrage. Hedge funds involved in emerging markets fared the worst, and a few were even forced into liquidation or near liquidation, such as HRO, Long-Term Capital Management, Shetland and Ellington.     

The fall of Long-Term Capital Management     

LTCM was founded at the end of 1993 by John Meriwether. Mr. Meriwether had been heading the legendary fixed income arbitrage team at Salomon Brothers before he was forced to resign. Nobel price winners Myron Scholes and Bob Merton and a few other celebrities joined the new company. Over a few months, LTCM raised $1.25b - entirely without existing official track record. Initial investors included Bank of China, Singapore Monetary Authority, Paine Webber, J. Baer, LGT, and some family offices, among others. These initial investors had to commit substantial investments and agree to highly restrictive liquidity. LTCM started trading in early 1994. Their main strategy was highly sophisticated G-12 fixed income arbitrage. Performance was incredibly good: +43% in 95; +41% in 96; and +17% in 97, with only few down months, and new assets kept flowing in. To restrict incoming capital flow, investors had to agree to 3-year lock-ins.     

At the end of 1997, LTCM had grown so big (AUM of $ 7.5b), that they decided to return money to the investors who were not among the initial strategic investors. The reasons cited were that fixed income arbitrage spreads had narrowed and, accordingly, trades become less profitable. Also, LTCM had simply become too big. With now “only” $4.8b under management (of which at least $700m their own money) and even less supervision by investors, the principals invested in riskier trades and at an even higher leverage. Unfortunately, the markets started to change.     

In the first 8 months of 1998, LTCM lost approximately 57% of their capital. In August, Russia crashed and LTCM was caught with a huge long exposure in Russian T-Bills. Almost as bad, their ruble exposure was hedged with collapsing Russian counterparties. LTCM defaulted on margin calls from their brokers. It turned out that LTCM was highly overleveraged. Practically all major Wall Street firms discovered huge counterparty exposures with LTCM in their books. UBS was caught naked with a USD 800m unhedged equity stake in LTCM. The NY Fed, fearing a systemic risk dragging down world financial markets even further and threatening the credibility of the banking system, organised a $3.5b rescue together with a consortium of the worst hit creditors. The idea is that this will allow the new owners to consolidate LTCM’s portfolio and liquidate it over the next few years without driving prices down.     

Could the LTCM debacle have been prevented?     

Fortunately, most funds of funds had been forced to divest from LTCM at the end of 1997. Nevertheless, many had been invested with LTCM back in 1997 and could have been caught in the disaster. How is it that these blue chip investors had not done their due diligence correctly? How is it that these Wall Street brokers and Swiss banks had been throwing money at LTCM? We argue that a better due diligence check by both creditors and investors could have prevented the worst excesses:        

1. LTCM was one of the least if not THE least transparent hedge fund. Nobody, not even their initial investors, was receiving any meaningful information on total portfolio positions and it was very difficult to organise a visit to one of their three global offices and talk to the principals. Apparently, however, many investors believed that Nobel price winners and an incredible past performance made up for the non-existent transparency.      

2. LTCM had simply grown too big. There was no way they could forever continue to produce the same stable high returns solely with G-12 fixed income arbitrage. Direct competitors such as III Ltd., Finsbury Partners, and Springfield Ltd. had been showing lower returns and higher volatility than usual for at least 12 months.      

3. There were some indications as to what was going on inside LTCM. The sheer size of LTCM ensured that their trades did not go unrecognised. It was a badly kept secret on New York’s Wall Street and Tokyo’s Kabutocho that LTCM was engaged in many areas not directly related to G-12 fixed income arbitrage. They were doing mortgage-backed securities, emerging markets debt, merger arbitrage, Japanese warrants, and had even started investing in private equity. Sadly, they never bothered communicating this to their investors.      

Until the end of 1997, LTCM enjoyed a very good reputation and produced incredible returns. But, to say the least, LTCM had always been a high risk investment, and sophisticated investors should have been aware of that. Many investors and creditors got blinded by that reputation and fabulous returns.     

As for LTCM, well, instead of relying on their models valid only for normal market situations, maybe they should have incorporated simple stress tests for 10 sigma adverse market movements into their risk management systems. They started very well 5 years ago but ended up taking way too much risk, especially in the last year before the hedge fund bubble burst. They were a victim of their own success.     

Implications for investors     

The fall of LTCM is a sad story for the hedge fund industry because the whole sector is now receiving bad publicity. Not all hedge funds have deserved this negative image. Perception is far worse than reality. Hedge funds are now being blamed for every single negative thing happening in global financial markets. This means that, unfortunately, it will probably take a while for investor confidence and liquidity to come back again.      

Should investors cancel all plans for a strategic asset allocation to hedge funds?     

Investors needs to be aware that there are certain risks involved with investing in hedge funds. There is no “free lunch” and, accordingly, hedge funds are not risk free. Many hedge funds are not leveraged, but some, depending on the strategy they pursue, may be highly leveraged. Market neutral and event driven hedge funds hedge their exposure to traditional stock market and interest rate movements but take on other risks such as credit risk and liquidity risk. Most hedge fund strategies should have a low correlation to stocks and bonds in normal market situations. Extreme market conditions such as August and September 1998, however, where so many negative events happen simultaneously, can increase the correlations drastically for a short period.      

On the other hand, hedge funds have not fared worse than equity markets.


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