I was thinking a bit more about the current economic crisis – let’s face it, it is all over the news, even if I didn’t want to, I’d be thinking about it – and what people were saying about hedge funds a couple of weeks ago.
One of the things that was discussed but I hadn’t mentioned was Long Term Capital Management. LTCM was a large hedge fund in the mid-1990s. It featured two Nobel prize winners amongst its founders – Myron Scholes and Robert Merton, who devised methods of valuing options and financial derivatives – as well as some of the biggest names on Wall Street. They had super-whizzy mathematical models to manage their investments, and they made spectacularly large amounts of money.
These were the financial superstars of the 1990s. They were the heroes of the time; and they had excessive hubris: they thought they couldn’t go wrong. They invented the ways hedge funds work.
They also invented the way hedge funds go bust – involving similarly spectacular large amounts of money.
Their basic strategy involved fixed interest arbitrage – which I think means they traded in government bonds of the major economies, using their models to spot small but profitable differences in different markets: they needed leverage to amplify those small returns. As more people invested, increasing the fund’s capital, they took on more and more risk to maintain their profits – they were leveraged about 25 times, with liabilities of $125bn and equity of $5bn.
In May and June 1998, LTCM made losses as a result of market turmoil stemming from the Asian financial crisis which reduced their capital; in August and September, the Russian financial crisis hit, and LTCM had to sell assets into falling markets. Clients wanted to free their capital, and LTCM faced a liquidity crisis – a run on the bank, if you will.
They went bust, and had to be rescued by a bailout organised by the Federal Reserve Bank of New York of $3.6bn spread across fourteen US and European banks.
Fundamentally, LTCM’s models, and the positions they took as a result of them, should have made the fund a lot of money, but the Asian and Russian crises created adverse trading conditions, and capital fled to safety, leaving LTCM high and dry. As Keynes said, “The market can stay irrational longer than you can stay solvent”.
What is interesting is the similarities between LTCM and hedge funds today – and, more pertinently, the broader financial crisis we find ourselves in:
- high leverage
- large off balance sheet positions
- resulting lack of transparency
- external stimuli (bursting bubbles)
- capital flight
- thereby increasing liquidity
- asset sales into falling markets
with the fund – or bank – going bust as a result.
The thing is, despite all the rocket-science mathematical models and financial engineering, this isn’t rocket science. This is what has happened time and time again. John McFall MPwas on 5Live this morning explaining why the Treasury Committee was competent to grill UK banking chiefs about their role in the crisis: and he replied with a list of previous crises his committee has reported on.
So why were shareholders, markets, governments and regulators so taken aback when the same thing has happened, yet again? Why have they not learned from past financial crises – their own past experience?
(The story of LTCM is told in When Genius Failed: The Rise and Fall of Long-Term Capital Management, by Roger Lowenstein.)