|
Frank Zhang
Author's Bio
Roger Lowenstein, author of the bestselling biography Buffett: The Making of an American Capitalist, had also reported for the Wall Street Journal for more than a decade and wrote the Journal's stock market column "Heard on the Street" from 1989 to 1991 and "Intrinsic Value" from 1995 to 1997. He has also written for The New York Times and The New Republic. He now writes a column in Smart Money magazine and lives in Westfield, New Jersey with his wife and three children.
The Failed Arbitrage
When Long Term Capital Management (LTCM) was first founded in 1993, it was hailed as one of the greatest hedge funds in history. Led by John Meriwether, former head of bond trading at Salomon, the firm enlisted many leading scholars in finance and economics. With the backing of financial institutions from every major economic power in the world, Long Term obtained a stunning $1.25 billion in initial capital--making them "the largest start-up ever."1 It seemed fate was on their side from the moment the fund first started trading in 1994. In a mere four years, the fund had grown to have $4.72 billion of equity, $124.5 billion of leveraged capital, and $1.25 trillion in various derivative positions. Long Term had made an astronomical profit in statistically "low-risk" arbitrage deals. However, the fundamental theory of Long Term's trades would come crashing down in the summer of 1998 when, in less then five weeks, Long Term's nearly $5 billion in equity dropped to a meager $350 million. Roger Lowenstein follows this brief, though fascinating, history in his Rise and Fall of Long Term Capital Management.
Nothing about John Meriwether's humble beginnings suggested he would be in charge of the largest and most powerful hedge fund of his time. Born in 1947 to a devout Catholic family, Meriwether was strongly disciplined and excelled in school. When he set out to start his own fund, the popular, albeit inaccurate, image of hedge fund operators was "risk takers who captured outsized profits or suffered horrendous losses."2 However, drawn to the natural orderliness of hedge funds and their mathematical emphasis, John Meriwether soon began looking for potential investors. Yet Meriwether was "staggeringly ambitious" and hoped to raise a "colossal sum of $2.5 billion" while charging its investors a considerably higher than average fee.3 Using his connections to many Wall Street firms from his pervious job at an investment bank, Meriwether soon obtained financial support from investment giants Merrill Lynch and Bear Sterns as well as a handful of foreign banks and private investors. Part of Long Term's appeal to investors was the fact that, unlike other hedge funds of its time, it employed a large percentage of academics in finance and economics.
With his impressive army of scholars and theoreticians, John Meriwether was able to apply advanced mathematical formulas to investment decisions. The idea behind hedge funds like Long Term was that these investors could "hedge" their bets by going both long and short on its securities. By shorting the overpriced stock, the fund will make money when the price of that stock decreases. Conversely, by going long on an undervalued stock, it will make money when the price of the stock increases. Moreover, by investing equally in shorts and longs, the hedge fund would be impervious to overall market fluctuations, betting instead on the prices of its longs and shorts to converge. The significantly reduced risk of this "market neutral, or hedged, portfolio" appealed to many investors--allowing Long Term to amass an enormous amount of capital which it could then leverage, or borrow against.4 The Black-Scholes formula, created by the same Myron Scholes who was a partner in Long Term, is essentially the idea that "over a long period [of time] prices would mirror¡random events" or a normal distribution bell curve provided that the volatility of a security remains constant.5 In other words, by arbitraging, or capitalizing on a temporary price difference between two markets, Long Term could, theoretically, make risk-free profits.
From the very beginning, the gods smiled on Long Term. Meriwether's timing in starting the fund was impeccable. The economic growth of the late 1980s and early 1990's was just coming to an end and Wall Street was beginning to experience greater fluctuations in prices. However, though investors long for a steady market, "the opportunities are richest when markets turn turbulent."6 Fearing the worst, panicky investors had begun selling stocks and options, making it easy for Long Term to buy at a low price. The wider the spread of bonds, the more Long Term stood to make when prices converged--as Merton and Scholes believed they inevitably would. Long Term's first trade would involve off-the-run and on-the-run U.S. Treasury bonds. The fund's researchers had discovered that the former was trading at a steep discount simply because it had half a year less to mature and was consequently slightly less liquid. Long Term was thus able to put to test its theory that the difference between prices of the two U.S. Treasury bonds would soon lessen when the market calmed and people became less concerned with liquidity. It turned out the mathematicians were right--and Long Term made millions. The fund continued such a practice to the point where, in 1996, this "small band of traders¡unknown to the public" made a total of $2.1 billion.7 To put it into perspective, Long Term earned more that year than what "McDonalds did selling hamburgers all over the world," more than such companies as Merrill Lynch, American Express, and Nike; and more than some of the best managed businesses in America.8 More importantly, Long Term was able to do it with little volatility; not once did the company suffer of monthly loss of even one percent.
However, such profits would soon come to a crashing halt as combined events resulted in sudden and unexpected losses for the fund. By the mid 1990s, the secret of bond arbitrage was out. As a result, banks and investors "whittled away the very spread that had attracted them."9 To make up for the lost sources of revenue, Long Term began to leverage further--borrowing increasingly large sums of money from banks that were only too happy to provide the loans. At the same time, the fund decided to make new, riskier investments into foreign markets, equities, and mergers. However, on Monday, August 17, "Russia declared a debt moratorium" and defaulted on some of its government-issued bonds. The repercussions of a nuclear power defaulting on its loans "chilled global markets like a Siberian gale."10 Almost immediately, investors from all over the world scrambled to sell their riskier, high-yielding bonds for safer ones. However, they soon realized that in such times of crisis, there were few buyers for these bonds. Thus, by dumping massive quantities of these unstable bonds onto the market, traders pushed prices to extreme lows. At the same time, investors were paying huge premiums for safer 30 Year Treasuries or Germany's ten-year Bund. As a result, spreads were being pushed farther than ever, and Long Term was "losing millions every minute."11 However, because of the lack of liquidity, the hedge fund could not sell its enormous quantities of securities without pushing prices even lower and losing more money in the process. Thus, the hemorrhaging fund could only sit and stare in disbelief as spreads widened indefinitely. Within five weeks, the fund had lost nearly 90 percent of its equity. Fearing if Long Term failed, "it could have a seriously destabilizing effect" that would threaten the stability of global finances, the Federal Reserve Bank of New York and a consortium of banks and investment institutions amassed, literally overnight, a colossal sum of $3.6 billion to bail out and take over the fund.12 However, by then, the fund had lost its reputation and was all but destroyed.
However, according to Lowenstein, Long Term's sudden collapse was not completely due to the unpredictable nature of the market. He believes that various factors contributed to the disastrous downfall: the flaws in Merton's and Scholes's theories, the heavily leveraged capital, and their expansion into risky, illiquid markets. At the center of it all, he claimed, was the partners' overbearing confidence and belief in their own infallibility. These scholars had the "deep seated¡arrogance of people who really believed that they were more intelligent than others."13 It was their pride that made them blind to the errors of the Black-Scholes formula and their mistakes in calculations. It was also their pride that led them to borrow immense sums of money and to invest such money in unstable markets. However, up until its crash, Long Term appeared to be everything its members believed it was--brilliant, efficient, and unerring. For this reason, firms were willing to loan millions with no haircut, among other benefits. However, by doing so, these firms were unknowingly ensuring that the fund's eventual (and according to Lowenstein, inevitable) fall would be immediate and unpreventable. Nonetheless, it was not until Long Term actually collapsed did its leaders see the errors in their judgment and admit that they had been wrong.
Early in the book, Lowenstein attacked some fundamental errors in the Black-Scholes formula. Many academics such as Eugene Fama, Scholes's thesis adviser, wondered if Merton and Scholes's models "might be too tidy for the real word.14 In doing his own research, Fama discovered that there were too many days of extreme price movements to be explained by a normal distribution. He stated that "an observation more than five standard deviations should be observed about once every 7,000 years" when, in fact, such observations occurred as often as once every three years.15 Lowenstein also adds that markets were not purely random because each new day is not completely independent of what happened the previous day. In other words, markets are subject to the fearful, bandwagon-jumping nature of investors. Furthermore, the author attacks Long Term's fundamental theory that all bonds converge. Though he concedes that in the end, the bonds that LTCM arbitraged did converge, the time it took and the width of the spread made it impossible for such an investment practice to be sustained over a long period of time.
Written not long after the burst of the stock market bubble in 2000, Lowenstein's book may be seen as a cautionary tale for future investors. By portraying how a group of men earned billions of dollars before suddenly losing it all, as many businesses did during the sudden decline of all stock indexes in 2000, Lowenstein shows how over-leveraging and buying securities with borrowed money is a dangerous practice. At the same time, he describes how "there was no liquidity in markets¡when everyone wanted out at the same time," and prices reached the extremes of the bell curve--much like what occurred during the burst of the dot com bubble in 2000.16 Yet it is also important to note that Lowenstein writes this book in retrospect and may be more critical of some decisions made by LTCM than he should be, for many hedge funds had made the same mistakes. At the same time, his complete rejection of the Black-Scholes formula may reflect his more conservative view of economics and his belief in the theories of John Maynard Keynes--which the leading academics of at Long Term had rejected. Nonetheless, the dramatic and fast-paced book does an effective job of telling the story. It not only gives an accurate description of Long Term itself, but also provides readers with an idea of the culture of Wall Street at the time. Despite the extensive use of financial jargon, Lowenstein does try to simplify many of the theories and practices of Long Term, and it is clear that the author has done extensive research into his subject.
However, there are those who would disagree with Lowenstein's description of Long Term. For instance, Ron Feldman, Assistant Vice President Banking Supervision Federal Reserve Bank of Minneapolis disputes Lowenstein's underlying assumption that "applying finance models and theories of efficient capital markets to financial markets" is impractical. Instead, he argues that many of the decisions Long Term made were very normal or "run of the mill." 17 The sudden flight to liquidity hurt all investors, and it was the unpredictable nature of the market itself, rather than the mistakes of Long Term's investors, that ultimately led to the fund's downfall. Another reviewer, James K. Galbraith, a professor of economics at the University of Texas, states that Lowenstein's "understanding of the statistical issue is not deep" and argues that the author's criticism of the Federal Reserve for intervening was "quite wrong." Instead, Galbraith believes that the Fed made the right move by attempting to save the fund. However, despite the book's flaws, both readers seem to concede that Lowenstein's account of LTCM was "clear, entertaining, [and] informative."18
Lowenstein saw the 1990s as a period of economic change that was reflected in Long Term. People were looking for new ways to get ahead, and by the late 1990s, many banks had begun employing mathematicians and theoreticians to manage their investments. At the time, hedge funds were also a relatively new, and misunderstood form of institutional investment that grew in popular during this period. In many ways, LTCM was a leader of such change. The brilliance of Merton and Scholes generated unprecedented interest in arbitrage. Banks, awash with liquidity and excess capital, "relentlessly chased the fund business" and in doing so exposed themselves to high levels of risk.19 The practice of leveraging and borrowing had, by then, also become immensely popular because of funds like Long Term. However, these funds influenced financial practices through their failures as much as their success. When Long Term collapsed in 1998, it threatened the survival of many major banks. As a result, for the next few years, banks began to keep a closer watch over their investments and required funds to maintain a lower debt to equity ratio. Additionally, major investment banks such as Bear Stearns and Merrill Lynch became much more wary of investments in hedge and mutual funds.
Though Long Term was, in a sense, a product of its times, it had surpassed the average Wall Street firm in daring and success. While Wall Street was, by the late 1990s "leverage 25 to 1," Long Term was leveraged at 35 to 1.20 The hedge fund would not only borrow more money than its counterparts, but it would bet more as well: "Long Term's trade was often ten times the size of Goldman's."21 In this sense, Lowenstein may be inaccurate in stating that the fund was a reflection of its time. Instead, it is more precise to view Long Term as an extreme example of hedge funds in the 1990s. It took the practices and exuberance of Wall Street and carried it farther than any other institution. Additionally, Lowenstein tends to over-dramatize the reaction of the market in 1998. The flight to liquidity was neither unheard of nor unexpected because the same situation had occurred four years ago--the situation Long Term took advantage of when it first started. Thus, it can be argued that the failure of Long Term was as much the result of unanticipated changes in the market as it was of mismanagement and miscalculation. Nonetheless, Long Term history marked a period various changes in investment including the extensive use of mathematics, the application of academic theories to investment decisions, and the practice investing in funds.
Long Term is remembered for both its quick and astonishing rise as well as its sudden and unprecedented decline. Its disastrous collapse has made "Long-Term's name¡synonymous with financial disaster."22 However, the story of Long Term is more than simply the story of a failed theory in arbitrage. On a deeper level, Long Term's success and ultimate failure teaches us invaluable lessons in arbitrage, bonds, and investing as a whole.
Endnotes
1. Lowenstein, Roger. The Rise and Fall of Long Term Capital Management. New York. Random House Trade Paperback. 2001. 39.
2. Lowenstein, Roger 25.
3. Lowenstein, Roger 27.
4. Lowenstein, Roger 25.
5. Lowenstein, Roger 66.
6. Lowenstein, Roger 40.
7. Lowenstein, Roger 94.
8. Lowenstein, Roger 95.
9. Lowenstein, Roger 96.
10. Lowenstein, Roger 144.
11. Lowenstein, Roger 145.
12. Lowenstein, Roger 183.
13. Lowenstein, Roger 89.
14. Lowenstein, Roger 182.
15. Lowenstein, Roger 84.
16. Lowenstein, Roger 151.
17. Galbraith, James K. "Capital Mismanagement." Washington Monthly. Sep 2000, Vol. 32 Issue 9, p46.
18. Feldman, Ron. "When Genius Failed (Book Review)" Region. Federal Reserve Bank of Minneapolis. Dec 2000, Vol 14. Issue 4, p 56.
19. Lowenstein, Roger 82.
20. Lowenstein, Roger 106.
21. Lowenstein, Roger 100.
22. Lowenstein, Roger, xi.
| |
