Ltcm Case Financial Institutions and Markets-Received A

Greg Snioch

Professor Koplik

Markets and Institutions

Second Case Assignment

05/01/2017

1.In the context of Long Term Capital Management’s portfolio and investment strategies, briefly describe the conditions and circumstances that led to LTCM’s demise. How did LTCM’s strategies and management expose it, as well as the broader financial system, to unforeseen risks?

There were a series of trading strategies LTCM employed, consisting of convergence, relative value strategy, swap-spreads, and other trades such as fixed rate residential mortgages and essentially” selling volatility.” LTCM would structure many of it trades to require a minimal amount of capital, and sometimes no actual outlay of capital. They would be able to obtain 100% financing on a fully collaterized basis. Since there was no explicit equity investment on positions, they could not measure return on equity, or the risk due to the notional sizes of the positions. Risk of a long-short position depended majorly on the degree to which profits on the long could deviate from profits on the short. They tended to measure risk in terms of a distribution curve pertaining to the potential profits and losses. Because of these different ways LTCM can take on risk it may not look like they are as risky as they are. When entering into derivative contracts, since the notional value would not appear on the balance sheet, only the money made or lost each day would. This would cause a firm to look like it does not have a lot of leverage on the books but in reality has a lot of exposure and risk. Since LTCM was so unregulated, it had the ability to operate in any market, while only having to report to the SEC and did not receive capital charges. This is essentially the reason they were able to engage in these credit default swap trades without actually putting up any capital; trading among counterparties which were regulated, while LTCM could leverage itself to no end.

The fund’s management would employ profit/loss testing analyzing how their positions would perform in a low probability high impact event occurred. A problem with this was that not all potential outcomes can be calculated, events which have not yet occurred are not included. Before the Great Depression, the likelihood of a Great Depression was virtually none, after it probably remained pretty high, just as after the Housing Crisis. Though LTCM had nearly 40 major counterparties, none of them recorded and off balance sheet leverage. They did not have to trade pertaining to mark-to-market regulations; their balance sheet assets were roughly $125 billion in 1998 based on four billion dollars in capital, not including their off balance sheet business which would amount to over one trillion watch represents a capital base leveraged well over 200 times. As their assets and returns grew, they became more open to taking on increasingly high risk positions.  Managers would perform these theoretical market risk models without placing much value on gap and liquidity risk. If they are not liquid, then they cannot make payments. The managers would essentially consider that there was little to no underlying risks in the underlying instruments pertaining to the derivatives, though liquidity risk would present itself here; there is risk in adverse price movement among each market that these derivatives are in. It is not easy to value the cash flows for underlying securities and who the owners really are, and many hedge funds were allowed to put on these crazy leverage multiples due to how little regulation there was in this area. Its counterparties would not be able to find out how exposed LTCM is to whatever other counterparties it is doing business with. Long Term Capital Management was a hedge fund; a non-bank counterparty which was pledging collateral and writing swaps in a multitude of markets for little to no capital, just as if it was a large regulated bank.

2. Why did the Federal Reserve Bank of New York believe it was necessary to intervene after it became aware of LTCM’s problems?

        As previously stated, the fund is not able to account for all risks and will not be able to correctly predict interest rate movements in the future as well. In the latter half of 1998, lenders began calling on LTCM to increase their equity as their losses increased each day. Because LTCM had so many counterparties and was so heavily leveraged, if there was one default by LTCM, this would lead to a massive close-out in derivative markets almost overnight. There were undoubtedly other funds in similar positions as well and one could assume that if LTCM failed then they would believe that they would meet a similar fate and hurt markets furthermore. In this fund’s case, LTCM was unable to meet calls of its creditors. This proposed the idea of a downfall and collapse of the fund with over a trillion dollars in derivatives and 80 billion dollars in equities. With such an instant liquidation of such a high value portfolio, the Fed believed this would create an obscene amount of systemic risk; basically meaning that the entire financial system would be harmed by the downfall of LTCM. It is tough to determine after-the-fact if there would in fact have been systemic risk had LTCM not been bailed-out. If the Fed had waited and there did prove to be systemic risk then they would regret the decision, but by playing it safe one can say that this was to prevent the downfall of not only developed countries’ economies, but developing countries as well since their economies and markets depend much on how markets such as the U.S., France, Germany, etc. are performing. The Fed claimed that banks had calculated that LTCM would be worth a greater value over a longer period of time than if they had a fire sale and were forced to sell off everything at once. They believed this was necessary to do due to the large uncertainties surrounding systemic risk and LTCM.

3. Compare the LTCM collapse in 1998 with the collapse, a decade later, of Bear Stearns. In what ways are they similar? In what ways are the different?

        A major difference between the collapse of LTCM and Bear Stearns is that when they were bailed-out, federal funds of nearly $30 billion were provided to facilitate the sale of Bear Stearns while in the case of LTCM, they were bailed out through the pooling of a number of banks. Bear Stearns was also LTCM’s clearing agent, and they had nearly $50 billion in mortgage-related assets on its balance sheets when the housing market was about to burst. They are similar compared to LTCM in this aspect because LTCM was betting that securities would go up and bonds would go down and the opposite happened, since they were so leveraged they could not come-up with the amount of capital necessary to maintain their positions with creditors. Regarding Bear Stearns, they believed the housing market would never default and geographic areas were not dependent on one another defaulting. Due to their high leverage, they were losing tremendous amounts of capital overnight.