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Commentary | PERSPECTIVE ON FINANCE

Bailing Out The Billion-Bettors

How could a small group of high-risk traders imperil both banks and finances around the world?

October 05, 1998|MARTIN MAYER | Martin Mayer is a guest scholar at the Brookings Institution and author of "The Bankers: The Next Generation."

As demonstrated by the severe market sell-off that followed the news, there is an even worse story than has yet been told in the collapse of Long Term Capital Management of Greenwich, Conn., the hedge fund deluxe that scorned the fellowship of anyone with less than $10 million to invest.

People dislike the idea that nobody is in charge but have learned to live with it--that's capitalism, where the invisible hand moves in mysterious ways. This story, however, means that nobody knows what's going on--and that really scares the market.

LTCM was founded four years ago by the former chief trader for Salomon Brothers and two sidekicks, one of whom was advertised as the first bond trader in history to receive a $24-million bonus for one year's work. It was run by an executive committee including two Nobel Prize-winners in economics and a former vice chairman of the Federal Reserve Board who had been a Harvard professor before that.

The work that these people did to make money was programming computers to spot "anomalies"--unusual differences between the prices of financial instruments with well-established historical price relationships. One did not have to know the cause of such relationships--the fact that the computer found them was good enough. Big bets would then be placed in such a way that they paid off when prices "converged" to their usual patterns.

It is probably worth noting that the work done at LTCM, while not illegal or sinful, was totally without redeeming social value. This is not "investing"; it enables the production of no goods or useful services. It is betting.

The formulas that funds like LTCM use give a very high probability of small gains, but also a very low probability of a big loss. If the bets are big enough and the turnover is fast enough--and if you can play with money borrowed at low interest rates--the small gains can add up to a very large return on each set of bets. In its first three years, LTCM made profits half again as much as the rise in the stock market. In January, the fund gave $2.8 billion, about a third of its total capital, back to the shareholders, professedly because the opportunities to make money on anomalies had declined, more likely because the insiders had decided to keep a bigger piece of the profits for themselves. All of this, of course, must be totally hush-hush. If others know what you're doing, they'll copy you and blunt your edge. Thus the banks in supplying fortunes to funds like LTCM have been schooled not to ask the uses to which the money will be put.

But the mathematical models that power these funds fail when something significant happens that the computer doesn't anticipate, like a Kobe earthquake or a Russian default. LTCM had made an especially big bet that higher-interest corporate bonds would gain in relative price while U.S. Treasury paper would decline in relative price, thus bringing the comparative yield on the two into a more familiar alignment. Instead, the corporate bonds went down and the Treasuries went up, and LTCM lost on both sides of its bets. The smartest mathematician cannot write an equation for "event risk."

LTCM admittedly lost $2 billion in August and probably as much again in the first three weeks of September. Its partners, not quite humbled (for they kept saying that if they had more time their strategies would work), scavenged the world for cash. Most of the LTCM positions were financed with repurchase agreements--the fund would sell the bank the instrument in question, under contract to buy it back at a slightly higher price in a specified number of days. As the value of the securities held under repurchase agreements declined, the lenders asked LTCM for more collateral, and soon the cupboard was bare. A $500-million loan from a group of multinational banks came due on Sept. 23. LTCM didn't have the money.

On the last day, the fund was kept alive by a consortium of a dozen big banks and investment houses, brought together for this purpose by the Federal Reserve Bank of New York. The bankers, presidents and CEOs--from Merrill Lynch and Chase, Morgan and Travelers Group, Goldman Sachs and their ilk--were surprised to see one another. LTCM was into each of them for considerably more than a billion dollars, but none of them knew the fund's relations with the others.

William McDonough, president of the Federal Reserve Bank of New York, testified before the House Banking Committee on Thursday that LTCM would have had to be liquidated if he had not organized the rescue. Its assets were still greater than its liabilities, he thought, but any effort to sell them to raise cash would have knocked down the price so far that the creditors would have suffered losses. Federal Reserve Chairman Alan Greenspan testified that the carnage in the markets from this "fire sale" might have ended prosperity in our time.

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