phik

The week before last I read a short book, something of a lighter and fluffier complement to the backbreaking tome about the Federal Reserve. This one was about the rise and fall of a hedge fund called Long-Term Capital Management, which after a celebrated four-year run up — during which they gave investors a more than 300% return — lost $4.5 billion in about five weeks. Their stunning collapse threatened to bring down more than one of America’s largest banks, who had foolished allowed them to leverage their capital more than 30 to 1, with no oversight into their trading activities.

Why would they do such a thing? Because LTCM had two Nobel prize-winning economists on board, and a team of celebrated arbitrage traders. Everyone, including themselves, believed that they had solved the puzzle, and devised a foolproof strategy for trading in bonds — particularly new and not-widely-understood derivatives. They had complicated models by which they supposedly predicted to the nth decimal place the likelihood that any given trade will fail. Eventually, other arbitrage desks caught on to how these new markets worked, so their yields became steadily smaller. Instead of backing away to safer ground — or closing the fund and returning the money to their investors — LTCM leveraged even more, and the fund collapsed spectacularly. A representative quote:

“You take Monica Lewinsky, who walks into Clinton’s office with a pizza. You have no idea where that’s going to go,” Conseco’s Max Bublitz, who had declined to invest in Long-Term, noted. “Yet if you apply math to it, you come up with a thirty-eight percent chance she’s going to go down on him. It looks great, but it’s all a guess.”

I found it thoroughly fascinating, but it’s not for everyone. When I started talking about the book, Deb looked at me like I had a live hamster in my mouth.

Adam’s comment is exactly right: I only told half the story.

In the beginning, LTCM had the market to themselves. People apparently didn’t consider bond arbitrage a sexy or lucrative practice yet, and they definitely didn’t yet understand new and complex derivatives. In that environment they cleaned up, using massive leverage to amplify the relatively small but “guaranteed” returns on their trades.

Then other arbitrage desks sprung up, and people caught on. That forced yields smaller, and the margin of error thinner. Instead of rethinking their strategy, they decided that smaller yields require more leverage.

Next, they started to feel the pain from what was described as effectively a blind spot in their diversification strategy. They predicted the likelihood of failure of a given trade with mathematical “certainty”, and didn’t conceive that the markets would simultaneously move against them, all around the world. Well, they did. The crisis in Asia, Russian default, South American devaluations, on and on, spreads widened instead of converged, and their highly leveraged trades lost a lot of money.

At that point, they had lost so much money that they needed additional investment to weather the storm. But these were no longer heady boom times, they were the days of worldwide financial crisis. And nobody was eager to invest in a fund on its way down, sight-unseen. So they reluctantly opened their books to a few banks, hoping that they would gain confidence in the fund, and help raise investment.

Well, once the market learned what was in LTCM’s portfolio, they did exactly as Adam wrote: all of their competitors began to trade against them. Knowing that at some point LTCM’s losses would be too great to bear, and they’d have to close shop and liquidate their trades, they all began to take opposite positions. I assume that this was more about making dump trucks full of money than crippling LTCM, but they didn’t have to choose — it did both.

It’s also worth pointing out that many of their derivatives were highly illiquid. There’s never liquidity in a crisis, but in LTCM’s case it was even worse. In the cases of some of these derivatives, only a few specialized bank desks would make these trades, and they were not helping LTCM to cash out.

And what very few in the market seemed to realize is just how big LTCM were. They made their trades through a dozen or more upstream banks, and each apparently had little clue:

Each bank knew the extent of its own exposure to an individual client, in particular to Long-Term. None bothered to think about whether the hedge fund might be similarly exposed to a dozen other banks. “You’d be doing big chunks of business with them,” recalled Siciliano, the manager at Swiss Bank. “You’d assume you were their number one provider, but really you were number ten. You couldn’t believe they were doing that much volume.”

So when they started to circle the toilet bowl, even the Fed took notice. And before long, the very banks that wanted nothing to do with them — including, grudgingly, even one or two who had no exposure whatsoever — ended up buying the portfolio and weathering the storm themselves, to avoid having to write off so many billions that it might undermine the entire banking fabric.

It’s started snowing, right on time. I don’t really believe that we’ll get the promised 14 inches, but who knows, maybe 8. I really want to go cross-country skiing again.

What’s really annoying, if you ask me, is that they start towing cars from the emergency snow roads long before the snow actually starts falling. Cambridge declared the cutoff to be midnight, and from our table at Bukowski’s the only traffic we saw was a steady stream of tow trucks in both directions. It’s a goddamn bumper crop for those towing companies.

Jacob doesn’t think an inch an hour is all that much, despite the fact that there are songs written about that much snow. It’s supposed to peak at three inches an hour tonight or tomorrow, but I’ll probably be asleep.