Ron J. Feldman - Assistant Vice President
Published December 1, 2000 | December 2000 issue
By Roger Lowenstein
The book suggests that the lenders were clueless as to the nature of the LTCM's assets and strategies and equally ignorant as to LTCM's total indebtedness. Rather, the banks relied on the brand name that LTCM had established through its roster of partners.
My version of the story, based on Roger Lowenstein's When Genius Failed: The Rise and Fall of Long-Term Capital Management, would read as follows: Sorcerers (Mathematically oriented bond traders led by John Meriwether) make the humans they serve rich (the investment banking firm Salomon Brothers). After this accomplishment, they find themselves fired and underappreciated (following a scandal involving a Meriwether employee). The magicians create a new organization (LTCM in 1993) with more powerful magic (quantitative models to discover and exploit price discrepancies in financial markets). Using their powers and the skills of their wizard high priests (Nobel Laureates Robert Merton and Myron Scholes), the geniuses build an even greater machine and accumulate a bigger pile of gold ($1 invested in LTCM in 1994 was worth $4 in 1998).
As they lord over mere mortals (the investment banks that provide LTCM with day-to-day funding), the magicians gain even more confidence that their guiding principles (financial markets are efficient) and methods (quantitative models) are infallible. But the incantations that worked at first ultimately fail when subjected to the foibles of the human world (LTCM almost goes insolvent in 1998 after Russia defaults; the firm lost about $3.6 billion in five weeks and suffered losses over $500 million on a single day). The arrogant sorcerers take financial hits and lose some of their luster (one LTCM partner saw his net worth drop from $500 million to -$24 million). The humans who had contact with the magicians get burned (the investment banks end up bailing out LTCM by buying the firm for $3.5 billion). Finally, the gods who intervened during the crisis (the Federal Reserve Bank of New York) faced skepticism from previously fawning acolytes.
LTCM is a great story/fable populated with memorable characters. Lowenstein does a nice job in pacing the story and I recommend reading the book for these reasons alone. There is a certain pleasure reading about the demise of the haughty and rich (or least people characterized that way). The book fails, however, in communicating a convincing moral. Lowenstein views the LTCM failure as a warning about applying high-tech, financial models and theories of efficient capital markets to financial markets that "are not always reasonable." There is also a general suspicion about the stability and effectiveness of financial markets that lurks throughout the book.
I did not buy it. Lowenstein seems to have fallen into the trap of confusing the failure of a firm with the failure of markets. As others have also noted, the decline of LTCM appears with 20-20 hindsight to be based on large, but surprisingly run-of-the-mill judgments, bets and strategic decisions that went wrong. Nothing in the book convinced me that the general methods (for example, using models) that informed those judgments, bets and decisions were systematically flawed. In fact, the one potential systemic failure that the book hints at relates to ill-conceived government policy.
Here are the "lessons" I took from Lowenstein's story.
Absent effective barriers, above-normal profits in an industry will attract entrants and imitation, which drives down returns. LTCM's initial returns were astounding. When the average bond investor lost money in 1994, LTCM generated returns of 20 percent, after subtracting out extremely high fees. In 1995, the return after fees was 43 percent; returns were 59 percent before fees. I had assumed that entry of firms into LTCM's markets and imitation by existing competitors would be limited, given popular accounts of LTCM's hard-to-replicate genius and ultra-secretive culture.
However, Lowenstein provides numerous examples suggesting that LTCM's strategies, models and even specific trades were either commonplace pre-LTCM or were quickly copied after their success. This did not bode well for LTCM as it meant competition, from new entry and imitation, would seriously erode profits. As one LTCM partner puts it in the book, "Everyone was catching up to us. ...We'd put on a trade, but when we started to nibble, the opportunity would vanish." Of course, if LTCM's techniques were not so special, one wonders how they were able to generate such large returns in the first place. At least one answer appears to be quite basic: lots of leverage.
Returns and losses are magnified by leverage. Consider the home buyer who has enough idle funds to pay cash for her $150,000 house. The next year she puts the house on the market and discovers it has appreciated $5,000. She has generated a return of 3.3 percent (5,000/150,000). Her brother bought a similarly valued house that had similar appreciation. But, he could only put $10,000 toward the purchase and had to borrow the rest. The return on his investment? A whopping 50 percent (5,000/10,000). The difference in this case was leverage. Borrowing allows the brother to put up little of his own money, or equity, thereby magnifying the gains on the asset when it grows in value. Of course, if the value of the house had fallen by $10,000, the brother would have been wiped out completely, while his sister would have lost only 7 percent. In this case, the brother had a leverage ratio (equity to assets) of 1 to 15.
Long-Term Capital's leverage was closer to 1 to 30 as early as 1995. A partner at LTCM described their technique as scooping up loose nickels created when prices in financial markets got slightly out of balance. However, it was only through leverage that such small bets created huge returns. And, as the house example demonstrates, such leverage left the firm extremely but knowingly vulnerable to an unfavorable shift in prices.
Brand names as substitutes for research. In addition to leverage, Lowenstein points to low financing costs as another source of supernormal profits for LTCM. Specifically, investment and commercial banks thought they would profit by providing short-term funding to LTCM at very favorable rates and terms. The banks, for example, lent money to LTCM without requiring much collateral, effectively driving down costs for LTCM and putting the lenders at greater risk of loss. Why would the banks make such loans? Little risk taking by LTCM is not the answer. Indeed, the book suggests that the lenders were clueless as to the nature of LTCM's assets and strategies and equally ignorant as to LTCM's total indebtedness. Rather, the banks relied on the brand name that LTCM had established through its roster of partners.
The group included economists who had pioneered financial tools that all the banks used, a former central banker with first-hand knowledge of monetary policy formulation and foreign governments, and a team of traders who had made significant profits for one of the banks. Just as consumers might look to a brand name for a sense of quality rather than investigating a product thoroughly, the banks considered the externally observable quality of LTCM's staff as a substitute for gaining inside information on firm operations. This proved to be a very poor decision and explains how LTCM was able to grow quickly and profitably. But, miscalculated decisions are just that and not evidence of failing markets. Indeed, I could probably tell an equal number of stories where relying on a brand name (for example,Warren Buffett) would seem like the stroke of genius.
Losing focus from your competitive advantage can be costly. LTCM compounded its problems by shifting away from areas where it benefited from comparative advantage. In response to the rising competition, partners in the firm moved from bond markets where many had spent their entire careers and had developed significant expertise, to stock markets where they had much less experience. For example, the firm made sizable bets on the completion of certain mergers, even though these markets did not lend themselves to LTCM's analysis or skills. Ultimately, the shifts into equities did not go well for LTCM and contributed to its failure.
In this context, the fable of LTCM is not a condemnation of new financial technology or of financial markets as a whole. Rather, we have a firm with access to easy money, facing increasing competition over time, shifting to markets it does not know well and relying on a strategy that leaves the firm extremely vulnerable to adverse price moves. Wrapped up in such a neat package, it would be surprising if LTCM did not fail! In his descriptions of these events, Lowenstein provides enough evidence to weaken his claim that LTCM was a firm where model devotion ran amok. From Lowenstein's descriptions it sounds as if the LTCM partners knew where their models were vulnerable.
They understood that future experience may not reflect the past. They understood that losses that occur infrequently could be larger than standard modeling assumptions project. They knew they were buying illiquid assets that would lose substantial value when sold quickly. Indeed, it would be amazing and unbelievable if the folks at LTCM were unaware of such concerns. By 1995, articles describing the deficiencies in the modeling approach used by LTCM to estimate exposure had even reached my humble cube (see, for example, Paul Kupiec, "Techniques for Verifying the Accuracy of Risk Measurement Models," Board of Governors of the Federal Reserve System, Financial and Economics Discussion Series Working Paper 95-24, May 1995).
In fact, Lowenstein describes LTCM as a firm whose comparative advantage was in "reading," not blindly following, the output of their models. In that vein, he also mentions detailed debates on specific trades and strategies that occurred over many weeks. Ultimately, it appears as if LTCM thought their predictions of future prices, warts and all, were better than alternative forecasts. As one LTCM partner summarized the firm's strategy, "What we did is rely on experience. ... If you're not willing to draw any conclusions from experience, you might as well sit on your hands and do nothing." While LTCM might have been better off "doing nothing," their failure seems to be a calculated risk that financial markets should encourage rather than an indictment of such risk taking.
Lowenstein's story gives the Fed a small operational role in the resolution of the LTCM crisis, relegating the New York Fed to an administrative role (for example, sponsoring meetings of those owed money by LTCM). The Fed did nothing to directly bail out LTCM, according to the author. But, the Fed, putting a very high value on limiting market turbulence, did lend its prestige to the effort to resolve the crisis. Lowenstein argues that absent the Fed's coordination effort, those that funded LTCM and the partners themselves would have come out worse. Unlike the banking crises of the 1980s and 1990s, where regulators allowed insured institutions to double up their losses after they became insolvent, the markets were proving themselves unrelenting in trying to shut down LTCM. Lowenstein correctly notes that by halting that process and encouraging protection, the Fed's behavior could have long-term costs.
By sparing creditors, equity holders and managers some of the pain of loss, we are more likely to see a repeat of the behavior that produced the LTCM crisis in the first place. Indeed, the expectation of future bailouts could have played a subtle role in the growth of LTCM in the first place. Did the favorable financing of LTCM go beyond reliance on the LTCM brand name and reflect the brand name and potential support of the U.S. government? Will LTCM's resolution make the too-big-to-fail problem even worse? Perhaps with time we will have a clearer sense if the benefits of the Fed's role in the LTCM resolution outweigh potential costs. For now, enjoy Lowenstein's fable but come up with your own more satisfying moral.