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Unformatted text preview: Long-Term Capital Management
When Genius Failed Evan Mueller Introduction Cast of Characters John Meriwether Eric Rosenfeld Victor Haghani Lawrence Hillibrand Myron Scholes Robert K. Merton David Mullins Introduction Mission and Vision Hedge Fund Leverage No "Haircuts" Financial techniques such as Repo Financing Types of Trades Used Treasury arbitrage Mortgage backed security trades Convergence trades Yield Curve trades Every derivative trade imaginable: Swaps Spreads Etc. Results 1994-1997 Began with a record $1.25 Billion start-up capital 1994: 28% return 1995: 56% return ($2.7B equity capital) 1996: 30% return ($3.7B equity capital) 1997: 60% return ($5.5B equity capital) ROA? Much less. Results 1994-1997 By the end of 1996, the fund had $3.6B in equity capital and $140B in assets plus $650B in derivative contracts Leveraged through the roof The Fall By 1997, opportunities began to dry up Risk averse climate Investors only wanted to be in the safest, most liquid securities (i.e. 10 year U.S. Treasury) Had so much capital but fewer opportunities to put it to work Management returned half of initial investor equity back to shareholders The Fall Currency Crises: Asian Currency Crisis: Case of too much liquidity Speculative attack Russian Ruble Crisis Speculative attack assuming Russia would devalue/default on its bonds LTCM bet it wouldn't Debt Moratorium, 1997 The Fall New Territory: Equities Unhedged plays Risk Arbitrage Equity Volatility The Fall Long-Term began to find itself on the wrong side of every trade! Speculative attack against Long-Term! Models were wrong! Markets kept sinking, becoming more risk averse than ever before Equity base shrinking, while markets dried up (increasing leverage further) The Bailout Eight major banks met at the U.S. Fed in New York to structure a bailout of LongTerm What would have happened had they gone bankrupt? No one knows for sure.... ....but it wouldn't have been good! Final Tally of Losses: Losses in 1998 alone: Russia/emerging markets: $430M Directional trades in developed countries: $371M Equity pairs: $286M Yield-curve arbitrage: $215M S & P 500 stocks: $203M High-yield arbitrage: $100M Merger arbitrage: Roughly even Final Tally of Losses: These seven categories made up a $1.6B loss Would not have put them under alone, if not for their losses in: Swaps: $1.6B Equity Volatility $1.3B Analysis Models and the human factor: Can you model human behavior? Speculative attacks? Are markets rational? Are markets normally distributed? Conclusions The future of models? The human element must be factored Expect the 100 year flood and expect it sooner, rather than later! ...
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- Spring '10