September saw a spasm of retrospectives on the 10-year anniversary of the financial crisis. Lost in all of the hoopla was the 20-year anniversary of another collapse — that of hedge fund Long-Term Capital Management in September 1998. In many ways, that episode was a precursor to the next crisis.
This privately-held investment firm believed — incorrectly, we later learnt — that it had come up with a new and more profitable way to invest capital. And for a while, it did: Returns soared, with annualised gains after fees of 21, 43 and 41 per cent in its first three years. The team had the appearance, according to journalist Roger Lowenstein, of being a “$100 billion moneymaking juggernaut”.
Although the firm’s managers were brilliant — two future Nobel winners had major roles in developing its investing strategies — they made some not-very-smart decisions.
This is what happens when too much risk and too much leverage meets too little humility. As detailed by Lowenstein in the masterful book*When Genius Failed: The Rise and Fall of Long-Term Capital Management,” the telling of the LTCM story reads like a crime thriller. But even more important, the story contained many of the themes that played out in the financial crisis.
The investment team at LTCM found many small, overlooked opportunities. Thus, it had an edge. But it was so small that it wouldn’t have created any worthwhile gains after expenses. The solution was leverage, and the key was managing the associated risk through hedging strategies.
At its peak, LTCM held $124.3 billion of assets against equity of $4.72 billion, for a 26-to-1 leverage ratio.
But let’s back up a bit and set the scene leading up to the firm’s collapse. Maybe it will seem familiar:
* Falling interest rates led fund managers to reach for yield;
* Asset managers searched the backwaters of finance for opportunities in exotic, illiquid credit markets;
* A single firm amassed huge derivative positions;
* Debt obligations of one firm intertwined with the rest of Wall Street, necessitating the involvement of the Federal Reserve.
You know how this ends: It doesn’t take a whole lot of trades to go sour for a fund that’s levered 26-to-1 fund to go bust. If LTCM only had had a few million dollars in holdings, no one would have ever heard of it, and it would have quietly gone bankrupt. But all of those big brains attracted billions of dollars; leverage that up enough and it begins to smell like what we now call systemic risk. By the end of September 1998 as the firm’s trades unravelled, capital had shrunk to a mere $400 million while assets were still more than $100 billion, giving the fund an unsustainable leverage ratio of about 250-to-1.
The towering leverage ratio and rapidly depleting equity meant an imminent bankruptcy. The Fed, under the guidance of Alan Greenspan, organised a group of 16 financial institutions to pony up $3.6 billion to keep LTCM afloat while the derivatives and illiquid holdings were unwound over time.
In an email exchange, Lowenstein said that the implosion of LTCM had many of the hallmarks of a financial panic.*In 1998, it didn’t feel like a dry run” for 2007, he wrote.*It felt like the end of the world.”
Lowenstein added that while the Fed’s rescue of LTCM worked to “soothe traders and numb investors,” it also taught the wrong lesson, namely that*the government would always be there” to help out in a crisis.
“Modern finance remains overly complicated.” Lowenstein observed. Speculation and bubbles are a regular part of markets. Government involvement and the occasional bailout is the default setting, rather than allowing market participants to suffer the consequences of their own actions when the pain would otherwise be too severe.”
This was exactly the moral hazard that helped to create the financial crisis. If the collapse of a private hedge fund leads to a bailout, well then, the lesson here is make sure you are big enough, highly leveraged and intertwined with the rest of Wall Street.
In a nutshell, Greenspan failed to understand the impact of private gains and socialised losses. In doing so, he set an awful precedent that to this day has not been corrected.
“We live in an age of bubbles, perforce of occasional crashes.” Lowenstein said. The Fed was created as a lender of last resort, and we should expect that its services (at some point) will be called upon again.”
It’s obvious that the lessons of LTCM were of no use in preventing the crisis that followed 10 years later. The same can probably be said of the main event in terms of the next crisis, I’m afraid.
Barry Ritholtz is the founder of Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He is the author of “Bailout Nation”.