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One of the largest financial disasters which can be traced to computer investing/trading in the 1990s was the collapse of the hedge fund, Long-Term Capital Management ("LTCM"). LTCM was organized in February, 1994 with a $1.25 billion equity base, raised from wealthy investors and financial institutions by a group of Wall Street professionals and several Nobel Laureate economists. These disparate individuals combined to create a computer trading and hedging program which focused on the differences between interest rates on various types of bonds. Those differences are called "spreads." Two famous economists, Robert C. Merton of Harvard, and Myron S. Scholes, one of the developers of the Black-Scholes model for pricing options, were initial partners in LTCM. They were proponents of the Efficient Market Hypothesis, popularly called the Random Walk Theory. We have looked at this investment theory in a past blog.
The fund's initial investment strategy was based on the theory that any unusual spreads between the interest rates of different bonds would, in a rational and efficient market, ultimately narrow and converge. LTCM's computers were programed to seek out and identify these spreads, which allowed LTCM to take market positions in the bonds which would be profitable if and when those spreads narrowed as predicted. When LTCM started, it was the only market player investing in such a way, which resulted in its spectacular early success. Based on that success, LTCM was able to borrow billions of dollars from large banks in order to make its investments on margin. Its early annual returns on equity were astronomical (28% in its first year of operation and 59% in 1995 before fees). Such returns led to more money coming in from investors and more money made available from lenders, a sort of virtuous circle.
There is an old saying that "imitation is the best form of flattery." As is so often the case, LTCM's success on Wall Street attracted attention and led other market professionals and their companies to figure out and copy LTCM's profitable trading strategy. Soon there were many funds and traders playing LTCM's game. This led to problems for LTCM because, with the new competition, it was more difficult to establish positions and profit from the spreads which LTCM previously had all to itself. As a result, LTCM started to trade other financial assets, hoping to garner the same profits as in the past including an asset called equity volatility (which is too complicated for me to understand other than to say it was a naked bet not an investment).
Unfortunately, expanding its trading horizons was not the answer. One of these new trades by LTCM was in Russian bonds. They believed that Russia would be able to pay its bonds, a belief they held right up to August 17, 1998, when the Russian government announced a debt moratorium and defaulted on its bonds. At this point, to make matters worse, Russia also devalued its currency, the ruble, which LTCM had also bet would not happen. During this time of market turmoil, almost all the other trades LTCM had set in place also turned against them. Since LTCM used so much leverage (margin loans at a ratio of $28 debt to $1 equity in 1997), its losses were staggering. It all came to a grinding halt for LTCM in August, 1998. Bond spreads had increased to levels never seen before, much wider than the computers at LTCM had been programmed to anticipate. LTCM lost $1.9 billion of its capital in one month. Its remaining capital, $2.8 billion was dwarfed by its $125 billion of assets. These numbers do not include the other LTCM positions in derivatives and swap spreads, which added to its unsustainable debt load. To make matters worse, the loans which had been so
freely extended early on were being called and finding new loans became
impossible, all at the worst possible moment for the fund.
There is a hard truth about lending money. If you lend someone $1,000, you are a creditor; however, if you lend someone $100 million, you are a partner. As LTCM moved ever closer to the bankruptcy cliff, it became apparent to everyone on Wall Street and in the Federal Reserve that a collapse of LTCM would have devastating effects upon the financial system, not only in the US, but around the world. It had so many outstanding trades with so many other institutions that its failure would have damaging ripple effects around the world. By September 21, LTCM had racked up additional losses of $553 million, and the markets continued to move against its trading positions. Something had to be done. The Federal Reserve brought together the biggest investment firms on Wall Street, including LTCM's lenders, in emergency meetings over several days to address the problems. The Fed forged an agreement which, with other countries, would provide $3.65 billion in equity to LTCM, which with its remaining $400 million in equity, would provide the fund with the needed capital to remain in existence until it could be liquidated in an orderly fashion.
The entire saga of LTCM is told in remarkable detail by Roger Lowenstein in his 2000 book, The Rise and Fall of Long-Term Capital Management, When Genius Failed. In summing up the little over four year run of LTCM with its arcane computer modeling and efficient market philosophy, Lowenstein said it best with the following:
Reared on Merton's and Scholes' teachings of efficient markets, the professors actually believed that prices would go and go directly where the models said they should. The professors' conceit was to think that models could forecast the limits of behavior. In fact, the models could tell them what was reasonable or what was predictable based on the past. The professors overlooked the fact that people, traders included, are not always reasonable. This is the true lesson of Long-Term's demise. No matter what the models say, traders are not machines guided by silicon chips; they are impressionable and imitative; they run in flocks and retreat in hordes.
The next time a Merton proposes an elegant model to manage risks and foretell odds, the next time a computer with a perfect memory of the past is said to quantify risks in the future, investors should run -- and quickly -- the other way.
Excerpts from The Rise and Fall of Long-Term Capital Management, When Genius Failed. Roger Lowenstein, copyright 2000, published by Random House, pages 234 & 235
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