1

Long Term Capital Management

Finance 4820

2

Conflicting Goals Goal of investment manager is to

gather assets

Goal of investor is large, consistent risk-adjusted returns

3

Pay for What Performance? Rf return - should be free Add market risk with risk premium

- should be almost free Lever market risk and premium -

should be almost free Create alpha - costly

4

Alpha is King

Investors want “repeatable” alpha Like quality earnings

As a result, managers present process in terms of approaches investors see as “repeatable”

5

Hedge Fund Basics Lack of transparency Fees, fees, fees 1% to 2% + 20% from

zero! Large returns needed for acceptable net Typical promise:

Equity-like volatility Equity-like returns Uncorrelated with equities

“Guru” rather than establishment Ability to cross markets

6

Arbitrage Most over-used term in finance? Arb = sure profit, zero investment, zero risk LTCM able to pull off the “zero investment”

part LTCM positions were “not zero risk, sure profit”

Leverage becomes an issue Correlation of positions becomes an issue Maximum loss becomes an issue

Due to leverage, instantaneous maximum

7

Trade Types Directional

Typical long or short (expected price movement) Mkt timing Unlimited loss short, 100% long

Relative Value Substitution or long/short Expected price or risk premium changes Potential loss more limited

Convergence Like realtive value, but:

Always long’/short End date/event that guarantees convergence

Less

Holding

Period

Risk

8

Leverage Leverage + illiquid assets = bankruptcy Traditional leverage

Borrow and purchase more assets Increases portfolio assets and portfolio volatility or

beta Cashless leverage

Futures/options OTC derivatives Structured securities

These do not increase portfolio assets, but do increase portfolio volatility or beta

9

Typical limits on Leverage Investor policy statement Internal reviews/controls Over-collateralization (haircut)

Treasurys 2-3% Agency MBS 4-5% High-grade corporate 5-10%

Maximum leverage = 1 / haircut %For MBS: 1/.05 = 20x

10

Leveraging “spread” trades Returns & especially spreads (risk

premia) tend to mean revert Extremely high or low risk premia

tend to be temporary Leverage makes the temporary

permanent

11

Leverage Risk - More Than LT Return Vol

-80.00%

-60.00%

-40.00%

-20.00%

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

Jun-02 Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02 Jan-03

10x

150x

12

Market Impact

Large trades can “move the market”

Bid/Ask on screen is not whole story

In addition to bid/ask, liquid market needs: Low costs Depth

13

Archipelago Limit Order Book

Apparent bid/ask

Of 10 cents

14

Quick Review Leverage Was Funded Primarily

Through the Use of Swap and Repos Little Capital Up Front, Cash Flows

Reflected Margin and Mark to Market ROA was Relatively Low/Huge

Leverage Magnified Returns VAR and Stress Testing More Useful

than Lvg. Ratios in Risk Management

15

Practical Problems With Var

Conditions are not stationary Including correlations

Limited data Liquidity crises Fat tails in financial markets

16

Sample Strategies Government Bond Spreads Swap Spreads Yield Curve Spreads Mortgage Spreads Volatility Spreads Risk Arbitrage Equity Relative Value

17

18

Trade Preferences Believed that Over Time Markets

Tend Toward Efficiency Limited Credit Risk in Outright

Positions Often Acted as a Source of Liquidity Tried to Isolate the Desired

Investment Risk and Hedge Away Other Risks

19

Monthly Swap Spreads 1990-2006

0

20

40

60

80

100

120

140

160

Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06

5yr Swap Spread 10 yr Swap Spread

20

5 Year CMT & Swap Rates 1990-2006

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

Jan-90Jan-91Jan-92Jan-93Jan-94Jan-95Jan-96Jan-97Jan-98Jan-99Jan-00Jan-01Jan-02Jan-03Jan-04Jan-05Jan-06

CMT

Swap

21

5 Year CMT 1953-2006

0

2

4

6

8

10

12

14

16

18

Apr-53Apr-56Apr-59Apr-62Apr-65Apr-68Apr-71Apr-74Apr-77Apr-80Apr-83Apr-86Apr-89Apr-92Apr-95Apr-98Apr-01Apr-04

22

Relative Volatility of Rates/Spreads 1990-2006

5 Year CMT Rate

5 Year Swap Spread

Ratio Rate Vol/Spread Vol

10 Year CMT Rate

10 Year Swap Spread

Ratio Rate Vol/Spread Vol

FNMA MBS OASL

Monthly SD

1.47%

.21%

7.0

1.33%

.23%

5.8

.11

Mean

5.48%

.49%

5.88%

.56%

.10%

23

FNMA MBS OASL 1995-2007

FNMA MBS OASL

-20

-10

0

10

20

30

40

50

Oct-95 Oct-96 Oct-97 Oct-98 Oct-99 Oct-00 Oct-01 Oct-02 Oct-03 Oct-04 Oct-05 Oct-06 Oct-07

Basis Points

24

5 yr Daily Swap Spread July - October 1998

40

50

60

70

80

90

100

110

7/1 7/8 7/15 7/22 7/29 8/5 8/12 8/19 8/26 9/2 9/9 9/16 9/23 9/30 10/710/14 10/21 10/28

5 yr Swap Spread 10 yr Swap Spread

25

LTCM Founded February, 1994 - Capital $1 Billion - Principal’s Share $146 MM

26

Salomon Bros. Pretax Income

1993 1992 1991 1990

Prop.Trading

$416 1,416 1,103 485

Other $1,159

(26) (67) (69)

27

LTCM Results

Net Return

Gross Return

Dollar Profits

Ending Capital

1994 20% 28% $0.4 $1.6

1995 43% 59% $1.3 $3.6

1996 41% 57% $2.1 $5.2

1997 17% 25% $1.4 $7.5

28

LTCM 12/97 Capital $7.5 Billion Principal’s Capital $1.9 Billion Assets $129 Billion Off Balance Sheet > $1 Trillion

29

Morgan Stanley 1996 $ BillionsNet Income $1.0Assets $129.4

Equity $7.4

Contractuals $1,317

30

Long Term Financing Equity Lock-Up (3year Staggered) $230 Million Unsecured 3 year

term Loans $700 Million Unsecured Revolving

Line of Credit, Annual Renewal Term Repos (6-12 months)

31

Back Office Complexity

7,600 Positions 6,700 Contracts 55 Counterparties Inability to Net Across Legally-

Distinct Entities within Large Firms

32

Liquidity Management Capital Uses: Mark to Market

Losses and Working Capital Working Capital Uses: Financing

Haircuts, Equity and Future Margin Requirements

Working Capital Sources:Equity Capital plus Term Debt plus Revolver

33

Risk Management Downside Risk Diminishes as Value

Discrepancies Become Extreme Leveraged Investors Commit First,

Followed by Unlevered Investors Stress Testing Diversification

34

Correlations

Long-Horizon Correlations Driven by Fundamental Risks

Short- Horizon Correlations Driven by Fundamental Risks and Liquidity Effects

35

Fund Size Desired Volatility of 15-20% Returns Uncorrelated with S&P 500 Expected Excess Return of $750MM Daily P&L Sigma =$45MM =$720mm p.a. =10.7% of CapitalModels est. sigma=$60mm.$960 p.a.

36

Fund Size

LTCM excess capital estimates of $2bn

Marginal Capital Earns Libor before Fees and Libor minus 2% after Fees

Return it! Alternative Strategies?

37

OOOPS……the Decision

Distribute $2.7bn on 12/31/97 “Favor” Strategic and Early

Investors Management Exempt Investors are MAD!!!

38

1998 through June

January through April: Flat May & June –16%, 4.1 Billion Firm Cuts Daily Sigma by 10% Liquidates Least Attractive (Most

Liquid) Positions

39

July 1998 Salomon Smith Barney Shuts Down

US Fixed Income Arbitrage Group LTCM Up 7% Through July Then Pattern of Daily Losses

Resumes Across Many Positions Global Equity Markets Under

Pressure Globally Volatility Spikes

40

August 1998 August 17: Russian Default, Flight

to Quality August 21: Fund Loses $550mm in

(Risk Arb and Swap Spreads) YTD down 40%, -$1.8BN, to $3bn Leverage (Cash basis) Now 44x

41

Working Capital Sources: Equity $2.95 Term Debt 0.23 Credit Facility 0.90 Total 4.08

Uses of Working Capital: $2.10

42

Lender Covenants Credit Facility Terminates if YTD

Loss is Greater than 50% Contractual Agreements terminate

if Fund Capital Falls Below $500MM

43

Choices? Liquidate?

Raise Capital?

Buy…gulp…More?

44

September Investor Letter Losses of 52% YTD (to 2.3bn Capital) YTD Losses of $2.5bn 82% of Losses RV, 18% Directional Positions Take Time to Efficiently

Accumulate Best Opportunities Ever Seen Want to Come Out and Play?

45

September 1998 Fund Raising Fails Negative Rumors Mkt Participants Bet Against LTCM Liquidation of Similar Positions Bear Stearns Demands More

Collateral Counterparties Mark to Worst

46

September 1998

9/21 One day Loss of $553 Million Capital Below $1 Billion 9/23 Consortium of Firms Put up

$3.6bn for 90% ownership and Oversight

Not Capital Adequate Until February 99

47

LTCM Losses 1/98-9/98 Fixed Income RV $1,628 Equity Volatility $1,314 Emerging Markets $430 Directional $371 Equity Pairs $306 Total $4,600

48

Issues Determining Staying Power

Who else Employs Similar Strategies? Liquidity Shocks Time Varying Risk and Return Diversification Funding Sources Franchise Value

49

Causes of LTCM Failure Arrogance - must be right Lack of any controls

Internal Investors Lenders Counterparties

Reliance on correlations Not stationary Market changes Fat tails

Size of positions Limited trading partners They all know/watch each other

50

Leveraged Returns Before/After 1998

1992 9.67%   Jun-98 0.0074

1993 4.90%   Jul-98 0.0058

1994 19.38%   Aug-98 0.0104

1995 9.06%   Sep-98 0.0147

1996 13.81%   Oct-98 -0.0483

1997 13.69%   Nov-98 0.0523

1998 9.28%   Dec-98 0.0139

1999 2.30%   Jan-99 0.0223

2000 2.16%      

2001 28.40%      

2002 20.22%      

2003 22.12%      

2004 6.45%      

         

12.42% Annual Arithmetic Mean  

12.15% Annual Geometric Mean  

8.33% Annual Standard Deviation  

51

Leveraged Returns During 19981992 9.67%   Jun-98 0.74%

1993 4.90%   Jul-98 0.58%

1994 19.38%   Aug-98 1.04%

1995 9.06%   Sep-98 1.47%

1996 13.81%   Oct-98 -4.83%

1997 13.69%   Nov-98 5.23%

1998 9.28%   Dec-98 1.39%

1999 2.30%   Jan-99 2.23%

2000 2.16%      

2001 28.40%      

2002 20.22%      

2003 22.12%      

2004 6.45%      

         

12.42% Annual Arithmetic Mean  

12.15% Annual Geometric Mean  

8.33% Annual Standard Deviation