LTCM Redux risk analysis

by Tim Official: Myron Scholes

Wall Street is running a trade similar to one used by Long-Term Capital Management that nearly destroyed the global financial system. The Federal Reserve Board's own economists know it too. They literally wrote a paper about it and named the paper after the fund that blew up. It's called "LTCM Redux?" and it ran in the Journal of Financial Economics. Here is what they are worried about repeating. Long-Term Capital Management launched in 1994 under John Meriwether, formerly head of bond trading at Salomon Brothers. Myron Scholes and Robert Merton sat on the board and won the 1997 Nobel Prize in Economics while the fund was running. A former vice chairman of the Federal Reserve Board was a partner. It returned 20% in its first year, 43% in the second, and 41% in the third. The strategy was to find nearly identical bonds priced slightly differently and bet the gap would close. The gaps were pennies, so the only way to make real money was to borrow enormous amounts against them. Entering 1998 the fund had $4.8 billion of its own capital, had borrowed more than $125 billion, and held derivatives with a notional value above $1 trillion. At the end of 1997 the partners handed capital back to investors without cutting their positions to match, which pushed their leverage higher still. Then Russia defaulted in August 1998. Money ran for safety, the gaps that were supposed to close widened instead, and every position moved against them at once. Equity fell from $4.8 billion to $2.3 billion by the first of September. Roughly $4.6 billion evaporated in under four months. On September 23 the New York Fed put 14 firms in one room and did not let them leave. By six that evening they had committed $3.6 billion and taken 90% of the fund. The Fed itself lent nothing. Those 14 firms were LTCM's own lenders, and a forced sale of more than a trillion dollars in positions into a market with no buyers would have torn through their balance sheets first. Even with the rescue in place, the chairman of Union Bank of Switzerland resigned over a $780 million loss on options it had written on the fund. And the ending of that story is what makes it matter now: The banks were repaid in full by 2000 and nobody was charged with anything. Meriwether raised a new fund the following year. The lesson the market took away was that when a leveraged fund gets big enough to threaten the plumbing, somebody convenes a room. That precedent is now sitting underneath the largest bond market on Earth. Hedge funds held $2.4 trillion of US Treasuries at the end of last year, financed with about $1.8 trillion of borrowed money in the repo market. The cash-futures basis trade alone reached $830 billion as of last September, close to double its previous peak. Leverage on it commonly runs 50x and can reach 100x. And the conditions for a disaster are already here... The 30 year yield hit its highest level since 2007 twice in the past week. The long end has been in a buyers' strike since June. Yesterday the Treasury abandoned its own published schedule and doubled its bond buybacks without warning. What killed LTCM was liquidity disappearing from the market where its borrowed money was parked. And this time the rescue is being drawn up in ADVANCE. Academics from Harvard, Columbia and Chicago have already published a proposal urging the Fed to build a standing facility to absorb these positions when they unwind. Morgan Stanley estimates these positions shrank by more than $200 billion in July as spreads compressed. On top of that, central clearing becomes mandatory at the end of this year. The trade genuinely makes Treasury markets more liquid on ordinary days. But ordinary days were never the problem. Two Nobel laureates and a former Fed vice chairman could not see it coming from inside the building. Whoever is running this version is not smarter than they were, and the position is far larger #MyronScholes