Liu on "Rise and Fall of LTCM", Part I

Les Schaffer godzilla at
Sat Nov 18 11:55:08 MST 2000

[part I of Henry Liu in response to post on LTCM, cleaned up
some. Les]

Galbraith's review of Book on LTCM

At the end of the review Galbraith says:

Lowenstein criticizes the Federal Reserve for intervening, and so
failing "to send the markets a needed dose of discipline." But here he
is quite wrong. The Fed's job is not to teach lessons, but to keep the
system afloat."

I don't agree with Galbreath's assessment of the Lowenstein criticism.
LTCM, as big as it was, was not the system.  The sky would not have
fallen if LTCM was allowed to fail. There are clear indications that
the bailout of LTCM perpetuated moral hazard and slowed and even
aborted needed momentum for reform of the deeply flawed global finance
architecture.  Hong Kong whose government suffered much criticism from
US sources when it staged a market "incursion" in 1998 to combat hedge
fund manipulative attacks on the HK equity markets (by exploiting the
inconsistency between the linked HK dollar and equity futures) only
days before the LTCM bailout, was able to mute much US criticism about
interfering with free markets after the bailout.  Under US finance
"hegemony" (Greenspan), pain in Asia or Russia or Latin America is not
considered fatal to the global system but pain on Wall Street is.
Meriwether has been talking, after the publication of the book, to the
WSJ and The NY Times.  Essentially, in order to raise funds for his
new undertaking, he now admits that the fundamental concept behind
LTCM had been flawed: that the two key factors (divesification and
size) that LTCM counted on to protect itself from illiquidity crunches
were in fact contributing to its liquidity crisis.  LTCM partner Eric
Rosenfeld told the Times that LTCM thought it was well diversified
because it was using different (compensatory) strategies in different
markets around the world but "it realised too late that there was a
thread running through all these trade" in different markets.  That
thread was the flight from illiquidity by all market participants that
the very size of LTCM's own trades triggered.  LTCM was riding a tiger
amid a colony of wolves.  While it was on top, the tiger gave it the
illusion of being king of the jungle.  But it could not get off
without being devoured by the pack of waiting wolves.

The real mistake made by LTCM was not one of experiential logic.  No
sane mind expected Washington to let the Russians default on their
bonds. It was a geo-political paradigm shift that LTCM did not figure.
The bailout target was not really LTCM.  It was the select victims of
counterparty risk, namely all the banks that lent money to LTCM and
all the counterparties of LTCM trades.  The group of investment houses
and commercial banks that finally provided that funds were actually
doing so to reduce their own losses, with the Fed's guidance.  LTCM
investors included a few central banks, including the central banks of
socialist China! LTCM reportedly lost $4 billion when the dust finally
settled, much less than otherwise would have without the bailout. The
bailout lenders actually made money from the bailout.  The innocent
victims of collaeral damage around the world were not as lucky.
Meriwether was able to raise $400 million by December 1999, for his
new fund by promising to keep to a 10 to 1 leverage (instead of the 30
to 1 by LTCM) and a return target of a mere 15% rather than the LTCM's
30%.  No lesson was learned except that hedge fund managers have nine

Galbraith wrote: "One day in the early fall of 1975 I sat in the
office of Rep. Henry S. Reuss (D-Wis.), Chairman of the House Banking
Committee, for whom I then worked, along with Governor Hugh Carey of
New York and Felix Rohatyn, Peter Goldmark, and David Burke of Carey's
emergency team. Our purpose was to nail down a legislative plan to
prevent the impending bankruptcy of the city of New York.

Toward the end of the meeting, Reuss asked me whether I had anything
to add.  "What about the windfall problem?" I asked. New York City
bonds were trading at 30 cents on the dollar (or so I recall). When
the bill went through, they would jump and anyone who bought them as
we spoke would make a fortune. Carey turned to Rohatyn, "What about
that, Felix?" Rohatyn shrugged, "Well, he's right."  Little did I
know. The speculator existed, and his name, as we learn from Roger
Lowenstein's genial account of Long-Term Capital Management, When
Genius Failed, was John Meriwether. The New York crisis marked the
takeoff of Meriwether's career, which went from bailout to bailout
over 23 very exciting years."

HCKL: But more than windfall profit was involved.  Meriwether ran the
bond arbitrage group at Soloman Brothers and was responsible for the
firm's eventual collapse.  Traders like Meriwether were not mere
speculators.  They were manipulators.  They played a role in putting
NYC bonds in jeopardy and then bought it up on the cheap knowing that
despite the headline of Reagan telling NYC to "Drop Dead", a bailout
would come.  Big MAC imposed some draconian restrictions of NYC's
budget for the subsequent decade, and the price was paid by city
workers in foregone paid raises and benefits, by citizens who saw
public services such as libraries hours and trash collection cut to
the bone, by private investors who invested in NY based on faith on
the City government promises.  I personally was developing an office
building in Jamaica, Queens, on land leased from the City on the
promise that the City would spend substantial sums to improve the
transporting links to Jamaica.  My project lost $20 million because
the City was unable to live up to its promise due to Big MAC
restrictions.  There were thousands of similar cases in NY during the
mid 1970's.  NY did not recover for more than a decade.  Reuss could
have required the "windfall" to be redistributed to the innoncent
victims of NYC's fiscal mismanagement, like teachers and city
employees, rather than allowing bond arbitrageurs to keep them. It was
the equivalent of allowing someone who had shot a lot of people
indiscriminately to also walk away with the hospital budget.

Galbraith wrote: "The professors, we learn here, were peripheral to
trading operations (Scholes, a "lesser partner" was "forever angling
for more money"), but they were central to the marketing campaign. In
this respect, their shared 1997 Nobel Memorial Prize didn't hurt at

HCKL: Lowenstein is off the mark on this point.  I have posted on PKT
several times on LTCM which detailed that the importance of the
Merton/Scholes-Black method of quantifying risk in prising options and
futures.  LTCM would not have worked without high speed computers that
could search for trade opportunities according to mathematical
formulae devised by Merton/Scholes-Black.

Galbraith: Leverage multiplies risk, but Long-Term believed that the
underlying risk was so low that multiplication by leverage would not
matter. This belief stemmed from a critical assumption: that the
spreads between two essentially identical assets would be randomly
distributed under a normal (bell) curve. Thus, the probability of a
spread between highly similar assets moving too far in the wrong
direction--of the cheap asset falling in price while the dear one
rose, would be very slight and could be precisely calculated from the
historical record.

HCKL: The above is not a complete rendition of LTCM trading
strategies.  The LTCM strategies are mathematically highly
sophisticatedand rather flawless.  What LTCM did not figure was that
it was not the only one with fast computers and operative
mathematics. Its strategies were copied by other market participants
within seconds, thus neutralizing their initial advantage before
maturity. Trading is basically a zero sum game against others market
participants.  When some one wins, some one else has to lose.  The
very function of arbitrage is to provide more market efficiency; and
that very function makes arbitrage is sucidial activity.  That is the
reason Meriwether conceeds that LTCM strategy was fundamentally

Galbraith: Lowenstein presents the statistical issue competently,
given that his own understanding is not deep and he expects his
readers to have none at all.  But he underplays a key issue.
Economists have known for decades that the assumption of normality in
the distribution of future events is false, particularly in financial
markets. In 1937, John Maynard Keynes made the distinction between
risk and incalculable uncertainty the foundation stone of his
theoretical revolution. But Merton, Scholes, and the others came from
a branch of economics that had rejected Keynes. That was their first

HCKL: I am not competent enough to coment on whether Merton/Scholes
rejected Keynes.  Granted I have not read enough of economics
literature, but of what I have read from Merton/Scholes, I have not
been left with the impression that they disagree much with Keynes.
Merton/Scholes are of a minor league when compared to the towering
Keynes, and their approach is mechanical and narrowly focused.  But
the concepts Merton/Scholes developed are undeniably operational.  The
Street took up their ideas only because they work.  Without them,
there would be no futures markets as we know them today, which in
todays's world paly a very large role in all markets.  Sure, futures
markets existed even in ancient times, before computers, but today's
futures markets are space travel, as the Marathon is to ancient future

Galbraith: By buying cheap and selling dear, they were always betting
on convergence.

HCKL: But this is not true.  There are also divergence strategies,
straddles and all other manners of vairiations.

Galbiaith: This was inevitable. A few weeks after the debacle, I
debated a Finance Department colleague in Texas on LTCM. He described
the operation as being like a bet on Secretariat at the Belmont, to
show. A sure thing, in other words. Do it with two dollars, you'll win
a nickel. Borrow a billion and do it, and you're a hedge fund.  The
analogy seemed exact to me, and I said so. But there was a twist. The
LTCM assumption was that the very same Belmont, the third jewel in the
Triple Crown, could be raced again, day after day after day. The
second time, the third time--it isn't the same race. And if you double
your bets every time, on the assumption that it is, bankruptcy is

HCKL: This is a bad analogy: Those who understand the basic principle
of hedging will know that the aim is not to pick a winner, even for
show, but to profit by the fact that there is always a winner.  The
idea is: no matter who wins, the bet pays, the only difference is the
amount paid. This is accomplished by the existence of other betters
who think one horse will win over those backed by others.  An
arbitrageurs exploits the open parity of the various bets.  All bets
carry the same risk, which is equalized by the odds given.  A lame
horse will have a million to one odd.  The risk of losing the bet is
exactly the same as the favorite which has a 1 to 1 odd. A hedge
exploit the flaw in evaluating the odds of vaious horses.  If there is
no flaw, then the hedge is a wash.  A good trading strategy has no
down side, or its is not effective hedging.  Hedging is the opposite
of gambling.  Hedging does not eliminate risk.  It only transfers risk
to a counterparty. Therin lies the motivation of LTCM counterparties
to bail it out.

Who was the genius, then? Not Merton, an "evangelical" devotee of the
bell curve. Not Scholes, a dapper and fast-talking marketing man. Not
the computer gurus, who couldn't see the larger context of their
operations and didn't think they needed to know. Not the top traders,
impetuous, volatile, and seduced into directional bets on Russian
bonds with no historical data. No, the genius here was John Meriwether
himself. It was Meriwether who saw a way to package academic
celebrity, infatuation with the new technology of computerized
investing, and his own aloofness into the ccreation of a firm that
would snow the big money men in New York, Paris, and Zurich, bringing
in the hundreds of millions of dollars of loans needed to leverage
LTCM's trades. This was a masterpiece of manipulation.

This is what Meriwether wants us to think.  He was the genius.  The
Nobel scientists left him down with bad O zeal rings.  Thats is why he
is doing it again, this time with a different strategy.  The opposite
is true.  Merton/Scholes made a real contribution in quantifying
market behavior in a way that can be exploited by computerized trading
and the emergence of a globalized financial market.  Their findings
were not earth-shaking except for the fact that they speeded up the
system.  It was a turbo effect, of rather minor significance in the
scheme of human affairs.  But it did change the way the Indy 500 was
run and how cars can take S turns at a few miles faster speed without
crashing into the wall, which is what financial markets are all about.
Turbo engines are now sold by Toyota.  Merton/Schoples formulae are
used now by individual day traders working with puny six-figure
portfolios, but hundreds of thousands of them.  The LTCM fiasco did
not destroy the hedge fund industry, no more than Milkin's jail term
destroyed the junk bond business. It only reshaped it.  Scores of
hedge funds today are still returning 40% quietly.  You can find them
all over the Internet or attend their conventions in Bermuda.

Galbreath: "And of course, when the big bankers realized they'd been
had, they were vengeful.  Lowenstein traces the unraveling of LTCM,
and darkly hints that Goldman Sachs undermined the firm deliberately
by selling identical positions while it was reviewing LTCM's books,
driving up losses and making the firm easier to acquire. Only an
effective intervention by a low-paid bureaucrat--Peter Fisher of the
New York Federal Reserve--kept the banks together long enough to
cobble together an orderly liquidation in the autumn of 1998.

HCKL: I have now read the book, and this sounds typical of naive
journalism. Is it still news that Wall Street is dog eat dog, infested
with double, triple dealings?  GS want to sell LTCM to Warren Buffet.
The British Rothchilds did the same to British bonds during the
Napoleanic wars.  My neighbor in 1998 was the USA country chief for
Credit Agicole-Indo Suez, which was also a minor creditor of LTCM.
Some stories I head from him, who was there is person in the Fed
meetings, left me with the impression that the unwinding (there was no
liquidation) was not all that orderly.  For months after the bailout
terms were struck, there were still confusion as to exact what LTCM's
position was and how much money it had actually lost.

Galbreath: Lowenstein criticizes the Federal Reserve for intervening,
and so failing "to send the markets a needed dose of discipline." But
here he is quite wrong. The Fed's job is not to teach lessons, but to
keep the system afloat. It cannot have known exactly what the
unraveling of LTCM's trillion-dollar exposure on the open markets
might have meant. And as to lessons, if Lowenstein's account of the
bankers is correct, the Fed would have been utterly foolish to suppose
any of them were capable of learning. Lowenstein's criticism of Alan
Greenspan, who has repeatedly defended the derivatives business on the
hyper-ludicrous grounds that lenders supervise it closely, is more on
the mark.

HCKL: Greenspan is saving his own skin as much as LTCM's.

Galbreath: That, of course, is the enduring dilemma of the LTCM
fiasco. These people who run the money world really aren't all that

HCKL: This has always been true.  If you really want to stay up
nights, neither are the people running the political world. We little
guys are all at their mercy. I only hope that Gore will keep his
promise of not letting the working families down.  It is not class
warfare.  Distributing income downward is the only way to avoid a
financial implosion of the current system.  I only wished Gore had
said working families of the world.

Still, I think we should be fair to Black and Scholes.

The Black-Scholes Formula made possible dynamic hedging which in turn
brought about the revolution in financial engineering and changed the
nature of risk from a liability to an asset.  Dynamic hedging reduces
risk by creating a perfect equilibrium in which fluctuations in the
portfolio cancels each other out. Black and Scholes found a
theoretical way to neutralize risk. Two risky positions taken together
can effectively eliminate risk itself. The application of mathematics
to risk management would lead to the creation of a multi-trillion
dollar derivatives industry.

They discovered a water tight formula for pricing options.  This
formula made it possible to use dynamic hedging which started the
field of structured finance that drives today's finance markets.  The
Scholes/Balck formula is still used every day on Wall Street and in
global markets, despite LTCM.

The effectiveness of dynamic hedging is bounded by the abscence of
paradigmic shifts which frequently tend to occur only infrequently,
;-).  Thus if one resist the temptation to escalate one's bets, the
law of averages and the law of big numbers yield the user of the B-S
formula a decided advantage.

Samulson said he located by chance in the early 1950s Bachelier's book
rotting in the library of the University of Paris, and "a whole new
world was laid out" before him.  Bachelier created the first complete
mathematical model of stock market fluctuations. He had found a way to
control risk, through an obscure financial contract called an
option. He realized options could protect investors from market
fluctuations and made the first attempt to figure out how to price
them.  To get the perfect formula to evaluate and to price options,
the elements needed are: the stock price, its volatility, the strike
price, the duration of the contract, the interest rate, and the
overall riskiness of the option. They were all measurable except one -
the level of risk.

The Black-Scholes formula states that the price of the call option is
equal to a fraction of the stock's current price minus a fraction of
the exercise price.  The fractions depend on five factors, four of
which are directly observable.  They are: the price of the stock; the
exercise price of the option; the risk-free interest rate (the
annualized, continuously compounded rate on a safe asset with the same
maturity as the option); and the time to maturity of the option.  The
only unobservable is the volatility of the underlying stock price.

Most traders, including those in my group, who have inadequate math
training, do not understand the maths behind the BS formula.  But
there is no denying that it works, even though its validity may be
based on common acceptance (a market standard) rather than mathematic
truth.  So Black and Scholes decided if they couldn't measure the risk
of an option exactly, perhaps they could make it less significant. The
method they devised was to become one of the most important
discoveries in economics in this century - hedging by betting in the
opposite direction. Their aim was to keep the overall value of the
portfolio in perfect balance.  They called this dynamic hedging, with
a purpose of eliminating the uncertainty of the movements in the

The flaw comes from others (not you, not me, but the fellows behind
the tree) who improperly apply the BS formula beyond its box of

The variety and number of derivative instruments are enormous and the
terminology used to describe them often bewildering. However,
derivative instruments, even in their most exotic forms can, and
should be, approached not as an endless series of discrete products
but as examples of how basic financial building blocks can be
assembled to produce an almost infinite series of products, namely, a
forward contract, a futures contract, a swap contract and an option

One of those building blocks -- and perhaps the most fundamental -- is
the forward contract.  Much confusion -- notwithstanding its long
history -- still attaches to precisely what the forward price in a
forward contract is indicating. The principles used to price a forward
contract are basic principles of widespread application that tell us
much about the workings of the international capital markets in

The essential difference between a forward contract and a futures
contract is that the latter is traded on exchanges which act as a
counterparty to all transactions and which requires market users to
post collateral or "margin" against their outstanding positions. The
forward contract, in distinction, is an "over-the counter" or OTC
instrument: it is traded not on organized exchanges but by dealers
(typically banks) trading directly with one another or with their
counterparties using the telephone, screens or faxes.

An interest rate swap, for example, is a series of forward contracts
on interest rates. At each settlement date (i.e. periodic date for the
exchange of cashflows) the fixed rate payer is obligated to sell a
fixed-rate cashflow for a price -- a floating rate cashflow --
specified in advance when the interest rate swap was entered into.

[to be continued]

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