Long Term Capital Management

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

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

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

22. Relative Volatility of Rates/Spreads 1990-2006 Monthly SD 1.47% .21% 7.0 1.33% .23% 5.8 .11 Mean 5.48% .49% 5.88% .56% .10% 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

23. FNMA MBS OASL 1995-2007

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

26. Salomon Bros. Pretax Income

27. LTCM Results

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

29. $ Billions Net Income $1.0 Assets $129.4 Equity $7.4 Contractuals $1,317 Morgan Stanley 1996

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 Capital Models 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