Deja Vu -- Long Term Capital Management

Tuesday, June 30, 2009

Inside the Head of a Conspiarcist

Tonight again, we will be commenting on excerpts from "The Partnership - The Making of Goldman Sachs" Charles D. Ellis 2008. This is the book about Goldman, by Goldman, trying to rewrite history. (My comments, as always, are in red text)

The Implosion of LTCM in 1999, has such a Deja Vu feeling to the credit crisis of 2008. The same "black swan" event, the same bankers, the same bailout plan (except it was the bankers that bailed each other out). Revisiting this event, goes to show, how the regualtory bodies learned ZERO or did ZERO in response. The only difference, today, the stakes are 1,000 times more. Back then, the deal was in millions. Today, the bailout is in billions and trillions!

Chapter 32 - Long Term Capital Management
page 582
Excepting that annus horribilis of 1994, 1998 was as bad as it gets. Goldman Sachs lost hundreds of millions of dollars in proprietary trading very nearly lost hundreds of millions moe in a major hedge fund's collapse. It stimultaneously missed----- by minutes and a few key words--- an opportunity to pull off a moneymaking coup that could have made hundreds of millions. (It's a sad state of the nation when modern hi-finance comes down to a few minutes and key words!) As a result, as the stock market declined, Goldman Sachs had to postpone indefinitely it's on -again, off-again plans for an IPO, on which John Corzine had expended much of his political capital. This would hurt his credibility as the firm's leader................................... (already starting with the scape- goating).

LTCM ----Long Term Capital Management -------appeared to have discovered or invented a wonderful way to manage a massive hedge fund with a low-risk, high-return portfolio. Only certified financial rocket scientists could really understand the details of how it worked, (sounds like the peolple at AIG)
but everybody new that LTCM -------a mysterious. glorious, golden money spinner------produced spectacular results. The fund was launched in 1993 by John W. Meriwether, known to admirers as J.M., the quietly charismatic leader of Salomon Brothers' justly fabled and notoriously profitable proprietary trading unit. At LTCM, fewer than two hundred people, including two Nobel laureates and a host of brillant Wall Streeters, managed a hugh, private, and very secretive model-driven hedge fund for for a partnership of fewer than one hundred large investors. In an era of financial creativity, it was truely outstanding. Four aspects of LTCM were large: the assets, the leverage, the egos of the principals, and the profits. (What's any different today? And what did we learn from LTCM? And why does 2008 feel so much llike LTCM?

But unknown to both LTCM and its lenders, there was one risk against which it was not diversified: the risk that somehow all the many different markets around the world all react the same way to a specific, important, very unlikely, and very detressing event ------(Oh, no NOT the BLACK SWAN, again) ------such as a sudden devaluation of the Russian ruble. .................................................

In 1996, LTCM gained an astonishing $1.6 billion ------57 percent, 41 percent not to investors after paying the general partners. (you will notice how these sums are 10 times less than what we are dealing with todat) If $1.6 billion sounds very big, there was an even more significant number that sounds very small: The real return on the portfolio was only 2.45 percent. As we shall see, the crucial factor in the giant gains to investors-----and to LTCM's general partners --------was leverage.* (Oh, no the "l" word) Lots of leverage.* (I guess it's better than the "d" word. "Leverage" has a sexual appeal to it!)

In addition to those two divergent numbers----- $1.6 billion and 2.45 percent------another annual number mattered greatly. LTCM's large-scale and hyperintensive portfolio turnover generated a hugh volumn of business for Wall Street. Paying fees, spreads, and commissions that totaled well in excess of $100 million annually made LTCM one of the world's largest customers for the securities industry. (Sounds alot like the mortgage business in 2008)While investors wanted to get in on the LTCM gravy train, their enthusiasm seemed almost restrained compared to the intensity with which the world's major banks and dealers, but Corizne's, "prop" desk was making similar, even identical "arb" trades, so it was also a competitor. (You don't say)

Not only was LTCM designed brillantly, but is was operating supremely well too. LTCM was a spectacular multiple success: success for investors, success for banks and brokers, (much like the real estate bubble), and success for LTCM's managing partners. Incredibly, however, spectacular success was becoming a problem, a large problem: LTCM had too much money to manage. Compared to the market's liquidity and trading volume, the partners decided LTCM had become to big. By 1997, investors' equity capital in LTCM 'was $5 billion. And it kept rising. At $7 billion in 1998, LTCM had more equity capital than Merrill Lynch, Wall Street's largest firm. Size was a problem because LTCM's buying or selling was moving prices and shrinking the profit opportunity in each market imperfection. (Sounds alot like Goldman)

So LTCM did something unusual for a hedge fund or any other type of investment manager: It obliged investors to take back $2.7 billion of their invested capital. And LTCM's general partners did something else that was unusual: While returning so much capital to outside investors, they deliberately did not reduce the size of LTCM's portfolio. Instead, the general partners chose to borrow more and increase the leverage so they and their investors could make even more money on their equity capital. (Sounds like Goldman with the TARP money) LTCM's were already rich, but now, with the increased leverage, they would be on their wayto being superrich, making really big money. And this they did.....but only for a few months. (Then Goldman, with full knowledge of their paired trades, traded against them until they were forced to close).

A futher problem was that LTCM was clearly not alone----the fund had too many imitators. Astute traders at the prop desk at major investment banks and the big hedge funds had studied together at the same business schools, trained together at the same Wall Street firms, and used the same sort of quantitative models and computer programs. They were out looking for the same trades, and talk with each other all the time, comparing notes and shaing insights and facts. Enjoying theri rivalries in discovering new things, they were more than glad to steal each other's ideas--------including the best ideas of LTCM. (blah, blah, blah and blah. Need I say more? )LTCM was the biggest and arguably the best, but many, many other smart quant traders were putting together the same perfect arbitrage pairs for the same reasons. And more and more bond arbitrage funds were being formed to exploitthe small niche anomalies in which LTCM specilaized. It could never be proved, but many on Wall Street believed that the dealer most actively engaged in trading against LTCM was Goldman Sachs. (hmm, that's what I was saying up there on top of the page!)

Then, in August, Russia abrubtly defaulted on its debt, and that changed everything. (here we go, another Black Swan).. In a massive flight to quality and liquidity , frightened investors everywhere scrambled to out of unusual and illiquid securities-(today we call them toxic)---exactly the securities LTCM was holding (sound familair yet) and buy into the higher-grade, more liquid securities that LTCM had sold short in its perfect arbitrage paired positions. Getting hit both ways-----longs being sold down and shorts being bought up------was obviously bad for LTCM. Now Meriwether was not entirely forthcoming: Performance disclosure was selective-----and performance was far worse than most LTCM investors realized. Goldman Sachs realized it, though, because its own proprietary trading gave it unusual access to crucial market information. (You don't say. "unusual " access to crucial market information sounds alot like my "self-actualizing" information theory.)

Volatility, or market risk, is roughly the opposite of what the most active investors and traders usually mean by "quality." Most investors, dislike price volatility, so they would to perfer to offload it. They can -----for a price----and others will, for a price, accept or "buy" volatility. Volatility cannot be bought or sold directly. But volatility can be bought and sold indirectly by selling short or buying stock-index futures. (The more Vol the bankers can create, the more money they make, for several reasons, which I will get into later)

Page 593

Long story short, they needed a bailout quick. Warren Buffet, George Soros , J.P Morgan and Merrill all offered $200 - $500 million during the week, in this back-and forth unfolding drama, much of which I will skip, except for a funny part on Warren.

Corzine (CEO of Goldman, now NY Governor) knew his negotiating position vis-a-vis Meriwether had suddenly become very strong. Dealing from a position of strength, he now offered Meriwether a proposition that was clearly tough, but just as clearly reasonable, given LTCM's grievously strained circumstances. For half ownership of LTCM, Goldman Sachs would provide $1 billion----party from the firm's own capital and partly from its clients-----and commit to raise another $1 billion from outsiders........(Typical of Goldman, to approach someone with a helping hand, complete due diligence, back out of the deal, and then trade against them until they collaspe. Semgroup? Lehman? )

The deal was conditional on Goldman Sach's delivering the capital infusion and on an examination of LTCM's books, (sounds fimiliar) so both sides began workingthrough LTCM's files immediately. (Goldman ran down to Kinko's and ran the copier machine all night.) Any deal involving a major commitment of the partners's capital would, of course, require approval of the newly formed successor to Goldman Sachs's management committee, the executive committee, but Corzine was increasingly thinking and acting as a senior partner, but as the dominating CEO he envisioned himself to be. (So at the end of this chapter they try to make us believe that Corzine was ousted because he committed $300 million to the bailout efforts of LTCM, when he was only authorized for $250 million. What a bunch of hog wash!)

page 594

Later some observers said Goldman Sach's traders, working in London and Tokyo, were selling short the positions they knew LTCM held then, to cover those shorts, were offering to buy them from LTCM at depressed prices. Goldman Sachs was certaintly trading actively , but if its traders were front-running LTCM, other dealers were surely doing the much the same. In the global bond markets (which Goldman ruled and had seen their books in due diligence) the squueze was on LTCM, particularly (totally) volatility----and all the majoe dealers knew LTCM, with massive positions ouststanding in futures and options (ohhhhh!, what is your definition of massive, or "systemic"), would have to come to them, and would have to pay up, greatly increasing their profits. Dealers all understood the rules of the marke: if they knew enough about the way institutions were moving their portfolios, they could and would profit by using this market information in their proprietary portfolio operations. (Sexy! Do you mean trading? And yes Goldman will always profit from "inside knowledge") That profit opportunity was why Goldman Sachs decided to get into proprietary trading in a major way and , as advocates told partners, "learn to deal with the conflicts of interest."

page 595

LTCM's portofolio was still large: $125 billion----and now fifty-five times its shrinking equuity capital. In addition, it held a large package of high-octane derivatives (ooooh, "high-octane"). With another portfolio loss of less than 2 percent, the management conpany and partners would be wiped out. In mathemathical theory, the odds of such an event actually happening had been nearly imossible just a few months before. (what changed?) But in real markets, traders say bell-shaped curves have "fat tails"------events that are very unlikely but do happen and cause great damage, recenetly popularized (before it was conspired) as "black swans." (Oh, no not the black swan!!)

page 596

Corzine was highly motivated to find a way to solve LTCM's problem, which was now the linchpin to launching the IPO (Goldmans)

Corzine understood that the major investors Goldman Sachs would be asking to join in a rescue had already been called------often several times by LTCM itself. One specific possibility, already called several times, was obvious to everyone: Warren Buffet at Berkshire Hathaway (da!) Buffet said he might be interested in buying LTCM's entir portfolio as its depressed market valuation, but he wanted no part of LTCM's management company or its partners. (Warren just wants the portfolio for 10 cents of the dollar without management and traderes. What the US goveshould done in 2008. Warren will be prevented from bidding, sort of.....)

page 596

Derivatives added a whole new dimension of pyramiding to the situation at LTCM (and how is that different from the credit crisis today?) They had real potential for disaster. LTCM had arranged seven thousand different derivative contracts with several dozen counterparties. (Sound fimilair yet?) Default one any one derivative contract could throw all those contracts into technical default. Their total notional value was spectacularly large-----nearly $1.5 trillion, (nothing like the 100 trillion of modern times) , or $5,ooo for every man, woman, and child in America-----and they involved almost every major financial institution in the United States of America in a complex spiderweb that now LTCM at its center. ( Now a days, the fun word for that condition is "systemic' risk. As I stated above, "what did we learn from LTCM?" Besides AIG?

page 597

Goldman Sachs was LTCM's only hope-----and the capital gap it needed to cover now jumped from $2 billion to $ 4 billion. (All in a matter of a couple months, imagine that!) John Thain, the firm's CFO and an increasingly central member of Goldmans Sach's senior management------a rartional market technocrat (nazi) with direct experience in the bond business----was moving into a key decision-making role. He didn't see a way to raise that much money for LTCM, but the firm would keep trying.

Another possibility was floated past Warren Buffet: a joint bid, perhaps with AIG, (this 1999, I thought AIG didn't come in to the picture until 2005?) the giant and innovative insurer that had extensive experience with derivatives, for LTCM's whole portofolio without the management company (but the trades are so, so complex! How would you unwind them without these rocket scientists Mr. Buffet?)

Corzine briefed president McDonough at the New York Fed, and McDonough called the other major banks. All agreed that an LTCM failure would seriously distrupt the nation's and the world's financial markets, McDonough wanted to have a Wall Street leader take up the task of privately organizing a cooperative. But he and John Whitehead , Goldman Sach's former managing partner and now chairman of the NY Fed, quickly agreed that no one person had the necessary stature or clout to do the job. McDonough accepted Coezine's offer to brief the FED on LTCM's portofolio on Sunday, but fearing that any sign of urgency could upset, the sensitive money markets, stayed with a previous plan to fly to London and sent his deputy instead. Before leaving , McDonough called Fed chairman Alan Greenspan and Treasury secretary Robert Rubin in Washington to warn them taht LTCM probably couldn't raise the necessary capital. ..............

As it happened, Buffet was with Bill Gates on a vaction float-trip in Alaska's fjords, where the sonic shadows of the steep mountains would break up cell-phone calls for more than an hour at a time. Buffett told Corzine it was okay for Goldman Sachs to work out the specifics of a Berkshire Hathaway takeoverb of LTCM so long as the management company and John Meriwether were specifically excluded. Such a takeover would require $4billion to $5billion. Only Berkshire Hathaway had that kind of money on hand and a decision maker like Buffet. Even so, Buffet would probably insist on a co-investment by Goldman Sachs...........

As a bond dealer, Corzine kept his options close to his vest while working to develop others. He had been working with Merrill Lynch's brainy presisdent, Herb Allison, on the design os a collective approach involving Wall Street's leading banks, but was still hoping he would be able to preempt the collective bailout with a Goldman-Berkshire bid for the whole LTCM portfolio.

AT 7:30 a.m on Tuesday, September 22, the New York Fed hosted a breakfast for Corzine and Thain of Goldman Sachs, Roberto Mendoza of J.P. Morgan, and David Komansky and Herb Allision of Merrill Lynch. Allision lacks a commanding physical presense, but his rational brillance was clear to everyone. To survive, LTCM needed $4 billion. If allowed to fail, the loses to the group could total $20 billion. Allision summarized: " We're in this together. This is a very complex problem and we know that in order to work, a complex problem must have a simple answer. In addition, as the nation's leading financail institutions, don't we have an obligation to the public?

page 600

The only way to achieve the necessary cooperation among so many banks and firms on such short notice would be foe the FED-----even though it would not be for it to support any specific plan-(Bullshit)---to call a meeting of all the banks. This was agreed late in the afternoon, and dozen major banks were informed that an emergency meeting would be held at the New York Federal Reserve Bank that very evening at eight. The four largest banks agreed to meet at the FED an hour eariler (and "fix" all the terms) . Merrill Lynch's plan would have 16 banks invest $250 million to reach the $4 billion capital infusion that John Thain had specifed was necessary. If the group put up less than $4 billion, speculators would be tempted to try to break the bank, as a decade before they had broken the Bank of England, forcing a devaluation of the British pound.

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