International Fixed Income

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International Fixed Income

• Topic 6BLTCM

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(From last time)B. Peso Crisis

• By the end of 1993, the MP traded at 3.1/ and
  was overvalued by PPP measures (3.5-4.1).
  Managed float.
• Mexicos international reserves surged towards
  30bn by year-end.
• In March, these reserves dropped 10bn when
  presidential candidate Colosio was assassinated.
  Mexicos reserves were almost completely depleted
  through November 1994.
• December 1, the new president, Zadillo, took
  office and shortly after devalued the peso,
  letting it float freely.

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Mexicos International Reserves
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Mexican Peso
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Mexican Peso
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Cetes Currency
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C. Russian Default

• By June 1998, the stock market was at a two-year
  low and the govt failed to collect enough funds
  from T-bill auctions to repay outstanding debt.
• August was a bad month
• 3-mth moratorium on debt payments
• 50 devaluation of ruble
• halting of FX trading
• debt rescheduling that would lead to
  unprecedented losses
• September
• Liberal reformers resigned
• Russian stock market dropped over 45

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Ruble
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Russia, -denominated 3, 2003
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Outline for LTCM lecture

• Chronology of events
• Review one way of creating leverage in fixed
  income markets
• Examples
• Off-the-run versus on-the-run Trreasuries
• swaps versus Treasuries
• International government bonds
• International credit spreads
• Summary

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Chronology

• After being forced to leave Salomon in 1991, in
  wake of the Treasury auction rigging scandal,
  John Meriwether founded Long Term Capital
  Management in late 1993.
• There was an exodus from Salomon during this
  period, giving LTCM (sometimes called Salomon
  North) a dream team of traders/researchers in
  the fixed income area.
• LTCMs original strategy was to take advantage
  of spreads between liquid and illiquid
  instruments in similar markets, and bank on a
  convergence of these securities - a so-called
  date with destiny. These strategies are highly
  levered because they are viewed as relatively
  riskless in the long run.
• In their first (shortened) year (1994), LTCM
  earned 20, with staggering returns of 43 and
  41 (in 19951996). In 1997, their returns
  dropped to 19, partly because they were getting
  to big to get the same levered returns. With
  amassed capital of 7 billion, they returned 2.7
  billion to investors, leaving only the original
  investors and themselves. The size of their
  positions, however, were maintained.

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Chronology continued

• Their trade positions had also ventured out of
  their usual convergence trades into other
  areas, such as risk arbitrage, credit spread
  bets, emerging market debt, corporate bond
  spreads, etc
• Also, in 1998, the partners bought an option from
  UBS, which in essence was structured such that
  UBS got some equity but mostly provided a loan
  (which gave them temporary significant equity in
  LTCM, which would get bought out by the partners
  later). The motivation on LTCMs part was tax
  driven.
• In early summer,
• LTCM reported its first losses to investors,
  primarily in the MBS area.
• On July 17th, Salomon closed down its fixed
  income arbitrage group (to get out of that type
  of business) this induced a price pressure
  effect which led to a further drop of around 10.
• On August 17, Russia defaulted on its debt, with
  an immediate flight to quality, i.e., to liquid
  instruments, the opposite of LTCMs trades.
• On August 21, swap spreads moved 20 basis points
  (a normal move would be around 1-2bps). LTCM lost
  550 million.
• On Sept. 2, Merriwether sent a letter stating the
  fund had lost 2.5 billion over the year (or 52
  of its value), with August producing 1.8 billion
  in losses.
• Soon after that date, LTCM began to look for an
  infusion of capital, including meetings with
  Soros, Robertson, Buffet, Goldman Sachs, etc...

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Chronology continued.

• In the third week of September, Bear Stearns
  (LTCMs clearing agent) asked for 500 mm in
  collateral to continue clearing trades. On
  Friday, September 18th, with market conditions
  deteriorating, there was discussion about LTCMs
  solvency.
• On Sunday, Sept. 20th,the NY Fed looked at LTCMs
  portfolio and found that LTCM had over 50
  billion of long-short positions in securities,
  notional amounts of futures contracts of 500
  billion, notional swaps of 750 billion, and
  options over 150 billion. It was clear that LTCM
  failure would affect many counterparties.
• On Monday, Sept. 21st, they lost another 500 mm,
  half of it on short positions in long-term equity
  options. LTCMs capital base was now only 600mm.
  In the evening, a consortium of banks and
  investment banks met to discuss what to do.
• On Tuesday, Sept. 22nd, Warren Buffet offered to
  buy the portfolio for 250mm, recapitalize it
  with 3 billion, with no management role for
  Meriwether. They had until 1230pm to decide
  whether or not to do it. The offer was declined.
• That evening, an alternative plan was devised,
  which required 13 banks to put in about 250 mm
  each, and then to oversee the management of the
  portfolio. There would be no fire sale of assets.
  The existing investors, including the LTCM
  partners, would maintain a 10 ownership, or
  roughly 400 mm.

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Chronology continued

• In the first two weeks after the bail-out, LTCM
  continued to lose money. There were even rumors,
  false as it turns out, that the consortium was in
  trouble. By mid-November, markets had clamed down
  (e.g., Brazil did not default, the Asian crisis
  was diminishing, etc), and the trades began to
  pay off.
• By June, 1999, the fund was up 14.1, net of
  fees, from the bailout date. Monies were
  gradually being paid back to the original
  investors and about 1 billion was returned to
  the consortium.
• By December 1999, the fund was officially
  closed, with the consortium getting their money
  back, and Meriwether announcing a new fund,
  Relative Value, keeping just a few of the
  original Salomon Partners.
• Who really lost ex-post?
• The LTCM partners lost 1.3 billion, most of
  their stake in the fund.
• UBS lost 690 million, most of the value of their
  equity and the loan they had put in to the fund.
• Bank of Italy, Sumitomo Bank, and Dresdner Bank
  lost around 100mm.
• A number of investors lost money in the 25-50mm
  range, including Merill Lynchs deferred
  compensation plan.

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The Repo Market

• The repo market (along with bank debt) is the
  primary way institutions borrow/lend in fixed
  income markets. (we will discuss this market in
  depth in a few weeks).
• Simultaneously borrow X from the dealer to
  purchase securities, and then lend the same
  securities as collateral to the dealer.
• Note that the haircut (i.e., margin) represents
  the dealer's protection against the collateral
  losing value.
• Institution repays the dealer X plus interest in
  return for the security. Institution bears market
  risk (credit risk aside).

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Example 1 Off- versus On-the-Run Treasuries

• Consider the 6.125 11/15/2027 off-the-run
  Treasury versus the 5.5 08/15/28 on-the-run
  Treasury.
• Characteristics of Bonds on 10/05/98

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The Strategy

• The basic idea of the strategy is to buy
  off-the-runs and short the on-the-runs.
• Since their cash flows should be pretty similar,
  they should have similar yields (because they are
  governed by the same discount rates). In fact,
  since the yield curve is upward sloping, the
  higher coupon bond (i.e., the off-the-run) should
  have a slightly lower yield as it relatively
  emphasizes earlier cash flows which are governed
  by lower rates.
• This was one of the strategies of Long Term
  Capital Management, and, in fact, had been one
  for many years.
• The coupon effect aside, the figure on the next
  page graphs the spread between the on-the-run and
  the closest off-the-run long-term treasury bond.

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Off- versus On-the-Run Spreads
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Explanation

• Historically, a 5 basis point spread was not
  unusual. The coupon effect aside, and assuming
  that any duration is hedged out in a portfolio
  context, this means that on every 1 mm invested,
  Long Term Capital was earning 5,000 for a .5
  annualized return.
• Now assume Long term Capital took a 1 billion
  dollar position on all the off-the-run/on-the-run
  trades combined, but with only 10 mm of capital
  (i.e., 1 haircut).
• With 10mm capital, they expect to earn 5mm for
  a 50 annualized return.
• What actually happened?
• The spreads widened 12-14 basis points, perhaps a
  great long-term trade, but giving a short-term
  mark-to-market loss of about 1 (after some
  calculations) of the 1 billion --- in other
  words, the entire 10mm capital invested.

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What happened after the bailout?
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Example 2 swap spreads

• A plain vanilla interest rate swap is one in
  which you exchange fixed cash flows for
  floating-rate cash flows (often benchmarked
  against LIBOR (London Interbank Offer Rate,
  appropriate for A-rated London banks on their
  dollar deposits).
• As we will learn about swaps later in the course,
  just realize for now that a swap has very little
  credit risk so the fixed rate from a swap will
  reflect the par rate on Treasuries plus the curve
  of the LIBOR spread above Treasuries.
• The figure graphs the swap spreads over the
  period.

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Swap Spreads
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The Strategy

• One of Long-Term Capital's strategies was to be
  long swaps and short treasuries --- the thinking
  being that swaps spreads were going to tighten.
• Over the weekend of August 21st-23rd, Russia
  essentially defaulted on its debt. The swap
  spread widened about 20 basis points during this
  period, which saddled Long Term Capital with
  substantial losses (as their positions were
  highly levered).

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What happened after the bailout?
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Example 3 European convergence trade

• With approach of European Monetary Union, one
  popular trade was to expect foreign gov't bonds
  to trade at similar yields, as their discount
  rates would eventually converge.
• One popular one was to long Italian governments
  and short German government bonds, as Italian
  gov'ts were offering higher yields.

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Italian vs. German govt bonds
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The Strategy

• Rather than converging, the government bonds
  actually diverged in yields, leaving the highly
  levered Long Term Capital saddled with losses. In
  essence, their invested capital on these trades
  has disappeared.

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What happened after the bailout?
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Example 4 European credit spreads

• As youll see later in the course, swap spreads
  represent the spread between future LIBOR (bank
  offer rates) and future T-bills. During the
  1996-1997 period, UK swap spreads began to rise
  relative to German swap spreads. In other words,
  UK swaps (relative to their treasuries) were
  cheap compared to German swaps (relative to their
  treasuries).
• LTCM went long UK swap spreads and short German
  swap spreads, betting they would eventually
  converge.

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Swap Spreads UK Germany
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Swap Spreads UK Germany
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Summary

• In fact, we could have described relative trades
  in the Commercial Mortgage-Backed Securities
  market, the straight MBS market, the spread
  between corporate bonds and governments in
  various markets, Danish MBSs, risk arbitrage
  trades in the equity market, volatility trades
  (especially in the French stock market), etc...
  Nearly every one of the trades moved against Long
  Term Capital in the summer of 1998, with extreme
  moves in late August September. As we have
  seen, leverage, while usually increasing the
  returns, can wipe out the capital quickly.