AC948 Case Studies in Financial Environments Lecture 5: The failure of LTCM

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AC948 Case Studies in Financial Environments
Lecture 5 The failure of LTCM

• Yuval Millo, AFM, U. of Essex

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Structural factors leverage and liquidity

• LTCMs collateral distribution system
• The system moved capital among the various
  positions that the fund held.
• The underlying assumption was that there would
  always be enough liquidity to allow easy exchange
  between assets and cash (or short-term bonds).
• Extreme volatility events broke this assumption

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Structural factors Oligopoly at the arbitrage
markets

• A relatively small number of agents performed
  arbitrage, each holding large positions
• In May and June 1998 it was rumoured that Salomon
  were unwinding their positions in the bond
  market. This caused prices to drop and caused
  LTCM heavy losses.

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VaR-related decision making 1

• When a VaR limit is breached, there are two ways
  of action to improve the situation.
• First, to decrease the positions, and second, to
  increase the reserve capital allocated for the
  trades. In any case, positions must be
  liquidated.
• Which assets should be liquidated, the liquid or
  the less liquid ones?

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VaR-related decision making 2

• The less liquid assets, (e.g. swap and bonds)
  provide more return than liquid ones and
  therefore investors would be reluctant to
  liquidate those positions
• However, this would result in an overall less
  liquid portfolio
• In case of additional potential liquidations it
  will be harder to raise the cash to meet possible
  VaR demands.
• It is very likely further demands to liquidate
  would be urgent
• In June 1998 LTCM liquidated liquid assets and
  exposed itself to increased risks if markets were
  to become less liquid and volatile.

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The Russian Bonds default

• Growing problems in Russia motivated the
  government to default on one of its bonds.
• Investors that were involved deeply in this
  market suffered heavy losses and went bankrupt.
• The losses were echoed in breaches of VaR limits
  in other markets.
• These breaches led to enforced portfolio-wide
  liquidations in order decrease expose to risk or
  to provide more reserve capital.

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Flight to liquidity

• In itself, the Russian default could not cause a
  market-wide shock arbitrage positions were
  supposed to be protected from such price drops.
• However, the atmosphere in the markets has
  changed.
• Arbitrage opportunities still existed, but
  virtually no one dared to buy assets that were
  potentially illiquid, in the fear that it would
  be hard to sell those assets.

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Increased Correlation

• Because of the flight to liquidity one simple
  rule the more liquid, the better seemed to
  replace more sophisticated deliberations.
• Result positions that usually moved in opposite
  directions started moving uniformly.
• Hedging became much more difficult as positions
  could no longer be protected by each other.
• VaR numbers rose, reflecting the increased risk
  of holding positions, positions were liquidated,
  feeding back into the flight to liquidity.

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Superportfolio (MacKenzie)

• FtL was amplified by imitation among investors.
• Indication when overall market volatility
  increased, it was expected that the volatility of
  positions held by both LTCM and imitators would
  increase further.

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Endgame 1

• In spite of losing positions LTCM could not sell
  easily
• Every one else was selling and that would mean
  receiving low prices, if there would be buyers at
  all.
• LTCM had relatively more illiquid assets since
  liquid ones were sold in May and June.
• Selling would signal that LTCM needed cash and
  was in trouble. This may motivate its rivals to
  wait, knowing that prices would go down

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Endgame 2

• What about increasing reserve capital?
• LTCM could not increase its capital easily, as it
  was already very highly leveraged and getting
  more cash would mean recruiting it from the
  outside.
• This was extremely difficult as the market was in
  turmoil
• It was August at the height of the holiday
  season.

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The systemic view

• By mid September 1998 investors were ready to
  demand bankruptcy arrangements from LTCM.
• This in itself would not solve the problem
  Positions would have to be liquidated, at a
  substantial loss.
• In fact, the positions of LTCM in some markets
  were, due to leverage, so big that if those were
  to liquidate, the prices in the entire market
  would drop.
• Some markets, such as high-yield bonds and
  mortgage-backed securities virtually stopped to
  operate or had their liquidity decimated.

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The bail-out

• To return markets to operation without suffering
  the results of sudden price drops, LTCMs
  positions were taken over and played to
  maturity and not liquidated.
• A consortium of investment banks and the
  regulator took over the positions and continued
  to trade.

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Implications discussion

• By rescuing LTCM, the regulators signalled
  effectively to market participants that
  ultimately there would always be a safety net
  for risk takers?
• Would such a signal increase the probability of
  incidents like LTCM reoccurring?
• Can it be that the right solution is not to allow
  any single actor to become a potential systemic
  risk?
• Also, to avoid the creation of high correlation,
  should secrecy be imposed on the markets?