Bulls, Bears and Butterflies - 08/15/02

"For want of a nail, the shoe was lost;
For want of a shoe, the horse was lost;
For want of a horse, the rider was lost;
For want of a rider, a message was lost;
For want of a message the battle was lost;
For want of a battle, the kingdom was lost!"

This little ditty has its origins in ancient folklore. It tells the story of a kingdom lost because a nail could not be found to shoe a horse. Just a small change in initial conditions can drastically change the long-term behaviour of a system. In modern times we would call this Chaos Theory. This phenomenon is a common element of chaos theory, otherwise referred to as a ?sensitive dependence on initial conditions?. The more popular analogy describing chaos theory tells how a single butterfly flapping its wings in China produces an infinitesimal change in the atmosphere around it. Over time this creates a series of domino like changes in the atmosphere eventually causing a tornado in Texas. So what does this all have to do with hedge funds?

In July 1997, Thailand, a small, almost forgotten country in Southeast Asia, nestled between Laos, Burma, Cambodia and Malaysia, triggered a chain reaction causing a financial crisis that would rock the world?s stock markets. By the mid 1990s the Thai economy was beginning to show cracks. There were rumours of over-borrowing for speculative investments, inadequate bank regulation, and so-called ?crony capitalism.? The current account balance continued to fall as did exports and a drop in consumer spending coincided with a rise in inflation. The writing was on the wall for a major set back in Thailand?s economy. By August 1997 Thailand was forced to float the Baht, leading immediately to a huge devaluation. The devaluation of the Thai Baht had the instantaneous effect of crippling the financial sector. Loans defaulted, bankruptcies ensued and the economy, along with the stock markets spiralled downwards. The problems engulfing Thailand were hardly a blip on the economic radar screens around the world, much like that butterfly flapping its wings.

Within a year, what would be called the Asian Contagion had spread throughout the continent like a wave, infecting country after country. The tidal wave soon spread beyond Southeast Asia and the northern Asian countries were caught in its wake. Beyond Asia, Russia was not immune from the effects of this unique variety of Asian Flu and on August 17, 1998 Russia was forced to declare a moratorium on its Rouble debt and on its domestic dollar debt. A series of events continued to unfold that would decimate the investment industry worldwide. One-time darlings of the investment world could hardly hold on to their shirts. And no exception to this was John Meriwether and the legends at Long Term Capital Management.

This story actually begins in 1991 when the head of fixed income trading at Salomon Brothers was quietly asked to leave after an auction rigging scandal was revealed at the firm. Although John Meriwether was absolved of any wrong doing, he was head of the department and someone had to be made an example of. Not one to sit back and mope about his situation, Meriwether, who still commanded the respect and loyalty of his team at Salomon Brothers, and his peers on ?The Street?, founded Long-Term Capital Partners in 1993.

Meriwether single-handedly compiled one of the most brilliant team of traders, including two Nobel laureates, Robert Merton and Myron Scholes. This would come to be recognized as a stroke of genius as Meriwether and Long Term Capital Management immediately had more credibility than most investment firms on Wall Street.
LTCM was set up as a Global Macro, Bond Arbitrage Hedge Fund. LTCM spawned wings in an unregulated and very discreet industry. It was free to operate in any market and with a fraction of the reporting responsibilities of most firms answering to the U.S. Securities & Exchange Commission (SEC).

Meriwether possessed unparalleled promotional skills. In less than a year he was able to penetrate the ?old boys? club on Wall Street. This meant that he was immediately given the opportunity to put on interest rate swaps at the market rate for no initial margin, which was an essential part of his strategy. It meant that he was able to leverage 100% of the value of any top-grade collateral and then take the leveraged money to a competitor of the initial lender and use it as collateral to leverage once again. Could you imagine your bank lending you $1 million and allowing you to take this money to another bank to use as collateral to borrow another $1 million? Now imagine this continuing in perpetuity. Impossible? Not for John Meriwether. Before the end of 1995 Meriwether had amassed an investment capital of $7 billion. Within three more years, John Meriwether had control of the largest investment fund in the world.

The theory behind arbitrage states that profits can be made by taking advantage of temporary pricing discrepancies between related securities. In theory this strategy would be taking little market risk since long positions in one instrument were offset by short positions in a similar instrument or its derivative. A typical trade for LTCM would involve going long on Italian government bonds while selling short German Bund futures. As the rest of the market discovered this pricing discrepancy the prices would converge over time and LTCM would make a profit as the inevitable reversion to the mean took place.

LTCM was so successful at applying this strategy that 40% returns were becoming the norm rather than the exception. However, to continue obtaining these returns, an increasing amount of leverage had to be applied. In theory the increased leverage should have little impact on market risk since the increased size of the trades should have little effect on a liquid instrument. In theory! In practice, the investment ran the risk of becoming so large that it became the market. Some of the larger macro hedge funds reduced this risk by reducing the size of their fund and returning capital to their investors. LTCM was among these funds when in the last quarter of 1997 they reduced their size by $2.7 billion. Many irate investors were literally kicked out of the fund. In most cases, a proportionate amount of leverage would be eliminated to coincide with the reduction in capital. In the case of LTCM the capital was returned but the leverage remained the same causing the leverage to capital ratio to be increased dramatically.

The demise of LTCM originated at this time but not primarily because of the increased leverage ratio. Arbitrage plays were becoming more and more difficult to find and spreads were reducing so the Nobel geniuses at LTCM decided to apply their investment models in areas they had little or no experience with. They applied their theories to equity trading, and took speculative positions in takeover stocks and in emerging markets, including Russia. One report indicated that LTCM had invested 8% of their entire book in Russia, almost $10 billion! The house of cards began to teeter.

By late 1998 the Asian contagion had become an epidemic felt around the world. LTCM were involved with many arbitrage positions that saw prices diverging instead of converging. Merton and Scholes believed in their model and their model told them to throw more money into the stew. Meanwhile all the serious money around the world was pouring into high quality instruments. Investors couldn?t get enough of U.S. and G-10 bonds. The principals at LTCM could only look on in horror as their spreads widened and near panic crept in when Russia declared they would not honour their loan payments. LTCM was on the verge of collapse when the expected convergence in positions was quickly becoming dramatic divergence and lenders were asking for more collateral to cover this divergence.

The trading losses were piling up at LTCM. On one particular day they lost more than $500 million. To add insult to injury, LTCM was being asked to liquidate positions to cover margin calls. On September 2, 1998 John Meriwether was forced to acknowledge to investors that his fund was down 52% that year. So much for theories! Despite the presence of two Nobel laureates it seems LTCM depended too much on theoretical market-risk models and not enough on stress-testing, gap risk and liquidity risk.

By this time, all of the king?s horses and all the king?s men couldn?t put LTCM back together again. This once inconsequential investment company was poised to take down the world?s over-the-counter derivatives market if a bailout didn?t happen soon. Action had to be taken at once. The intervention finally came on September 18, 1998 from New York Federal Reserve chairman Bill McDonough, who orchestrated the formation of a consortium of Wall Street banks and brokerage firms to bail out LTCM. The ride was over.

So there you have it. Economic Chaos Theory! A butterfly flaps its wings in a remote country called Thailand and in less than two years, arguably the largest investment fund in the world was torn apart by the tornado.

An argument can be made that the biggest culprit in the whole LTCM scandal was poor information. The lack of transparency by LTCM, as with many hedge funds, was a major factor that allowed the firm to leverage as much as it had. There was no mechanism in place that allowed lenders or investors to see how exposed LTCM was to other lenders. Investors were denied information on investment strategies and positions. The devaluation of the Thai Baht was the catalyst that ultimately caused the failure of LTCM but no one can say for certain that the firm would have survived in any event. Investors today are requesting more and more transparency from their investments. How long could LTCM operate in their bubble before investors began withdrawing assets.

LTCM is the most notorious of hedge fund collapses. So-called experts will be writing opinions about this event for decades to come. What the reader should understand is that most investments come with a component of risk, some higher than others. Hedge funds are no different. The best risk control an investor can take is education. Knowledge about hedge funds, their strategies and a comprehensive due diligence procedure are indispensable tools that can help mitigate the risks involved in investing in the wonderful world of hedge funds.         _x000D_