Remember Long Term Capital Management?
Twenty years ago a couple of traders teamed up with some Nobel Prize winners to create an investment company premised on the notion that similar things act similarly—that in the long run, finance obeys rational rules. Small differences in price can be understood and used to create financial returns.
For example, the returns on 30-year US Treasury Bonds and 29 3/4 year treasuries shouldn’t be all that different. The company would buy one, short the other, and wait for the prices to converge. Because there is so little risk to these assets, they could use leverage to magnify their returns. Their idea was to earn about 1%, on assets, lever it 20 times, and have a 20% return on equity—over the long term.
Initially, they were pretty successful. They earned 21% their first year and 43% their second year, after fees. More and more capital wanted to invest with them. But all that money created a problem: they had $4 billion in equity and $130 billion in assets. But there weren’t enough low-risk opportunities out there. So they expanded into more risky trades. For example, the Dutch-listed and US-listed shares of Royal Dutch Shell should trade at a similar level. But these are stocks, not bonds, trading in different countries with different regulators and different tax rules. Their values can diverge a long way for a long time.
When the Asian Financial Crisis hit in 1997 and Russian Financial Crisis in 1998, panicked investors sold European and Japanese securities to buy US-based assets. There was a flight to liquidity. The profits on many of LTCM’s convergence trades diverged. The difference between Dutch Shell and US Shell shares went from 10% to over 20%. These mark-to-market losses meant the fund had to raise capital to satisfy its lenders. Since they couldn’t raise new money, they had to liquidate many trades and realize their losses. Because they had grown so large, these positions dominated the markets where they had been placed, making the final losses even worse.
Value of $1000 invested with LTCM. Source: Wikipedia
In the end, LTCM’s capital went from $4 billion to zero. The banks that had lent them money took the firm over, assuming their arbitrage positions and wiping out management. When the founders left, they expected the new owners to fail as well. But the positions weren’t wrong—they were just illiquid. The banks had enough capital to wait out the crises. In the end, the lenders were able to liquidate the fund and make a modest profit.
Long Term Capital’s demise proves the notion that markets can remain irrational longer than a levered investor can remain solvent. Their trades weren’t wrong, they were just early. By using leverage to magnify their returns, LTCM ran the risk of having its equity-stake destroyed by temporary market fluctuations—like a home-owner going upside-down on a mortgage. The borrowings put short-term pressures on their long-term trades.
Archimedes is supposed to have said, “Give me a lever and I can move the world.” Maybe. Sometimes, leverage means the world can just fling right you back.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!