Long-Term Crummy Models
Super high intellect, working in a field they knew. And essentially they went broke.
Reminiscing about Long-Term Capital Management and its repercussions…
"Remember Long Term Capital Management, which should have been called Short Term Capital management, because they weren't even in business for five years? That was a bad construct right there."
Jeff Gundlach on Realvision
The hedge fund known as 'Long-Term Capital Management' recently collapsed, through overconfidence in its highly leveraged methods, despite I.Q's of its principals that must have averaged 160. Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods.
These are the types of people the Fed works for
Equipped with the brightest traders and the leading theoretical minds in the financial world, Long-Term Capital Management attracted investments from the cream of Wall Street, including David Komansky, head of Merrill Lynch (who along with 122 Merrill colleagues invested a total of $22 million), Donald Marron, chief executive of PaineWebber, and James Cayne, chief executive of Bear Stearns. Other investors included the Bank of China, Banque Julius Baer, a private Swiss bank, Michael Ovitz, the former Hollywood agent, and a number of partners of McKinsey &Co., the management consultants. With such a glittering roster of investors, LTCM became known as the Rolls-Royce of hedge funds.
Greenspan Murdered Moral Hazard
Greenspan’s legacy became tarnished by the 1998 bailout of hedge fund Long-Term Capital Management, which represented a shift in the Fed’s strategy. It signaled to the market that if conditions got bad enough, the Fed would step in to save floundering banks. This strategy carried through to the Internet bubble and post-Greenspan to the crisis in 2007 and 2008, when unusual policy actions protected the banks and others from their own mistakes.
Capitalism? What’s that?
Nor was it satisfactorily explained why an earlier offer for LTCM led by Warren Buffett of Berkshire Hathaway had been turned down. (Apparently Buffett's offer left no residual value for LTCM s partners or investors, who after the Fed-sponsored bailout still retained a 17 per cent annual return on their original investment.)
Greenspan as Drug Cartel Leader
…You can’t fight market forces? As we will see, Greenspan did so constantly. He continually tried to fight the forces of creative destruction. Throughout history, markets have risen and fallen, but he tried to thwart the functional equivalent of financial gravity. More importantly, as Fed Chairman, it was incumbent on him to fight market forces when they threatened to cause serious long-term damage to the economy.
Remember that former Fed Chairman Paul Volcker allowed interest rates to climb to 20 percent briefly in order to break the back of double-digit inflation in the early 1980s. The well-respected former Fed Chairman William McChesney Martin, who chaired the Fed throughout the 1950s and 1960s, stated that the Fed was in “the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”^ Greenspan preferred to spike it.
A double standard: one for Main Street and another one for Wall Street
Echoing Pecora’s accusation of Wall Street's "heads I win, tails you lose" ethics in the 1920s, Representative Bruce F. Vento, a Democrat of Minnesota, accused Greenspan of having "two rules, a double standard: one for Main Street and another one for Wall Street." The Fed's involvement in the bailout of LTCM resembled the type of "crony capitalism" which the United States was continually decrying in Asian countries. Thus, at a crucial moment in the global financial crisis, the moral authority of the U.S. government and its ability to dictate economic policies to other nations were undermined.
How the Eggheads Cracked
I can recall the dreadful minutes after I had asked them to walk me through one of their trades, when my brain felt like a beaten cornerback watching the receiver dancing into the end zone. On top of it all was their Spock-like analytical detachment, which still hung heavy in the air in Greenwich and overshadowed any larger consideration, like shrewd management of the press. ''If everything had gone well,'' one of the young professors said not long after I stepped off the elevator, ''we wouldn't be talking to you.'' But everything did not go well, and they had decided to explain themselves to someone they had practice explaining things to…
In its broad outlines, the Long-Term Capital story could be described by a couple of pie charts. The first pie chart would lay out its losses. Of the $4.4 billion lost, $1.9 belonged to the partners personally, $700 million to Union Bank of Switzerland and $1.8 billion to other investors, half of them European banks. But as original investments had long ago been paid back to most of the banks, the losses came mainly out of their profits. The second and more interesting pie chart would describe how the money was lost. The public accounts have suggested that it was lost in all manner of exotic speculations that the young professors had irresponsibly digressed into. The speculations were exotic enough, but they were hardly digressions. When I paged through their trades, the only thing I hadn't expected to find was a taste for betting on corporate takeovers…
The big losses that destroyed Long-Term Capital occurred in the areas the young professors had for years been masters of. The killer blows -- a good $3 billion of the $4.4 billion -- came from two bets that Meriwether and his team had been making for at least a decade: interest-rate swaps and long-term options in the stock market…But as Ayman Hindy, a Long-Term Capital strategist, puts it: ''The models tell you where things will be in five years. But they don't tell you what happens before you get to the moment of certainty.''
…Wall Street firms began to get out in front of the fund's positions: if a trader elsewhere knew Long-Term Capital owned a lot of interest-rate swap, for instance, he sold interest-rate swaps, and further weakened Long-Term's hand. The idea was that if you put enough pressure on Long-Term Capital, Long-Term Capital would be forced to sell in a panic and you would reap the profits. And even if Long-Term didn't break, the mere rumor that it had problems might lead to a windfall for you. A Goldman, Sachs partner had been heard to brag that the firm had made a fortune in this manner. A spokesman for Goldman, Sachs said that the idea that the firm had made money from Long-Term Capital's distress was ''absurd'' in light of how much Goldman, Sachs had lost making exactly the same bets.
The trouble led the New York Federal Reserve to help bring together a consortium of Wall Street banks and brokerage houses to come to the rescue. Goldman, Sachs, a consortium member, was dissatisfied to find itself one of many. It had hoped to control Long-Term, and to acquire the wisdom of the young professors. And so before the consortium finalized its plans, Goldman, Sachs turned up with Warren Buffet and about $4 billion in an attempt to buy the firm.
…After negotiations among the fund and Goldman, Sachs and Warren Buffett broke down, a new wave of articles appeared…On Sept. 23, a consortium of 14 Wall Street banks and brokerage houses gave Long-Term $3.6 billion, in exchange for 90 percent of the firm.
E. Lee Hennessee, head of Hennessee Hedge Fund Advisory in New York, said that while most hedge funds never come close to using the leverage Long-Term Capital used, she sees a need for greater disclosure of borrowing by the funds, particularly in the case of bond-market bets.
“Whatever else comes out of this, one of the problems is a lack of disclosure” of hedge-fund leverage and of who has lent how much to whom, she said.
L.A. Times, Sept. 25, 1998
Question: You were rumored to be one of the rescue buyers of Long Term Capital. What was the play there? What did you see?
The whole story is really fascinating because if you take John Merriwether, and Eric Rosenfeld, Larry Hilibrand, Greg Hawkins, Victor Haghani, the two Nobel Prize winners, Merton and Scholes, if you take the 16 of them, they probably have as high an average IQ as any 16 people working together in one business in the country…an incredible amount of intellect in that room. Now you combine that with the fact that those 16 had had extensive experience in the field they were operating in…In aggregate, the 16 had probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor that most of them had virtually all of their very substantial net worths in the business. So they had their own money up. Hundreds and hundreds of millions of dollars of their own money up. Super high intellect, working in a field they knew. And essentially they went broke. And that to me is fascinating.
…to make money they didn’t have and didn’t need, they risked what they did have and did need, and that’s foolish. That is just plain foolish. Doesn’t make any difference what your IQ is. If you risk something that is important to you for something that is unimportant to you, it just does not make any sense. I don’t care whether the odds are 100 to one that you succeed or 1,000 to one that you succeed. If you hand me a gun with a thousand chambers – a million chambers in it – and there’s a bullet in one chamber, and you said, “put it up to your temple, how much do you want to be paid to pull it once?” I’m not going to pull it. You can name any sum you want but it doesn’t do anything for me on the upside and I think the downside is fairly clear. [Laughter] So I’m not interested in that kind of a game. And yet people do it financially without thinking about it very much…
There was a great book…the title was, “You Only Have to Get Rich Once.” Now that seems pretty fundamental, doesn’t it? …If you’ve got $100 million at the start of the year, and…you’re going to make 10% if you’re unleveraged, and 20% if you’re leveraged, 99 times out of 100. What difference does it make at the end of the year whether you’ve got $110 million or $120 million? It makes no difference at all…It makes absolutely no difference. It makes no difference to your family. It makes no difference to anything. And yet the downside, particularly in managing other people’s money, is not only losing all your money, but it’s disgrace and humiliation, and facing friends whose money you’ve lost and everything. I just can’t imagine an equation that that makes sense for. And yet 16 guys with very high IQs who are very decent people, entered into that game…I think it’s madness…
Those guys would tell me…a six sigma event wouldn’t touch us…but they were wrong…history does not tell you the probabilities of future financial things happening…The same thing in a different way could happen to any of us…where we really have a blind spot about something that’s crucial because we know a whole lot about something else…It’s like Henry Kaufman said… “the people who are going broke in this situation are of two types: the ones who knew nothing, and the ones that knew everything. (Partial transcript of Warren Buffett)
“We were seeing things that were 25-standard deviation moves, several days in a row.”
- David Viniar, Goldman Sachs CFO from 1999 until 2013, in 2007.
“…the probability of a 25 sigma event is comparable to the probability of winning the lottery 21 or 22 times in a row”
TRILLION DOLLAR BET
NARRATOR: It was a brilliant discovery that revolutionized modern finance.
MERTON MILLER: When I saw the formula I knew enough about it to know that this is the answer. This solved the ancient problem of risk and return in the stock market. It was recognized by the profession for what it was as a real tour de force.
NARRATOR: An elegant mathematical formula that helped create a multi-trillion dollar industry.
STAN JONAS: Up until the time that they came up with their insight, the world was full of uncertainty and risk, uncontrollable and un-analyzable. And then in a moment of tremendous clarity they realized that two risky positions taken together can effectively eliminate risk itself.
NARRATOR: This bold idea shaped one of the most ambitious investment strategies in history - attracting the elite of Wall Street, until it confronted them with the biggest risk of all.
ROGER LOWENSTEIN: Markets began to act in ways that no one had seen before and they began to lose 100 million and more, day after day after day, until finally there was one day when they dropped half a billion dollars, 500 million in a single day.
NARRATOR: These money machines, driven by mathematical models, had earned fantastic sums. Now as they spiraled out of control, investors froze in terror.
“A portfolio might be leveraged 50 times and have almost no risk. A portfolio might be leveraged five times and be perfectly mad.” - Michael Lewis
"If you look at the computer models, which not just the bank of England, but other central banks use, whatever you do to monetary policy, inflation always comes back to 2%. Why does it do that? Because the model says it has to..." - Mervyn King
Former Fed economist Alan Boyce with Raoul Pal in 2016.
"Look, you worked at the Fed, surely they can't be this stupid?"
The Rise of Moral Hazard
TODAY, with stock markets stronger and bond markets quietly going about their workaday business, it hardly seems possible that less than three months ago some of Wall Street's smartest and most powerful people thought the problems of one giant hedge fund, Long-Term Capital Management L.P. of Greenwich, Conn., might push the world's markets to the brink of disaster.
In fact, the 14 Wall Street banks and brokerage houses that pumped in $3.6 billion and took 90 percent ownership of the fund when it was only hours away from collapse may now see windfall profits on what seemed like a desperate roll of the dice, a daring bailout encouraged by nervous regulators at the Federal Reserve Bank of New York.
The fund's recovery does not itself resolve the argument over whether the Fed should have brokered the arrangements that rescued Long-Term Capital from bankruptcy on Sept. 23. Supporters say the Fed saved the day and laid the groundwork for the current rebound, while critics say the rebound proves that markets do just fine without such heavy-handed interference
Yellen couldn’t. Bernanke couldn’t see a housing bubble that was a three-sigma 100-year event, where were his statisticians? The answer is the Federal Reserve statisticians do not do asset bubbles. They are, in that respect, utterly clueless. And we apparently never see that.
Devil Take The Hindmost
The standing of the U.S. Federal Reserve was also damaged by the LTCM affair. Among Meriwether's partners was a former vice-chairman of the Federal Reserve named David Mullins. A few years earlier, Mullins had been responsible for the Fed's investigation into the Salomon bond-rigging scandal which had precipitated Meriwether's departure from the bank. At the time, the Department of Justice accused two large hedge funds, Steinhardt Management and the Caxton Corporation, of collaborating in the manipulation (they subsequently paid a $70 million fine without admitting wrongdoing). Presumably, Mullins found no conflict of interest in later accepting a job at a hedge fund from Salomon's former vice-chairman.
In Japan such behaviour would have been quite conventional. Indeed, the Japanese have a word to describe the custom by which a government official takes a job in an industry he has formerly regulated: they call it amakaduri or "descent from heaven."
Mullins's friend and former colleague Alan Greenspan was also embarrassed by events at LTCM. For several years, Greenspan had vigorously resisted calls to regulate both the derivatives markets and hedge fund activities. Only a couple of weeks before the bailout, Greenspan had insisted to Congress that hedge funds were, in his words, "strongly regulated by those who lend the money." Yet the leverage at LTCM showed clearly that this was not the case.
Throughout the years of the bull market, Greenspan had delivered a series of opaque and ambiguous speeches, half warning of the dangers of speculation and half congratulating America on its economic revival. After the LTCM bailout, complaints were raised that Greenspan had failed to do enough to stem the growth of a stock market bubble caused partly by excessive monetary growth. The reputation of the man who not long before had been described by a member of Congress as a "national treasure" was beginning to look as fragile as the stock market itself.
MFG Asset Management Adviser Janet Yellen, July 2020. Yellen thinks what the Fed did in 1998 with LTCM was a GOOD thing.
Ms Yellen, who is an adviser to funds management giant Magellan, said in an interview with Magellan’s billionaire chairman Hamish Douglass the Fed’s willingness to act “quickly and forcefully” by dropping interest rates and buying about $US3 trillion ($4.3 trillion) worth of assets had prevented the sort of breakdown seen when the Long Term Capital Management crisis brought markets to their knees in 1998.
Well, they certainly saved billionaire Hamish Douglass.
“None other than Merrill Lynch observed in its annual report for 1998, “Merrill Lynch uses mathematical risk models to help estimate its exposure to market risk.” In a phrase that suggested some slight dawning awareness of the dangers in such models, the bank added that they “may provide a greater sense of security than warranted; therefore, reliance on these models should be limited.
If Wall Street is to learn just one lesson from the Long-Term debacle, it should be that. The next time a Merton proposes an elegant model to manage risks and foretell odds, the next time a computer with a perfect memory of the past is said to quantify risks in the future, investors should run—and quickly—the other way.”
Roger Lowenstein, When Genius Failed