Long-Term Capital Management

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					Long-Term Capital Management (LTCM)

 Canadian Financial Institutions
 Mark Anttila
    Outline for Today’s Presentation

   Why LTCM was successful

   Sources LTCM‟s problems

   The two offers to save LTCM

   Was the Federal Reserve justified?

   What can we learn from LTCM?
        Why LTCM was Successful

   Generous financing agreements
       Increased demand for hedge fund

       Favourable economic conditions

       A „halo effect‟ that surrounded LTCM

       Misconceptions about LTCM

       LTCM‟s secrecy
     Sources of LTCM’s Problems

   Poor risk management

   The $2.7 billion return of capital

   Salomon‟s exit from the market

   LTCM „reduces‟ its risk

   The Russian ruble default

   LTCM‟s desperate attempts to recapitalize
          Sources LTCM’s problems
               Poor Risk Management

   Lack of oversight and controls
    within LTCM
       Source of strength and weakness

   Over Reliance on VAR analysis
       Assumes “that the future will be
        approximately like the past”
        Sources LTCM’s problems
         The $2.7 billion Return of Capital

   Inadequate return yield in 1997

    (5 % below S&P 500)

   Reduced capital base to increase
    leverage and enhance returns

   Bad timing because of the recent
    „Asian Flu‟
         Sources LTCM’s problems
           Salomon’s Exit from the Market

   LTCM had suspected some of its poor
    performance was due to Salomons
    retreat from arbitrage

   Situation was exacerbated by bad
    press; many Wall Street firms started
    to exit as well
         Sources LTCM’s problems
              LTCM ‘Reduces’ its Risk

   Reduced the amount of volatility (losses)
    it could suffer in one day by 15 percent;
    reducing it from approximately $45
    million to $34 million

   Instead of reducing its illiquid (but higher
    yielding) positions, it reduced its more
    liquid positions
         Sources LTCM’s problems
             The Russian ruble Default

   Caused a global „flight to quality‟

   Higher quality investments sold began
    selling at premiums and lower quality
    investments at deep discounts

   Credit spreads widened to beyond their
    historical range
      Sources LTCM’s problems
            Attempts to Recapitalize

   Information of their portfolio leaked

   Some launched speculative attacks
    on LTCM‟s portfolio
         Two Offers to Save LTCM

   Warren Buffet
       Berkshire-Hathaway, AIG, and
        Goldman Sachs

       Offered $250 million to the partners
        and investors

       Pledged to add $3.6 billion dollars to
        LTCM‟s equity
         Two Offers to Save LTCM

   The Federal Reserve
       14 major banks convened at the
        request of Federal Reserve

       Injected $3.6 billion of new capital into
        the fund

       Took a 90% stake in the firm
    Was the Federal Reserve Justified?

   Ensured the well-being of U.S.
    financial markets
       Failure would have meant losses of $3
        to $5 billion for creditors/counterparties
       Staved off a fire sale of securities
   Public Funds were not used
    Was the Federal Reserve Justified?


   LTCM would have been forced to
    accept the Buffet offer

   Creates a Moral Hazard

   Undermines its own moral authority
    and credibility
      Recommendations to Avoid this
      Situation from Occurring Again

Increase Regulatory Oversight
     Hedge funds would emigrate to off-
      shore financial centres

     Market discipline would weaken
      Recommendations to Avoid this
      Situation from Occurring Again

Increase Market Discipline
     Financial Institutions should increase
      their own credit standards

     Increase Regulatory Oversight for the
      Institutions that lend to Hedge Funds
   Five measures that investment banks and securities
firms must use when assessing the risk of a hedge fund:

   Include due diligence assessments of the financial
    soundness and managerial ability of the counterparty,
    including its risk profile.
   Require ongoing disclosure of financial reports,
    supplemented by information on the prospective volatility
    of the counterparty‟s positions, as well as qualitative
   Impose collateral requirements to cover potential credit
    exposures when insufficient information is available on a
    counterparty‟s creditworthiness.
   Should have its own credit limits on counterparty
   Should have ongoing monitoring of a counterparty‟s
    financial position
Questions and Discussion