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Long Term Capital Management

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					Long Term Capital Management

        Finance 4820




                               1
Conflicting Goals
   Goal of investment manager is to
    gather assets


   Goal of investor is large, consistent risk-
    adjusted returns



                                             2
Pay for What Performance?
   Rf return - should be free
   Add market risk with risk premium -
    should be almost free
   Lever market risk and premium - should
    be almost free
   Create alpha - costly



                                        3
Alpha is King
   Investors want “repeatable” alpha
       Like quality earnings

   As a result, managers present process
    in terms of approaches investors see as
    “repeatable”



                                         4
Hedge Fund Basics
   Lack of transparency
   Fees, fees, fees 1% to 2% + 20% from zero!
   Large returns needed for acceptable net
   Typical promise:
       Equity-like volatility
       Equity-like returns
       Uncorrelated with equities
   “Guru” rather than establishment
   Ability to cross markets

                                            5
Arbitrage
   Most over-used term in finance?
   Arb = sure profit, zero investment, zero risk
   LTCM able to pull off the “zero investment” part
   LTCM positions were “not zero risk, sure profit”
      Leverage becomes an issue

      Correlation of positions becomes an issue

      Maximum loss becomes an issue

           Due to leverage, instantaneous maximum




                                                       6
         Trade Types
              Directional
Less              Typical long or short (expected price movement)
                  Mkt timing      Unlimited loss short, 100% long
Holding
              Relative Value
Period            Substitution or long/short
Risk              Expected price or risk premium changes
                  Potential loss more limited

              Convergence
                  Like realtive value, but:
                      Always long’/short

                      End date/event that guarantees convergence




                                                                     7
Leverage
   Leverage + illiquid assets = bankruptcy
   Traditional leverage
       Borrow and purchase more assets
       Increases portfolio assets and portfolio volatility or beta
   Cashless leverage
       Futures/options
       OTC derivatives
       Structured securities
            These do not increase portfolio assets, but do increase portfolio
             volatility or beta



                                                                          8
Typical limits on Leverage
   Investor policy statement
   Internal reviews/controls
   Over-collateralization (haircut)
       Treasurys 2-3%
       Agency MBS 4-5%
       High-grade corporate 5-10%

Maximum leverage = 1 / haircut %
For MBS: 1/.05 = 20x



                                       9
Leveraging “spread” trades
   Returns & especially spreads (risk
    premia) tend to mean revert
   Extremely high or low risk premia tend
    to be temporary
   Leverage makes the temporary
    permanent



                                         10
 Leverage Risk - More Than LT Return Vol

100.00%

80.00%

60.00%

40.00%

20.00%                                                                             10x

 0.00%                                                                             150x

          Jun-98   Jul-98   Aug-98   Sep-98   Oct-98   Nov-98   Dec-98   Jan-99
-20.00%

-40.00%

-60.00%

-80.00%


                                                                                  11
Market Impact

   Large trades can “move the market”
   Bid/Ask on screen is not whole story
   In addition to bid/ask, liquid market
    needs:
       Low costs
       Depth



                                            12
Archipelago
Limit Order
Book




Apparent bid/ask
Of 10 cents




                   13
Quick Review
   Leverage Was Funded Primarily
    Through the Use of Swap and Repos
   Little Capital Up Front, Cash Flows
    Reflected Margin and Mark to Market
   ROA was Relatively Low/Huge Leverage
    Magnified Returns
   VAR and Stress Testing More Useful
    than Lvg. Ratios in Risk Management

                                      14
Practical Problems With Var

   Conditions are not stationary
          Including correlations
   Limited data
   Liquidity crises
   Fat tails in financial markets



                                     15
Sample Strategies
   Government Bond Spreads
   Swap Spreads
   Yield Curve Spreads
   Mortgage Spreads
   Volatility Spreads
   Risk Arbitrage
   Equity Relative Value
                              16
17
Trade Preferences
   Believed that Over Time Markets Tend
    Toward Efficiency
   Limited Credit Risk in Outright Positions
   Often Acted as a Source of Liquidity
   Tried to Isolate the Desired Investment
    Risk and Hedge Away Other Risks


                                           18
                         Ja
                              n-




                                     0
                                         20
                                              40
                                                   60
                                                        80
                                                             100
                                                                   120
                                                                         140
                                                                               160
                                90
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                              n-
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                                98




     5yr Swap Spread
                         Ja
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                                99
                         Ja
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                                00
                         Ja
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                                01
                                                                                     Monthly Swap Spreads 1990-2006




                         Ja
                              n-
     10 yr Swap Spread

                                02
                         Ja
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                                03
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                                04
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                                05
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                                06
19
              0.00
                     1.00
                            2.00
                                   3.00
                                          4.00
                                                 5.00
                                                          6.00
                                                                 7.00
                                                                        8.00
                                                                               9.00
                                                                                      10.00
     Jan-90

     Jan-91

     Jan-92

     Jan-93

     Jan-94

     Jan-95

     Jan-96

     Jan-97

     Jan-98

     Jan-99

     Jan-00

     Jan-01

     Jan-02

     Jan-03
                                                                                              5 Year CMT & Swap Rates 1990-2006




     Jan-04

     Jan-05

     Jan-06
20
                                                    CMT
                                             Swap
              0
                  2
                      4
                          6
                              8
                                  10
                                       12
                                            14
                                                 16
                                                      18
     Apr-53

     Apr-56

     Apr-59

     Apr-62

     Apr-65

     Apr-68

     Apr-71

     Apr-74

     Apr-77

     Apr-80

     Apr-83

     Apr-86
                                                           5 Year CMT 1953-2006




     Apr-89

     Apr-92

     Apr-95

     Apr-98

     Apr-01

     Apr-04
21
Relative Volatility of Rates/Spreads 1990-2006

                               Monthly SD   Mean

   5 Year CMT Rate             1.47%        5.48%

   5 Year Swap Spread           .21%        .49%

   Ratio Rate Vol/Spread Vol    7.0


   10 Year CMT Rate            1.33%        5.88%

   10 Year Swap Spread          .23%         .56%

   Ratio Rate Vol/Spread Vol    5.8


   FNMA MBS OASL                .11          .10%




                                                    22
                        Basis Points




     -20
           -10
                    0
                         10
                               20
                                       30
                                            40
                                                 50
           Oct-95


           Oct-96


           Oct-97


           Oct-98


           Oct-99


           Oct-00


           Oct-01
                                                      FNMA MBS OASL




           Oct-02


           Oct-03


           Oct-04
                                                                      FNMA MBS OASL 1995-2007




           Oct-05


           Oct-06


           Oct-07
23
                                       5 yr Daily Swap Spread July - October 1998

110



100



 90



 80



 70



 60



 50



 40
      7/1


            7/8


                  7/15


                         7/22


                                7/29


                                          8/5


                                                8/12


                                                       8/19


                                                              8/26


                                                                     9/2


                                                                           9/9


                                                                                 9/16


                                                                                           9/23


                                                                                                  9/30


                                                                                                         10/7


                                                                                                                10/14


                                                                                                                        10/21


                                                                                                                                     10/28
                                                5 yr Swap Spread       10 yr Swap Spread



                                                                                                                                24
LTCM
   Founded February, 1994
     - Capital $1 Billion
     - Principal’s Share $146 MM




                                   25
Salomon Bros. Pretax Income

          1993     1992    1991    1990

Prop.
Trading    $416    1,416   1,103    485


Other     $1,159    (26)   (67)      (69)

                                          26
LTCM Results
        Net       Gross     Dollar     Ending
        Return    Return    Profits    Capital
1994   20%       28%       $0.4       $1.6

1995   43%       59%       $1.3       $3.6

1996   41%       57%       $2.1       $5.2

1997   17%       25%       $1.4       $7.5

                                             27
LTCM 12/97
   Capital $7.5 Billion
   Principal’s Capital $1.9 Billion
   Assets $129 Billion
   Off Balance Sheet > $1 Trillion




                                       28
Morgan Stanley 1996
               $ Billions
Net Income     $1.0
Assets         $129.4

Equity         $7.4

Contractuals   $1,317


                            29
Long Term Financing
   Equity Lock-Up (3year Staggered)
   $230 Million Unsecured 3 year term
    Loans
   $700 Million Unsecured Revolving Line
    of Credit, Annual Renewal
   Term Repos (6-12 months)


                                        30
Back Office Complexity

   7,600 Positions
   6,700 Contracts
   55 Counterparties
   Inability to Net Across Legally-Distinct
    Entities within Large Firms



                                           31
Liquidity Management
   Capital Uses: Mark to Market Losses
    and Working Capital
   Working Capital Uses: Financing
    Haircuts, Equity and Future Margin
    Requirements
   Working Capital Sources:Equity Capital
    plus Term Debt plus Revolver

                                         32
Risk Management
   Downside Risk Diminishes as Value
    Discrepancies Become Extreme
   Leveraged Investors Commit First,
    Followed by Unlevered Investors
   Stress Testing
   Diversification


                                        33
    Correlations

   Long-Horizon Correlations Driven by
    Fundamental Risks
   Short- Horizon Correlations Driven by
    Fundamental Risks and Liquidity Effects




                                          34
Fund Size
 Desired Volatility of 15-20%
 Returns Uncorrelated with S&P 500

 Expected Excess Return of $750MM

 Daily P&L Sigma     =$45MM
                      =$720mm p.a.
                      =10.7% of Capital
Models est. sigma=$60mm.$960 p.a.
                                          35
Fund Size

   LTCM excess capital estimates of $2bn
   Marginal Capital Earns Libor before Fees
    and Libor minus 2% after Fees
   Return it!
   Alternative Strategies?



                                          36
OOOPS……the Decision

   Distribute $2.7bn on 12/31/97
   “Favor” Strategic and Early Investors
   Management Exempt
   Investors are MAD!!!




                                            37
1998 through June
   January through April: Flat
   May & June –16%, 4.1 Billion
   Firm Cuts Daily Sigma by 10%
   Liquidates Least Attractive (Most Liquid)
    Positions



                                          38
July 1998
   Salomon Smith Barney Shuts Down US
    Fixed Income Arbitrage Group
   LTCM Up 7% Through July
   Then Pattern of Daily Losses Resumes
    Across Many Positions
   Global Equity Markets Under Pressure
   Globally Volatility Spikes

                                       39
August 1998
   August 17: Russian Default, Flight to
    Quality
   August 21: Fund Loses $550mm in
    (Risk Arb and Swap Spreads)
   YTD down 40%, -$1.8BN, to $3bn
   Leverage (Cash basis) Now 44x


                                            40
Working Capital
   Sources:           Equity $2.95
                  Term Debt     0.23
               Credit Facility  0.90
               Total           4.08

   Uses of Working Capital: $2.10


                                       41
Lender Covenants
   Credit Facility Terminates if YTD Loss is
    Greater than 50%
   Contractual Agreements terminate if
    Fund Capital Falls Below $500MM




                                           42
Choices?
   Liquidate?

   Raise Capital?

   Buy…gulp…More?



                     43
September Investor Letter
   Losses of 52% YTD (to 2.3bn Capital)
   YTD Losses of $2.5bn
   82% of Losses RV, 18% Directional
   Positions Take Time to Efficiently
    Accumulate
   Best Opportunities Ever Seen
   Want to Come Out and Play?

                                       44
September 1998
   Fund Raising Fails
   Negative Rumors
   Mkt Participants Bet Against LTCM
   Liquidation of Similar Positions
   Bear Stearns Demands More Collateral
   Counterparties Mark to Worst


                                       45
September 1998

   9/21 One day Loss of $553 Million
   Capital Below $1 Billion
   9/23 Consortium of Firms Put up $3.6bn
    for 90% ownership and Oversight
   Not Capital Adequate Until February 99


                                       46
LTCM Losses 1/98-9/98
   Fixed Income RV     $1,628
   Equity Volatility   $1,314
   Emerging Markets      $430
   Directional            $371
   Equity Pairs          $306
           Total         $4,600


                                  47
Issues Determining Staying
Power

   Who else Employs Similar Strategies?
   Liquidity Shocks
   Time Varying Risk and Return
   Diversification
   Funding Sources
   Franchise Value
                                           48
Causes of LTCM Failure
   Arrogance - must be right
   Lack of any controls
       Internal
       Investors
       Lenders
       Counterparties
   Reliance on correlations
       Not stationary
       Market changes
       Fat tails
   Size of positions
       Limited trading partners
       They all know/watch each other
                                         49

				
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