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    3 LTCM and Lehman

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    Гюльнар Мамедова
    1) Long-Term Capital Management (LTCM) was a highly successful hedge fund in the 1990s that collapsed in 1998 after experiencing major losses. It had to be bailed out by a consortium of banks with assistance from the Federal Reserve to avoid triggering a broader financial crisis. 2) Lehman Brothers was a major investment bank that collapsed and filed for bankruptcy in September 2008 due to large losses from the subprime mortgage crisis. Its failure contributed to the onset of the late 2000s global financial crisis. 3) Both LTCM and Lehman Brothers failed due to taking on excessive risk, high leverage, and exposure to the mortgage market. Their collapses highlighted weaknesses in risk management practices on Wall Street.

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    3 LTCM and Lehman

    Uploaded by

    Гюльнар Мамедова
    44 views21 pages
    1) Long-Term Capital Management (LTCM) was a highly successful hedge fund in the 1990s that collapsed in 1998 after experiencing major losses. It had to be bailed out by a consortium of banks with assistance from the Federal Reserve to avoid triggering a broader financial crisis. 2) Lehman Brothers was a major investment bank that collapsed and filed for bankruptcy in September 2008 due to large losses from the subprime mortgage crisis. Its failure contributed to the onset of the late 2000s global financial crisis. 3) Both LTCM and Lehman Brothers failed due to taking on excessive risk, high leverage, and exposure to the mortgage market. Their collapses highlighted weaknesses in risk management practices on Wall Street.

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    1) Long-Term Capital Management (LTCM) was a highly successful hedge fund in the 1990s that collapsed in 1998 after experiencing major losses. It had to be bailed out by a consortium of banks with assistance from the Federal Reserve to avoid triggering a broader financial crisis. 2) Lehman Brothers was a major investment bank that collapsed and filed for bankruptcy in September 2008 due to large losses from the subprime mortgage crisis. Its failure contributed to the onset of the late 2000s global financial crisis. 3) Both LTCM and Lehman Brothers failed due to taking on excessive risk, high leverage, and exposure to the mortgage market. Their collapses highlighted weaknesses in risk management practices on Wall Street.

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    © All Rights Reserved
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    Download as pdf or txt
    44 views21 pages

    3 LTCM and Lehman

    Uploaded by

    Гюльнар Мамедова
    1) Long-Term Capital Management (LTCM) was a highly successful hedge fund in the 1990s that collapsed in 1998 after experiencing major losses. It had to be bailed out by a consortium of banks with assistance from the Federal Reserve to avoid triggering a broader financial crisis. 2) Lehman Brothers was a major investment bank that collapsed and filed for bankruptcy in September 2008 due to large losses from the subprime mortgage crisis. Its failure contributed to the onset of the late 2000s global financial crisis. 3) Both LTCM and Lehman Brothers failed due to taking on excessive risk, high leverage, and exposure to the mortgage market. Their collapses highlighted weaknesses in risk management practices on Wall Street.

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    of 21

    Class 3

    LTCM vs. Lehman Brothers


    LTCM: When genius failed

     Hedge fund Long-Term Capital Management was founded in


    Feb 1994 by several partners, including
    – John Meriwether from Salomon Brothers
    – Myron Scholes and Bob Merton (Nobel prize, 1997)
    – Charging lofty fees: 2% of assets p.a. + 25% of profits
     Starting with $1 bln, it provided net returns over 40% p.a. in
    1995 and 1996,
     …but lost $4.6 bln in 1998,
     …was rescued by the consortium of banks with the aid of Fed
     …and folded in early 2000.
    “LTCM collapse demonstrates that modern
    financial risk management techniques do not work”
    Was the strategy of LTCM closer to
    (quasi-)arbitrage or speculation?
     Fixed income arbitrage (relative value / convergence trades)
    – Long off-the-run Treasury bonds, short on-the-run (recently issued and
    more liquid) Treasuries
    – The tiny difference of a few basis points is magnified by high leverage
     Derivatives arbitrage
    – Swaps, futures, options, etc.
     Merger arbitrage
    – Buying potential takeover targets
     Investing in the sovereign debt
    – Italy, Russia, etc.
     Selling options on S&P500
    – Earning low stable income unless the index falls a lot
    What were main risks for LTCM?

     Market, liquidity and credit risk


    – What if spreads go up, volatility rises, bond defaults happen,…?
    – OTC derivatives positions are illiquid
     …magnified by high leverage
    – Turning tiny profits (losses) to attractive returns (huge losses)
     Large positions relative to the market
    – Followed by multiple imitators
     Highly sensitive to market-wide liquidity

    Picking up pennies in front of a steamroller


    N. Taleb
    How to manage risks for
    such a big portfolio?
     LTCM’s position in January  Emergency funding
    1, 1998 – $230 mln unsecured 3y term
    – Balance sheet assets: $125B loan
    – Notional of the derivatives (off – $700 mln unsecured line of
    balance): over $1.25T credit, annual renewal
    – 7,600 positions
    – 55 counterparties  Equity lock up period for
     Own capital: $4.8B investors: 3 years
    – 30 times leverage for balance
    sheet assets only!

     In 1997 LTCM earned ‘only’ 17% and returned at the end


    of the year $2.7 bln to investors (the new ones)
    How could LTCM measure market risk?

     Historical volatility?
    – Could underestimate risk in a favorable market environment
    – Cannot fully account for the complicated derivatives positions

     Exposure to relevant factors


    – Including volatility, liquidity,…

     VaR and ES adjusted for liquidity and correlation risk


    – Would give a rough estimate of the potential losses

     Stress testing
    – Factor push: liquidity, correlations,…
    – Scenarios taking into account LTCM’s huge market position
    LTCM early crisis management

     May-Jun 1998: -16% return


    – Salomon Brothers bond arbitrage desk closes its portfolio
    – LTCM liquidates least attractive (most liquid) positions to meet margin
    calls
     Aug 17, 1998: Russian default caused flight to safety and rise
    in risk premiums
    – LTCM lost $550 mln in August 21
    – YTD losses 40% ($1.8B), capital down to $3.0B
     Sep 2, 1998: letter to investors
    – YTD losses 52% ($2.5B), capital down to $2.3B
    – 82% of losses in relative value trades
    LTCM vs. the market, sep 1998

     Negative rumors
     Fund raising fails
     Prime broker (Bear Stearns) demands more collateral
     Some market participants liquidate similar positions
     Some bet against LTCM: marking to worst
    “When it became apparent they were having difficulties, we thought that if
    they are going to default, we’re going to be short a hell of a lot of
    volatility. So we’d rather be short at 40 than 30 right? So it was clearly
    in our interest to mark to as high a volatility as possible. That’s why
    everybody pushed the volatility against them, which contributed to their
    demise in the end.” RISK, Oct 99
    Should have regulators interfered in such
    a situation?
     Sep 23: consortium of 16 banks (organized by Fed)
    offered $3.6B for 90% stake in the LTCM
    – In July 1999 the fund was closed with small profit (10%)
    – 88% of the original investors made a profit (around 18%)
     Avoiding the financial crisis?
    – LTCM’s default could cause price collapse
    – …and trigger chain reaction (cross-defaults of counterparties)
     Too many important people to bear the losses?
    – There was an alternative offer in Sep 22: $4B by W.Buffett
    (together with AIG & Goldman Sachs) for 95% stake in LTCM
     What were the long-term consequences of Fed’s
    interference?
    Alan Greenspan’s testimony before
    Congress

    12
    Lessons of LTCM: was it bad luck or
    risk management failure?
     Risk management at LTCM
    – Limitations of VaR and model risk
     Risk management at LTCM broker (Bear Stearns)
    – Partner relations and low haircut (high leverage)
     Risk management at LTCM counterparties
    – Interaction with a highly leveraged offshore institution
     Risk management at other financial institutions
    – Citi, JP Morgan, etc. also suffered big losses in Aug-Sep 1998
     Regulation / supervision
    – Moral hazard: will the Fed save all big losers whose default can
    endanger the whole financial system?
     Were LTCM managers and investors ready for such losses?
    Lehman Brothers: from a major investment
    bank to the largest corporate bankruptcy
     One of the oldest and most  New strategy: moving from
    profitable investment banks low-risk brokerage to high-risk
    – Founded in 1850 global banking model
    – Bought by AmEx in 1984, but – Diversified to equity and
    spun off in 1994 via IPO advisory businesses
     Traditional strength: – …and mortgages (29% assets)
    – Fixed income underwriting &  Market presence
    trading (39% income, 59% assets) – One of the largest dealers in the
    commercial paper market
    – Top-10 counterparty in the CDS
    market ($800B notional)

    14 Richard Fuld, Lehman Brothers CEO


    Position of Lehman at the end of 2007:
    4th largest US securities firm
     2007 results: record profits  Leverage ratio:
    $4.2B and revenues $19.3B Assets/Equity = 30.7
    – Target: 13% growth in – Funding went mostly via short-
    revenues term repos ($215B with avg
     Total assets: $691B maturity 24d), no retail deposits
    (typical shadow banking model)
    – $79B of mortgage-related
    securities incl. $5.3B subprime  Liquidity management: the
     Market cap: $35B (down goal was to provide 12
    from $60B in Feb 2007) months of funding under
    stress
     Equity: $22.5B – $35B in cash / equivalents
     Over 1,000 subsidiaries and – $50B of high-quality assets that
    28,000 employees could be sold or used as
    collateral

    15
    Events: beginning of the end

     July 2007: bankruptcy of two hedge funds managed by Bear


    Stearns
    – Highly leveraged investment into mortgages
     By end-2007 the total losses of banks on MBS exceeded $100B
     March 16, 2008: collapse of Bear Stearns
    – Acquired by JP Morgan at $2 per share (under Fed’s request)
    – Rumors about insolvency of Lehman using a similar business model (just
    like in 1998 during LTCM events)
     March 18, 2008: earnings announcement by Lehman led to 46%
    share rise
    – $489M profit beating expectations ($4.7B losses offset by hedging)
    – The leverage increased to 31.6 despite $1.9B preferred shares issue
     April 1, 2008: another $4B issue of preferred convertibles
    – Shares went up by 18%

    16
    Events: heading towards failure

     April 8, 2008: David Einhorn (Greenlight Capital hedge fund)


    announced shorting Lehman
    – Lehman’s write-downs on mortgages should be larger
    – High leverage makes them vulnerable (they need 3-5 times more capital)
     June 2, 2008: S&P downgraded Lehman’s rating from A+ to A
    (together with Merrill Lynch and Morgan Stanley)
     June 9, 2008: Lehman announced first ever quarterly loss as a
    public company, $2.8B
    – Total losses $17B partly offset by $7.5B hedging gains and asset sales
    – Leverage went down to 25
    – Announcing sales of $6B stocks at 15% discount to market price
     June 12, 2008: CFO and President were fired

    17
    Events: the end

     August 2008: Lehman laid off 1,500 employees (6% workforce)


     Sep 7, 2008: the gvt seized control over Freddy Mac & Fannie Mae
     Sep 10, 2008: Lehman announced a second quarterly loss $3.9B
    – …along with intention to sell of most of its investment mgt business
    – This led to credit rating downgrade and stock price plunge
     Sep 13, 2008: the Fed organized a meeting of bankers to discuss
    the future of Lehman
    – The gvt refused to bail out them, encouraged private buyout
    – Before that, Lehman tried to engage the Korea Development Bank, the
    Bank of America and Barclays, but with no success
     Sep 15, 2008: Lehman filed for bankruptcy
    – The international offices were ordered to transfer money to NY, but chose
    to file for bankruptcy or liquidation
     Later Lehman’s assets were sold to Barclays, Nomura, …

    18
    Consequences: the ‘perfect storm’ in the
    financial markets
     The largest bankruptcy in the  Dollar fell
    US history  Flight from corporate
    – Affecting company’s employees, securities to Treasuries
    counterparties, investors,…
    – Leading to chain reaction
     CDS spreads widened
     Sep 15: BoA acquired Merrill  Money market funds
    Lynch for $50B faced heavy redemptions
     Sep 16: Fed announced $85B  Global equity markets
    rescue package for AIG lost trillions of dollars
     Sep 22: Goldman Sachs &
    Morgan Stanley convert into
    bank holding companies

    19
    LTCM vs. Lehman: what is the difference?

     What was the main reason  Why didn’t the Fed save
    of the failure? Lehman like it saved
    – Lehman is a corporate LTCM?
    governance case! – Regulators had done too
    – Using Repo 105 program, LB many bail-outs before Sep 15.
    could hide its true leverage
    • Lehman accounted for repos
    as asset disposals (hiding the
    obligation to buy back the
    collateral)
    • $50B in sep08, reducing
    leverage from 13.9 to 12.1

    20
    Common lessons from LTCM and Lehman
    failures
     Right incentives
    – Short or long horizon
     Market position
    – Small or big fish
    – Heisenberg effect
     Actions of competitors
    – With / against the crowd
    – Predatory trading
     Role of models
    – Art vs. science
    – Statistical analysis vs. scenario planning

    21

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