Thread by @ReformedTrader

1/ When Genius Failed: The Rise and Fall of Long-Term Capital Management (Roger Lowenstein)

"If there was one article of faith that John Meriwether had discovered at Salomon Brothers, it was to ride your losses until they turned into gains."

amazon.com/When-Genius-Fa…

2/ "He often bet that a spread—say, between a futures contract and the underlying bond, or between two bonds—would converge.

"Occasionally, other investors might get scared and withdraw, causing spreads to widen further and causing Meriwether to lose money, at least temporarily.

3/ "But if he had the capital to stay the course, he’d be rewarded in the long run, or so his experience seemed to prove. Eventually, spreads always came in; that was the lesson he had learned from the Eckstein affair, and it was a lesson he would count on, years later, at LTCM.

4/ "But there was a different lesson, equally valuable, Meriwether might have drawn, had his success not come so fast: while a losing spread trade may turn around eventually, the turn could arrive too late to do good—meaning, of course, that he might go broke in the interim."

5/ "Meriwether was the priest of the calculated gamble. He was cautious to a fault.

"What Meriwether lacked, he must have sensed, was an edge, something that would distinguish Salomon from every other bond trader. His solution was simple: Why not hire traders who were smarter?

6/ "Traders who would treat markets as an intellectual discipline, as opposed to the folkloric, unscientific Neanderthals who traded from their bellies... Academia was teeming with nerdy mathematicians who had been publishing unintelligible dissertations on markets for years.

7/ "Wall Street had started to hire them, but only for research, where they’d be out of harm’s way.

"It was the element of passion that Meriwether wanted to eliminate; he preferred the cool discipline of scholars, with their rigorous and highly quantitative approach to markets."

8/ “Given the shape of yield curves, volatilities, and interest rates, are the markets making statements that are inconsistent with each other?”

"This is how they talked and thought. Every price was a “statement”; if two statements were in conflict, there might be an arbitrage.

9/ "All of Wall Street did this trade. The difference was that Meriwether’s Arbitrage Group did it in very big dollars. If a trade went against them, they merely redoubled the bet. Backed by their models, they felt more _certain_ than others did—almost invincible.

10/ "The professors had a protector who shielded them from company politics and got them the capital to trade.

"They were brilliant at reducing a trade to pluses and minuses. They could strip a ham sandwich to its component risks but could barely carry on a normal conversation.

11/ "Meriwether created a safe, self-contained place for them to develop their skills; he adoringly made Arbitrage into a world apart. Because of Meriwether, the traders fraternized with one another, and they didn’t feel the need to fraternize with anyone else."

12/ "Very few traders left, and those who remained all but worshiped Meriwether.

"His interest and curiosity stimulated the professors; it challenged them and made them better. He rewarded them with heartfelt loyalty.

"Combined with the traders’ uncommon self-confidence,

13/ "Meriwether’s faith in them was a potent but potentially combustible mix. It inflated their already supreme self-assurance. Meriwether’s (J.M.’s) willingness to bankroll them with Salomon’s capital dangerously conditioned the troops to think there would always be more."

14/ "Others in Salomon began to seethe. J.M. would send one of his boys—Hilibrand or Victor Haghani—to Salomon’s London office or its Tokyo office, and the emissary would declare, “This trade is very good, but you should be ten times bigger in it.” Not two times, but ten times!

15/ "As if they couldn’t fail. Hilibrand and Haghani were in their twenties, and they might be talking to guys twice their age. Then they started to say, “Don’t do this trade; we’re better at this than anyone else, so we’ll do all of this trade on the arbitrage desk.”

16/ "Driven by fanatical loyalty to Meriwether, the Arbitrage Group nurtured an us-against-them clannishness that would leave the future LTCM dangerously remote from the rest of Wall Street.

"Others at Salomon weren’t sure quite what the group was doing or what its leverage was,

17/ "but they instinctively trusted Meriwether. Even his rivals in the firm liked him."

"Hilibrand made a near-catastrophic bet in mortgages and fell behind by $400 million. Most traders would have called it a day, but he coolly proposed that Salomon double its commitment.

18/ "Because he believed in his trade devoutly, he could take pain as no other trader could. Like a Slinky out of shape, eventually the market would spring back. It was said that only once had he ever suffered a permanent loss, a testament to the fact that he was not a gambler.

19/ "But his supreme conviction in his own rightness cried out for some restraining influence, lest it develop a reckless edge. Doubling up was too much, but management let Hilibrand keep the trade he had. Eventually, it was profitable,

20/ "but it reminded Salomon’s managers that while Hilibrand was critiquing various departments as being so much extra baggage, Arbitrage felt free to call on Salomon’s capital whenever it was down. The executives could never agree on just how much capital Arbitrage was tying up

21/ "or how much risk its trades entailed, matters on which the dogmatic Hilibrand lectured them for hours. In short, how much—if, sometime, the Slinky did not bounce back—could Arbitrage potentially lose?"

22/ "J.M. laid plans for a new and independent arbitrage fund, perhaps a hedge fund, and he proceeded to raid the Arbitrage Group that he had so lovingly assembled.

"Meriwether planned from the very start that LTCM would leverage its capital twenty to thirty times or even more.

23 /"This was a necessary because the gaps between the bonds it intended to buy and those it intended to sell were, most often, minuscule.

"Merrill agreed to take on the assignment of raising capital for Long-Term. J.M.’s design was staggeringly ambitious.

24/ "He wanted nothing less than to replicate the Arbitrage Group, with its global reach and ability to take huge positions but without the backing of Salomon’s billions in capital, credit lines, information network, and seven thousand employees.

25/ "Having done so much for Salomon, he was bitter about having been forced into exile under a cloud and eager to be vindicated, perhaps by creating something better. And Meriwether wanted to raise a colossal sum, $2.5 billion. (The typical fund starts with perhaps 1% as much.)

26/ "Everything about Long-Term was ambitious.J.M. and his partners would rake in 25% of the profits in addition to a yearly 2% charge on assets. (Most funds took only 20% of profits and 1% on assets.) Such fees, J.M. felt, were needed to sustain a global operation.

27/ "The fund insisted that investors commit for at least three years, an almost unheard-of lockup in the hedge fund world. The lockup made sense; if fickle markets turned against it, Long-Term would have a cushion of truly “long-term” capital."

28/ "They had made a ton of money at Salomon: investors warmed to the idea that they could do it again. In the face of intellectual brilliance, investors—having little understanding of how Meriwether’s gang operated—gradually forgot that they were taking a leap of faith."

29/ "The securities might be unrelated, but the same investors owned them, implicitly linking them in times of stress.

" “Liquidity” is a straw man. Whenever markets plunge, investors are stunned to find that there are not enough buyers to go around.

30/ "Long-Term was doubly fortunate: spreads widened before it invested much of its capital, and once opportunities did arise, Long-Term was one of a very few firms in a position to exploit the general distress. It started to make money on the positions almost immediately."

31/ "Some institutions were so timid, so bureaucratic, that they refused to own anything but the most liquid paper. They were willing to pay a premium for on-the-run paper, and Long-Term’s partners, who had often done this trade at Salomon, happily collected it.

32/ "They called it a “snap trade:” the bonds usually snapped together after only a few months.

"Since LTCM tended to buy the less liquid security in every market, its assets were not entirely independent and would be susceptible to falling in unison if everyone wanted to sell."

33/ "LTCM, with trademark precision, calculated that owning one bond and shorting another was 1/25 as risky as owning either bond outright and could therefore prudently leverage the arbitrage 25x. It pulled off the entire $2 billion trade without using a dime of its own cash."

34/ "The partners would insist that the fund was so well heeled that it didn’t need to post an initial margin and wouldn’t trade with anyone that saw this differently. Merrill Lynch agreed to waive its haircut requirement. So did Goldman Sachs, J. P. Morgan, and Morgan Stanley."

35/ "Frequently, though not always, it got the same terms on repo financing of actual securities. Also, Long-Term often persuaded banks to lend to it for longer periods than the banks gave to other funds.

"This was where Meriwether’s marketing strategy really paid dividends.

36/ "If the banks had given it a moment’s thought, they would have realized that Long-Term was at their mercy. But the banks saw the fund not as a credit-hungry start-up but as a luminous firm of celebrated scholars and brilliant traders."

37/ "The banks had no trouble rationalizing these easy terms. They did hold collateral, after all, and Long-Term generally settled up in cash at the end of each day.

"Only if Long-Term lost money with unthinkable suddenness—would the value of the collateral be threatened.

38/ "The Street was slowly shifting from research & client services to the lucrative business of trading for its own account, fostering a wary rivalry between Long-Term and its lenders.

"As a precaution, LTCM would place orders for each leg of a trade with a different broker."

39/ "If the firm could have been distilled into a single person, it would have been Hilibrand. While veteran traders tend to be cynical and insecure, the result of years of wrong guesses and narrow escapes, Hilibrand was cool and maddeningly self-confident."

40/ "There was subtle pressure on the staff to invest their bonuses in the fund, but most of them were eager to do so anyway—ironically, it was considered a major perk of working at Long-Term. And so the staff confidently reinvested most of their pay."

41/ "The partners excelled at identifying particular mispriced risks and hedging out the rest. Long-Term was searching for pairs of trades—or often, multiple pairs—that were “balanced” enough to be safe but unbalanced in one or two very particular aspects.

42/ "Markets in Europe, as well as in the Third World, were less efficient than America’s; they had yet to be picked clean by computer-wielding arbitrageurs (or professors). For Long-Term, these underexploited markets were a happy hunting ground with a welter of opportunities."

43/ "For all its attention to risk, LTCM’s management had a serious flaw. Unlike at banks, where independent risk managers watch traders, LTCM's partners monitored themselves. Though this enabled them to sidestep the rigidities of a big organization, there was no accountability."

44/ "Long-Term was plugged in to Italy’s central bank, which had invested $100 million in the fund and lent it $150 million more.

"The partners assumed that, all else being equal, the future would look like the past.

45/ " “You could pick up a Journal of Finance and see where someone was applying models,” a London-based trader at Salomon noted with respect to the Italy trade. “Anyone who had done first-year university math could do it.” Other firms had been doing similar trades for years.

46/ "By the time LTCM started to trade, spreads in Italy had begun to narrow; rival firms were bidding arrivederci. Haghani got his first billion dollars’ worth or so of Italian bonds from Salomon, which wanted out. The common notion that LTCM had a unique black box was a myth.

47/ "Other Wall Street firms had also found their way to MIT, and most of the big banks were employing similar models—and applying them to the same couple of dozen spreads in bond markets.

"Long-Term’s edge wasn’t in its models but in its experience _reading_ the models.

48/ "With financing so accessible—and with the partners so supremely confident—Long-Term traded on a greater scale, squeezing nickels long after others had quit. “We focused on smaller discrepancies than other people. We thought we could hedge further and leverage further.”

49/ "Klarman warned, “Successful investors have positioned themselves to avoid the 100-year flood. That way of thinking has become passé.” Given LTCM's leverage, even a single serious mistake would put a “major dent” in its capital. “Two major errors would be catastrophic.” "

50/ "The fact that the group’s ship hadn’t capsized in the past didn’t guarantee that the group had properly calculated the odds of a tidal wave—just that such waves were relatively infrequent.

"Paul Samuelson, Merton’s mentor at MIT, had doubts when Long-Term was organized.

51/ "He recognized that “continuous time” was merely an ideal state; in real time, traders took seconds, minutes, or even hours to analyze events and react. When events overwhelmed them, the markets gapped. Heat molecules didn’t jump out of line; IBM most certainly did."

52/ "In markets, we are never sure that the sample is complete. The universe of all trades looked one way throughout the 1920s and another way after the Great Depression. The pattern changed again during the inflationary 1970s, yet again in the effervescent 1990s.

53/ "After which of these periods was the picture “normal,” and how do we know that the next new period won’t change the story again?

"In the early 1960s, Fama had written his thesis on the price movements of the thirty DJIA stocks and discovered a remarkable pattern.

54/ "For every stock, there were many more days of extreme price movements than would occur in a normal distribution. Fama’s stocks were like a world in which most people were average height but every twentieth person was either a giant or a dwarf.

"As Fama put it,

55/ "If the population of price changes is strictly normal, on the average for any stock... an observation more than five standard deviations from the mean should be observed once every 7,000 years. In fact such observations seem to occur about once every three to four years."

56/ "By the time Long-Term was formed, it was well-documented that virtually all financial assets behaved like the stocks that Fama had studied.

"The most obvious example was Black Monday, when, on no apparent news, the market plunged 23%.

57/ "Economists later figured that, on the basis of the market’s historic volatility, had the market been open every day since the creation of the Universe, the odds would still have been against its falling that much on any single day.

58/ "In fact, had the life of the Universe been repeated one billion times, such a crash would still have been theoretically “unlikely.” But it happened anyway.

"Markets have memories. Sometimes a trend will continue just because traders expect (or fear) that it will."

59/ "Merton showed disdain for the possibility that investors could be anything but calculating automatons, blithely ignoring the times when their emotions ran riot. He took credit for the contribution that his theories made to “the portfolio-insurance products of the 1980s,”

60/ "as if he were blind to the fact that, when real people had tried those products, portfolio insurance had miserably failed.

"Long-Term’s traders were not automatons. They debated, sometimes hotly, for hours every week, about what the models implied and recommended.

61/ "They were also aware of the “fat tail” criticism—the idea that unexpected disaster should be expected—and tried to adjust the models for it.

"The problem with the math is that it adorned with certitude events that were inherently uncertain."

62/ "By the spring of 1996, Long-Term had an astounding $140 billion in assets, thirty times its underlying capital. Though still unknown to 99% of Americans, it was 2.5x as big as Fidelity Magellan, the largest mutual fund, and four times the size of the next largest hedge fund.

63/ "It now controlled more assets than Lehman Brothers and Morgan Stanley and were within shouting distance of Salomon.

"Five years into a bull market, the banks were awash in liquidity, and the hedge fund trade was a lucrative way for Wall Street to employ its surplus capital.

64/ "The banks accomplished this by a practice known as “renting out the balance sheet”—literally, transferring their enormous borrowing power to hedge funds with lesser credit ratings, a service for which they charged mere pennies on every $100 of credit.

65/ "LTCM, easily the biggest hedge fund customer, was reputed to be throwing off $100-200 million/year in fees to Wall Street. Each bank wanted as big a share as possible.

"Merrill Lynch and Salomon Brothers were LTCM’s biggest sugar daddies, at least in terms of financing."

66/ "It wasn’t clear what Merrill was getting. LTCM shaved too much from bid and ask to leave a normal profit for its broker.

"Merrill salesmen promoting their prize account rationalized that financing LTCM was the key to trading with it and enabling Merrill to see order flow.

67/ "Since Merrill saw only one side of each trade, the information was of dubious value. The usually healthy tension between the financing and sales desks was tilted in LTCM’s favor, as people knew the account was “special.” LTCM could tap friends at every level of the firm."

68/ "The partners wanted a warrant on their own fund to add a layer of personal leverage to the enormous leverage already in the portfolio. Even though they had virtually all of their personal assets in the fund, the partners, especially Hilibrand, were hot for more exposure.

69/ "The partners could also claim profits from the warrant as capital gains and defer them until the warrant expired.

"Though they fought for a clearing agreement that would protect them during a crisis, with own capital, they seemed not to consider the possibility of failing."

70/ "The partners’ nervy decision to keep redoubling their bets had vaulted them into the ranks of the superrich overnight. Unlike corporate titans, who hedged their bets by continually peeling off shares, J.M., Hilibrand, Rosenfeld, and the rest left every nickel on the table.

71/ "When they needed spending money, they redeemed a bit of the fund, which they treated like a personal checking account.

"Not once in 1996 did LTCM suffer a monthly loss of 1%. To Hilibrand, Haghani, and Hawkins, the results proved convincingly that diversification worked.

72/ "The fund’s diverse trades were blending with symphonic perfection like independent dice.

"Long-Term asked its investors to agree to stagger the dates on which they could take out money in the future. People who did not agree could take their money home (none did).

73/ "This gave LTCM added protection should investors withdraw en masse. Money was pouring into arbitrage via rival banks and competitor funds. This forced spreads tighter and was one reason for LTCM’s recent profits. But it would make new opportunities tougher to find."

74/ "They were increasingly intrigued with the idea of making less liquid, more permanent investments in businesses, beyond the reach of copycats.

"By 1997, it had >$5 billion in equity, which would have to be invested, but the computers were failing to find opportunities.

75/ "The paired-share trades weren’t perfect arbitrages: the two sides were never precisely equivalent. A preference share was worth a premium, esp. as, in Germany & elsewhere in Europe, managements did not feel the same obligation as in the U.S. to treat all stockholders fairly.

76/ "No one could say precisely what the “right” premium was, only that the 40% premium in VW’s case, for example, seemed excessive. But the spread could persist or even widen—models be damned. Given such uncertainties, most players limited paired-share trades to moderate size.

77/ "But with its coffers burgeoning, LTCM developed a sense of proportion all its own; like a man who buys dinner with $100 bills & never asks for change, it had lost the habit of moderation.

"In practical terms, positions as large as the ones LTCM took were totally illiquid."

78/ "One offshoot—largely unintended—of derivatives' growth was that banks’ financial statements became increasingly obscure. Derivatives weren’t disclosed in any way meaningful to outsiders. As volume exploded, the banks’ balance sheets revealed less of their total obligations."

79/ "The Street had bought into a massive faith game. Each bank had become knitted to its neighbor through a web of contractual obligations requiring little/no down payment.

"Institutions considered healthy one day went up in smoke the next due to hidden derivative exposures."

80/ "The banks’ own balance sheets were steadily ballooning; by the late 1990s, Wall Street was leveraged 25 to 1. Awash with liquidity if not quite drowning in it, the banks had to find an outlet for their capital. The most tempting targets were hedge funds.

81/ ""As banks relentlessly chased the fund business, they silently relaxed their standards. No borrower had to account for its total exposure; no lender asked. Each bank knew the extent of its own exposure to an individual client, in particular to Long-Term.

82/ "None bothered to think about whether the hedge fund might be similarly exposed to a dozen other banks. “You’d be doing big chunks of business with them. You’d assume you were their #1 provider, but you were really #10. You couldn’t believe they were doing that much volume.”

83/ "To leverage even further, the LTCM management company, borrowed $100 million from a trio of banks: money the partners plowed right back into the fund.

"For men who prided themselves on being disciples of reason, their drive to live on the edge seemed inexplicable."

84/ "Hilibrand personally borrowed $24 million more from Crédit Lyonnais, which set up a program to let the partners borrow against their interests in the fund. Hans Hufschmid, who specialized in currency trades, borrowed $15 million, & two other partners borrowed lesser amounts.

85/ "In addition, some of the partners had leveraged personally with Bear Stearns, their broker. Considering that the fund itself was so heavily leveraged, the partners, Hilibrand in particular, were dangerously adding leverage to leverage.

86/ "As opposed to a poor man who bets the limit, the already-rich Hilibrand had little to win and everything to lose. The UBS warrant raised $1 billion at the worst moment—when LTCM was struggling to find places to invest the money it already had and was fighting competitors."

87/ "Even in Japan, the partners pursued a controversial trade. In 1997, Japan’s long bond was yielding only 2%. Long-Term placed a naked, unhedged bet that this rate would rise.

"Many of the partners had doubts about the trade, which for Long-Term was unusually speculative.

88/ "Hilibrand & Haghani were increasingly running the firm irrespective of other partners’ wishes. With results so good, it was easy to dismiss naysayers as worrywarts.

"LTCM’s plan was to return, at the end of 1997, all profits on money invested during 1994, its first year,

89/ "and to return all principal & profits invested after that date. It excluded partners & employees and partially excluded some big strategic investors. They added an unusually self-serving touch, tacking on fees to the bonus money invested by some of their own employees."

90/ "The implication was that LTCM was prudently scaling back in the face of shrinking spreads. Yet returning capital only reduced the equity supporting its assets.

"By forcing outsiders to sell, the partners were, once again, increasing their personal leverage in the fund.

91/ "The personal debt, on top of the leverage in the management company and the debt in the fund itself, made for three levels of debt precariously pyramided one atop the other.

"Long-Term Capital dodged the bullet again. The fund broke even in October and November.

92/ "It began to place hefty derivative bets that volatility would fall. This was risky stuff. Salomon had made this bet before October & lost $110 million. But shorting volatility was the most natural of bets for Long-Term. In a sense, its spread trades were bets on volatility."

93/ "Early in 1998, LTCM began to short large amounts of equity volatility.

"When the models told them that the markets were mispricing equity vol, they were willing to bet the firm on it.

"LTCM deduced that the options market was anticipating stock market volatility of 20%.

94/ "Long-Term viewed this as incorrect; actual volatility was only 15%. Thus, it figured that option prices would fall. So Long-Term began to short options—specifically, options on the S&P 500 stock index and on the equivalent indices on the major exchanges in Europe."

95/ "This was—so unlike the partners’ credo—rank speculation. By putting themselves at the mercy of short-term fluctuations, the partners had abandoned whatever advantage lay in their precise models. Long-Term sold volatility at 19%. As option prices rose, it continued to sell.

96/ "Eventually, they had a staggering $40 million riding on each percentage point change in equity volatility in the U.S. and an equivalent amount in Europe—perhaps a fourth of the overall market. Morgan Stanley coined a nickname for the fund: the Central Bank of Volatility."

97/ "The models implied that it would take a ten-sigma event—a statistical freak occurring one in every 10²⁴ times—for the firm to lose all of its capital within one year. If the partners were anxious, it was not about losing; it was that they wouldn’t find enough investments.

98/ "As the pressure to find trades mounted, they strayed into more exotic tundra, such as Brazilian and Russian bonds and Danish mortgages.

"Long-Term also began to make more directional bets, abandoning (for a fraction of its portfolio) its trademark hedging strategy.

99/ "Scholes was deeply upset by such trades, particularly the big position in kroner. He argued that LTCM should stick to its models; it did not have an informational advantage in Norway.

"Long-Term bought heaps of tech stock puts and hedged them by selling puts on the S&P 500.

100/ "Long-Term was succumbing to the fatal temptation to put its money _someplace_. In a clear speculation, it bet on the U.S. stock market to decline via options.

"Alain Sunier proposed buying stocks that, according to a model, were likely to be added to the S&P index.

101/ "Hilibrand got very interested in this trade. He ignored Sunier’s model, discarding Sunier’s companies and adding new ones. And Hilibrand insisted on buying hefty stakes in every one of them.

"The banks continued to give the fund a free ride.

102/ "Merrill Lynch financed the fund in Brazil on the slimmest of haircuts. The repo desk squawked to McDonough, the credit officer responsible for hedge funds, about LTCM’s emerging market exposure. McDonough just laughed. “We’re in bed with them. If they go down, we go down!”

103/ "On April 1, 123 Merrill executives purchased (in individual, separate stakes) most of Merrill’s investment in LTCM for their own deferred compensation plans. Komansky, Merrill’s chairman, put in $800,000; in total, the executives invested $22 million."

104/ “We misread the haircuts we needed to be protected. It wasn’t a mistake we made singly for LTCM. To suffer the organization telling you you are losing business—it takes a tremendous amount of courage to say, ‘I’m not going to do it.’ The Street got that collectively wrong.”

105/ "In the manner of markets, the first hints of trouble were scattered, small, and seemingly unrelated.

"Succo declared that the senior managements at some—possibly all—Wall Street firms had no idea of the risks being run by their twenty-six-year-old traders.

106/ "He hedged, adding that his management was better informed. But for suggesting that Wall Street’s top brass was uninformed, the prophetic Succo was forced to resign from Lehman.

"In May, contrary to the forecasts of Long-Term’s models, arbitrage spreads began to widen.

107/ "Bond arbitrageurs suffered losses, setting off a modest but hard-to-break cycle of selling. Firms such as Salomon, which had less capital as a result of the losses, now were in violation of their own computer-determined guidelines regarding the ratio of capital to assets.

108/ "Thus, they sold a bit more. “As people liquidated, volatility moved up. That forced more people to liquidate.”

"Russia’s financial system was now on the verge of collapse.

"Credit spreads widened in every market in which LTCM was active. In every market, it was losing.

109/ "There was a pervasive sense that markets had been undercharging for risk.

"Implied volatility rose to 27%, creating a substantial loss for LTCM.

"Salomon’s selling helped tip LTCM’s portfolio into negative territory; arguably, it triggered the fund’s downhill spiral."

110/ "As repo loans were rolling over, Wall Street banks, Lehman among them, were finally asking the professors for margin.

"The partners thought they had reason to be optimistic; spreads had widened so much, they felt, that now, surely, they could only narrow.

111/ "According to one trader at LTCM, the fund went “outright long in Russia—right at the end.” Said another, miserably, “It was so against our way.”

"On Aug. 17, Russia declared a debt moratorium. It would rather use its rubles to pay Russian workers than Western bondholders.

112/ "Nor would it attempt to maintain the value of those rubles in foreign markets. In short, it was a devaluation and, on at least some of its borrowings, a default from a government that had promised that it would do neither.

113/ "Enigmatic to the end, Russia said its moratorium would apply to $13.5 billion of local (ruble) debt—breaking the rule, honored even in the depths of the Latin American debt crisis, that a government honors its own coin.

114/ "The default shattered the lazy but convenient assumptions of investors that the safety net would always be there. It “punctured a moral hazard bubble” that had been inflating expectations since Rubin had ridden to the rescue of Mexico."

115/ "On an active day, U.S. swap spreads might change by as much as a point. But on this morning, swap spreads were wildly oscillating over a range of 20 points. They ended an astonishing 9 points higher. In Britain, they surged to 62, a dozen points wider than in July.

116/ "The traders hadn’t seen a move like that—ever. True, it had happened in 1987 and again in 1992. But the models didn’t go back that far. As far as Long-Term knew, it was a once-in-a-lifetime occurrence—a practical impossibility—and one for which the fund was unprepared."

117/ "The losses came from every corner. They were swift, encyclopedic in breadth, and utterly unexpected.

"LTCM, which had calculated that it was unlikely to lose >$35 million on any one day, had dropped $553 million—15% of its capital (and a third of its equity since April).

118/ "Disturbingly, the traders said there was no demand for Long-Term’s trades, despite their seeming soundness.

"In such a climate, there was no way Long-Term could get out of its humongous trades without moving the markets even more.

119/ "They were certain spreads would eventually converge. But owing to its loss of capital, the leverage had become dangerously high. To reduce their risk, the partners would have to sell something.

120/ "When a firm has to sell in a market without buyers, prices run to the extremes beyond the bell curve.

"Long-term thinking is a luxury not always available to the highly leveraged; they may not survive that long."

More on this:

https://twitter.com/ReformedTrader/status/1452718699664711680

121/ "Because none of its banks had the whole picture (each was counterparty to only one side of each of LTCM's pair trades), none saw that most of its trades were hedged and tended to offset one another; therefore, each was demanding more margin than it otherwise would have.

122/ "Long-Term was trying to move pairs of trades to the same house, but the job was overwhelming: the fund had a mind-boggling 60,000 individual positions.

"The problem of pairing trades wouldn’t have arisen but for Hilibrand’s earlier insistence on keeping banks in the dark.

123/ "This is a timeless irony: when you need money most, the most likely sources of it (in Long-Term’s case, other operators such as Soros, as well as investment banks and institutions) are likely to be hurting as well."

124/ "The bond market had effectively closed; no one could trade out of anything without suffering horrendous losses.

"August was the worst month ever recorded in credit spreads. In the past, such ballooning spreads had presaged an economic collapse.

125/ "But this time, no depression threatened Main Street; perhaps a slowdown, nothing more.

"The fund had $125 billion in assets—98% of its prior total & 55x its now-shrunken equity—in addition to massive leverage in derivative bets, such as equity volatility and swap spreads.

126/ "This leverage was simply untenable. If its assets continued to fall, its losses would eat through that $2.28 billion sliver of equity in an eye blink. Yet that leverage could not be reduced—not given the size of the trades and the utter loss of liquidity."

127/ "As it scavenged for capital, LTCM was forced to reveal bits and pieces and even the general outline of its portfolio. The secrecy-obsessed hedge fund became an open book.

"Rival firms began to sell in advance of what they feared would be an avalanche of liquidations."

128/ "J.M. believed that with spreads so wide, a golden vindication lay around the corner. “We dreamed of the day when we’d have opportunities like this,” Rosenfeld said. What they lacked was the means to exploit them.

"But each day, the 'rare opportunity' merely got cheaper.

129/ "It had bet on risk all over the world. In every arbitrage, it owned the riskier asset; in every country, the least safe bond. It had made that same bet hundreds of times. Now that bet was losing.

"The fund was immobilized by sheer mass. The smaller fish were liquidating.

130/ "Normally, a free market cures bubbles. In 1980, for instance, the Hunt brothers had tried to corner the silver market, briefly taking the price to $50 an ounce. But then people began to sift through attics for stowed-away silver. Scrap dealers worldwide melted it down.

131/ "When that metal reached the market, the price went back to $5 an ounce, and the Hunts filed for bankruptcy. But equity volatility was a rare bird. No one had stored volatility in his attic, there was no surplus source of supply.

132/ " “Equity volatility was the ultimate short squeeze,” said a Long-Term employee. “There were only four or five dealers. And they refused to sell.”

"Finance is often poetically just: it punishes the reckless with special fervor."

133/ "The banks’ willingness to finance Long-Term without any haircuts had enabled the fund to operate right up to the edge. Now, if it defaulted, nothing would be left.

"Ironically, only a very intelligent gang could have put Wall Street in such peril.

134/ "Lesser men wouldn’t have gotten the financing or attracted the following that resulted in such a bubble.

"If Long-Term defaulted on any of its seven thousand derivative contracts, it would automatically trigger a default in all the others: $1.4 trillion in notional value."

135/ "The total loss on Monday was $553 million, coincidentally equal to its loss of a month before. In percentage terms, this Monday’s was far worse: it ate a third of LTCM’s equity, leaving it with just under a billion dollars. And the fund still had >$100 billion in assets.

136/ "Thus, even omitting derivatives, its leverage was greater than 100 to 1—a fantastic figure in the annals of investment. Now, if Long-Term lost even a mere 1% more, it would be wiped out."

137/ "Since the day after Meriwether’s Sept. 2 letter, the press hadn’t breathed a word about LTCM.

"Wall Street pundits were preoccupied with the expected release of a tape of Clinton’s testimony in the Monica Lewinsky sex scandal, which was said to be depressing markets."

138/ "The result was a downward spiral which fed upon itself driving market positions to unanticipated extremes well beyond the levels incorporated in risk management and stress loss discipline." —LTCM Confidential Memorandum, January 1999

139/ "Larry Hilibrand, the most cocksure of traders, who had previously been worth half a billion dollars, was broke. Forced to live off his wife's assets, he pled with Crédit Lyonnais to spare him the ignominy of personal bankruptcy while he tried to work off a $24 million debt.

140/ "Most of the other partners lost ≥90% of their wealth—everything they had in the fund. Thanks to the takeover encouraged by the Fed, most of the partners remained far richer than ordinary Americans. High finance rewards success, but here, it strangely protected failure too.

141/ "The partners (including Hilibrand) kept their elegant homes even though the super-rich days were over. Never conspicuous spenders, they suffered more for their branding as socially irresponsible speculators. But no moral scandal ensued. The money was lost but honestly lost.

142/ "Haghani was haunted by the devastation partly caused by his insistence on betting the house.

"Recapitalized with a fresh $3.65 billion, LTCM continued to plummet. In its first two weeks, the consortium lost $750 million. It was happening again—the scariest of epilogues.

143/ "Merrill Lynch’s stock price plummeted by 2/3 in three months: not the 92% drawdown in LTCM’s equity but astonishing nonetheless. Komansky & Allison had taken pride in shielding Merrill from proprietary trading, but Merrill’s bond traders lost a billion dollars all the same.

144/ "By mid-October, not only was LTCM imploding again, but its new owners, the leading Wall Street banks, were in trouble.

"Greenspan decided he'd seen enough. On Oct. 15, he cut rates for a second time—a signal that he would cut and keep cutting until liquidity was restored.

145/ "Wall Street rallied, & bond spreads narrowed.

"Thanks to the rescue, Long-Term met every margin call. All of its debts were repaid in full.

"Most of its’s outside investors came out ahead—saved, ironically, by the forced repatriation of their capital at the end of 1997."

146/ "Investors who had been granted the special dispensation of being allowed to keep more of their capital invested ultimately lost money. Bear’s Jimmy Cayne was one such “favored” loser. Komansky, chairman of Merrill, who invested at the top, was a loser, too.

147/ "Through April 1998, the value of a dollar invested in LTCM had quadrupled to $4.11. By the time of the bailout five months later, 33¢ of that total remained. After deducting fees, the results were even sorrier: each invested dollar, having grown to $2.85, shrank to 23¢."

148/ "The employees had gotten most of their pay in the form of year-end bonus money. Most of those bonuses had been invested in the fund.

"Following the bailout, unhappy partners gradually left the firm. Most were able to tap past connections and resume a normal working life.

149/ "No stigma was attached; second acts on Wall Street are as common as they are in politics. Perhaps one cycle, be it an election cycle or an economic cycle, is the extent of the public’s memory.

"J.M. & Co. generally denied that their basic strategy had been flawed.

150/ "Rather, in meeting after meeting, the partners blamed the irrationality and venality of other traders. They portrayed Long-Term as the victim of outside events, specifically, of a liquidity shortage in August followed by hostile front-running in September."

151/ Rosenfeld: “It was something that never happened before.” But it had happened many times—in Mexico, on Wall Street, in stocks, in bonds, in silver, in Thailand, in Russia, in Brazil. People in such cataclysms feel singularly unlucky, but history is replete with fat tails.

152/ "In the summer of 1999, U.S. swap spreads once again ballooned, to 112 points—wider, even, than at the astronomical height of the previous year’s panic. The once-in-a-century flood had struck twice in two years.

153/ "On September 28, 1999, a year after the bailout, swap spreads remained at 93 points and equity volatility at 30%—each far higher than when LTCM had entered the respective trade. In the first year after the bailout, the fund earned 10%—hardly a dramatic recovery."

154/ "One can be big (and therefore illiquid); one can (within prudent limits) be leveraged. But the investor who is highly leveraged and illiquid is playing Russian roulette. To stay in business, he must be right about the market not merely at the end, but every single day."

155/ "In December, fifteen months after he lost $4.5 billion in an epic bust that seemed about to take down all of Wall Street, Meriwether raised $250 million, much of it from former investors in the ill-fated Long-Term Capital. He was off and running again."

156/ Related reading

Inventing Money: The Story of Long-Term Capital Management

https://twitter.com/ReformedTrader/status/1271108014498385920

Fortune's Formula

https://twitter.com/ReformedTrader/status/1452718699664711680

Leveraged Trading

https://twitter.com/ReformedTrader/status/1229120228425994246

How do you maximize compound returns?

https://twitter.com/ReformedTrader/status/1457797335430225922