But Liar's Poker author Michael Lewis suggests they may have been as much victims of other firms' envy and greed as oftheir own speculation. One way to understand the panic of August , and to see how bizarre it was, is to imagine a world with two kinds of dollars, blue dollars and red dollars. The blue dollar and the red dollar are both worth a dollar, but you can't spend them for five years. In five years, you can turn them both in for green dollars.
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But Liar's Poker author Michael Lewis suggests they may have been as much victims of other firms' envy and greed as oftheir own speculation.
One way to understand the panic of August , and to see how bizarre it was, is to imagine a world with two kinds of dollars, blue dollars and red dollars. The blue dollar and the red dollar are both worth a dollar, but you can't spend them for five years.
In five years, you can turn them both in for green dollars. But for all sorts of reasons - a mania for blue, a nasty article about red - the blue dollar becomes more expensive than the red dollar. If you are an ordinary, sane person who holds blue dollars, you simply trade them in for more red dollars. If you are Long-Term Capital Management, or any large Wall Street firm for that matter, and are able to borrow money cheaply, you borrow against your capital and buy a lot of red dollars and sell the same number of blue dollars.
The effect is to force the price of red dollars and blue dollars back together again. In any case, you wait for blue dollars and red dollars to converge to their ultimate value of a dollar apiece. At best, the odd passions that drove the red and the blue dollar apart subside quickly, and you reap your profits now.
At worst, you must wait five years to collect your profits. But they don't tell you what happens before you get to the moment of certainty. Which brings us to the case of Long-Term Capital in August , when the red dollar and the blue dollar were driven apart in value to ridiculous extremes. Actually, when you look at the firm's books, you can see that the first sign of trouble came earlier, on July 17, when Wall Street powerhouse Salomon Brothers announced that it was liquidating all of its red dollar-blue dollar trades, which turned out to be the same trades Long-Term Capital had made.
This was no coincidence: for years, firms up and down Wall Street had been trying to mimic its success. Every time Long-Term Capital took action, others noticed and copied it.
So for the rest of that month, the fund dropped about 10 per cent because Salomon was selling all the things that Long-Term owned. Then, on August 17, Russia defaulted on its debt. At that moment the heads of the other big financial firms recanted their beliefs about red dollars and blue dollars. Their fear overruled their reason. Once enough people gave into their fear, fear became reasonable.
Fairly rapidly, the other big financial firms unwound their own trades, which, having been made in the spirit of Long-Term Capital, were virtually identical to the trades of Long-Term Capital. The history of red dollars and blue dollars made the probability of that happening 1 in 50 million.
And if you're not willing to draw any conclusions from experience, you might as well sit on your hands and do nothing. August 21, , was the worst day in the young history of scientific finance.
LTCM's attachment to higher reason was a great advantage only as long as there was a limit to the market's unreason. Suddenly there was no limit. It was one thing for the average stockmarket investor to panic; it was another for the world's biggest financial firms to panic. Financial institutions created a bank run on a huge, global scale. Long-Term Capital had worked on the assumption that there was a pool of professional money around that would see that red dollars and blue dollars were both dollars and therefore should maintain some reasonable relation to each other.
But in the crisis, it was the only firm that clung to such reasoning. Even so, the fund might well have survived and prospered. But what started as a run on the markets, at least from Long-Term Capital's point of view, turned into a run on Long-Term Capital.
For nearly 15 years, Long-Term Capital's founder, John Meriwether, and his colleagues had been engaged in an experiment to determine how far human reason alone could take them. They failed to appreciate that their fabulous success had made them, quite unreasonably, part of the experiment.
No longer were they the creatures of higher reason who could remain detached and aloof. They were the lab rats lost in the maze. Inside Long-Term Capital, the collapse is understood as a two-stage affair.
First came the market panic by big Wall Street firms that made many of the same bets as Long-Term Capital. Then came a kind of social panic. Word spread that Long-Term was weakened. That weakness, Meriwether and the others say, very quickly became an opportunity for others to prey upon.
All of a sudden they were liquidating our positions. The trades that the strategists had made lost money, but they would recover their losses if they could obtain the capital to finance them. If Long-Term Capital could ride out the panic, Meriwether figured, it would make more money than ever.
Meriwether called people rich enough to put up the entire sum Long-Term Capital needed, among them one of America's richest men, Warren Buffett. Buffett was interested in the portfolio but, because of his role in Meriwether's resignation from Salomon in over an episode in which everyone agreed he had done no wrong, not in Meriwether.
Because of the Salomon scandal he couldn't be seen to be in business with J. Meriwether also called Jon Corzine at Goldman, Sachs. Goldman, Sachs agreed to find the capital but in exchange wanted more than a fee. It wanted to own half of Long-Term Capital.
Meriwether and Corzine had been aware of each other's existence since the late '60s, when they studied together at the University of Chicago. For 15 years, Corzine had done his best to figure out what Meriwether was up to. This was his chance to know for certain. What neither man realised was that the game of saving Long-Term Capital was over before it began. First came the rumours.
Long-Term Capital staff, who had not been selling stocks or anything else, watched in wonder. Staff say they owned no such things. The rumours that contained some truth were more damaging, of course, and now the truth was out there, available to Goldman, Sachs and others.
Every day someone would publish something about them that left them more exposed than ever to those who might prey on them. That was 10 times what we actually had.
Banks that called up to bid on Long-Term Capital's positions would say things like, "We can't buy all of what we've heard you've got, but we'd like a piece". They would then ask to buy twice what Long-Term actually owned.
According to LTCM's partners, 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 swaps, 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 rumour 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 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.
When one player in any market is sufficiently big and weak, its size and weakness are reason enough for the market to destroy it. The rumours about Long-Term Capital led to further losses, which led to more rumours.
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 its staff. Long-Term Capital was caught in a squeeze. Half of that was lost in its second disastrous trade, a short position in five-year equity options.
Essentially, it had sold insurance against violent movement in the stockmarket. The price it received for the insurance was so high that the bet would almost certainly be hugely profitable - in the long run. But on September 21 the short run took over, in a new and more venal fashion.
Meriwether received phone calls from JP Morgan and Union Bank of Switzerland telling him that the options he had sold short were rocketing up in thin markets thanks to bids from a US insurance company, American International Group. The brokers were outraged on Meriwether's behalf, as they assumed that AIG was trying to profit from Long-Term's weakness. A spokesman for AIG declined to comment.
But what the people who called Meriwether did not know was that at just that moment AIG was, along with Buffett and Goldman, Sachs, negotiating to purchase Long-Term Capital's portfolio. One consequence of AIG's activities was to pressure Meriwether to sell his company and its portfolio cheaply. It is interesting to look over the clippings and see the role played by the media in this stage of Long-Term Capital's demise.
After the firm entered negotiations to sell its portfolio through Goldman, Sachs, rumours about its holdings trickled out in the financial press, exposing Long-Term Capital's trading positions to outside attack. After negotiations among the fund and Goldman, Sachs and Warren Buffett broke down, a new wave of articles appeared. Carol Loomis wrote in Fortune: "Warren Buffett is a longtime friend of this writer," and then went on to tell the following tale - that Long-Term Capital had refused his bid because John Meriwether didn't like his terms.
The story played down the fact that William McDonough, president of the New York Federal Reserve, came to the same conclusions as Meriwether - different from Buffett's - that the fund could not legally sell without consulting its investors, which Buffett had given them less than an hour to do. Buffett declined to comment. The Fortune story and others like it, the Long-Term Capital strategists maintain, created even more pressure on Meriwether to sell the next time someone made a low bid.
Meriwether also says that the AIG trade was "minor compared to some of the things we saw". But he declined to say what these things were, and no wonder. Some of the things Meriwether "saw" could well have been perpetrated by some of the very Wall Street firms that now own his firm, and that he now works for. In the financial markets this is not true. The more people write financial insurance, the more likely it is that a disaster will happen, because the people who know you have sold the insurance can make it happen.
So you have to monitor what other people are doing. In October , the markets took power from people who traded with their intuition and bestowed it upon people who traded with their formulas. In August , the markets took power away from people with formulas who hoped to remain detached from the market-place and bestowed it upon the large Wall Street firms that oversee the market-place.
These firms will do pretty much exactly the same complicated trading as Long-Term Capital, perhaps in a slightly watered-down form, once the whiff of scandal vanishes from the activity.
How the Eggheads Cracked
These articles explain the mood and market factors leading up to each crisis and then with hindsight report on what actually happened. The financial panics include Black Monday, the stock market crash; the bursting of the Internet bubble; the Asian currency crisis; the Russian default that prompted the failure of the hedge fund Long-Term Capital Management in ; and the current subprime mortgage crisis. This is a portrait of today s money culture—its players, victims, and the widespread consequences of these historic catastrophes. Informative and timely, it is an excellent book for a wide range of library patrons.
Examination of VAR after Long Term Capital Management
Michael Lewis's article Jan. However, there is one aspect of the story that he did not mention. According to numerous press accounts, Long-Term Capital Management returned a large portion of profits to its investors before the troubles in , telling them that opportunities in the markets were diminished and so it did not require the use of their capital. Yet, at the same time, as Lewis himself pointed out, the partners left their profits and bonuses in the fund. This suggests that, just as the crisis approached, the amount of Long-Term's assets held by its partners became disproportionately large. It is as if it engineered what was effectively a management buyout at exactly the wrong time. Lewis points out that most press accounts have overemphasized the role of leverage in the fall of Long-Term Capital Management.
NY Times: How the Eggheads Cracked by Michael Lewis