Further to these faulty positions that LTCM had held, there were additional flaws. The underlying assumptions behind Black, Scholes and Merton’s theories that were used in Delta hedging, were incorrect. The theories assumed markets were frictionless, continuous and that stocks and other assets followed a random walk. Although frictionless and continuous markets were not far from the reality investment banks worth billions of dollars were able to operate within, for the retail investor, a market without transaction costs or the ability to continuously trade was not realistic. The third assumption however is most important. The theory that stocks and other assets followed ‘a random walk’ placed considerable faith in the efficient market theory. Where ‘such beautiful simplicity’ was captured by the bell-shaped curve of the Normal distribution. However the Normal distribution doesn’t tell the whole story. More importantly, the Normal distribution is just a description of a data set, it cannot be used to predict with absolute accuracy and therefore cant account for random ‘fat tails.’
Therefore, sadly for LTCM, the picture is not accurate. Freak events occur more frequently than the model would suggest. And why not, LTCM should have anticipated such an event given takeover bids or threats of bankruptcy; things of that nature can make stocks leap in a single day. This happened to Microsoft. Its return went down by six standard deviations in a single day, an event you’d expect to occur only once every four million trading years assuming a normal distribution. Apparent limitless liquidity in U.S. stock markets, lead academics to pay even less attention to the assumption of continuous markets than the attention they paid to the assumption that markets were frictionless. These assumptions were about come under further scrutiny. Steps taken by the U.S. government further undermined the position of LTCM. ‘First, on 14 October, the U.S. congress began debating new legislation to cut tax breaks for aggressive takeovers- a source of much wealth on Wall St. The, Treasury Secretary James Barker reacted to poor economic growth by suggesting that the dollar was over valued and should be allowed to weaken- a signal that foreign investors should pull their money out of U.S. stocks. As explained earlier, a hedge fund such as that set up by LTCM was specifically structured to provide pass-through tax treatment of investor earnings. Such moves were strongly against the favour of an organisation like LTCM.
The psuedo promise of liquidity in U.S. markets also threatened LTCM. In 1987, the Dow and the Standard & Poor’s index fell by roughly 21% each in a single day. Dreaded ‘corners’ began to appear which threatened that seemingly limitless liquidity. The problem was fundamental. ‘Liquidity depends on the ability to buy and sell, but what if everyone decides to sell and nobody wants to buy?’ Buyers see prices rapidly falling and therefore sit and wait to see what happens. The result is a backlog of sell orders in market marker’s books and prices that continue to fall. This is not a normal situation and what was a random walk has now been turned into a downward jump by the lack of liquidity. As a result of these losses, as of August 31, 1998, LTCM's capital base was reduced to $2.3 billion. This diminished capital base supported recorded trading positions totalling $107 billion, yielding a leverage ratio in excess of 50-to-1. To avoid the market impact of a disorderly winding down of LTCM's positions, several of its largest creditors created a rescue plan for LTCM. On Wednesday, September 23, 1998, LTCM reached an agreement with its principal lenders to continue operations. This agreement was brokered principally by the heads of The Goldman Sachs Group, L.P., Merrill Lynch & Co., J.P. Morgan & Co., and certain commercial banks, and facilitated by the Federal Reserve Bank of New York. The plan, which calls for fifteen major domestic and foreign commercial and investment banks to infuse a total of $3.5 billion of equity capital into the hedge fund, provides LTCM a respite from loan repayments and with much needed liquid capital. This consortium will now own 90% of the equity in LTCM and will form an oversight committee to direct LTCM's overall strategy and manage its exposures.
LTCM's creditors' decision to acquire the hedge fund was based, in part, on their concerns about possible disruptions in the U.S. and global marketplace if LTCM had failed. By September 23, the fund's equity capital had almost been wiped out. Hurried liquidations of LTCM's positions could have potentially disrupted these financial markets, resulting in losses for other participants in these markets. It is for this reason that the consortium approach was considered at first. Initially however, it had emerged that LTCM’s positions were so complicated and the components of money machines so dispersed among the fund’s counter-parties, that transferring the positions in a simple way was impossible. “When it came to bailing them out, we were completely opposed to that. We wanted them to bite the dust.” The U.S. government was also against the helping, asking why they had got involved in rescuing a group of high rolling gamblers.
Unquestionable faith in the system they had created together with disregard of potential warning signs, those behind LTCM watched idly as their organisation came crashing down terrifically. The decision for the consortium’s intervention was primarily to guard against any further repercussions rippling through and causing further havoc within the financial world.
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Bibliography
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Milne, A (2003), BSc BIF 2nd Year Autumn term notes, London: Cass Business School
- SEC publications (1998), Testimonials on Hedge Funds
