How to Avoid Disaster

September will mark the 25th anniversary of the failure of the massive hedge fund, Long-Term Capital Management (LTCM), and my podcast feed is filling up with retrospectives.

One podcast featured Roger Lowenstein, the author of When Genius Failed, which is considered the definitive work on the subject. I read it when it came out in 2000 and once again in subsequent years, and it’s a great book that I thoroughly enjoyed.

Another podcast had another author, Nicholas Dunbar, who wrote a second book called Inventing Money: LTCM and the Search for Risk-Free Profits. I hadn’t heard of this book, which came out in 1999, so I read it over the last few weeks.

The stories are the same, and in case you haven’t heard of LTCM, the story is as follows: a band of genius bond traders that include two Nobel Laureates formed a hedge fund in the late 1990s with the promise of incredible returns without meaningful risks.

As you might expect, even if you don’t know the LTCM story, the traders weren’t as smart as they all thought. The hedge fund took outsized risks and failed spectacularly.

The fund was so prominent then that the Federal Reserve engineered a bailout because they feared that LTCMs failure could lead to a Lehman Brothers-type moment, even though that wouldn’t happen for another decade.

The story is at least as old as Icarus, whose overconfidence allowed him to fly too close to the sun, melt his wax wings and fall to the sea and drown. We can see it as a story of hubris and the human desire to reach greater heights in the face of significant risks.

I’ve always found the Icarus angle only somewhat interesting but have always been more fascinated by the ‘complex trading’ or ‘sophisticated models’ that all of the writers refer to without actually explaining.

The Dunbar book goes into a lot more detail, which I loved, and it turns out that even though a lot of the trading is complicated, it’s also reasonably straightforward.

Let me give you an oversimplified trade example. If a 30-year Treasury is issued today, it is considered on-the-run. In three months, the Treasury will issue another 30-year bond regarded as on-the-run, and all others issued prior with similar maturities will become off-the-run.

Even though the two bonds in this example are almost identical, the on-the-run bond will trade a slight price premium to the off-the-run version because the on-the-run bond is more liquid. Or, said another way, the off-the-run bond trades at a slight discount.

A classic arbitrage is to buy the off-the-run Treasury and simultaneously sell the on-the-run bond and profit from the slight price difference. Because the trade is both long and short two bonds that are effectively the same, a lot of the risk cancels out.

The big problem is that profit opportunity is tiny, and a lot of leverage is needed to make a reasonable return. In the case of LTCM, they were borrowing $125 for every $1 investment in the fund. That’s right; they were 125:1. At that leverage level if the holdings lose just -0.8 percent, the fund is wiped out.

So, the first lesson in avoiding disaster is not to use leverage, especially not at those levels.

Once LTCM’s positions started to sour, they had to begin selling securities to meet margin calls, and they faced a classic problem. Should they sell their most liquid holdings and take a significant loss or try to sell their less liquid holdings that might have a smaller loss?

LTCM did what everyone in their situation does: sell the most liquid holdings at the best price possible and cross your fingers that you don’t need to sell anymore. One problem, though: once you sell the liquid assets, you become concentrated in the illiquid assets. If you need to keep selling (as they did), the problem compounds.

Lesson number two in how to avoid disaster: maintain a liquid portfolio. When everything is liquid, you don’t have to worry about what to sell first because you can sell anything anytime.

And that leads to the third problem. Although LTCM was diversified in the sense that it had 60,000 positions, there were only a handful of trades. In my on-the-run/off-the-run example, you can execute that trade in many countries at multiple maturities, but it’s really only one trade.

And that’s the third lesson in how not to fail: avoid concentration and maintain a diversified portfolio.

Lastly, the problem at LTCM started with something that no one could have predicted. Salomon Brothers, the investment bank where all the LTCM people came from, decided to get out of these trades and shut down that business unit.

Solomon’s fire sale hurt the prices of the securities that LTCM owned, which started the death spiral. That spiral worsened when Russia defaulted on its bonds, another unpredictable event.

Even the most sophisticated risk management couldn’t save LTCM. They fell prey to some simple issues: excessive leverage on an illiquid, concentrated portfolio.

No one at Acropolis has a Nobel prize – or even a Ph.D. in finance. And yet, we knew better than the folks at LTCM. That’s the Icarus part of the story – they probably felt smarter than everyone else and could take the risks that nobody else could.

It worked for a few years, but then LTCM went bankrupt. Bankruptcy isn’t as bad as falling from the sky and drowning in the ocean, but we’re happy to avoid all of it.