August 2013: 15 years have passed since collapse of Long Term Capital Management (LTCM) and from financial crisis of 1998. A story that deserves reflection. Yeah, because if the LTCM crisis hadn't happened, there probably wouldn't have been the crisis."subprime” of 2008, the bankruptcy of Lehman Brothers and, perhaps, we wouldn't be here talking about the FED's Quantitative Easing.
When the LTCM case exploded I was a young risk manager, always immersed in mathematical models and mountains of data: it was a great life lesson. I try to tell the facts.
Birth
in 1992 John Meriwether, legendary trading head of Salomon Brothers and his team, along with the two Nobel laureates Myron Scholes e Robert Merton and the ex-FED chairman David Mullins, establishes LTCM. It is a "hedge fund" which represents the fruit of the evolution of the financial species, one in which market practice is combined with quantum physics and with the most sophisticated financial theories. The operations carried out are surrounded by an aura of mystery and complexity, but the presence of big names among the shareholders dispels any doubts about the fund's credibility.
Growth
In 1995 and 1996 LTCM generates profits above 40% and attracts large investors, including the Bank of Italy, then led by Antonio Fazio, who invested in it through the Italian Exchange Office. Almost all "institutional" operators buy LTCM. I remember the cameo of when the "sales" came to see us to sell us shares in the fund: they were brilliant, elegant, arrogant (...but we didn't buy, as far as I know). Serena Torielli instead recalls the secretary of the London office, a former Brazilian model, obviously beautiful. In short, the signs of success.
Affirmation
The fund, reaches in 1998 the gigantic size of $ 130 billion, with a $1,25 trillion face value derivatives portfolio. LTCM is a leviathan using the financial leverage unimaginable until then. The assets are a monstrous amount of government bonds and related derivatives. Many of LTCM's investments consist of "carry trade” which are substantiated in the purchase of peripheral European government securities (for example Italian, Greek, Spanish), against which LTCM sells German or US securities. The idea is that, due to the entry into force of the euro, the yield on Italian bonds, for example, must converge to the level of German ones. In short, these are bets on spreads. But there are also investments in currencies of emerging countries and in illiquid government bonds.
The machine jams
In the summer of 1998, Russia collapses: Russian debt defaults and ruble depreciates devastatingly against the US dollar. It's a well-known movie: Investors are fleeing higher-risk investments to move to "safe haven" ones, such as German and US bonds. Italian spreads on Spanish and other relatively risky bonds widen dramatically. In short, the market takes the diametrically opposite direction to that hoped for by LTCM. Starting to lose mountains and mountains of money. The "LTCM theory" dramatically stops working.
As of September 1998 LTCM loss is over 90%. Due to the size of the fund and the extensive use of derivative instruments entered into with many different counterparties, contagion spreads and the international financial system is at risk. It is as if a large island were sinking, with the risk of causing a gigantic tsunami in the ocean capable of flooding the five continents.
The medicine
The FED intervenes, then governed by Alan Greenspan, with a "bailout” which involves, without many choices, the creditor banks of LTCM: the fund is in fact “Too big to fail” (in later years I will hear this phrase repeated many times). The Fed cuts interest rates and floods the markets with liquidity, to allow the banks involved in the “bailout” to borrow money on favorable terms.
The lesson of history
- I got the concept right away systemic risk watching via a Bloomberg screen the prices of all the "risky" asset classes fall simultaneously at uncontrolled speed.
- The financial system was in danger of imploding due to a group of very intelligent and overconfident people who took over huge risks in the belief that nothing could go wrong. This pattern repeated itself over the next 15 years. With the addition of one ingredient, the “moral hazard”: the almost certainty that, if things go wrong, being “Too big too fail” saves you.
- LTCM has been a problem because of the dimensions which it was able to achieve thanks to the support of large investors, including central banks. It was a manifestation of thathuman madness that I have learned to acceptas a disturbing feature of our species: think about it, central banks, i.e. the custodians of financial order, invested in LTCM, engaged in intense connivance with it, and when it became Armageddon, bailed it out. After all, there weren't many other options available.
- Il violent and lasting flow of liquidity that wipes out any systemic and economic risk it has become the standard course of action. In spite of huge distortions which it causes on the markets and in the real economy.
- From "quant", I touched the “dark side” of models: they almost never work perfectly in the financial world. And often, those with the reins of power use models as a Trojan horse to get rich, by making any demented idea pass through the charm of science (the case of mortgages is striking "subprime”, when the possibility of mortgages failing simultaneously was artfully excluded – which they duly did, with the consequences we know – to have the maximum rating on securities that were just piles of financial junk).
