Did we learn nothing from the collapse of LTCM?
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Simon Nixon gave a pretty comprehensive overview last week of just who the guilty parties are amid the global market turmoil. Ratings agencies, investment banks, commercial banks, subprime borrowers, hedge funds and private-equity groups – all complicit, one way or another, in the widening debacle. Just to focus on one group in particular – hedge-fund managers – what I find truly astonishing this time around is how few lessons have been learned since the Long Term Capital Management (LTCM) crisis of 1998.
The blow-up of LTCM has been well studied. Roger Lowenstein in When Genius Failed (Fourth Estate, 2002) wrote the definitive text. In short, a group of quantitative traders spiced with some Nobel Laureate economists created a doomsday machine out of supposedly riskless credit arbitrage – exploiting tiny anomalies between similar debt instruments. For a time all went well. Then Russia defaulted, the debt markets froze up, there was no bid for even high-quality paper, and suddenly all of LTCM’s trades went against them. The fund’s uncontrolled use of leverage backfired horribly, rival traders in the market scented blood and exploited its temporary weakness, and LTCM imploded – though not before scaring the wits out of the global financial system, thanks to the extent of its gearing. Only a Federal Reserve-engineered bailout with the forced support of Wall Street brokerages saved the day (though not LTCM).
Fast forward to today. Quantitative hedge funds have been haemorrhaging money. The credit markets have again frozen up and investors have lost all sympathy for any but the most conservative forms of risk. The Fed has ostensibly ridden to the rescue, albeit this time to the market as a whole rather than to one individual firm. Last week’s emergency Fed discount rate-cut was treated with knee-jerk euphoria, but investors should let the dust settle before opening the champagne. Eerily, huge sums have been lost because of a) too much faith in financial models; b) too much ill-disciplined use of leverage; c) general overconfidence; and d) too much faith in the ability of the market to provide sufficient liquidity to enable the orderly unwinding of positions. Quantitative trading funds have been taking a bath, but many so-called hedge funds are seeing significant drawdowns and investor redemptions. Not all will make it through this crisis, irrespective of whether central banks pour in liquidity. Another question is whether easier money from central banks merely postpones the day of reckoning and fuels the next round of overconfident excess.
As Nietzsche said, what doesn’t kill us makes us stronger. The current market environment will prove a compelling ‘stress test’ for unproven hedge-fund managers – who, after all, are supposed to preserve capital in all market conditions. The reality, of course, is that for every genuine hedge-fund manager, there are a dozen overconfident chancers along for the ride (and the management fees). An industry that controlled a few hundred billion dollars in 1998 has something like two trillion under its control today. But probably not tomorrow. As Ray Dalio of Bridgewater Associates said in Barron’s in May, “The amount of money flowing is almost out of control, and it’s making everything overvalued. A client of mine said it’s like there are 11,000 planes in the sky and only 100 good pilots – an accident is bound to happen.”
Up to a point, the machinations of hedge funds have little to do with the rest of us. The website Hedge Fund Implode-o-Meter goes to the heart of the matter: hubris, extreme leverage and other people’s money. But the market gyrations, partly triggered by the forced sales of hedge-fund managers, are having a profound impact on the real world. As bond trader Tom Graff says, it is now difficult, if not impossible, to trade many “plain vanilla” bonds. “For anything housing related, forget it. There are no bids.” Banks holding untradeable bonds are constrained from further lending – their capital is frozen. Large parts of the mortgage market are grinding to a halt. This is already the case in the US; the mortgage and lending markets in other parts of the world, not least the UK, could easily become similarly afflicted. As Graff puts it, “Nothing the Fed is going to do will make delinquent borrowers current again. The Fed injecting liquidity won’t do a damn thing to help hedge funds and/or financial institutions suffering real losses from bad loans.”
What is clear is that in the scramble to attract assets and earn management fees, several investment houses have disgraced themselves – Goldman Sachs and Bear Stearns among them. Investors should remember the advice of Yale endowment manager David Swensen, who points out that investment boutiques and private firms have less potential for conflicts of interest than full-service investment banks. The material damage to Wall Street will pass. The damage to reputations ought to persist.
Tim Price is CIO of Global Strategies at Union Bancaire Privée, London. Tim also runs his own share-tipping service, The Price Report.
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