Example research essay topic: Federal Reserve Bank Failure - 3,960 words

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LONG TERM CAPITAL MANAGEMENT L. P. ? A CASE STUDY Rarely if ever has a single firm had as tremendous an impact on international economics as Long Term Capital Management L. P. (LTCM). This report describes the company itself and its investment strategies, with particular attention paid to its international influence and importance. LTCM?

s activities in the financial world ultimately caused a near-collapse in the entire international financial system. In fact, had the Federal Reserve Bank of New York (FRBNY) not intervened to coordinate a major buyout of LTCM after it sunk into insolvency, the entire financial system could have been seriously jeopardized. Company Profile Set up as a particularly large hedge fund, and comprised of Ph. D.

economists and established Wall Street bond traders, LTCM is a very interesting case, as well as an extremely volatile and important fund. &# 61623; Key Members and Their Backgrounds Founded in part by Nobel laureates Robert Merton and Myron Scholes, LTCM based its investment strategies on the mathematical models developed by Scholes, Merton, and Fischer Black. The model itself, commonly known as the? Black-Scholes Options Pricing Model? , is famous for two major insights into economic thought. First, the model determines how to eliminate risk as a variable in the option-pricing equation. This was accomplished as a result of the second major insight, which was the idea of using continuous time for option pricing as opposed to second-by-second timing, a most crucial element that Robert Merton borrowed from a Japanese rocket scientist named Ito. Discovering how risk can be eliminated from large-scale investing is obviously an enormous break-through that puts greed in peoples?

eyes and gets major investment players fighting for the chance to invest where the model will first be used in practice. Integrating the notion of continuous time into the pricing model eliminated the problem of an appropriate option price being out-of-date by the time it was calculated. As champions of these powerful tools, Merton and Scholes decided to play the very financial markets that had already been transformed by their insights. The Black-Scholes model is: Value of a call option = P 0 N (d 1) X [N (d 2) ] ert Where Po = the current price of a stock X = the exercise (strike) price on the option t = time remaining until expiration of the option KRF = continually compounded risk-free interest rate e = the natural antilog of 1. 00 or 2. 71828 N (d) = the probability that a standardized, normally distributed random variable will have a value less than or equal to d, essentially the hedge ratios. 1 The Black-Scholes pricing model can adjust the value of options to reflect continuously changing stock prices. Black, Scholes and Merton appeared to have made the break-through that could finally bring perfect efficiency to the world?

s markets. John Meriwether, a wealthy and famous Wall Street bond trader from Soloman Brothers Inc. , also played an integral role in the history of the firm. Meriwether left Soloman after having his name too closely associated with a bond-auction fraud scandal orchestrated by one of his colleagues. Meriwether, an old friend of Scholes, brought his expertise in bond markets and bond futures to the firm as its top executive. Also a co-founder, Meriwether brought with him from Soloman several of his former colleagues, who had also left Soloman after the bond fraud scandal in 1992. &# 61623; Hedge Funds and the Uniqueness of LTCM A hedge fund is organized much like a mutual fund (both are private, pooled investment accounts), but with some significant differences. Legally, a hedge fund is distinguishable by the fact that it limits the number of investors to 500 per fund.

Also, to qualify to invest in American hedge funds requires a minimum capital amount of US$ 5 million for individuals, and US$ 25 million for institutional investors. In the case of LTCM, only those individuals and institutions that the fund? s partners sought out were able to invest in the firm. Other things that distinguish hedge from mutual funds are: &# 61636; Hedge fund managers have almost complete autonomy in determining what assets to hold, and are not at all limited in what types of assets they can hold. &# 61636; Hedge funds are allowed to engage in short selling. &# 61636; Hedge funds may use leverage to increase levels of funding and of risk and return. &# 61636; Hedge funds can limit the amount cash injected into and withdrawn from the fund by its investors. 2 LTCM was therefore able to engage in virtually any investment strategies its managers chose.

The fund? s founders were not subject to any rules regarding the types of assets they could hold in the fund, including derivative securities, margins, bond futures and currencies. The fund? s managers could also short-sell assets at will. Many believe the excessive use of leverage became a serious problem at LTCM. Holders of this theory even believe that excessive leverage caused the fund?

s near collapse. The term hedge fund is essentially a misnomer, as it sounds like? hedging? but is almost the opposite idea.

Hedging refers to investment strategies that reduce the risk associated with owning financial assets, usually by use of derivatives. A hedge fund is a large, privatized pool of investment money that is normally invested in relatively high-risk securities. LTCM was not the average hedge fund. It primarily used techniques and strategies of arbitraging between bonds and bond futures derived from the mathematical insights provided by the Black-Scholes model that allowed them to continually monitor the? true?

value of derivative securities. The sheer size of their investments distinguished them as well. Starting with about US$ 4 billion of initial capital, the fund rapidly grew to obtain a peak position of US$ 1. 2 trillion. The institution? s risk-management practices consisted of attempting to eliminate risk by continually adjusting their holdings to react to continually changing market prices. When LTCM nearly collapsed, the partners themselves personally lost US$ 1. 9 billion, of the total US$ 4. 4 billion that the fund lost (see Exhibit A?

Pie Chart of Losses). &# 61623; Investment Strategies Using arbitrage techniques that appeared infallible, LTCM used excessive leverage to magnify its earnings. Contrary to the myth, hedge funds are not all highly leveraged. LTCM was often leveraged at about thirty times its capital and the institution was primarily borrowing from the same companies that had invested in it. Many companies invested in LTCM under the assumption that LTCM? s strategies were infallible. 3 LTCM essentially engaged in the types of trades that no one else would think of, and for this reason, they quickly became the?

firm-to-watch? and emulate for many fund managers. In fact, some believe that this mirroring of investment strategies contributed to its downfall. LTCM was chiefly involved with making trades in bond markets where price-determination is still somewhat inefficient. 4 The institution placed bets on interest rate spreads between corporate bonds and government bonds, and on the volatility of markets. LTCM used the Black-Scholes pricing model and other state-of-the-art price-determination techniques to see which bonds were undervalued and which were overvalued according to those mathematical models, and then placed their bets accordingly. The firm watched differences between government bonds and corporate bonds, and when the difference was believed to be at its peak, it would buy into the relatively cheap corporate bonds and short sell the relatively expensive government bonds.

When the gap between the two tightened, the fund would profit, but if the gap spread further, the fund would sustain a loss. However, in LTCM? s case, the sheer size of the investments the company was making could often drive the rates in LTCM? s desired direction. 5 One particular trade that persisted in LTCM and exemplified their overall trading strategies was a bet on the convergence of yield spreads between French bonds (OATs) and German bonds (bund's). According to parties associated with LTCM, the fund? engaged in dozens of cash and futures trades, interest rate swaps, currency forwards and options...

to build a US$ 10 billion position. ? 6 When the spread between the OATs and the bund's went to 60 basis points in the forward market, LTCM decided to double its position. Another competing arbitrageur says that this deal was actually? only one leg of an even more complex convergence bet, which included hedged positions in Spanish peseta and Italian lira bonds. ? 7 LTCM reportedly derived approximately one third of its profits from an Italian tax-driven arbitrage deal of which many other arbitrageurs were also taking advantage. 8 LTCM was distinguished in its trading strategies primarily by two things; the thoroughness of its preparations for the trades it made, and the fund? s propensity to invest abnormally large amounts of cash in profitable deals. With all of these factors working in the company? s favor, it is difficult to see how LTCM could fail so miserably and suddenly.

What Went Wrong In September 1998, LTCM found itself in a crisis situation. It appears that the institution had underestimated the consequences that short-term liquidity problems could pose. 9 Shortly after falling into insolvency, the Federal Reserve Bank of New York rescued the company from bankruptcy. &# 61623; LTCM? s Collapse and Possible Causes It is impossible to determine for certain what specific factors caused LTCM? s collapse and near-demise. Many say that the excessive amount of leverage the fund was using (about 30 times their capital) magnified their losses inordinately when they began losing cash. 10 Also, LTCM relied on an academic pricing model that ultimately proved to be a model only applicable during? normal?

market conditions, and not in extreme conditions. Magnified risk and theoretical economics certainly played a role in LTCM? s near demise. Another contributor was the global financial crisis in September 1998. There were two likely? smoking guns?

of that particular global financial anomaly. The first was the currency reform in Thailand and the ensuing devaluation of the nation? s currency. The second was the Russian government defaulting on their debts, which dried up the liquidity associated with the ruble and Russian financial assets. In mid- 1998, Thailand switched from a fixed exchange rate system to a floating rate system. When the demand they had expected for their assets did not materialize, their currency value plummeted.

This led to the collapse of a few large Asian banks that had significant stake in Thailand, which led to a general, rapid economic downturn in the Asian countries in which LTCM had outstanding interest rate options. Around the same time period, Russia, another country with which LTCM had outstanding currency bets, was in the midst of an economic collapse of their own. Social revolt against the communist government put a stranglehold on Russia? s fiscal policy discretion and control. When the Russian Government defaulted on their debts, the market?

s reaction was expected catastrophic, and LTCM among others lost all their interests in Russia. The million-to-one chance that these types of events would happen simultaneously actually materialized. LTCM had left itself particularly susceptible to losses in this type of situation. When a hedge fund arbitrages between the currency bonds of several major economic nations and futures on those bonds, a major collapse in one of those nations can begin a domino effect with the potential of destroying all the players involved, essentially by drying up the liquidity in those assets. For example, if LTCM is betting on interest rates in Japan to increase, and they do, LTCM will assume they are? in the money?

on that deal. They will use the cash they have not yet received to secure similar interest rate bets with, say, Germany. Then, if Japan defaults on the money they owe LTCM, the German options they have secured will also dry up. The German institution with which LTCM was trading will then also be out of the money it expected to receive from LTCM. It is then clear that supply and demand for liquidity of financial assets is at the root of LTCM? s investment strategies.

LTCM relied on the global diversity of its positions, assuming that global diversification cancels out all risk. 11 But correlation between global markets tend to magnify upward in times of trouble, reflecting economic linkages between markets and social factors. Representatives of LTCM believe the near collapse of the company was a result of two stages of external panic. 12 First, Wall Street firms began to doubt LTCM. Social panic followed Wall Street firms? market panic. Rumors spread that LTCM had weakened. LTCM believe that other companies used their weakness as an opportunity to strengthen.

Wall Street firms began to duplicate LTCM? s investment strategies, which weakened LTCM? s market position. The institution was weak and owned a huge portion of the market. Of course, other companies would want to destroy LTCM to strengthen their own positions.

Another suggested contributor to the near collapse of LTCM is as follows. A large number of positions in the LTCM portfolio depended on a narrowing of the spread between two related securities (i. e. hedging two securities).

This means that investors take a long position (i. e. buy) the higher yielding security, and take a short position (i. e. sell) the lower yielding security and hope the spread will narrow. When substantial leverage is used, the spread can be extremely profitable if the spread relationship remains constant or narrows.

In fact, betting on volatility in markets this way leads to a? catch- 22? situation. A firm is betting on markets to be volatile, and will profit when they are, but buying derivative securities such as volatility swaps and straddles is a zero-sum game. When the firm profits, its counterparty loses, which makes the firm less likely to collect their money because the loss could put the counterparty into bankruptcy. This is called?

counterparty risk? , and LTCM was certainly affected by it when the liquidity in Russian and Asian markets dried up. If the liquidity had been available, LTCM might have been able to survive. Therefore, the problem was not necessarily the leverage LTCM employed; the lack of market liquidity might have been a more direct cause of the fund? s failure.

Other companies with similar trades were trying to narrow these spreads at the same time. This caused spreads to widen, resulting in big losses by banks and highly leveraged hedge funds such as LTCM. 13 LTCM lost money at unprecedented rates. After returning over 40 % for three consecutive years, the fund lost US$ 500 million, on two consecutive days. 14 Very few firms, if any, have the liquidity not to be overwhelmed by a US$ 1 billion loss in a period of 48 hours. LTCM became insolvent very suddenly, and the portfolio? s value continued to plummet due to psychological market reactions (i. e.

loss of confidence, changed credit ratings). Over a six-week period in August/September 1998, LTCM lost approximately US$ 4. 4 billion, and would have declared bankruptcy had it not been for the FRBNY? s intervention. &# 61623; How The Fed Saved LTCM and Why They Did So The FRBNY saved LTCM from bankruptcy by consolidating fourteen American investment banks and securities firms to collectively bail out LTCM for $ 3. 625 billion in September 1998. The company still exists, and John Meriwether is now involved in slowly reimbursing many of the funds? initial investors for what Myron Scholes calls a? non-fault bankruptcy. ? 15 Why did the Fed go to such trouble to rescue this particular company?

What did it stand to gain by doing so? What was it trying to accomplish or avoid? The answer is that after conducting an audit of LTCM? s books, the FRBNY recognized the strategic importance of this firm? s international financial position. The FRBNY was concerned that LTCM?

s default could pose great danger to the entire international financial system due to the size, nature and complexity of the wealth they had spread around the globe. The international significance of LTCM? s investments is discussed in the following section. LTCM? s International Significance LTCM had spread its investment position into 75 different nations, in order to avoid concentrating risk in any one given area. 16 This ultimately worked to the fund? s detriment, as its position nearly created an international catastrophe.

However, it also worked to LTCM? s benefit, as the Fed would not have saved them were they not so extensively diversified and internationally important. However, the financial well being of LTCM was of no direct concern to the supervisory authorities of the United States. Rather, the FRBNY saved LTCM to prevent the potential direct and indirect effects of LTCM? s failure on other financial markets and institutions around the world. 17 Direct losses, such as those to credit positions and owners of LTCM?

s capital, would likely have been controllable, but were not the concern of the FRBNY anyway. However, the Fed was concerned about the consequences of LTCM? s default on the functioning of the financial system, i. e.

the systematic effects associated with the global market resulting from LTCM. Potentially, the default could have affected liquidity to the degree that markets would have been unable to function properly. This might have had serious negative effects on the positions and soundness of financial intermediaries, including even those institutions that had no direct trading with LTCM. In addition, the FRBNY feared that loss of confidence in the functioning of credit markets would lead to extreme risk aversion, thereby threatening the viability of debt markets and ultimately the ability of businesses to borrow and invest. For these reasons, the FRBNY was motivated to keep LTCM liquid enough so as to avoid this calamity. Central banks and supervisory authorities have recognized the importance of maintaining financial stability in the past few decades.

The increased interaction between large institutions has increased the rapid spread of financial problems across institutions and markets. Financial problems, such as sharp reduction of financial resources, may have negative consequences on production, welfare and employment. Since the supervision of registered investment institutions does not protect against investment risks, a large equity base and trading position hedge fund, such as LTCM, may pose a threat to financial stability. In this context, supervisory authorities were worried about the size of trading positions, the potentially high leverage and the lack of disclosure by these institutions. It leads one to ask; was LTCM an isolated incident? Could another firm pose this sort of danger again?

In national forums and in an international context, authorities are discussing the improvement of disclosure of financial data by unregulated participants in financial markets. This can be done on a voluntary basis with initiatives towards self-regulation of groups of institutions or by internationally coordinating regulations. Supervisory authorities support this idea, but doubt whether increased disclosure is enough to fix the potential problems large hedge funds, such as LTCM, can create. 18 &# 61623; Lessons Learned LTCM? s near default has caused banks to become more aware of the risks associated with investing in hedge funds. The difficulty of analyzing and monitoring a hedge fund contributes to the risk.

Also, since hedge funds are not limited by regulations, institutions operating hedge funds can assume more leverage. Another factor contributing to risk is a hedge funds reliance on properly functioning financial markets and models, making systematic risk very prominent. To avoid another such a number of banks have tightened their lending policy to such institutions. Advantages of hedge funds include an improvement of market liquidity (under normal circumstances) and an improvement of market efficiency through value-at-risk (VAR) trading. Disadvantages may be periodic increases in volatility, which the LTCM case exemplified, and a concentration of risks in unregulated markets.

If banks and securities firms are more careful in their use of hedge funds, the systematic risks associated with the use of hedge funds could be reduced. This is because the size of positions taken by hedge funds increases the systematic risk in those markets. The LTCM case brought to light a number of important issues. The Committee of G- 10 banking supervisors made recommendations to help improve banks risk management. A paper on sound practices is geared towards guiding banks and supervisory authorities when considering a credit relationship with hedge funds or other highly levered institutions. The first recommendation is that organizations should only invest in institutions with a sound lending strategy.

In other words, the organization must consider the institutions desired risk / return ratio, diversification objectives, and risk management framework. The second recommendation is that if a bank does decide to do business with highly leveraged institutions, it should conduct a thorough and frequent analysis of the credit-worthiness of the institution, i. e the risk profile and risk management of the institution. Finally, banks should concentrate on risk measurement of derivative positions, collateral management and the use of attendant covenants. 19 Summary Ultimately, the cause of LTCM? s near default was a combination of its excessive use of leverage, the inefficiency of the Black-Scholes model under extreme market conditions, the drying-up of liquidity in financial assets, social and psychological investment factors, and global systematic risk. The Fed did not underestimate the importance of LTCM to the international financial system, as shown by the FRBNY?

s US$ 3. 625 billion intervention. The most frightening aspect of the whole ordeal was how quickly and efficiently one American firm, a hedge fund, was able to position itself as a real potential threat to the global economy. It is difficult to believe that LTCM was actually so special as to be the only firm that could ever accomplish such an obscene feat. The private mutual funds industry may need to be further regulated, or at least controlled, in order to avoid a reoccurrence.

Banks and financial institutions learned a valuable lesson from the LTCM fiasco, as these institutions will now be more cautious in doing business with hedge funds. Bibliography 1. Davis, Alfred H. R. and Pinches, George E. , ? Canadian Financial Management? (Addison Wesley, 1997) p. 632 2.

Federal Reserve Bank of Cleveland, May 1, 1999 3. Copyright: Institutional Investor Systems Inc. , November 1996 4. Organization for Economic Cooperation and Development, ? The LTCM crisis and its Consequences for Banks and Banking Supervision? , June 1999. 5. ? The LTCM crisis and its Consequences for Banks and Banking Supervision? 6. ? The LTCM crisis and its Consequences for Banks and Banking Supervision? 7.

Copyright: Institutional Investor Systems Inc. , November 1996 8. Copyright: Institutional Investor Systems Inc. , November 1996 9. Copyright: Institutional Investor Systems Inc. , November 1996 10. Capon, Andrew? What went wrong at Long Term Capital Management? (Global Investor, London, October 1999) 11. Jacobs, Bruce I. , ?

When seemingly infallible arbitrage strategies fail. ? (Journal of Investing, New York, Spring 1999) 12. Lewis, Michael? The Price of Behaving Rationally in a Market Meltdown? (The New York Times Magazine, New York, January 24, 1999) p. 42 13. Capon, Andrew?

What went wrong at Long Term Capital Management? (Global Investor, London, October 1999) 14. ? What went wrong at Long Term Capital Management? 15. Anonymous, ? Finance and economics: Economic focus: When the sea dries up. ? (The Economist, London, September 1999) 16. Lewis, Michael? The Price of Behaving Rationally in a Market Meltdown? (The New York Times Magazine, New York, January 24, 1999) p. 32 17.

Jacobs, Bruce I. , ? When seemingly infallible arbitrage strategies fail. ? (Journal of Investing, New York, Spring 1999) 18. Organization for Economic Cooperation and Development, ? The LTCM crisis and its Consequences for Banks and Banking Supervision? , June 1999. 19. ? The LTCM crisis and its Consequences for Banks and Banking Supervision?

Research essay sample on Federal Reserve Bank Failure