A CASE STUDY IN THE FAILURE OF FINANCIAL THEORY—THE LONG-TERM
CAPITAL MANAGEMENT DEBACLE
The failure of rationality and arbitrage in the face of irrational behavior was empirically
but unfortunately demonstrated by the collapse of Long-Term Capital Management
(LTCM) in 1998. Managed by extremely knowledgeable and sophisticated
professionals, this fund had two Nobel Prize winners, Scholes and Miller, on its
advisory staff. It leveraged itself by avoiding Federal Reserve margin requirements
and otherwise sane ratios of safety into almost 30-to-1 positions of investments to
cash and controlled thereby over 300 billion dollars’ worth of arbitraged positions. In
addition, it held over a trillion dollars in derivative obligations that, had they failed,
would have brought that amount of exposure to otherwise secure positions in the
banks that were on the other side of these contracts, and it would have forced them to
liquidate also. In other words, LTCM was in a position to bring down the U.S. and
perhaps world financial system if it failed.
One of the problems of pure arbitrage is that the marketplace, over very short time
periods, is efficient enough that bid-ask spreads are extremely small and the potential
profit so minimal that meaningful profit can only come from a very large position,
similar to a grocery store making many small profits on high turnover. Leverage
48 Part I Introduction
1. “Shiller used the phrase during testimony before the Federal Reserve, and Alan Greenspan repeated it in his famous
December 1996 speech.” (Interview of Professor Shiller by Chris Rugaber, Motley Fool [Fool.com], April 11, 2001). The
apparent origin of the phrase, however, goes back to Hamilton (1922).
must then be used to increase the size of the position. The danger is that although
leverage can increase profit, it can also increase the risk of capital loss to the point
where, depending on the size of the leverage, a small movement against a position
can wipe out the underlying assets. With a 30-to-1 leverage and 300 billion in contracts,
a move of only 3.4% against the positions would be enough to wipe out the
fund and force liquidation. This is essentially what happened to LTCM.
Here was a portfolio managed on the most modern versions of finance theory that
collapsed because certain unrealistic assumptions were made, based on the EMH,
and where “mispricing” became worse before it became better, forcing the covering
of positions at the worst time and thus exacerbating the mispricing even more.
Investors flocking to safety and liquidity in the aftermath of the Russian
(debt) default in August 1998 were stronger, at least for several months,
than the forces of rationality. (Lo, 2004)
Thus, even when a series of theoretically risk less spread positions were entered
with rational expectations, the reaction to an event overwhelmed those positions, and
lack of liquidity as well as the pressure of margin calls created a substantial collapse.
Finally, several major banks and brokerage firms, with the insistence and support of
the Federal Reserve, had to take over the assets of LTCM, force it out of business,
and gradually liquidate its positions over time as the market spreads improved.
The lesson learned from this expensive adventure into the EMH was that market
forces may abide by the principles of efficiency a majority of the time, but occasionally
and unexpectedly, irrational forces can overwhelm rationality and cause a disaster.
Several months after the LTCM debacle, arbitrage professionals analyzed the
LTCM portfolio and agreed that the positions were reasonable, and after a time the
spreads initiated did return to their mean. In other words, had LTCM not been so
highly leveraged and had it been able to withstand the short-term losses, it would
eventually have profited. To achieve a high return on capital, however, LTCM needed
leverage. Leverage introduced another risk, over the risk of volatility—the risk of
ruin. And when the markets ran outside the normal distribution of returns and developed
a “fat tail,” LTCM was out of business. This is why the assumption of a normal
distribution in price returns can be hazardous. It is also why the subject of behavioral
finance was born.
No comments:
Post a Comment