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Hedge Fund Ltcm Case Study

Long-Term Capital Management L.P. (LTCM) was a hedge fund management firm[1] based in Greenwich, Connecticut that used absolute-return trading strategies combined with high financial leverage. The firm's master hedge fund, Long-Term Capital Portfolio L.P., collapsed in the late 1990s, leading to an agreement on September 23, 1998, among 16 financial institutions—which included Bankers Trust, Barclays, Bear Stearns, Chase Manhattan Bank, Credit Agricole, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Paribas, Salomon Smith Barney, Societe Generale, and UBS—for a $3.6 billion recapitalization (bailout) under the supervision of the Federal Reserve.[2]

LTCM was founded in 1994 by John W. Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Members of LTCM's board of directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives".[3] Initially successful with annualized return of over 21% (after fees) in its first year, 43% in the second year and 41% in the third year, in 1998 it lost $4.6 billion in less than four months following the 1997 Asian financial crisis and 1998 Russian financial crisis, requiring financial intervention by the Federal Reserve, with the fund liquidating and dissolving in early 2000.

Founding[edit]

John W. Meriwether headed Salomon Brothers' bond arbitrage desk until he resigned in 1991 amid a trading scandal.[4] According to Chi-Fu Huang, later a Principal at LTCM, the bond arbitrage group was responsible for 80–100% of Salomon's global total earnings from the late 80s until the early 90s.[5]

In 1993 Meriwether created Long-Term Capital as a hedge fund and recruited several Salomon bond traders—Larry Hilibrand and Victor Haghani in particular would wield substantial clout[6]—and two future winners of the Nobel Memorial Prize, Myron S. Scholes and Robert C. Merton.[7][8] Other principals included Eric Rosenfeld, Greg Hawkins, William Krasker, Dick Leahy, James McEntee, Robert Shustak, and David W. Mullins Jr.

The company consisted of Long-Term Capital Management (LTCM), a company incorporated in Delaware but based in Greenwich, Connecticut. LTCM managed trades in Long-Term Capital Portfolio LP, a partnership registered in the Cayman Islands. The fund's operation was designed to have extremely low overhead; trades were conducted through a partnership with Bear Stearns and client relations were handled by Merrill Lynch.[9]

Meriwether chose to start a hedge fund to avoid the financial regulation imposed on more traditional investment vehicles, such as mutual funds, as established by the Investment Company Act of 1940—funds which accepted stakes from 100 or fewer individuals with more than $1 million in net worth each were exempt from most of the regulations that bound other investment companies.[10] In late 1993, Meriwether approached several "high-net-worth individuals" in an effort to secure start-up capital for Long-Term Capital Management. With the help of Merrill Lynch, LTCM secured hundreds of millions of dollars from business owners, celebrities and even private university endowments and later the Italian central bank. The bulk of the money, however, came from companies and individuals connected to the financial industry.[11] By 24 February 1994, the day LTCM began trading, the company had amassed just over $1.01 billion in capital.[12]

Trading strategies[edit]

The core investment strategy of the company was then known as involving convergence trading: using quantitative models to exploit deviations from fair value in the relationships between liquid securities across nations and asset classes. In fixed income the company was involved in US Treasuries, Japanese Government Bonds, UK Gilts, Italian BTPs, and Latin American debt, although their activities were not confined to these markets or to government bonds.[13]

Fixed Income Arbitrage[edit]

Fixed income securities pay a set of coupons at specified dates in the future, and make a defined redemption payment at maturity. Since bonds of similar maturities and the same credit quality are close substitutes for investors, there tends to be a close relationship between their prices (and yields). Whereas it is possible to construct a single set of valuation curves for derivative instruments based on LIBOR-type fixings, it is not possible to do so for government bond securities because every bond has slightly different characteristics. It is therefore necessary to construct a theoretical model of what the relationships between different but closely related fixed income securities should be.

For example, the most recently issued treasury bond in the US – known as the benchmark – will be more liquid than bonds of similar but slightly shorter maturity that were issued previously. Trading is concentrated in the benchmark bond, and transaction costs are lower for buying or selling it. As a consequence, it tends to trade more expensively than less liquid older bonds, but this expensiveness (or richness) tends to have a limited duration, because after a certain time there will be a new benchmark, and trading will shift to this security newly issued by the Treasury. One core trade in the LTCM strategies was to purchase the old benchmark – now a 29.75-year bond, and which no longer had a significant premium – and to sell short the newly issued benchmark 30-year, which traded at a premium. Over time the valuations of the two bonds would tend to converge as the richness of the benchmark faded once a new benchmark was issued. If the coupons of the two bonds were similar, then this trade would create an exposure to changes in the shape of the yield curve: a flattening would depress the yields and raise the prices of longer-dated bonds, and raise the yields and depress the prices of shorter-dated bonds. It would therefore tend to create losses by making the 30-year bond that LTCM was short more expensive (and the 29.75-year bond they owned cheaper) even if there had been no change in the true relative valuation of the securities. This exposure to the shape of the yield curve could be managed at a portfolio level, and hedged out by entering a smaller steepener in other similar securities.

Leverage and Portfolio Composition[edit]

Because the magnitude of discrepancies in valuations in this kind of trade is small (for the benchmark Treasury convergence trade, typically a few basis points), in order to earn significant returns for investors, LTCM used leverage to create a portfolio that was a significant multiple (varying over time depending on their portfolio composition) of investors' equity in the fund. It was also necessary to access the financing market in order to borrow the securities that they had sold short. In order to maintain their portfolio, LTCM was therefore dependent on the willingness of its counterparties in the government bond (repo) market to continue to finance their portfolio. If the company was unable to extend its financing agreements, then it would be forced to sell the securities it owned and to buy back the securities it was short at market prices, regardless of whether these were favourable from a valuation perspective.

At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt-to-equity ratio of over 25 to 1.[14] It had off-balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.

UBS Investment[edit]

Under prevailing US tax laws, there was a different treatment of long-term capital gains, which were taxed at 20.0 percent, and income, which was taxed at 39.6 percent. The earnings for partners in a hedge fund was taxed at the higher rate applying to income, and LTCM applied its financial engineering expertise to legally transform income into capital gains. It did so by engaging in a transaction with UBS (Union Bank of Switzerland) that would defer foreign interest income for seven years, thereby being able to earn the more favourable capital gains treatment. LTCM purchased a call option on 1 million of their own shares (valued then at $800 million) for a premium paid to UBS of $300 million. This transaction was completed in three tranches: in June, August, and October 1997. Under the terms of the deal, UBS agreed to reinvest the $300 million premium directly back into LTCM for a minimum of three years. In order to hedge its exposure from being short the call option, UBS also purchased 1 million of LTCM shares. Put-call parity means that being short a call and long the same amount of notional as underlying the call is equivalent to being short a put. So the net effect of the transaction was for UBS to lend $300 million to LTCM at LIBOR+50 and to be short a put on 1 million shares. UBS's own motivation for the trade was to be able to invest in LTCM – a possibility that was not open to investors generally – and to become closer to LTCM as a client. LTCM quickly became the largest client of the hedge fund desk, generating $15 million in fees annually.

Diminishing Opportunities and Broadening of Strategies[edit]

LTCM attempted to create a splinter fund in 1996 called LTCM-X that would invest in even higher risk trades and focus on Latin American markets. LTCM turned to UBS to invest in and write the warrant for this new spin-off company.[15]

LTCM faced challenges in deploying capital as their capital base grew due to initially strong returns, and as the magnitude of anomalies in market pricing diminished over time. James Surowiecki concludes that LTCM grew such a large portion of such illiquid markets that there was no diversity in buyers in them, or no buyers at all, so the wisdom of the market did not function and it was impossible to determine a price for its assets (such as Danish bonds in September 1998).[16]

In Q4 1997, a year in which they earned 27%, LTCM returned capital to investors. They also broadened their strategies to include new approaches in markets outside of fixed income: many of these were not market neutral – they were not dependent on overall interest rates or stock prices going up (or down) – and they were not traditional convergence trades. By 1998, LTCM had accumulated extremely large positions in areas such as merger arbitrage (betting on differences between a proprietary view of the likelihood of success of mergers and other corporate transactions would be completed and the implied market pricing) and S&P 500 options (net short long-term S&P volatility). LTCM had become a major supplier of S&P 500 vega, which had been in demand by companies seeking to essentially insure equities against future declines.[17]

Downturn[edit]

Main articles: 1997 Asian financial crisis and 1998 Russian financial crisis

Although periods of distress have often created tremendous opportunities for relative value strategies, this did not prove to be the case on this occasion, and the seeds of LTCM's demise were sown before the Russian default of 17 August 1998. LTCM had returned $2.7 bn to investors in Q4 of 1997, although it had also raised a total in capital of $1.066bn from UBS and $133m from CSFB. Since position sizes had not been reduced, the net effect was to raise the leverage of the fund.

Although 1997 had been a very profitable year for LTCM (27%), the lingering effects of the 1997 Asian crisis continued to shape developments in asset markets into 1998. Although this crisis had originated in Asia, its effects were not confined to that region. The rise in risk aversion had raised concerns amongst investors regarding all markets heavily dependent on international capital flows, and this shaped asset pricing in markets outside Asia too.[19]

In May and June 1998 returns from the fund were -6.42% and -10.14% respectively, reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. Because the Salomon arbitrage group (where many of LTCM's strategies had first been incubated) had been a significant player in the kinds of strategies also pursued by LTCM, the liquidation of the Salomon portfolio (and its announcement itself) had the effect of depressing the prices of the securities owned by LTCM and bidding up the prices of the securities LTCM was short. According to Michael Lewis in the New York Times article of July 1998, returns that month were circa -10%. One LTCM partner commented that because there was a clear temporary reason to explain the widening of arbitrage spreads, at the time it gave them more conviction that these trades would eventually return to fair value (as they did, but not without widening much further first).

Such losses were accentuated through the 1998 Russian financial crisis in August and September 1998, when the Russian government defaulted on its domestic local currency bonds.[20] This came as a surprise to many investors because according to traditional economic thinking of the time, a sovereign issuer should never need to default given access to the printing press. There was a flight to quality, bidding up the prices of the most liquid and benchmark securities that LTCM was short, and depressing the price of the less liquid securities it owned. This phenomenon occurred not merely in the US Treasury market but across the full spectrum of financial assets. Although LTCM was diversified, the nature of its strategy implied an exposure to a latent factor risk of the price of liquidity across markets. As a consequence, when a much larger flight to liquidity occurred than had been anticipated when constructing its portfolio, its positions designed to profit from convergence to fair value incurred large losses as expensive but liquid securities became more expensive, and cheap but illiquid securities became cheaper. By the end of August, the fund had lost $1.85 billion in capital.

Because LTCM was not the only fund pursuing such a strategy, and because the proprietary trading desks of the banks also held some similar trades, the divergence from fair value was made worse as these other positions were also liquidated. As rumours of LTCM's difficulties spread, some market participants positioned in anticipation of a forced liquidation. Victor Haghani, a partner at LTCM, said about this time "it was as if there was someone out there with our exact portfolio,... only it was three times as large as ours, and they were liquidating all at once."

Because these losses reduced the capital base of LTCM, and its ability to maintain the magnitude of its existing portfolio, LTCM was forced to liquidate a number of its positions at a highly unfavorable moment and suffer further losses. A vivid illustration of the consequences of these forced liquidations is given by Lowenstein (2000).[21] He reports that LTCM established an arbitrage position in the dual-listed company (or "DLC") Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8%–10% premium relative to Shell. In total $2.3 billion was invested, half of which was "long" in Shell and the other half was "short" in Royal Dutch.[22]

LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge because in their belief the present value of the future cashflows of the two securities should be similar. This might have happened in the long run, but due to its losses on other positions, LTCM had to unwind its position in Royal Dutch Shell. Lowenstein reports that the premium of Royal Dutch had increased to about 22%, which implies that LTCM incurred a large loss on this arbitrage strategy. LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade.[23]

The company, which had historically earned annualised compounded returns of almost 40% up to this point, experienced a flight to liquidity. In the first three weeks of September, LTCM's equity tumbled from $2.3 billion at the start of the month to just $400 million by September 25. With liabilities still over $100 billion, this translated to an effective leverage ratio of more than 250-to-1.[24]

1998 bailout[edit]

Long-Term Capital Management did business with nearly everyone important on Wall Street. Indeed, much of LTCM's capital was composed of funds from the same financial professionals with whom it traded. As LTCM teetered, Wall Street feared that Long-Term's failure could cause a chain reaction in numerous markets, causing catastrophic losses throughout the financial system.

After LTCM failed to raise more money on its own, it became clear it was running out of options. On September 23, 1998, Goldman Sachs, AIG, and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $3.75 billion and to operate LTCM within Goldman's own trading division. The offer was stunningly low to LTCM's partners because at the start of the year their firm had been worth $4.7 billion. Warren Buffett gave Meriwether less than one hour to accept the deal; the time lapsed before a deal could be worked out.[25]

Seeing no options left, the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets.[26] The principal negotiator for LTCM was general counsel James G. Rickards.[27] The contributions from the various institutions were as follows:[28][29]

  • $300 million: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P.Morgan, Morgan Stanley, Salomon Smith Barney, UBS
  • $125 million: Société Générale
  • $100 million: Paribas, Credit Agricole[30]
  • Bear Stearns and Lehman Brothers[30] declined to participate.

In return, the participating banks got a 90% share in the fund and a promise that a supervisory board would be established. LTCM's partners received a 10% stake, still worth about $400 million, but this money was completely consumed by their debts. The partners once had $1.9 billion of their own money invested in LTCM, all of which was wiped out.[31]

The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices, which would force other companies to liquidate their own debt in a vicious cycle.

The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):[21]

Long-Term Capital was audited by Price Waterhouse LLP. After the bailout by the other investors, the panic abated, and the positions formerly held by LTCM were eventually liquidated at a small profit to the rescuers. Although termed a bailout, the transaction effectively amounted to an orderly liquidation of the positions held by LTCM with creditor involvement and supervision by the Federal Reserve Bank. No public money was injected or directly at risk, and the companies involved in providing support to LTCM were also those that stood to lose from its failure. The creditors themselves did not lose money from being involved in the transaction.

Some industry officials said that Federal Reserve Bank of New York involvement in the rescue, however benign, would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf in the event of trouble. Federal Reserve Bank of New York actions raised concerns among some market observers that it could create moral hazard since even though the Fed had not directly injected capital, its use of moral suasion to encourage creditor involvement emphasized its interest in supporting the financial system .[32]

LTCM's strategies were compared (a contrast with the market efficiency aphorism that there are no $100 bills lying on the street, as someone else has already picked them up) to "picking up nickels in front of a bulldozer"[33]—a likely small gain balanced against a small chance of a large loss, like the payouts from selling an out-of-the-money naked call option.

Aftermath[edit]

After the bailout, Long-Term Capital Management continued operations. In the year following the bailout, it earned 10%. By early 2000, the fund had been liquidated, and the consortium of banks that financed the bailout had been paid back, but the collapse was devastating for many involved. Mullins, once considered a possible successor to Alan Greenspan, saw his future with the Fed dashed. The theories of Merton and Scholes took a public beating. In its annual reports, Merrill Lynch observed that mathematical risk models "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited."[34]

After helping unwind LTCM, Meriwether launched JWM Partners. Haghani, Hilibrand, Leahy, and Rosenfeld signed up as principals of the new firm. By December 1999, they had raised $250 million for a fund that would continue many of LTCM's strategies—this time, using less leverage.[35] With the credit crisis of 2008, JWM Partners LLC was hit with a 44% loss from September 2007 to February 2009 in its Relative Value Opportunity II fund. As such, JWM Hedge Fund was shut down in July 2009.[36]

In 1998, the chairman of Union Bank of Switzerland resigned as a result of a $780 million loss incurred from the short put option on LTCM, which had become very significantly in the money due to its collapse.[1]

See also[edit]

Notes[edit]

  1. ^ abA financial History of the United States Volume II: 1970–2001, Jerry W. Markham, Chapter 5: "Bank Consolidation", M. E. Sharpe, Inc., 2002
  2. ^Greenspan, Alan (2007). The Age of Turbulence: Adventures in a New World. The Penguin Press. pp. 193–195. ISBN 978-1-59420-131-8. 
  3. ^The Bank of Sweden Prize in Economic Sciences 1997. Robert C. Merton and Myron S. Scholes pictures. Myron S. Scholes with location named as "Long Term Capital Management, Greenwich, CT, USA" where the prize was received.
  4. ^Dunbar 2000, pp. 110–pgs 111–112
  5. ^"Chi-Fu Huang: From Theory to Practice"(PDF). Archived from the original(PDF) on 2015-09-23. 
  6. ^When Genius Failed. 2011. p. 55.  
  7. ^Dunbar 2000, pp. 114–116
  8. ^Loomis 1998
  9. ^Dunbar 2000, pp. 125, 130
  10. ^Dunbar 2000, p. 120
  11. ^Dunbar 2000, p. 130
  12. ^Dunbar 2000, p. 142
  13. ^Henriques, Diana B.; Kahn, Joseph (1998-12-06). "BACK FROM THE BRINK; Lessons of a Long, Hot Summer". The New York Times. ISSN 0362-4331. Retrieved 2015-08-22. 
  14. ^Lowenstein 2000, p. 191
  15. ^Lowenstein, Roger (2000). When Genius Failed: the Rise and Fall of Long-Term Capital Management. Random House Trade Paperbacks. pp. 95–97. ISBN 978-0-375-75825-6. 
  16. ^Surowiecki, James (2005). "Chapter 11.IV". The wisdom of crowds. New York: Anchor Books. p. 240. ISBN 9780385721707. OCLC 61254310. 
  17. ^Lowenstein 2000, pp. 124–25
  18. ^Lowenstein 2000, p. xv
  19. ^O'Rourke, Breffni (1997-09-09). "Eastern Europe: Could Asia's Financial Crisis Strike Europe?". RadioFreeEurope/RadioLiberty. Retrieved 2015-08-22. 
  20. ^Bookstaber, Richard (2007). A Demon Of Our Own Design. USA: John Wiley & Sons. pp. 97–124. ISBN 978-0-470-39375-8. 
  21. ^ abLowenstein 2000
  22. ^Lowenstein 2000, p. 99
  23. ^Lowenstein 2000, p. 234
  24. ^Lowenstein 2000, p. 211
  25. ^Lowenstein 2000, pp. 203–04
  26. ^Partnoy, Frank (2003). Infectious Greed: How Deceit and Risk Corrupted the Financial Markets. Macmillan. p. 261. ISBN 0-8050-7510-0. 
  27. ^Kathryn M. Welling, "Threat Finance: Capital Markets Risk Complex and Supercritical, Says Jim Rickards"welling@weeden (February 25, 2010). Retrieved May 13, 2011
  28. ^Wall Street Journal, 25 September 1998
  29. ^Bloomberg.com: Exclusive
  30. ^ abhttp://eml.berkeley.edu/~webfac/craine/e137_f03/137lessons.pdf
  31. ^Lowenstein 2000, pp. 207–08
  32. ^GAO/GGD-00-67R Questions Concerning LTCM and Our Responses General Accouting Office, February 23, 2000
  33. ^Lowenstein 2000, p. 102
  34. ^Lowenstein 2000, p. 235
  35. ^Lowenstein 2000, p. 236
  36. ^"John Meriwether to shut hedge fund - Bloomberg". Reuters. July 8, 2009. Retrieved 11 January 2018. 

Bibliography[edit]

  • Coy, Peter; Wooley, Suzanne (21 September 1998). "Failed Wizards of Wall Street". Business Week. Retrieved 2006-09-04. 
  • Crouhy, Michel; Galai, Dan; Mark, Robert (2006). The Essentials of Risk Management. New York: McGraw-Hill Professional. ISBN 0-07-142966-2. 
  • Dunbar, Nicholas (2000). Inventing Money: The story of Long-Term Capital Management and the legends behind it. New York: Wiley. ISBN 0-471-89999-2. 
  • Jacque, Laurent L. (2010). Global Derivative Debacles: From Theory to Malpractice. Singapore: World Scientific. ISBN 978-981-283-770-7. . Chapter 15: Long-Term Capital Management, pp. 245–273
  • Loomis, Carol J. (1998). "A House Built on Sand; John Meriwether's once-mighty Long-Term Capital has all but crumbled. So why did Warren Buffett offer to buy it?". Fortune. 138 (8). 
  • Lowenstein, Roger (2000). When Genius Failed: The Rise and Fall of Long-Term Capital Management. Random House. ISBN 0-375-50317-X. 
  • Weiner, Eric J. (2007). What Goes Up, The Uncensored History of Modern Wall Street. New York: Back Bay Books. ISBN 0-316-06637-0. 

Further reading[edit]

  • "Eric Rosenfeld talks about LTCM, ten years later". MIT Tech TV. 2009-02-19. 
  • Siconolfi, Michael; Pacelle, Mitchell; Raghavan, Anita (1998-11-16). "All Bets Are Off: How the Salesmanship And Brainpower Failed At Long-Term Capital". Wall Street Journal. 
  • "Trillion Dollar Bet". Nova. PBS. 2000-02-08. 
  • MacKenzie, Donald (2003). "Long-Term Capital Management and the Sociology of Arbitrage". Economy and Society. 32 (3): 349–380. doi:10.1080/03085140303130. [permanent dead link]
  • Fenton-O'Creevy, Mark; Nicholson, Nigel; Soane, Emma; Willman, Paul (2004). Traders: Risks, Decisions, and Management in Financial Markets. Oxford University Press. ISBN 0-19-926948-3. 
  • Gladwell, Malcolm (2002). "Blowing Up". The New Yorker. Archived from the original on 2011-02-24. 
  • MacKenzie, Donald (2006). An Engine, not a Camera: How Financial Models Shape Markets. The MIT Press. ISBN 0-262-13460-8. 
  • Poundstone, William (2005). Fortune's Formula: The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street. Hill and Wang. ISBN 0-8090-4637-7. 
  • Case Study: Long-Term Capital Management erisk.com
  • Meriwether and Strange Weather: Intelligence, Risk Management and Critical Thinking austhink.org
  • US District Court of Connecticut judgement on tax status of LTCM losses
  • Michael Lewis – NYT – How the Egghead's Cracked-January 1999
  • Stein, M. (2003): Unbounded irrationality: Risk and organizational narcissism at Long Term Capital Management, in: Human Relations 56 (5), S. 523–540.
On September 23, 1998, the chiefs of some of the largest investment firms of Wall Street—Bankers Trust, Bear Stearns, Chase Manhattan, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Smith Barney—met on the 10th floor conference room of the Federal Reserve Bank of New York (pictured) to rescue LTCM.

Hedge Funds, Leverage, and the Lessons of

Long-Term Capital Management

Report of

The President's Working Group on Financial Markets

April 1999


April 28, 1999

The Honorable J. Dennis Hastert

The Speaker

United States House of Representatives

Washington, D.C. 20515

Dear Mr. Speaker:

We are pleased to transmit the report of the President's Working Group on Financial Markets on Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (LTCM).

The principal policy issue arising out of the events surrounding the near collapse of LTCM is how to constrain excessive leverage. By increasing the chance that problems at one financial institution could be transmitted to other institutions, excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets. This issue is not limited to hedge funds; other financial institutions are often larger and more highly leveraged than most hedge funds.

In view of our findings, the Working Group recommends a number of measures designed to constrain excessive leverage. These measures are designed to improve transparency in the system, enhance private sector risk management practices, develop more risk-sensitive approaches to capital adequacy, support financial contract netting in the event of bankruptcy, and encourage offshore financial centers to comply with international standards.

The LTCM incident highlights a number of tax issues with respect to hedge funds, including the tax treatment of total return equity swaps and the use of offshore financial centers. These issues, however, are beyond the scope of this report and are being addressed separately by Treasury.

A number of other federal agencies were full participants in this study and support its conclusions and recommendations: the Council of Economic Advisers, the Federal Deposit Insurance Corporation, the National Economic Council, the Federal Reserve Bank of New York, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision. We are grateful for their extensive assistance.

We appreciate the opportunity to convey this report to you, and we look forward to continuing to work with you on these important issues.

(signed)                                                                         (signed)

Robert E. Rubin                                                                     Alan Greenspan

Secretary                                                                               Chairman

Department of the Treasury                                                    Board of Governors of the Federal Reserve

(signed)                                                                          (signed)

Arthur Levitt                                                                          Brooksley Born

Chairman                                                                               Chairperson

Securities and Exchange Commission                                      Commodity Futures Trading Commission


April 28, 1999

The Honorable Al Gore

President of the Senate

United States Senate

Washington, D.C. 20510

Dear Mr. President:

We are pleased to transmit the report of the President's Working Group on Financial Markets on Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (LTCM).

The principal policy issue arising out of the events surrounding the near collapse of LTCM is how to constrain excessive leverage. By increasing the chance that problems at one financial institution could be transmitted to other institutions, excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets. This issue is not limited to hedge funds; other financial institutions are often larger and more highly leveraged than most hedge funds.

In view of our findings, the Working Group recommends a number of measures designed to constrain excessive leverage. These measures are designed to improve transparency in the system, enhance private sector risk management practices, develop more risk-sensitive approaches to capital adequacy, support financial contract netting in the event of bankruptcy, and encourage offshore financial centers to comply with international standards.

The LTCM incident highlights a number of tax issues with respect to hedge funds, including the tax treatment of total return equity swaps and the use of offshore financial centers. These issues, however, are beyond the scope of this report and are being addressed separately by Treasury.

A number of other federal agencies were full participants in this study and support its conclusions and recommendations: the Council of Economic Advisers, the Federal Deposit Insurance Corporation, the National Economic Council, the Federal Reserve Bank of New York, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision. We are grateful for their extensive assistance.

We appreciate the opportunity to convey this report to you, and we look forward to continuing to work with you on these important issues.

(signed)                                                                  (signed)

Robert E. Rubin                                                              Alan Greenspan

Secretary                                                                        Chairman

Department of the Treasury                                             Board of Governors of the Federal Reserve

(signed)                                                                  (signed)

Arthur Levitt                                                                   Brooksley Born

Chairman                                                                        Chairperson

Securities and Exchange Commission                              Commodity Futures Trading Commission


TABLE OF CONTENTS

                                                                                                                                                                         Page

EXECUTIVE SUMMARY                                                                                                                                  xiii

I. BACKGROUND                                                                                                                                                1

Hedge Funds                                                                                                                                                 1

A. General Description                                                                                                                         1

B. Trading Practices                                                                                                                             4

C. Disclosure and Monitoring                                                                                                               6

D. Counterparty and Credit Relationships                                                                                             6

The LTCM Episode                                                                                                                                     10

A. Background                                                                                                                                   10

B. LTCM's Near Failure                                                                                                                     12

C. The LTCM Fund Achieved Extraordinary Levels of Leverage and Risk                                           14

D. Counterparty Losses and Market Disruptions That May Have Resulted from a Default of LTCM    17

II. PUBLIC POLICY ISSUES                                                                                                                                23

Leverage and Risk                                                                                                                                         23

A. Measuring Leverage and Risk                                                                                                         24

B. Private Counterparty Discipline and Government Regulation                                                             25

Bankruptcy Issues                                                                                                                                         26

A. Closeout Netting                                                                                                                            26

B. Transnational Issues                                                                                                                        27

III. CONCLUSIONS AND RECOMMENDATIONS                                                                                          29

1. Disclosure and Reporting                                                                                                                          32

2. Supervisory Oversight                                                                                                                               34

3. Enhanced Private Sector Practices for Counterparty Risk Management                                                      36

4. Capital Adequacy                                                                                                                                     37

5. Expanded Risk Assessment for the Unregulated Affiliates of Broker-Dealers and Futures Commission Merchants                                                                                                                                                    38

6. Bankruptcy Code Issues                                                                                                                           40

7. Offshore Financial Centers and Tax Havens                                                                                               41

8. Additional Potential Steps                                                                                                                         42

APPENDIX A: ADDITIONAL INFORMATION ON HEDGE FUNDS

1. Hedge Fund Performance Fees, Leverage, and Short-term Outlook                                                          A-1

2. Hedge Fund Performance and Survival                                                                                                     A-3

3. Market Impact, Positive and Negative                                                                                                      A-5

APPENDIX B: THE SEC AND HEDGE FUNDS

1. Exemptions from Securities Laws                                                                                                             B-1

2. Oversight of Broker-Dealer Exposure                                                                                                      B-4

3. Management of Clearing Risks                                                                                                                 B-12

4. Other Issues Raised by LTCM                                                                                                                B-13

APPENDIX C: THE CFTC AND HEDGE FUNDS

1. Description of CPO and CTA Regulation                                                                                                         C-1

2. Reporting of Exchange-Traded Commodity Positions                                                                             C-5

3. Oversight of FCM Exposure to Hedge Funds                                                                                         C-7

4. Management of Clearance Risks                                                                                                            C-10

5. LTCM and U.S. Futures Markets                                                                                                          C-12

6. CFTC Analysis of Hedge Fund Data                                                                                                      C-12

7. Conclusion                                                                                                                                             C-15

APPENDIX D: THE SUPERVISION OF BANK EXPOSURE TO HEDGE FUNDS

1. Commercial Bank Relationships with Hedge Funds                                                                                  D-1

2. Supervision of Bank Credit Exposures to Hedge Funds                                                                            D-1

3. Credit Risk Management Issues                                                                                                               D-12

APPENDIX E: BANKRUPTCY ISSUES

1. Background                                                                                                                                             E-1

2. The U.S. Legal Framework's Treatment of Derivative Contracts in Insolvencies                                         E-2

3. Practical Application of the Bankruptcy Code to a Hedge Fund Failure                                                     E-5

APPENDIX F: VOLUNTARY INDUSTRY INITIATIVES

1. The Derivatives Policy Group Initiative                                                                                                      F-1

2. The Counterparty Risk Management Policy Group Initiative                                                                      F-3

3. International Centralized Credit Database                                                                                                 F-4

4. International Swaps and Derivatives Association 1999 Collateral Review                                                  F-5

APPENDIX G: SUPERVISORY EFFORTS AND STATEMENTS POST-LTCM

1. Basle Committee on Banking Supervision                                                                                                 G-1

2. International Organization of Securities Commissions                                                                                G-1

3. G-7 Finance Ministers and Central Bank Governors                                                                                 G-1

4. Board of Governors of the Federal Reserve System                                                                                 G-2

5. Office of the Comptroller of the Currency                                                                                                G-2

6. New York State Banking Department                                                                                                     G-3


EXECUTIVE SUMMARY

The President's Working Group on Financial Markets recommends a number of measures designed to constrain excessive leverage in the financial system. The events in global financial markets in the summer and fall of 1998 demonstrated that excessive leverage can greatly magnify the negative effects of any event or series of events on the financial system as a whole. The near collapse of Long-Term Capital Management ("LTCM"), a private sector investment firm, highlighted the possibility that problems at one financial institution could be transmitted to other institutions, and potentially pose risks to the financial system.

Although LTCM is a hedge fund, this issue is not limited to hedge funds. Other financial institutions, including some banks and securities firms, are larger, and generally more highly leveraged, than hedge funds.

While leverage can play a positive role in our financial system, problems can arise when financial institutions go too far in extending credit to their customers and counterparties. The near collapse of LTCM illustrates the need for all participants in our financial system, not only hedge funds, to face constraints on the amount of leverage they assume.

Our market-based economy relies primarily on market discipline to constrain leverage. But market discipline can break down. In the case of LTCM, its investors, creditors, and counterparties did not provide an effective check on its overall activities. Moreover, some of the same market and credit risk management weaknesses that permitted LTCM to achieve its extraordinary leverage were evident in other market participants. In the immediate aftermath of LTCM's near collapse, credit risk management practices vis-a-vis highly leveraged institutions were tightened. But market history indicates that even painful lessons recede from memory with time.

Therefore, the Working Group recommends the following measures:

· More frequent and meaningful information on hedge funds should be made public.

· Public companies, including financial institutions, should publicly disclose additional information about their material financial exposures to significantly leveraged institutions, including hedge funds.

· Financial institutions should enhance their practices for counterparty risk management.

· Regulators should encourage improvements in the risk-management systems of regulated entities.

· Regulators should promote the development of more risk-sensitive but prudent approaches to capital adequacy.

· Regulators need expanded risk assessment authority for the unregulated affiliates of broker-dealers and futures commission merchants.*

· The Congress should enact the provisions proposed by the President's Working Group to support financial contract netting.

· Regulators should consider stronger incentives to encourage offshore financial centers to comply with international standards.

The Working Group will be monitoring and assessing the effectiveness of the measures outlined above. If further evidence emerges that indirect regulation of currently unregulated market participants is not effective in constraining excessive leverage, there are several matters that could be given further consideration; however, the Working Group is not recommending any of them at this time.

Concerns have been expressed about the activities of highly leveraged institutions with respect to their impact on market dynamics generally and vulnerable economies in particular. Such activity can affect markets in some circumstances and for limited periods although, as a number of independent studies that have been undertaken so far have suggested, the activities of highly leveraged institutions do not appear to have played a significant role in precipitating the financial market crises of the past few years. Further study of this issue will be undertaken by the Financial Stability Forum, recently established by the G-7.

This report includes a Background section that provides a description of hedge funds, their activities and their counterparties, and also describes the events surrounding the near collapse of LTCM. The second section, on Public Policy Issues, discusses a number of questions raised by LTCM. In the Conclusions and Recommendations section we fully discuss the recommendations summarized above. This report also includes a number of appendices that address some key topics in more detail.


Hedge Funds, Leverage, and the Lessons of

Long-Term Capital Management

Report of

The President's Working Group on Financial Markets

I. BACKGROUND

Hedge Funds 1

A. General Description

The term "hedge fund" is commonly used to describe a variety of different types of investment vehicles that share some similar characteristics. Although it is not statutorily defined, the term encompasses any pooled investment vehicle that is privately organized, administered by professional investment managers, and not widely available to the public. The primary investors in hedge funds are wealthy individuals and institutional investors. In addition, hedge fund managers frequently have a stake in the funds they manage. Entities classified as hedge funds are commonly organized as limited partnerships or limited liability companies, and in many cases are domiciled outside the United States.

Hedge funds are not a recent invention, as the founding of the first hedge fund is conventionally dated to 1949.2 A 1968 survey by the Securities and Exchange Commission ("SEC") identified 140 funds operating at that time. During the last two decades, however, the hedge fund industry has grown substantially. Although it is difficult to estimate precisely the size of the industry, a number of estimates indicate that as of mid-1998 there were between 2,500 and 3,500 hedge funds managing between $200 billion and $300 billion in capital, with approximately $800 billion to $1 trillion in total assets. Collectively, hedge funds remain relatively small when compared to other sectors of the U.S. financial markets. At the end of 1998, for instance, commercial banks had $4.1 trillion in total assets; mutual funds had assets of approximately $5trillion; private pension funds had $4.3 trillion; state and local retirement funds had $2.3 trillion; and insurance companies had assets of $3.7 trillion.3

With $200 - $300 billion spread among approximately 3,000 hedge funds, most hedge funds are relatively small, with the vast majority controlling less than $100 million in invested capital. In fact, according to commodity pool operator ("CPO") filings with the CFTC, there are perhaps only a few dozen hedge funds today that have a capital base larger than $1 billion, and only a small handful that exceed $5 billion.4 The very largest hedge funds have less than $12 billion in investor capital, although some "families" of funds have greater stakes. Although individually and as an industry, hedge funds represent a relatively small segment of the market, their impact is greatly magnified by their highly active trading strategies and by the leverage obtained through their use of repurchase agreements and derivative contracts.

Apart from size, hedge funds differ in other important ways from alternative types of investment vehicles. Hedge funds are able to sell securities short and to buy securities on leverage. While this activity is not unique to hedge funds, hedge funds often use leverage aggressively. Hedge funds also charge advisory fees based on performance, and they tend to pursue short-term investment strategies.

In general, active market participants such as hedge funds can provide benefits to financial markets by enhancing liquidity and efficiency. Additionally, they can play a role in financial innovation and the reallocation of financial risk. However, some hedge funds, like other large highly leveraged financial institutions, also have the potential to disrupt the functioning of financial markets. Indeed, some observers have asserted that hedge funds are responsible for large and sometimes disruptive market movements in vulnerable economies. According to several comprehensive analyses of the issue, however, hedge funds do not appear to have played a significant role in precipitating the financial market crises of the past few years.5 Further study of this issue will be undertaken by the Financial Stability Forum, recently established by the G-7.

There is no single market strategy or approach pursued by hedge funds as a group. Rather, hedge funds exhibit a wide variety of investment styles, some of which use highlyquantitative techniques while others employ more subjective factors. Researchers and other industry observers therefore often classify hedge funds according to the main investment strategy practiced by the funds' management. Global-macro funds, for instance, take positions based on their forecasts of global macroeconomic developments, while event-driven funds invest in specific securities related to such events as bankruptcies, reorganizations, and mergers. A relatively small set of market-neutral hedge funds employ relative-value strategies seeking to profit by taking offsetting positions in two assets whose price relationships are expected to move in a direction favorable to these offsetting positions.

Hedge funds are also diverse in their use of different types of financial instruments. Many hedge funds trade equity or fixed income securities, taking either long or short positions, or sometimes both simultaneously. A large number of funds also use exchange-traded futures contracts or over-the-counter ("OTC") derivatives, to hedge their portfolios, to exploit market inefficiencies, or to take outright positions. Still others are active participants in foreign exchange markets. In general, hedge funds are more active users of derivatives and of short positions than are mutual funds or many other classes of asset managers. In this respect, the trading activities of hedge funds are similar to those undertaken by the proprietary trading areas of large commercial and investment banks.

Hedge funds that conform to certain requirements are eligible for various exemptions from federal securities laws. In particular, unlike mutual funds, hedge funds are exempt from SEC reporting requirements, as well as from regulatory restrictions on leverage or trading strategies. They also face fewer limitations on the structure and size of fees they may charge. The sponsors of hedge funds that trade on organized futures exchanges and that have U.S. investors, however, are typically required to register with the CFTC as a CPO. Registered CPOs are subject to periodic reporting, recordkeeping, and disclosure requirements.

To avoid the registration and reporting requirements of the federal securities laws, hedge funds generally do not raise funds via public offerings of their securities, advertise broadly, or engage in general solicitation. Hedge funds also typically have either no more than 100 beneficial owners or require their investors to meet rigid minimum size requirements.6

Recent studies of hedge fund performance have generally found that hedge funds as a group offer greater return, yet greater risk, than investment benchmarks such as Standard and Poor's S&P 500 stock index.7 Not surprisingly, particular classes of hedge funds have at timesoutperformed benchmark measures on a risk-adjusted basis, while other classes have at times underperformed. Importantly, the performance of many hedge funds historically has not been highly correlated with overall market performance, thus accounting for their inclusion in the portfolios of wealthy individuals and institutional investors who seek a broad diversification of their investments.

B. Trading Practices

Hedge funds are only one example of a collection of institutions that actively trade securities and derivative instruments. An assessment of the public policy issues posed by hedge funds might therefore benefit from a consideration of hedge funds in the broader context of trading activity. In today's economy, the markets for traded securities are performing an increasingly important role in the intermediation of credit. Among the wide range of institutions participating in this trading activity are hedge funds, trading desks of banks, securities firms and insurance companies, mutual funds, and other managed funds. Some of these institutions engage in trading activity more intensively than others.

The diverse collection of institutions, including hedge funds, that engage in trading activity can be characterized by similarities in their use of mark-to-market discipline, leverage, and active trading.

Mark-to-market

Mark-to-market practices, the discipline of periodically valuing positions at current market prices, may be imposed through external accounting or regulatory requirements, or through internal risk management practices. In addition, mark-to-market practices may be imposed through counterparties' valuation of trading exposures and collateral. This discipline is useful for preventing the concealment of losses and for encouraging the timely resolution of problems. While they may not necessarily be required to do so, hedge funds generally practice this discipline.

The use of mark-to-market valuation for managing collateral and variation margin to mitigate credit risk can impose cash flow and liquidity strains on a trading entity. Such liquidity and cash flow problems can be particularly severe for a highly leveraged trading vehicle, especially during episodes of extreme price volatility when mark-to-market driven collateral and margin calls can impose a very short time frame for resolving liquidity problems.

Leverage

Leverage allows hedge funds to magnify their exposures and, as a direct consequence, magnify their risks. The term leverage can be defined in balance-sheet terms, in which case it refers to the ratio of assets to net worth. Alternatively, leverage can be defined in terms of risk, in which case it is a measure of economic risk relative to capital. Hedge funds obtain economic leverage in various ways, such as through the use of repurchase agreements, short positions, andderivative contracts. At times, the choice of investment is influenced by the availability of leverage. Beyond a trading institution's risk appetite, both balance-sheet and economic leverage may be constrained in some cases by initial margin and collateral at the transaction level, and also by trading and credit limits imposed by trading counterparties. For some types of financial institutions, regulatory capital requirements may constrain leverage, although this limitation does not apply to hedge funds. Hedge funds are limited in their use of leverage only by the willingness of their creditors and counterparties to provide such leverage.

Hedge funds vary greatly in their use of leverage. Nevertheless, compared with other trading institutions, hedge funds' use of leverage, combined with any structured or illiquid positions whose full value cannot be realized in a quick sale, can potentially make them somewhat fragile institutions that are vulnerable to liquidity shocks. While trading desks of banks and securities firms may take positions similar to hedge funds' investments, these organizations and their parent firms often have both liquidity sources and independent streams of income from other activities that can offset the riskiness of their positions.

Like banks and securities firms, but unlike most mutual funds, hedge funds lever their capital bases to increase their total asset holdings by a multiple of the amount of capital invested in the funds. CPO reports, however, suggest that the significant majority of reporting hedge funds have balance-sheet leverage ratios (total assets to capital) of less than 2-to-1. There are, of course, important exceptions. According to September 1998 CPO filings, at least ten hedge funds with capital exceeding $100 million leveraged their capital more than ten times. At the extreme, the most leveraged hedge funds in this group levered their capital more than thirty times.

Active trading

Active trading, which is typical of hedge funds, is a practice in which investment positions are changed with high frequency. Such trading may be conducted to maintain a desired risk-return profile as market prices fluctuate, or it may be conducted to attempt to profit from short-term changes in prices. While turnover in hedge funds' portfolios differs widely, the typical hedge fund's use of active trading strategies is closer to that of financial intermediaries' proprietary trading desks than to a mutual fund or pension fund.

Active trading strategies rely on market liquidity and access to credit to meet funding needs. However, an entity's ability to trade actively can diminish either because creditworthiness concerns cause counterparties to cut trading and credit limits or because of a broader disappearance of market liquidity. The inability to execute active trading strategies can lead to unexpectedly large mark-to-market losses as positions that had been thought of as modifiable exposures become longer-term positions.

C. Disclosure and Monitoring

A trading entity is often subject to disclosure and monitoring of its financial condition, and these requirements can serve to limit the trader's activities. Trading desks of a few major banks and securities firms are constrained by internal risk management functions, by risk-based capital requirements,8 and by public disclosure of the firms' overall trading activity.9 No such limitations apply, however, to hedge funds. In fact, hedge funds are subject to fewer public disclosure requirements and less monitoring than many other financial institutions.

Disclosures by hedge funds to counterparties and investors are often made using accounting and balance-sheet concepts. While such information includes notional amount and market value of derivatives contracts, the typical accounting statement is still not informative about the risk profile of trading activity (e.g., the nature of the exposures to market risk and credit risk).

D. Counterparty and Credit Relationships

In order for hedge funds to conduct their active trading and to employ leverage, it is necessary for them to enter into business relationships with other entities. This section describes the nature of these relationships.

Credit exposures

Credit exposures between hedge funds and their counterparties arise primarily from trading and lending relationships, such as through derivatives and repurchase agreement ("repo") transactions.10 These exposures, which are often reciprocal, are created when changes in market prices cause the replacement values of transactions to rise above their value at inception. Thus, a default of either the hedge fund or the counterparty would cause a loss to the other party because the transactions can only be replaced at the market prices prevailing after default.

The credit exposure of a typical transaction has two components, the current credit exposure and the potential future exposure. The current credit exposure at a moment in time is the market value of the contract, and represents the replacement cost of the contract if one party to the transaction defaults at that moment. The potential future exposure is an estimate of the possible increase in the contract's replacement value from the point of view of a particular firm over a specified interval in the future, such as between the time of a potential default and the time the counterparty is able to replace the contract.

In addition to the credit exposures stemming from trading relationships, further credit exposure may be realized by counterparties when they extend credit to hedge funds through credit lines. Hedge funds can face considerable liquidity risk through mismatched cash flows of assets and liabilities. Revolving lines of credit and broker loans are sometimes used to bridge these mismatches. However, these credit lines often entail high costs, and thus are not typically used for establishing leverage. Hedge funds can achieve economic leverage in their positions more cheaply in other ways, such as through repo and derivatives transactions.

Counterparties manage these exposures through a variety of safeguards including due diligence, disclosure, collateral practices, credit limits, and monitoring.

Due diligence and documentation

Due diligence reviews by extenders of credit to hedge fund customers typically include assessments of: offering circulars or private placement memorandums; partnership agreements; performance history; investment authority; management ability and reputation; capital, including size, growth, investor concentration, and management share of the capital base; risk profile implications of the fund's investment and trading styles; liquidity, including types of positions and investor withdrawal rules; leverage, including on- and off-balance-sheet leverage, and fit with liquidity of positions; risk management; and front and back office operations.

In addition to such reviews, maintaining up-to-date documentation of all outstanding contracts is an important component of credit-risk management. Generally, signed master agreements are required prior to initiation of transactions. In cases where a continuing business relationship has not been established and master agreements have not been signed, "full" confirmations containing many of the provisions found in a master agreement are used. Master agreements usually include standard ISDA (International Swaps and Derivatives Association) and IFEMA (International Foreign Exchange Master Agreement) default clauses, supplemented with additional termination events covering the dissolution or liquidation of the fund, the resignation of the fund's general partner or principals, or decreases in net asset values beyond a certain threshold.

Information provided to counterparties

Banks and securities firms typically impose on-going financial reporting requirements on their hedge fund customers as part of their credit-risk assessment and risk-management process. Such reporting usually includes audited annual financial statements, quarterly financial statements, and monthly net asset value statements.

The variability of a hedge fund's financial position and risk profile, however, makes traditional tools of financial statement analysis less effective in assessing the credit exposure to a hedge fund. As noted in a 1994 Bank for International Settlements ("BIS") report on public disclosure of risks arising from trading activity, traditional accounting-based information is not alone sufficient to describe the risks associated with trading activity.11 That report emphasized the importance of information about the volatility of trading portfolio values, both retrospectively and prospectively, for assessing a counterparty's creditworthiness. While such information is produced by most risk-management information systems, the degree to which that information is drawn upon in reports to trading counterparties still varies widely.

Given the limitations of the typical financial statement for timely assessment of a hedge fund's trading risks, banks and securities firms supplement traditional financial analysis with occasional on-site visits and qualitative evaluations of the fund's risk management practices, trading strategies, and performance. Such qualitative evaluations, however, may not eliminate counterparties' need for better quantitative information.

Collateral practices

Because of the difficulties of assessing the creditworthiness of hedge funds, counterparties typically use collateral as a risk mitigation device. Generally, unsecured credit extension occurs only if sufficient information is available to assure the creditor that the borrower's credit risk is low. In practice, the degree of collateralization tends to vary with the creditworthiness of the borrower. For higher-risk counterparties, or counterparties for which credit related information is unavailable or too costly to acquire, credit exposures are more likely to be collateralized. A trading counterparty may be asked to post collateral if the current credit exposure rises, or if the creditworthiness of the counterparty deteriorates. In addition, collateral may be required to cover the potential future exposure either at inception or upon subsequent periodic review.

While collateral can mitigate credit risk in trading relationships, it does not eliminate it. For example, the liquidity support provided to a hedge fund may be withdrawn during periods of stress when it is most needed. This vulnerability of the fund, in turn, can affect other hedge fund counterparties, especially those that use collateral to control credit risk. In other words, the requirement to cover the mark-to-market exposure with collateral can foster a false sense ofsecurity because a hedge fund's ability to post collateral may evaporate, leaving the counterparty that relies on collateral with the unsatisfactory prospect of liquidating positions in a declining market. Thus, counterparties typically use collateral in conjunction with other methods of credit exposure management.

While collateral is now used to a greater degree than in the past, before last fall, greater competition for hedge fund business by banks and securities firms appeared to have loosened collateral terms and conditions. In many cases, banks and securities firms did not require collateral for potential future exposure. In addition, one-way collateral agreements in which the hedge fund was required to post collateral to the dealer, but not vice versa, gave way to reciprocal collateral agreements where either party could be required to post collateral, depending on the direction of the credit exposure. Such arrangements were typical only for the more established market participants.

More recently, because of the information problems associated with hedge funds and the volatility of hedge fund net asset values, banks and securities firms now usually require collateral on their exposures to hedge fund customers. Generally, collateral is required to cover the current credit exposure or current replacement value. Even though the option to make daily collateral calls exists, to reduce the need for frequent small transfers of collateral, some business is conducted on a loss-threshold basis under which additional collateral is not required until a certain replacement value amount is exceeded. The current exposure thresholds that trigger collateral calls are usually small, however, and current replacement values are generally well collateralized.

Credit limits

Credit limits on counterparty exposures are an important credit-risk management tool that serve to control credit-risk exposures through diversification. Like other sources of credit risk for banks and securities firms, credit exposures to hedge funds arising from both trading activities and direct lending are subject to credit limits. Credit limits may take the form of an overall limit across all product and business lines, and sub-limits may be applied at the level of individual products. Limits may also be applied at the industry level - for instance, to hedge funds as a group.

The size of a credit limit imposed by a creditor is based upon the counterparty's creditworthiness, and limits are applied to hedge funds as determined by an assessment of their relative returns and risks. The adequacy of spreads relative to the risks involved, compared to other business opportunities, plays a role in the dialogue between business units and the risk-management function in the setting of credit and trading limits.

The nature of the credit exposure, such as the maturity, or whether secured or unsecured, is also a factor in determining the size of a credit limit. In addition, when netting arrangements are enforceable, a credit limit may be applied to the net exposure as well as the gross amount. The metric in which the exposure is measured can be a nominal amount, the current market value,or a measure of potential exposure. Depending on the products comprising the exposure, the limit may be applied to a combination of all three measures.

Monitoring

Monitoring of credit exposures is an important part of credit-risk management. This monitoring may cover both an on-going assessment of the counterparty's financial condition as well as monitoring the status of the current exposure. The monitoring systems include on-going financial reporting requirements, as well as daily mark-to-market valuation of exposures.

The daily monitoring of exposures and the active management of exposure and collateral levels can help control the credit risk in a trading relationship. For example, some warning of problems may be inferred if a customer's ability to post collateral becomes irregular. Such procedures may identify potential problems, allowing timely adjustment of trading and credit limits, or in an extreme case, a more orderly unwinding of positions.

For the assessment of changes in the financial condition of a counterparty, monitoring of exposures provides only a partial view of a hedge fund's condition because a dealer's own transactions with the hedge fund might not reveal the fund's overall risk profile.

The LTCM Episode

A. Background

Long-Term Capital Management, L.P. ("LTCM") was founded in early 1994. Although LTCM itself is a Delaware limited partnership with its main offices in Connecticut, the fund that it operates, Long-Term Capital Portfolio, L.P., ("the LTCM Fund," or "the Fund") is a Cayman Islands partnership.12 LTCM sought to profit from a variety of trading strategies, including convergence trades13 and dynamic hedging.14 LTCM's principals included individuals with substantial reputations in the financial markets and especially in the economic theory of financial markets. From its inception, LTCM had a prominent position in the community of hedge funds, both because of the reputation of its principals, and also because of its large initial capital stake.

The LTCM Fund produced returns, net of fees, of approximately 40 percent in 1995 and 1996, and slightly less than 20 percent in 1997. At the end of 1997, LTCM returned approximately $2.7 billion in capital to its investors, reducing the capital base of the fund by about 36 percent to $4.8 billion. Despite this reduction in its capital base, however, the hedge fund apparently did not reduce the scale of its investment positions. Put another way, the managers of the Fund decided to increase its balance-sheet leverage by reducing its capital base rather than by increasing its positions.

Approximately 80 percent of the LTCM Fund's balance-sheet positions were in government bonds of the G-7 countries (viz., the United States, Canada, France, Germany, Italy, Japan, and the United Kingdom). Nevertheless, the Fund was active in many other markets, including securities markets, exchange-traded futures, and OTC derivatives. Its activity was also geographically diverse, encompassing markets in North America, Europe, and Asia. Specifically:

· The LTCM Fund participated in government bond markets, mortgage-backed securities markets, corporate bond markets, emerging bond markets, and equity markets. The LTCM Fund held long and short positions in these markets, and supported these positions in many cases through repo and reverse repo agreements and securities lending agreements with a large number of other market participants.

· The LTCM Fund took on futures positions at about a dozen major futures exchanges worldwide, including some very sizable positions. These were primarily concentrated in two areas - interest rate (including bond) futures and equity index futures.

· The LTCM Fund engaged in OTC derivatives contracts with several dozen counterparties. These positions included swap, forward, and option contracts, and were predominantly focused on interest rates and equity markets.

· The LTCM Fund participated in the foreign exchange markets to support its activities in multiple national markets. Although the Fund sometimes held open foreign exchange positions, it was not substantially engaged in efforts to profit from foreign exchange fluctuations.

· The LTCM Fund's involvement in the markets for physical commodities, if any, was negligible.

Overall, the distinguishing features of the LTCM Fund were the scale of its activities, the large size of its positions in certain markets, and the extent of its leverage, both in terms of balance-sheet measures and on the basis of more meaningful measures of risk exposure in relation to capital. The Fund reportedly had over 60,000 trades on its books, including long securities positions of over $50 billion and short positions of an equivalent magnitude. At the end of August, 1998, the gross notional amounts of the Fund's contracts on futures exchanges exceeded$500 billion, swaps contracts more than $750 billion, and options and other OTC derivatives over $150 billion.

Moreover, the Fund held large relative positions in several markets, such as in U.S. and foreign futures exchanges. For example, a number of the Fund's futures positions represented more than five percent of open interest, and in a few cases, well above ten percent. Relative to daily turnover in those markets, the scale of the fund's positions were even larger. In addition, the LTCM Fund also held very significant positions in specific securities.

With regard to leverage, the LTCM Fund's balance sheet on August 31, 1998, included over $125 billion in assets. Even using the January 1, 1998, equity capital figure of $4.8 billion, this level of assets still implies a balance-sheet leverage ratio of more than 25-to-1. The extent of this leverage implies a great deal of risk. Although exact comparisons are difficult, it is likely that the LTCM Fund's exposure to certain market risks was several times greater than that of the trading portfolios typically held by major dealer firms.

The LTCM Fund's size and leverage, as well as the trading strategies that it utilized, made it vulnerable to the extraordinary financial market conditions that emerged following Russia's devaluation of the ruble and declaration of a debt moratorium on August 17 of last year. Russia's actions sparked a "flight to quality" in which investors avoided risk and sought out liquidity. As a result, risk spreads and liquidity premiums rose sharply in markets around the world. The size, persistence, and pervasiveness of the widening of risk spreads confounded the risk management models employed by LTCM and other participants. Both LTCM and other market participants suffered losses in individual markets that greatly exceeded what conventional risk models, estimated during more stable periods, suggested were probable. Moreover, the simultaneous shocks to many markets confounded expectations of relatively low correlations between market prices and revealed that global trading portfolios like LTCM's were less well diversified than assumed. Finally, the "flight to quality" resulted in a substantial reduction in the liquidity of many markets, which, contrary to the assumptions implicit in their models, made it difficult to reduce exposures quickly without incurring further losses.

B. LTCM's Near Failure

On July 31, 1998, the LTCM Fund held $4.1 billion in capital, down about fifteen percent from the beginning of the year. During the single month of August, the LTCM Fund suffered additional losses of $1.8 billion, bringing the loss of equity for the year to over fifty percent. The Fund's capital base was now $2.3 billion, and LTCM reported to investors that it was seeking an injection of capital.

During the first two weeks of September 1998, concern about LTCM was a major topic of conversation in the financial markets. The LTCM Fund suffered substantial further losses and found it difficult to reduce its positions because of the large size of those positions. In addition, as its condition deteriorated, previously flexible credit arrangements became more rigid and thedaily mark-to-market valuations for collateral calls by counterparties became more contentious. These factors added to the liquidity pressures facing LTCM.

By Friday, September 18, these liquidity pressures, together with continuing declines in the Fund's capital, were causing serious concerns among the Fund's principals about the ability of the Fund to continue meeting its cash flow obligations in the event of further shocks to its market value. As LTCM's efforts to raise new capital remained unsuccessful, its condition was also a source of major concern to numerous market participants. These market participants were concerned about the possibility that LTCM could abruptly collapse in the very near term and about the consequences that such a collapse might have on what already were extremely fragile world markets.

By September 21, the LTCM Fund's liquidity situation was bleak. Bear Stearns, LTCM's prime brokerage firm, had required LTCM to collateralize potential settlement exposures, reducing the fund's overall liquidity resources. LTCM's repo and OTC derivatives counterparties were seeking as much collateral as possible through the daily margining process, in many cases by seeking to apply possible liquidation values to mark-to-market valuations. The cash-flow strains were raising the risk that the LTCM Fund would be unable to meet payments due at the end of September. Moreover, in the absence of additional injections of liquidity, further unfavorable market movements could have led to a default as soon as Wednesday, September 23. Thus, a very short period of time remained for the participants to explore resolution alternatives. While LTCM's plight had been known to some market participants to varying degrees, no one had as yet stepped forward to offer an alternative that would avoid a default.

The primary trading counterparties and creditors to the LTCM Fund were themselves the firms most exposed in a default scenario. These firms had played an important role in allowing LTCM to build up such large positions. The self-interest of these firms was to find an alternative resolution that cost less than they could expect to lose in the event of default.

On Tuesday, September 22, a Core Group of four of the most concerned counterparties began seriously exploring the possibility of mutually beneficial alternatives to default. The main alternative the Core Group focused on came to be known as the consortium approach and involved the recapitalization of the LTCM Fund through mutual investments by its major counterparties in a recently set up feeder fund and a relatively small investment in a newly set up limited liability company which became a new general partner of the LTCM Fund. Under this approach, the stake of the original owners would be written down to 10 percent and the consortium would acquire the remaining 90 percent ownership share, as well as operational control of LTCM.

Following lengthy discussions in the afternoon and evening of September 23, fourteen firms agreed to participate in the consortium. The Federal Reserve Bank of New York provided the facilities for these discussions and encouraged the firms involved to seek the least disruptive solution that they believed was in their own collective self-interest. The agreement was reachedonly after the firms involved became convinced that no other alternative to default was possible. The agreement followed the unraveling of a last minute alternative resolution which was presented to LTCM late in the morning of September 23. Another investor group had offered to purchase LTCM's portfolio, and at that time, all discussions related to the consortium approach were suspended. The consortium discussions reconvened only after it became clear that this alternative would not take place.15

The firms participating in the consortium invested about $3.6 billion in new equity in the fund, and in return received a 90 percent equity stake in LTCM's portfolio along with operational control. The responsibility and burden of resolving LTCM's difficulties remained with the counterparties that had allowed the hedge fund to build up its positions in the first place. The principals and investors in LTCM suffered very substantial losses on their equity stakes in the fund when their claim was reduced to ten percent.

C. The LTCM Fund Achieved Extraordinary Levels of Leverage and Risk

Assessed against the trading practices of hedge funds and other trading institutions discussed above - namely, mark-to-market, leverage, and active trading - and disclosure and monitoring requirements, the LTCM Fund stood out with respect to its opaqueness and low degree of external monitoring, and its high degree of leverage. At the time of its near-failure, the LTCM Fund was the most highly leveraged large hedge fund reporting to the CFTC. The combination of LTCM Fund's large capital base and high degree of leverage allowed it to hold more than $125 billion in total assets, nearly four times the assets of the next largest hedge fund. LTCM then faced severe market liquidity problems when its investments began losing value and the fund attempted to unwind some of its positions. The liquidity problems faced by LTCM were compounded by the large size of its positions in certain markets.

Although its mark-to-market valuations called LTCM's managers' attention to the Fund's problems well before the Fund's net worth was exhausted, individual counterparties - partly because there were so many - were not necessarily aware of the depth of LTCM's liquidity problems. Neither were the balance sheet and income statements that LTCM provided to its counterparties very informative about the Fund's risk profile and concentration of exposures in certain markets. This opaqueness of LTCM's risk profile is an important part of the LTCM story and raises a number of concerns regarding credit-risk management and counterparty trading relationships.

First, the LTCM Fund was able to acquire positions that proved large enough to strain its ability to manage the resulting market and liquidity risks. An issue here is whether the LTCM Fund's investors and counterparties were aware of the nature of the exposures and risks the hedgefund had accumulated, such as the Fund's exposure to market liquidity and funding liquidity risks. They almost certainly were not adequately aware since, by most accounts, they exercised minimal scrutiny of the Fund's risk-management practices and risk profile.

This insufficient monitoring arose, in part, because of LTCM's practice of disclosing only minimal information to these parties, information such as balance sheet and income statements that did not reveal meaningful details about the Fund's risk profile and concentration of exposures in certain markets. In LTCM's case, this minimal level of disclosure was tolerated because of the stature of its principals, its impressive track record, and the opportunity for the Fund's investors and counterparties to profit from a significant relationship with LTCM. LTCM's willingness to bear risk also made it an attractive counterparty for those firms seeking to hedge their own exposures. Thus, the main limitation on the LTCM Fund's overall scale and leverage was that provided by its managers and principals.

A related concern is whether the LTCM Fund's counterparties were lulled into a false sense of security based solely upon their collateral arrangements with the Fund. Counterparties' current credit exposures were in most cases covered by collateral. However, their potential future exposures were likely not adequately assessed, priced, or collateralized relative to the potential price shocks the markets were facing at the end of September 1998, and relative to the creditworthiness of the LTCM Fund at that time. Further, expectations about the ability to collect on collateral calls were probably unrealistic for an entity like the LTCM Fund, particularly in the market environment of last Fall. Thus, counterparties that were relying on variation margin to manage credit risk were left with the unsatisfactory prospect of liquidating collateral and closing out exposures in a declining market.

A further issue concerns the degree to which the management of credit risk in trading relationships should take account of the link between market risk, liquidity risk, and credit risk. The fall-out from recent market shocks shows the need to go beyond value-at-risk and potential future exposure models built only on very recent price data that may underestimate both the size of potential shocks to risk factors and their correlation. It appears that some of the risk models used by LTCM and its creditors and counterparties were flawed.

While nearly all major trading firms make use of risk-measurement models to estimate the amount of risk being assumed, the decision about how much estimated risk can be safely borne for each dollar of capital is one that depends ultimately on the judgment of the firm's managers. Although it is not known how large a margin of error LTCM's principals allowed for in their estimates of the risks they were assuming, it is clear that LTCM's models underestimated the risk they were taking and the effect of their own positions in markets. Prior to this episode, LTCM maintained that the LTCM Fund's positions embodied risk similar to that of investing in the S&P 500 index on an unleveraged basis but were essentially uncorrelated with equity returns. LTCM's creditors and counterparties may have accepted this contention or had risk models which produced similar results.

Although individual counterparties imposed bilateral trading limits on their own activities with LTCM, none of its investors, creditors, or counterparties provided an effective check on its overall activities. Thus, the only limitation on the LTCM Fund's overall scale and leverage was that provided by its managers/principals. From their perspective, the desire to maximize returns (and management fees) on each dollar of invested capital naturally created an incentive to increase leverage. In this setting, the principals, making use of internal risk models, determined the frontier for safe operation of the fund.

A point whose significance was apparently missed by LTCM and its counterparties and creditors was that, while LTCM was diversified across global markets, it was not very well diversified as to strategy. It was betting in general that liquidity, credit and volatility spreads would narrow from historically high levels. When the spreads widened instead in markets across the world, LTCM found itself at the brink of insolvency. In retrospect, it can be seen that LTCM and others underestimated the likelihood that liquidity, credit and volatility spreads would move in a similar fashion in markets across the world at the same time.

Moreover, not only did liquidity, credit and volatility spreads widen, but the liquidity of many markets dried up. This compounded the problem faced by LTCM's creditors, because a liquidation of LTCM's positions would have been disorderly and could have had adverse market effects on their positions and that of many other market participants. The possibility of this situation occurring was not fully considered by either LTCM or its creditors.

This raises the issue of how events that are assumed to be extreme and very improbable should be incorporated into risk-management and business practice, and how they should be dealt with by public policy. The risk management weaknesses revealed by the LTCM episode were not unique to LTCM and its creditors and counterparties. Financial market participants have made significant progress in recent years in strengthening risk-management capabilities. Nevertheless, as new technology has fostered a major expansion in the volume and, in some cases, the leverage of transactions, some existing risk models have underestimated the probability of severe losses. This shows the need for ensuring that decisions about the appropriate level of capital for risky positions become an issue that is explicitly considered; when outlier events are omitted from risk models, such decisions are made by default. While newer models are endeavoring to reflect such new realities more accurately and realistically, policy initiatives that are aimed at simply reducing default likelihoods to extremely low levels might be counterproductive if they unnecessarily disrupt trading activity and the intermediation of risks that support the financing of real economic activity.

The larger issue raised by LTCM is how to enhance the robustness of trading activity. Specific concerns include how to constrain the build-up of fragile positions with excessive exposure to risk without impeding trading activity that is needed to provide liquidity and absorb market shocks. Better credit discipline in trading relationships can help in both of these areas. First, improvement in credit discipline can prevent the build-up of large or concentrated exposures whose liquidation might destabilize markets, as appeared to have happened in the case of LTCM. Second, better information about counterparties can reduce the likelihood of surprises about a trader, and make a destabilizing pulling back by counterparties less likely. Beyond changes in risk appetites that cause investors to withdraw from markets, doubts about a trader's creditworthiness also can impair the trader's ability to continue trading during periods of market turmoil. Thus, greater confidence about credit exposures in trading relationships will strengthen the ability of markets to withstand shocks.

One consideration regarding the possible approaches to managing the credit risk problem is that each has different costs and liquidity implications for different types of traders. In addition, market participants also have diverse levels of creditworthiness. Thus, the costs and benefits of alternative credit-risk control arrangements are different across market participants, and such differences probably should be taken into account in policy initiatives.

D. Counterparty Losses and Market Disruptions That May Have Resulted from a Default of LTCM

A default by the LTCM Fund would have caused counterparties to move quickly to limit their exposures. These risk-limiting moves may have required the liquidation or replacement of positions and collateral in the many markets where the LTCM Fund held sizable positions at depressed prices. These very actions in a market that, last September, was already suffering from a substantial reduction in liquidity could have resulted in significant losses. LTCM itself estimated that its top 17 counterparties would have suffered various substantial losses - potentially between $3 billion and $5 billion in aggregate - and shared this information with the fourteen firms participating in the consortium. The firms in the consortium saw that their losses could be serious, with potential losses to some firms amounting to $300 million to $500 million each. Moreover, if the LTCM Fund had defaulted last September, the losses, market disruptions, and the pronounced lack of liquidity could have been more severe if not for the use of closeout, netting, and collateral provisions.

LTCM's trading activities and counterparties

LTCM's counterparties and the assets that they traded included the following.

Prime Broker. Like most hedge funds, LTCM centralized much of its custodial, recordkeeping, clearance, and financing services with a single firm. This bundle of services is typically referred to as prime brokerage and generally includes the following: providing intraday credit to facilitate foreign exchange payments and securities transactions; providing margin credit to finance purchases of equity securities; and borrowing securities from investment fund managers on behalf of hedge funds to support the hedge funds' short positions (thus allowing investment funds to avoid direct exposure to hedge funds). LTCM's prime broker was, and still is, Bear Stearns.

Futures clearing firms

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