Lessons from the Collapse of Hedge Fund, Long-Term

LESSONS FROM THE COLLAPSE OF HEDGE FUND, LONG-TERM CAPITAL MANAGEMENT By David Shirreff Barings, the Russian meltdown, Metallgesellschaft, Procter & Gamble, LTCM. These are all events in the financial markets which have become marker buoys to show us where we went wrong, in the hope that we won't allow quite the same thing to happen again. The common weakness, in these cases, was the misguided assumption that ‘our counterparty and the market it was operating in, were performing within manageable limits.’ But once those limits were crossed for whatever reason, disaster was difficult to head off. The LTCM fiasco is full of lessons about: 1. Model risk 2. Unexpected correlation or the breakdown of historical correlations 3. The need for stress-testing 4. The value of disclosure and transparency 5. The danger of over-generous extension of trading credit 6. The woes of investing in star quality 7. And investing too little in game theory. The latter because LTCM's partners were playing a game up to hilt. John Meriwether, who founded Long-Term Capital Partners in 1993, had been head of fixed income trading at Salomon Brothers. Even when forced to leave Salomon in 1991, in the wake of the firm's treasury auction rigging scandal (another marker buoy), Meriwether continued to command huge loyalty from a team of highly cerebral relative-value fixed income traders, and considerable respect from the street. Teamed up with a handful of these traders, two Nobel laureates, Robert Merton and Myron Scholes, and former regulator David Mullins, Meriwether and LTCM had more credibility than the average broker/dealer on Wall Street. It was a game, in that LTCM was unregulated, free to operate in any market, without capital charges and only light reporting requirements to the US Securities & Exchange Commission (SEC). It traded on its good name with many respectable counterparties as if it was a member of the same club. That meant an ability to put on interest rate swaps at the market...