Friday, February 6, 2009

Déjà vu

This story is about a organisation which was structured to look at potential mispricing in the bond markets in terms of spreads between 2 instruments and look at those spreads reaching the long term average. The organisation worked its models around bonds, mortgages, equities and derivatives across myraid asset classes. The organisation spearheaded extensive use of quant and modeling in bond trading.

The organisation worked on magnifying its return by taking enormous amount of leverage 30:1. In a 5 year tenure it delivered a return of over 40% per annum. However its enormous leverage in the derivatives market of over $1 trillion wend bad in a month when markets across the world collapsed with a correlation of 1 throwing all the models out of the window. So we reached the stage where the organisation was on the verge of bankruptcy and threatened to take the entire financial system down with them. The huge counterparty risk coupled with fear threatened to freeze markets across the globe.

The bankers of course rushed to the big daddy FED who promptly worked out a bailout package to save the organisation and the markets. And we all lived happily ever after or did we?

I m sure most of us will look at this and the names that will come to our mind are Lehman Bros, AIG, Citi etc

Well this was about a hedge fund called Long Terms Capital Management which went down under in 1998 before the bailout.

The fund was started by John Meriwether ex head of bond trading for Salomon Brothers where he was forced to resign after his top bond trader admitted to falsifying bids in the US treasury auction. J M managed to rope in Nobel price winners Robert Merton and Myron Scholes of the famous Black Scholes model as partners and the funds partners were positioned as a intellectual breed apart. I just finished the book When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein. Interesting read.

There is a strong sense of déjà vu that creeps in as you see the same cycle repeating itself bringing financial markets to a crisis and I can lay a bet that we will see it play out again. “We learn from history that we don’t learn from history” - I had earlier written a blog on this.

PS: Here’s the amazing follow up to the storyline - John Meriwether post the LTCM fiasco went on along with his colleagues to start JWM partners which floated a Relative Value Opportunity Fund where the fund document stated that it would keep its leverage down to 15:1.

The funds posted gains for several years, but in the first quarter of 2008 posted losses, of 31% in the flagship Relative Value Opportunity bond fund.

JM quotes “While we are clearly disappointed by our recent performance, we remain optimistic about the current opportunity set,".
"While we do not welcome the increased volatility in our returns, we believe that increased market volatility is one of the primary preconditions for creating interesting relative value situations," he added
And this was first quarter last year. Bond spreads kept widening significantly post that. History repeats.

1 comment:

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