The failure of LTCM to some extent is similar to that of Enron (They suffered from the same mistakes). The table given below shows commonalities as well as differences:
Ineichen (Absolute Returns: The Risk and Opportunities of Hedge Fund Investing) writes: In terms of absolute wealth destruction LTCM was a minor glitch when compared with the collapse of Enron or some of the other corpaorate governance failures of 2002. <> The nominal annual return for the initial investor was around 18 percent in the case of LTCM but much lower for Enron. Most retail investors did not hold the stock from its launch inm 1972. Most investors had close to a total loss rather than a 1.8 percent nominal annual return (p. 78).
Some interesting LTCM-facts:
- Warren Buffett offered to bail out LTCM, an offer that was ultimately declined by LTCM. Why? Here is the story: "A group consisting of Warren Buffett’s firm, Berkshire Hathaway, along with Goldman Sachs and American International Group, a giant insurance holding company, offered to buy out the shareholders for $250 million and put $3.75 billion into the fund as new capital. That offer would have put the fund on a much firmer financial basis and staved off failure. However, the existing shareholders would have lost everything except for the $250 million takeover payment, and the fund’s managers would have been fired. The motivation behind this offer was strictly commercial; it had nothing to do with saving world financial markets. As one news report later put it: "Buffett wasn’t offering public charity. He was trying to do what he preaches: buy something for much less than he thinks it’s worth. Ditto for Goldman Sachs, which made tons of money dealing in bankruptcies, salvaging financially distressed real estate. . . . These folks weren’t out to save the world’s financial markets; they were out to make a buck out of Long-Term Capital’s barely breathing body." Had it been accepted, that offer would have ended the crisis without any further involvement of the Federal Reserve—a textbook example of how private-sector parties can resolve financial crises on their own, without Federal Reserve or other regulatory involvement." (Too big to fail?, Kewin Dowd, Cato Briefing Papers)
- Rahl (2000) elegantly used the term "iceberg risk" in connection with the lesson learned from LTCM. The visible tip of the iceberg (for example, the volatility of returns) is not necessarily a clear indication of the full risk (Ineichen p. 442). One of the hidden risks was liquidity risk, which causes losses when volatility increases. Traditional value at risk (VaR) methods assume that the fund is a price taker,; that is, it is not large enough to affect prices (Ineichen p. 235). MacKenzie (2004) writes: LTCM’s loss in August 1998 was a -10.5σ-event on the firm’s risk model, and a -14σ-event in terms of the actual previous price movements. ;-DDD
What I would like to know:
One the one hand, Ineichen writes on page 65 (without any further comment):
Leverage: <> The notional amount of LTCM's total over-the-counter (OTC) derivatives position was $1.3 trillion at the end of 1997 and $1.5 trillion at year-end 1998. As of December 1997, total swap positions amounted to $697 billion, futures to $471 billion, with options and other OTC derivatives accounting for the rest. The Bank for internatinal Settlements (BIS) reported the total swap market to be around $29 trillion at the same date. Hence, LtCM's swap positions accounted for 2.4 percent of the 29 percent of the $29 trillion swap market, and its futures positions for 6 percent of the $7.8 trillion futures markets. Only six banks had a notional derivatives amount above $1 trillion at the time. The equity capital was around $5 billion.
On the other hand, he writes on page 156:
...the gross notional size of the fund's off-balance sheet positions, was approximately $1.25 trillion. This figure, handed around broadly by the popular press, was practically meaningless. It simply summed the absolute values of the notional amounts of the contractual agreements and futures, even when their risks where offsetting. What matters was the toal risk of the fund.
And interestingly, in this RiskNews (incentives matter!) article on the LTCM collapse (lang: DE, Herdentrieb, R. Erben) the gross notional size of the fund's off-balance sheet positions isn't mentioned at all.
So was this a scary number or not (concerning LTCM and the economy)?
Ineichen (Absolute Returns: The Risk and Opportunities of Hedge Fund Investing) writes: In terms of absolute wealth destruction LTCM was a minor glitch when compared with the collapse of Enron or some of the other corpaorate governance failures of 2002. <> The nominal annual return for the initial investor was around 18 percent in the case of LTCM but much lower for Enron. Most retail investors did not hold the stock from its launch inm 1972. Most investors had close to a total loss rather than a 1.8 percent nominal annual return (p. 78).
Some interesting LTCM-facts:
- Warren Buffett offered to bail out LTCM, an offer that was ultimately declined by LTCM. Why? Here is the story: "A group consisting of Warren Buffett’s firm, Berkshire Hathaway, along with Goldman Sachs and American International Group, a giant insurance holding company, offered to buy out the shareholders for $250 million and put $3.75 billion into the fund as new capital. That offer would have put the fund on a much firmer financial basis and staved off failure. However, the existing shareholders would have lost everything except for the $250 million takeover payment, and the fund’s managers would have been fired. The motivation behind this offer was strictly commercial; it had nothing to do with saving world financial markets. As one news report later put it: "Buffett wasn’t offering public charity. He was trying to do what he preaches: buy something for much less than he thinks it’s worth. Ditto for Goldman Sachs, which made tons of money dealing in bankruptcies, salvaging financially distressed real estate. . . . These folks weren’t out to save the world’s financial markets; they were out to make a buck out of Long-Term Capital’s barely breathing body." Had it been accepted, that offer would have ended the crisis without any further involvement of the Federal Reserve—a textbook example of how private-sector parties can resolve financial crises on their own, without Federal Reserve or other regulatory involvement." (Too big to fail?, Kewin Dowd, Cato Briefing Papers)
- Rahl (2000) elegantly used the term "iceberg risk" in connection with the lesson learned from LTCM. The visible tip of the iceberg (for example, the volatility of returns) is not necessarily a clear indication of the full risk (Ineichen p. 442). One of the hidden risks was liquidity risk, which causes losses when volatility increases. Traditional value at risk (VaR) methods assume that the fund is a price taker,; that is, it is not large enough to affect prices (Ineichen p. 235). MacKenzie (2004) writes: LTCM’s loss in August 1998 was a -10.5σ-event on the firm’s risk model, and a -14σ-event in terms of the actual previous price movements. ;-DDD
What I would like to know:
One the one hand, Ineichen writes on page 65 (without any further comment):
Leverage: <> The notional amount of LTCM's total over-the-counter (OTC) derivatives position was $1.3 trillion at the end of 1997 and $1.5 trillion at year-end 1998. As of December 1997, total swap positions amounted to $697 billion, futures to $471 billion, with options and other OTC derivatives accounting for the rest. The Bank for internatinal Settlements (BIS) reported the total swap market to be around $29 trillion at the same date. Hence, LtCM's swap positions accounted for 2.4 percent of the 29 percent of the $29 trillion swap market, and its futures positions for 6 percent of the $7.8 trillion futures markets. Only six banks had a notional derivatives amount above $1 trillion at the time. The equity capital was around $5 billion.
On the other hand, he writes on page 156:
...the gross notional size of the fund's off-balance sheet positions, was approximately $1.25 trillion. This figure, handed around broadly by the popular press, was practically meaningless. It simply summed the absolute values of the notional amounts of the contractual agreements and futures, even when their risks where offsetting. What matters was the toal risk of the fund.
And interestingly, in this RiskNews (incentives matter!) article on the LTCM collapse (lang: DE, Herdentrieb, R. Erben) the gross notional size of the fund's off-balance sheet positions isn't mentioned at all.
So was this a scary number or not (concerning LTCM and the economy)?
Mahalanobis - am 2005-02-22 00:43 - Rubrik: economics
