LTCM and the current financial crisis

I. Introduction

Long-Term Capital Management (LTCM) was an American hedge fund, which developed trading strategies in the 1990's. After many years of growth, success and triumph, this company collapsed amazingly in early 2000 and provoked a huge chaos in the financial environment. How did such a drama occur? What was the role of the financial authority regulation? ... Many questions occurred from that collapse. It appears that the financial system has not managed to cure from that incident and problems have not been resolved yet. In fact the current crisis emphasises the existence of many issues and problems in the banking system. After a brief description and analysis of LTCM collapse, the following report will aim to find out some similarities between that failure and the current crisis.

II. Description and analysis of LTCM bankrupt

A. A quick development to become a major actor within the financial industry
LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Among the directors of LTCM, there were also Myron Scholes and Robert Merton, who were both Nobel Prize in Economics. During the first years, LTCM managed to develop quite rapidly. Furthermore LTCM attracted plenty of investors by achieving amazing annualized returns of over 40% in its first years. LTCM hedge fund focused its business on trading strategies such as fixed income arbitrage, statistical arbitrage, and pairs trading, combined with a high leverage.

B. An amazing and unexpected failure, which generated a domino effect
However the dream of LTCM did not last very long. It turned out that their system was not that good. Their success was only a fiction; and reality finally occurred. That reality was very harsh! In 1998 LTCM indeed lost $4.6 billion in less than four months following the Russian financial crisis. Therefore LTCM suddenly became a sad example of the existing risk in the hedge fund industry. Finally LTCM hedge fund collapsed in 2000. This major failure then lead to a massive bailout by other banks and investment houses, which was supervised by the Federal Reserve.

III. Similarities with the current financial crisis: some reasons that lead to the failure

A. The danger of models based on mathematics
The failure of LTCM was devastating for many involved. In fact Merton and Scholes lost huge amount of money, but that is not all. Their theories were also quite damaged.
Both LTCM and the current crisis emphasise the existence of mathematical risk models. Although mathematical theories generate kind of a sense of security, reliance on these models should be limited. Perfect models do not exist; and actually it is not the role of models to predict exactly the future. Models should only be used to help take decision; nevertheless they should not be used systematically.
The problem is our brains are prepared for narrative, not statistical uncertainty. Therefore models are prepared to establish simplified stories to explain the complex reality. This is the message that Nassim Taleb try to transmit in his book “the black swan”. According to him, the truth is that bankers have no idea why stock markets go up or down. Their theories are grossly simplified, if not wrong! All the current theory is based on the normal distribution theory. However LTCM and the current crisis prove that finance is not governed by such a mathematical law. Exceptional facts are much more common than predicted by the normal distribution. Mr Talib calls these exceptional facts “Black Swans”. He therefore makes a reference to a 17th century philosophical thought experiment. In Europe all most of people only knew white swans, which made them believe that all swans are white, while black ones actually existed.Finally it appears that most of the big events in our world are rare and unpredictable. Therefore trying to extract generalizable stories to explain them is practically useless.

B. Lack of effectiveness from the regulation authority
Both crises emphasise the lack of regulation from the various authorities: Federal Reserve, bankers, rating agencies, charted accountants…

Alan Greenspan: is the myth declining?
Although the former chairman of the Fed has managed to become the genius of finance and the most important person in the world, it appears now that some specialists are criticizing his previous policy.
Greenspan was chairman of the Fed from 1987 to 2006...almost twenty years! During these years, he managed to build a wonderful reputation. He maintained the interest rates at a low level for a long while in order to boost the economy and avoid a recession. Thanks to this policy, Greenspan enabled USA to reach very high level of growth.
Some analysts criticize him regarding his policy. They claim current financial problems of USA are due to previous mistakes of Greenspan. According to them, Greenspan shouldn't have slashed interest rates to such a low level to avoid housing bubble.
On the other hand, Greenspan claims nothing can avoid a bubble.”Bubbles are unavoidable”. Fed policy is not the origin of this crisis...the bubble was a world phenomenon! By trying to avoid the housing bubble, Fed might have created a recession.
Bernanke, the new chairman of the Fed, has decided to defend Greenspan policy by claiming he would have done exactly the same.

Dangerous products allowed by regulation authority
Subprime loans are a very dangerous tool. They were provided most of time to “bad” customers, whose credit rating was under medium average. In fact these borrowers who did not qualify for loans from mainstream lenders. This phenomenon was widespread in the US, where about six million people who have no money have borrowed about 100% of the value of a house, right at the top of housing market which has since fallen sharply. These are the subprime borrowers. With subprime loans, customers pay only the loan's interests for a long while and then have to pay suddenly all the borrowed money. This is very risky... Furthermore these loans depended on the interest rates. As central banks raised their interest rates, it became harder and harder for customers to pay back their loans. A slowdown in the US housing market coupled with rising US interest rates have also hit the subprime system.
A lot of people have been unable to pay their debts. Thus banks lost huge amounts because of this risky tool. All the financial community is suffering from this incident. Banks are afraid and refuse to lend money each other. Thus Central Banks are now obliged to lend huge amounts to banks.

C. Do authorities have to rescue banks in trouble?
Some industry officials said that Federal Reserve Bank of New York involvement in the rescue of LTCM, 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.
In comparison central banks and governments are providing huge amount of money to help bank prevent from collapsing in the current crisis. Since the announcement of Northern Rock' crisis, the bank of England has already lend huge and impressive amounts to help this bank to survive. Similarly most of banks have received help. Only the giant Lehman Brothers did has not been saved by the authority. Was it a good idea for financial authorities to intervene in such a situation?
In short-run, a helpful policy enables financial authorities to avoid a crisis by rescuing banks in trouble. It helps bank's customers, who might have lost all their savings and also helps bank's employees, who may lose their job and thus increase unemployment rate.
Furthermore this policy avoids a domino effect, which could have drastic consequences on the financial community as a whole. Central banks may also intervene for personal reasons...pride and honour instead of rational and realistic judgment!
Fortunately authorities refuse to rescue banks sometimes. For example it happened in the UK, when Barings collapsed. Barings Bank was the oldest merchant banking company in London until its collapse in 1995 after one of the bank's trader lost $1.4 billion in speculation.
Let us move on to the reasons not to help. If a company has a harmful management, why should authorities help it? By rescuing such banks, authorities may appear weak and thus may encourage careless management.
Moreover by lending money to banks in trouble, central banks risk losing even more money in the future. Here is a big dilemma...a helpful policy may avoid the crisis in the short-run, whereas it might create a bigger one in the future. Financial authorities have to be credible. Thus banks would be aware of risks and that is crucial!

D. Stock Options: why might they be responsible of crisis?
Although the banking system is suffering huge losses similarly to the LTCM hedge fund at the time, most of directors still earn impressive wages, bonuses and other kind of inflows such as stock options payout! Therefore the public opinion is getting worse and worse with regards to this policy. As a result stock options are strongly attacked at the moment. People want this tool to disappear.
Stock options have been created originally in order to motivate managers to work efficiently. Their earnings were indexed to the company's shares value. Theoretically this tool was supposed to help all the stakeholders. Shareholders would eliminate the agency problem, which claims managers may not work for the benefit of shareholders. And Managers would have the possibility to increase their earnings.
However the real and effective impact of stock options is different. Managers use their insider knowledge for their own goals. They focus on short-run to maximise shares value and thus their earnings. Then just before bad news announcement, they sell illegally the shares. It is illegal because it privileges an investor over another and establishes asymmetric information. Thus stock market confidence goes down. This problem is not new. Previous financial scandals such as Enron emphasized it.
Finally financial failures may release the end of stock options existence. New French government intends to establish new rules to prohibit them and act to curb so-called “golden handshakes”

E. The crucial role of information
LTCM failure and the current crisis both emphasise the crucial importance of information. In fact it appears that both of these failures are the result of poor information flows. Therefore it might be useful to change the organisation of financial markets, in order to enable better information.
Nowadays world is organized around the concept of financial markets, which are a mechanism that allows people to easily trade. The appearance and development of these markets have given a crucial role to information.
In fact information has become a key tool in the current system. It enables people to get a knowledge of the market and thus to trade efficiently.
Most of time knowledge is not equal; some agents may have more information or maybe different information than the others. These problems of asymmetric and non perfect information may destroy the effectiveness of the market. Such inconveniences have been the origin of substantial researches in economics, like the market of lemons theory. Moreover this year, American economists received the Nobel price regarding their contribution to the establishment of a more efficient market.

Firms and investors are willing to pay huge amounts to get the best information possible. Thus they make a kind of intangible investment, as information is supposed to generate profits in the future. Information has become a quite valuable asset.
Another crucial point is the information flows speed. Time is important; those who get information first have a great advantage over the others. Sometimes a difference of only a few seconds can create a gap of millions pounds. As a result, companies need efficient system to spread and find information.

IV. Conclusion
The analysis of both LTCM and the current crisis emphasises some issues in the financial system. Several aspects of the banking system should therefore be modified. Although mathematical theories generate kind of a sense of security, reliance on these models should be limited. Perfect models do not exist. The systematic uses of normal distribution on financial markets lead to awful losses. Furthermore those failures also emphasised the lack of effectiveness of the financial regulation: rating agencies, charted accountants, audit... Also the organisation of financial markets does not enable good information flows. Finally the current crisis proves that the system did not change enough to prevent banks from collapsing like LTCM. Hopefully authorities will arrange a new and better organised system in the future.