A Retrospective on the Demise of Long-Term Capital Management

The 10th anniversary of the harrowing financial events of September 2008 is nearly upon us.  The anniversary will undoubtedly be marked by various retrospectives analyzing those events.  For a longer-term perspective, though, it may be helpful to consider another anniversary that will be observed in September 2018:  the near failure of Long-Term Capital Management, L.P. and its fund, Long-Term Capital Portfolio, L.P. (collectively “LTCM”) 20 years ago.  LTCM was the largest hedge fund operating in the United States and its brush with death provided a preview of some of the forces that would contribute to the near collapse of the U.S. financial system in September 2008.  In August and September 1998, as in September 2008, market fears were all consuming.  Secretary of the Treasury Robert Rubin was quoted at the time as saying that “the world is now experiencing its worst financial crisis in 50 years,” and Chairman of the Federal Reserve Board Alan Greenspan said that “he had never seen anything in his lifetime that compared to the terror of August 1998.”[1]  Ironically, the success of the U.S. authorities in minimizing the effects of the near collapse of LTCM and the effects of other market disruptions in the 1990s may have lulled the markets and the authorities themselves into a false sense of confidence in their ability to manage future crises.[2]

Significant failures in risk management by LTCM and, more important, by many of its large and sophisticated counterparties, were highlighted by the LTCM episode as were gaps in regulating certain financial practices and products such as over-the-counter (“OTC”) derivatives.  The events of September 1998 did not involve subprime mortgage-backed securities or credit default swaps, which were significant factors in the 2008 financial crisis.  Nonetheless, the events leading to the financial crisis in September 2008 suggest that important lessons from the LTCM case were not adequately internalized either by the market participants or by the regulators.  The problems identified in the LTCM case, which I discuss in detail in a recent article, all reappeared and were the significant factors in the 2008 financial crisis.

The first lesson from the LTCM episode was the realization that the financial difficulties of a large nonbank financial company could present systemic risk.  Previously, the concept of systemic risk and its corollary concept of too-big-to-fail had been analyzed in terms of banking institutions.  As the chairman of the House Banking Committee noted at the outset of the initial congressional hearing on LTCM, the rescue of LTCM was the first time that the too-big-to-fail doctrine had been applied beyond insured depository institutions.[3]  The systemic risk presented by the nonbank financial entities as exemplified by Bear Stearns, Lehman Brothers, and AIG would be at the center of the financial crisis in 2008.

The second lesson related to the risk presented by excessive leverage.  Virtually every analysis of the LTCM case concludes that the excessive leverage of LTCM through its balance sheet and off-balance-sheet exposures was a crucial factor in causing its near failure.  The issue of excessive leverage was not limited to LTCM or other hedge funds.  Other financial institutions in 1998 were as leveraged as, and in some cases, more highly leveraged than LTCM.  A report prepared by the President’s Working Group on Financial Markets on the LTCM episode observed that at the beginning of 1998 (before LTCM began to experience losses), LTCM had a balance sheet leverage of more than 25-to-1, which “implie[d] a great deal of risk.”[4]  The report further noted that at year-end 1998 the five largest investment banks had an average leverage ratio of 27-to-1.[5]  Excessive leverage in the financial system was seen as a major contributor to the 2008 crisis.[6]

The third lesson was a heightened appreciation for the liquidity risks presented by nonbank financial entities.  LTCM relied to a very significant extent on repurchase agreements (“repos”) to leverage its balance sheet.  The general fragility of short-term repo financing for nonbank entities like Bear Stearns and Lehman Brothers would come to be recognized in 2008.[7]  The LTCM story actually provides an interesting counterpoint on the use of repos.  To mitigate the funding risk from its heavy reliance on repo financing, LTCM chose to use term repos to fund most of its balance sheet.[8]  In contrast, excessive reliance on short-term repos such as overnight or open repos was a principal source of the liquidity problems at Bear Stearns and Lehman Brothers.[9]  This short-term funding strategy resulted in a so-called “run on the repo” during the 2008 financial crisis.  The regulatory response to the 2008 financial crisis has been to create incentives for regulated financial institutions to switch from overnight or open repos to longer term repos.  The use of term repos was a rare positive lesson from the LTCM episode, although even the use of term repos could not in the end protect LTCM from the deluge of collateral calls on its huge derivatives book.

The fourth lesson related to the risks presented by large off-balance-sheet exposures, particularly those created through OTC derivatives.  LTCM had an unusually large off-balance-sheet exposure, but in the run-up to the 2008 financial crisis other financial institutions did as well (with AIG’s exposure on credit default swaps perhaps the most prominent example).[10]  The United States General Accounting Office identified the OTC derivatives market as a possible source of systemic risk in a 1994 report.[11]  The LTCM episode appeared to represent an instance of systemic risk arising from a very large OTC derivatives exposure at a financial firm.  Nonetheless, efforts to regulate the OTC derivatives market were blocked by the enactment of the Commodity Futures Modernization Act of 2000 (the “CFMA”) at the specific request of the federal regulatory authorities.  The judgment reflected in the CFMA on the treatment of OTC derivatives would be revisited after the events of September 2008.

The fifth lesson related to a general lack of rigor in the risk management policy, process and procedures at LTCM and at many of its lenders and counterparties.  Although significant strides in counterparty risk management were thought to have been made by large banks and securities firms in the years following the LTCM episode, the Senior Supervisors Group reports issued in March 2008 and October 2009 found significant risk management failures at many of the largest financial institutions in the run-up to the 2008-2009 financial crisis.[12]  Federal Reserve Board Chairman Ben Bernanke would testify in 2009 that no episode in the financial crisis made him angrier than the fact that AIG was in effect running a huge unsupervised hedge fund in its Financial Products unit.[13]  Chairman Bernanke might have taken similar umbrage at the failure of the large sophisticated counterparties of AIG’s Financial Products unit to manage their exposure to AIG, just as the large sophisticated counterparties had failed to manage their exposure to LTCM.

The sixth lesson related to the deficiencies in the internal risk or VaR models used by LTCM and its counterparties.  The Basel Committee on Banking Supervision was in 1998 in the process of developing a new approach that would rely to a significant extent on the internal VaR models of the largest banks for determining their capital requirements.  The use of internal VaR models for calculating capital requirements would come to the fore again at the time of the 2008-2009 financial crisis.

The seventh lesson related to the potential systemic vulnerability created by the prospect of a mass close-out of derivative positions in the case of a default by a large counterparty, resulting in a fire sale of collateral supporting the derivative positions.  The rescue of LTCM by its counterparties was prompted by concerns among its largest counterparties about such a prospect.  This particular vulnerability arises from the exemption for a derivative counterparty from the automatic stay and other related provisions in the Bankruptcy Code.  These exemptions mean that a counterparty can, in the event of a default (or cross-default) by its counterparty, immediately close out the derivative transaction and sell the underlying collateral.  Intended originally to protect the non-defaulting counterparty, it would likely (by virtue of cross-default provisions) lead to a simultaneous close-out and fire sale of collateral by many counterparties.  This issue was encountered again in September 2008 when several large financial institutions like Lehman Brothers filed for bankruptcy or, like AIG, faced the imminent prospect of having to do so.

Aside from the enactment of the CFMA (which actually prohibited the regulation of OTC derivatives), no legislation was adopted in response to the problems identified in the LTCM episode.  Legislation in the form of the Dodd-Frank Wall Street Reform and Consumer Protection Act would have to await the events of 2008-2009 financial crisis.  Some observers might suggest that in 1998 we let a good crisis go to waste by not enacting any reforms.  We did not make the same mistake after the 2008-2009 financial crisis.

ENDNOTES

[1]      Michael Lewis, How the Eggheads Cracked, N.Y. Times, Jan. 24, 1999, https://www.nytimes.com/1999/01/24/magazine/how-the-eggheads-cracked.html.

[2]      See, e.g., Janet L. Yellen, Vice Chair, Bd. of Gov. of the Fed. Res. Sys., Macroprudential Supervision and Monetary Policy in the Post-Crisis World (Oct. 11, 2010), https://www.federalreserve.gov/newsevents/speech/yellen20101011a.htm (noting that the successes in managing the Asian financial crisis in 1997, the LTCM failure in 1998, and the stock market crash in the early 2000s may have contributed to a false sense of confidence among government authorities).

[3]      Hedge Fund Operations:  Hearing Before the H. Comm. on Banking and Financial Services, 105th Cong. 2 (1998) (statement of Rep. James Leach).  Prior to the LTCM episode, discussion of systemic risk and too-big-to-fail issues focused on the banking sector.  See, e.g., Richard J. Herring & Robert E. Litan, Financial Regulation in the Global Economy 95-107 (1995) (discussing systemic risk exclusively in the context of banking institutions).

[4]      The President’s Working Group on Financial Markets, Hedge Funds, Leverage, and The Lessons of Long-Term Capital Management 12 (1999).  In August 1998, following the Russian government default, LTCM suffered large losses, increasing its leverage ratio to 50-to-1, and by the end of the third week in September, further losses, increasing its leverage ratio to 130-to-1.  LTCM’s balance sheet leverage was compounded by its very large off-balance-sheet leverage achieved through OTC derivative positions.

[5]      Id. at 29.  The U.S. General Accounting Office in its own report on LTCM noted that in 1998 two of the largest investment banks had balance sheet leverage ratios in the range of 30-1 to 34-to-1.  U.S. General Accounting Office, GAO/GGD-00-3, Long-Term Capital Management:  Regulators Need to Focus Greater Attention on Systemic Risk 7 (1999).

[6]      See, e.g., Financial Crisis Inquiry Report, Final Report of the National Commission on the causes of the Financial and Economic Crisis in the United States xviii-xx(2011).

[7]      See, e.g., Gary B. Gorton, Slapped in the Face by the Invisible Hand:  Banking and the Panic of 2007 (May 19, 2009), https://ssrn.com/abstract=1401882.

[8]      Philippe Jorion, Risk Management Lessons from Long-Term Capital Management, 6 Eur. Fin. Mgmt. 277, 280 (2000).

[9]      See, e.g., Viral V. Acharya et al., Regulating Wall Street:  The Dodd-Frank Act and the New Architecture of Global Finance 319-320 (2011); Gorton, supra  note 7.

[10]     Financial Crisis Inquiry Report, supra note 6, at 139-142, 243-244 & 265-274.

[11]     U.S. General Accounting Office, GAO/GGD-94-133, Financial Derivatives:  Actions Needed to Protect the financial System 10-12 (1994).  This report actually occasioned a response by Professor Myron Scholes, a principal of LTCM and a recipient of a Nobel prize in economics for his work on the Black-Scholes model for pricing options.  See Myron S. Scholes, Global Financial Markets, Derivative Securities and Systemic Risks, 12 J. Risk & Uncertainty 271 (1996).  In his article, Scholes concluded that there was no empirical evidence to support “the conjectures that derivative contracts can lead to massive failures and create systemic risk.”   Id. at 285.  He was nonetheless prescient in identifying the scenario that would two years later lead to the collapse of LTCM:

Lack of liquidity or depth in markets can lead to the failure of financial institutions.  OTC-derivative contracts are illiquid.  There is not a developed secondary market for these derivatives, and it is virtually impossible to remarket esoteric derivative contracts, let alone to do so over a short time period.  In pricing OTC-derivative contracts, financial institutions must reserve capital or suffer large losses if forced to liquidate their positions over a short period of time.  That is, if the markets are illiquid, market-price spreads are likely to increase dramatically when many dealers are trying to reduce the size of their positions and all are on the same side of the market.

Id. at 279-280.

[12]     See Senior Supervisors Group, Observations on Risk Management Practices During the Recent Market Turbulence (March 2008); Senior Supervisors Group, Risk Management Lessons from the Global Banking Crisis of 2008 (Oct. 2009).

[13]     Economic and Budget Challenges for the Short and Long Term:  Hearing Before the S. Comm. on the Budget, 111th Cong. 19 (2009) (statement of Ben S. Bernanke, Chairman, Bd. of Gov. Fed. Res. Sys.).

This post comes to us from Paul L. Lee, of counsel to Debevoise & Plimpton LLP and a member of the adjunct faculty of Columbia Law School.