Re: [gang8] Re: Is this it? for the price TO THE HONOUR OF Alfred Nobel

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

LTCM did not survived.  The Fed imposed rescue allowed it to stay in business for
about an additional year to minimize distrubance to the market and to unwound its
derivative positions in an orderly manner.

On September 21, two days before the consortium agreement to rescue LTCM, the firm?s
NAV dropped to below $1 billion, with total assets above $100 billion. The firm was
leveraged more than 100:1. On September 23, capital adequacy was restored to the fund
by 14 banks, which invested $3.6 billion in return for a 90 percent stake in the
firm.  This allowed LTCM to unwound its derivative positions in an orderly manner.
It eventually paid back all the $3.6 billion, and disbanded.

John W. Meriwether went on to become a principal and co-founder of JWM Partners, LLC
("JWMP"), an investment management firm based in Greenwich, Connecticut. Mr.
Meriwether is the chief executive officer of JWMP and in that capacity is active in
all aspects of the firm's business  including trading, new investment and general
management.

JWMP and its wholly owned subsidiary JWM Partners (UK), Ltd. specialize in the
development and application of sophisticated financial technology to investment
management. JWMP currently has approximately $320 million under management.  A big
comedown from LTCM.

LTCM used industry-standard risk management methodologies, but put undue reliance on
value-at-risk numbers at the expense of stress testing. LTCM partners also admit the
firm badly misjudged market dynamics and liquidity issues, and failed to reduce the
firm?s risk in the wake of losses.

In January 1998, Long-Term Capital Management was of the world?s most respected hedge
funds.
During the previous year, the firm decided to return $2.7 billion to investors,
explaining that investment opportunities in its core relative-value market had
diminished. Many investors thought the explanation smelled like an excuse to push
them out.  They did not know how luck they were.

LTCM was perceived as the master of relative-value trading, which involves buying one
instrument
and simultaneously selling another. The theory was that the portfolio would make
money on the increase or decrease in the spread between the two positions and would
be unaffected by the absolute level of the instruments.

Like most players in the derivatives market, LTCM used a variety of risk management
techniques, including value-at-risk, stress testing and scenario analysis. VAR
analysis estimates the maximum loss that can be suffered at a certain level of
confidence, often 95 percent or 99 percent. VAR numbers are estimated using
historical information about volatility and correlation. The assumption is that the
future will be approximately like the past.

LTCM?s firm-wide VAR analysis analyzed the thousands of positions it held and
generated predictions about the daily profit-and-loss volatility it was likely to
face. During the beginning of 1998, LTCM managers say they carefully geared their
portfolios so that the daily firm-wide P&L volatility remained at about $45 million.

Risk managers were comforted by other statistics. According to LTCM models discussed
in the roadshow, a 10 percent loss in its portfolio was judged to be a
three-standard-deviation event?an
event that would occur once in a thousand or so trading periods. A loss of 50 percent
of its portfolio
was unthinkably high. According to one of its estimates, the firm would have had to
wait 10-to-the-30th days?several billion times the life of the universe?to experience
that kind of loss. By massaging the data, and applying other, more conservative
econometric techniques, it would have had to wait 10-to-the-ninth days.

Like most hedge funds, LTCM was prepared to adjust its portfolio risk when it
suffered losses. If it lost 10 percent in a particular month, it had to be ready to
take its risk down by an equivalent amount. If it lost another 10 percent the
following month, it had to be prepared to do the same thing again and again.

This kind of portfolio adjustment is necessary to avoid a phenomenon called gamblers
ruin. The goal is to bet a constant proportion of your total capital instead of
betting an absolute number. A gambler who starts out at the racetrack with $10 and
promptly loses $5 would bet $2.50 in the next race, and so on.

Although LTCM had presented itself as master of relative-value trading, it had
strayed into a number of other trading specialties that were not market neutral,
including risk arbitrage and emerging-market cash bonds. The firm also made big bets
that volatility in European and U.S. stock indices would return to normal levels.

In early 1998, however, most of the firm?s balance sheet was concentrated in
government and agency securities and reverse repurchase agreements necessary for its
core relative-value trading.  Most of the firms that engaged in these types of trades
at the time tended to buy lower-quality  non-government bonds and short
higher-quality government bonds. They performed this bond arbitrage by borrowing the
bond they were short in the repo market and lending the bond they were long. LTCM
also took positions involving the spread between off-the-run Treasuries (30-year
securities with less than 30 years to maturity) and on-the-run Treasuries (newly
minted 30-year bonds). Their strategy was designed to exploit the difference in
yields that resulted from differences in liquidity rather than differences in credit
quality.

 Most arbitrageurs who perform these strategies suffer from a critical weakness:
Although they may be able to borrow the bonds they need overnight, they have no
assurance they?ll be able to get them again the next night. The investor who loaned
the bonds one night might decide to sell them the next, forcing traders executing the
strategy to close out their positions. LTCM managers say they thought they had
eliminated the risks on the firm?s short bond positions. Instead of borrowing the
bonds in the repo market, LTCM used its clout with banks to secure long-term
financing of its short positions.

LTCM managers were also reassured by the presence of other participants in the
relative-value game. It put very little emphasis on what other leveraged players were
doing, because it assemed they would behave similarly to it. In other words,  LTCM
believed prices were not likely to fall dramatically because its competitors would
continue to see long-term values and hold onto their positions when markets got
rocky. Relative-value players often double-up on positions when prices drop on the
assumption that they will return to normal, and LTCM may have assumed that LTCM
competitors would buy aggressively instead of panicking during a market downturn.

LTCM managers say they were also reassured by the firm?s degree of leverage. Although
LTCM?s leverage ratio eventually reached 100:1, its leverage before the crisis was
about 25:1, with about $4.7 billion in capital and $125 billion in debt. In their
post-bailout presentations, LTCM partners compared the firm?s targeted 25:1 leverage
during that period to the 34:1 leverage common at securities firms and the 24:1
leverage common at money-center banks. According to another LTCM explanation, the
firm was trying to earn 1 percent on assets, leveraged 25 times, which would result
in a 25 percent return.

According to LTCM managers, the trouble began in May and June of 1998. A downturn in
the mortgage-backed securities market forced some key hedge funds to liquidate their
emerging-market
positions. Meanwhile, the Treasury bond market was rallying. That led to a general
widening of credit spreads that inevitably put pressure on relative-value strategies,
which are chronically short Treasuries.

LTCM was also feeling pressure on another front. During the same period, Salomon
Brothers was quietly closing down its proprietary trading business. LTCM knew that
Salomon was moving out of its positions, but misjudged the effect. LTCM may have
thought that other relative-value players would step in to buy Salomon?s positions.
Few did, and the positions held by both firms sank like a stone.

LTCM experienced a 16 percent drop in its net asset value during May and June 1998,
the first time it had experienced losses in two consecutive months. In a letter sent
to investors at the time, Meriwether reported that ?future expected returns are
good.? In the roadshow presentation, the firm explains that it began moving out of
positions in order to take the firm?s expected risk down from the $45 million-a-day
level closer to $34 million a day.

The firm admits, however, that in doing so it made a critical mistake: Instead of
taking every single  position down 15 percent, it decided that some of the
investments looked better than others, and took off the ones that looked the least
attractive. The least-attractive positions tended to be the more liquid investments
that generated modest returns. The highest-return trades, by contrast, were usually
the funkiest and most illiquid.

At first, however, everything seemed fine. The models confirmed that the firm?s
portfolio risk had been reduced from 45 percent to about 35 percent. The problem was
that the portfolio had become much more illiquid, and the LTCM models did not take
this into account. Reality inevitably caught up with the models. Instead of the $35
million daily P&L volatility the models forecasted, managers say daily volatility
soon reached $100 million and higher. Something was clearly wrong with the way the
firm was modeling its risk.

Then came August 1998, when the market moves were sharper than anything the firm had
expected. On August 17, Russia announced it was restructuring its bond payments?a de
facto default. The losses forced many investment banks, hedge funds and other
institutional investors to reduce their positions en masse. The flight to quality
boosted prices for Treasury bonds and sunk prices for lower quality bonds in an
unprecedented fashion.

Credit spreads had never moved so far so fast. The most dramatic manifestation of the
phenomenon was in swap spreads, which represent the differential in interest rates
paid by high-grade banks and Treasury securities. Swap spreads had never moved more
than two or three basis points in a two-day period. On the morning of August 21,
1998, they moved 21 basis points.

LTCM?s losses were breathtaking. On August 21 alone, the firm lost $550 million.

In late August, the fund found itself down 44 percent for the year, with more than 80
percent of its losses in its core relative-value trades. The models had judged that
kind of loss to be a 14-standard-deviation event, something that occurs once in
several billion times the life of the universe. But the event had occurred within
five years of the fund?s launch.

LTCM partners were particularly disturbed about their new leverage ratio. The losses
in equity had made the firm involuntarily overleveraged. But the partners had not
given up hope. Although the firm was undercapitalized, and involuntarily
overleveraged, the partners believed they would not be threatened by margin calls. On
top of that, they believed their trades looked great because, over time, the credit
spreads would have to return to normal. In the face of total collapse, they decided
to stick with their core strategy.

But something had to be done about the firm?s leverage ratio. It desperately needed
to get more capital to shore up its $100 billion in debt. With $2.3 billion in
equity, its leverage ratio was an abysmal 43:1. With $1.5 billion in fresh capital?a
total of $3.8 billion?the ratio would be a more respectable 26:1.

In some respects, raising that kind of money was not a preposterous dream. In 1997,
LTCM had forcibly returned $2.7 billion to unwilling investors. Now it wanted to
borrow some of it back. By this time, however, the firm?s P&L was moving $100 million
or $200 million a day. And as the losses mounted, the firm needed more and more
capital to survive.

The problem was timing. The $1.5 billion had to be raised during the last week in
August, a time when most of Europe was on vacation and most of Wall Street was in the
Hamptons. But the firm had no choice. On September 1, LTCM was scheduled to announce
its net asset value. Once it revealed it was down 50 percent for the year, the
financial world would rush to protect itself from an LTCM meltdown.

In retrospect, trying to raise $1.5 billion during that particular week seems
desperate, naïve or both.
In the course of begging from Wall Street, the firm was forced to reveal many of its
positions. And          the more people knew about LTCM, the more eager the market
was to protect itself from?and take
advantage of?an LTCM collapse.

LTCM became the victim of a classic squeeze by the arbitrageurs it competed with. The
drama of  Wall Street sharks eating one of their own is chronicled in Lewis? Times
article (Michael Lewis, author of Liar?s Poker). According to Lewis, many Wall Street
firms got out in front of LTCM?s positions and made bundles of money?including
A.I.G., which was trying to weaken LTCM?s positions so it could buy its portfolio on
the cheap.


When LTCM was started, the principals went to great lengths to lock up enough capital
to support their trading strategy. Yet they clearly failed to secure enough long-term
capital to get the firm through the summer of 1998. LTCM mistakenly assumed that its
principal liquidity risk would be from investor withdrawals following a big fund
loss, and protected itself by locking up investors? capital for years at a time. It
also assumed it could protect its short repo positions with long-term financing. But
in the end, the firm was brought down when a foolhardy bet on takeover stocks
triggered a gigantic margin call by Bear Stearns. Ultimately, the firm misjudged the
expected duration of trades and the financing that supported them.

If LTCM had less leverage and more capital, it may have survived. Instead of going
begging to Wall Street and revealing its positions, the firm could have simply
announced a 50 percent drop in NAV and waited until the market returned. In
hindsight, of course, the fund shouldn?t have given back that $2.7 billion in 1997.
Of course a lower leverage would have lowered LTCM's rate of return.

During the crisis, LTCM saw dozens of tantalizing trading opportunities it didn?t
have the resources to pursue. Since the bailout, many of the LTCM?s original
positions have turned into big money makers, and partners say there are still plenty
of opportunities to exploit. Although LTCM made some disastrous risk management
mistakes, the partners may have been right. On Wall Street, however, being right
doesn?t matter if you don?t have enough money. The final irony may be that Long-Term
Capital Management didn?t have enough long term capital.


As for Amartya Sen. the pro-democracy development theorist Amartya Sen claims that
democracy prevents famines:  "...in the terrible history of famines in the world, no
substantial famine has ever occurred in any independent and democratic country with a
relatively free press. We cannot find exceptions to this rule, no matter where we
look: the recent famines of Ethiopia, Somalia, or other dictatorial  regimes; famines
in the Soviet Union in the 1930s; China's 1958-61 famine with the failure of
the Great Leap Forward; or earlier still, the famines in Ireland or India under alien
rule. China,  although it was in many ways doing much better economically than India,
still managed (unlike India) to have a famine, indeed the largest recorded famine in
world history: Nearly 30 million people died in the famine of 1958-61, while faulty
governmental policies remained uncorrected for three full years. The policies went
uncriticized because there were no opposition parties in parliament, no free press,
and no multiparty elections. Indeed, it is precisely this lack of challenge that
allowed the deeply defective policies to continue even though they were killing
millions each year. The same can be said about the world's two contemporary famines,
occurring right now in North Korea and Sudan."
     Democracy as a Universal Value, Amartya Sen, 1999.

Sen's data (30 millon deaths) on China has since been proved wrong.  His
understanding of the famine during the GLF was also faulty.  China in 1966 was the
victim of a hundred year adverse climate cycle that brought three consecutive years
of exteremely bad harvest.  The US embargo against China prevented Autralia and
Canada, who were ready and willing to extend unlimited credit for grain to China, to
supply China with grain.  China has since adopted a national policy of maintaining a
three-year food supply reserve, which unfortunately China may discontinue after WTO
accession.

The rich democratic states had enough resources to feed all the people suffering
famine around the world: and they did not.  Structurally, they did not. Amartya Sen
does not regard this as a defect of democracy: indeed, he seems blind to the issue.
If opposition parties in parliament, a free press, and multiparty elections stop
famines, and the worlds richest state has all of these, then why are there still
famines on this planet?  By not asking that question, Sen was awarded a Nobel Prize.

In terms of inequality, it seems that a planet may be better off without any
democracies. Historically, the rise of democracies coincided with a period of
unprecedented global inequality. Supporters of the democratic peace theory imply
causal relations from this kind of simple correlation ("if there is no war,
then democracy caused the peace"). Similar conclusions can be drawn in connection
with these testable propositions, such as these about inequality...

Absolute global inequality between states, as the gap between the gross domestic
product (GDP) per capita in the poorest and the richest state, is greater since
modern democracies emerged relative inequality between states, as the ratio of per
capita GDP in the richest and poorest states, is greater since modern democracies
emerged statistical measures of 'national-income' inequality will show a greater
coefficient of inter-state inequality in the period of democracies (about the last
150 years) than before it inter-state inequalities of this kind are greater between
democracies and non-democracies, than within the group of democracies, or the group
of non-democracies.  It can be argued that democracy is a luxury that the rich can
afford only after they exploited the rest of the world.  Democracy is like table
manners of the bourgeoisie: it is a ritual of well being, not the root cause of well
being.

According to the most recent figures from the World Bank, about 2,8 billion people
have an
'income' of under $2 a day. Of these, 1,2 billion live on less than $1 a day. The
income ratio - of the
poorest 20 countries to the richest 20 - has doubled in the last 40 years. And for
that time at least, most of
these rich countries were democracies. There are a few rich non-democracies, such as
the United Arab
Emirates, and some poor democracies such as Cape Verde. But the correlation between a
democratic
regime and prosperity is now so strong, that some democracy theorists see prosperity
as a pre-condition
of democracy. Neoliberals claim a causal link in the other direction - "democracy
makes you rich". Perhaps - but the statistics suggest it does so by keeping others
poor.


Henry


kevin donnelly wrote:

> In message <002001c17aba$e87f7f20$0100a8c0@daastolcom>, Arno Mong
> Daastoel <am@xxxxxxxxxxx> writes
> >Michael,
> >A one hour program that I taped from Swedish State Television the other day, in
> >a serial on the Nobel Price, was on the price on economics.
> >Peter Nobel's efforts probably will not be successful because formally the price
> >is NOT a Nobel price. It is called a price TO THE HONOUR OF Alfred Nobel.
> >The program dealt mainly with the historical roots ands some of the winners.
> >On the negative side (in a critical light) was Friedman, who indirectly was made
> >a paranoid fool on the program (he claimed that Swedish teenage protesters were
> >hired by Moscow). The winners, and then losers of the LTCM (which went down in
> >the $ bill crash the year after) were also not the best decision.  In a positive
> >light was Gunnar Myrdal and  ...  that brilliant Indian guy on food and
> >poverty....
> >
> >Arno
> >
>  I thought LTCM survived.  Have I missed something?
>         Kevin
> --
> kevin donnelly
>
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