IS A HEDGE FUND?
|Explainer||Newspapers report that Long-Term Capital Management--the
high-profile hedge fund run by a hotshot bond trader and two Nobel laureates--nearly
plunged the world into financial ruin last week. And it's not just journalists
who say so. Intent on forestalling global financial disaster, a group of
big-money Wall Street banks convened by the Fed ponied up almost $3.5 billion
to bail out the fund.
What are hedge funds? Why are their meltdowns so spectacular?
A hedge fund is nothing more than a pool of money which a manager invests for a group of wealthy investors (minimum buy-in is often $10 million). Hedge funds promise an investment strategy that makes money when the market rises and when it falls. The hedge fund manager takes 15 to 20 percent of profits, the rest goes to investors. Sounds grand, but how does it work?
Long-Term's manager, backed by a star-studded research division, dealt in so-called derivatives. Derivatives are financial creations whose value is based upon, or derived from, the price of some underlying item, like stocks, bonds, commodities, or currencies. For example: stock options are a wager on the future price of, say, AT&T stock; commodity futures are a wager on the future price of, say, pork bellies. Both count as derivatives, as do more exotic creations like swaptions and quantos (don't ask).
Derivatives permit a fund manager to reduce certain kinds of risk. Suppose the manager is holding a portfolio whose value rises when interest rates rise but falls when interest rates fall. Adding an appropriate derivative--one which bets for an interest rate fall--to the portfolio mitigates losses if, in fact, interest rates fall. (Hence the name "hedge funds"--one investment position offsets, or hedges, another investment position.)
Of course hedge fund managers do more than just bet both for and against some outcome. At the end of the day, they must bet on something, right? It seems that Long-Term was betting on the yields of bonds from G-7 countries (no one is sure since Long-Term won't disclose details of its dealings). By analyzing historical data, Long-Term developed predictions about the relative rates of return on different countries' bonds. The firm used a series of hedges--which means buying derivatives--to make sure that they were insulated from general rises and falls in interest rates, stock exchanges etc... That's the beauty of hedging with derivatives--they let you bet on precisely what you want to. In theory, other perturbations are not supposed to affect your assets.
But something happened that the financial "rocket scientists"--so named because many have doctorates in math or physics--either didn't expect or couldn't conceive of. An article by MIT economist Paul Krugman considers just what might have gone wrong. (He thinks the rocket scientists were smart but naïve. In other words, their computer models didn't sufficiently account for extremely unlikely but extremely serious developments, like economic crisis in Russia and political gridlock in Japan.)
Krugman also thinks that investors were naïve
to believe that Long-Term offered return without risk. The chance of things
going wrong may have been slim, but when things went wrong, they went spectacularly
wrong. One key feature of derivatives is they can get you in a pot of trouble
very quickly. If you buy stock, and its price falls by 10 percent, you've
simply lost 10 percent of your money. But if, for instance, you buy a so-called
call option (which is a bet that the stock will rise) and the stock falls
by 10 percent, you may lose all your money. (A call option allows you to
buy the stock at a specified price, known as the strike price. If the market
price falls and stays below the strike price, then the option is worthless.)
There are even derivatives--such as futures contracts--with which you can
lose more than your original investment if you bet on the wrong horse.
No one but Long-Term really knows what Long-Term held, but the fund's asset
pool has reportedly shrunk to one-tenth the size it was in January.
(posted Thursday, Oct. 1, 1998)
|Rarely in the course of human events have so few
people lost so much money so quickly. There is no mystery about how Greenwich-based
Long-Term Capital Management managed to make billions of dollars disappear.
Essentially, the hedge fund took huge bets with borrowed money--although
its capital base was only a couple of billion dollars, we now know that
it had placed wagers directly or indirectly on the prices of more than
a trillion dollars' worth of assets. When it turned out to have bet in
the wrong direction, poof!--all the investors' money, and probably quite
a lot more besides, was gone.
But the really interesting questions are all about why. Why did such smart people--and the principals in LTCM are smart, even if some of them have Nobel Prizes in economics--take such seemingly foolish risks? Why did the world give them so much money to play with? As Akira Kurosawa could have told us, the beginning and end of the story are not enough: We need to know the motivations and behavior in between.
LTCM was secretive about how it made money, but the basic idea went something like this. Imagine two assets--say, Italian and German government bonds--whose prices usually move together. But Italian bonds pay higher interest. So someone who "shorts" German bonds--receives money now, in return for a promise to deliver those bonds at a later date--then invests the proceeds in Italian bonds, can earn money for nothing.
Of course, it's not that simple. The people who provide money now in return for future bonds are aware that if the prices of Italian and German bonds happen not to move in sync, you might not be able to deliver on your promise. So they will demand evidence that you have enough capital to make up any likely losses, plus extra compensation for the remaining risk. But if the required compensation and the capital you need to put up aren't too large, there may still be an opportunity for an exceptionally favorable trade-off between risk and return.
OK, it's still not that simple. Any opportunity that straightforward would probably have been snapped up already. What LTCM did, or at least claimed to do, was find less obvious opportunities along the same lines, by engaging in complicated transactions involving many assets. For example, suppose that historically, increases in the spread between the price of Italian as compared with German bonds were correlated with declines in the Milan stock market. Then the riskiness of the bet on the Italian-German interest differential could be reduced by taking out a side bet, shorting Italian stocks--and so on. In principle, at least, LTCM's computers--programmed by those Nobel laureates--allowed the firm to search for complex trading strategies that took advantage of even subtle market mispricings, providing high returns with very little risk.
But in the course of a couple of months, somehow it all went bad. What happened?
One version of events makes the principals at LTCM victims of circumstance. Their trading strategy, goes this story, was basically sound. But there is no such thing as an absolutely risk-free investment strategy. If the gods are sufficiently against you, if a peculiar, nay, unprecedented combination of events--debacle in Russia, stalemate in Japan, market crash in the United States--comes to pass, even the best strategy comes to grief. According to this version, there is no particular moral to the story, except that **** happens.
Most people in the investment world, however, are not that forgiving of LTCM. Their version of events does not accuse the principals of evil intent, but it does accuse them of myopia. The magic word is "kurtosis," a k a "fat tails." The story goes like this: Everyone knows that there are potential events that are not likely to happen but will have very big effects on financial markets if they do. A realistic assessment of risk should take into account the possibility of these large, low-probability events--in effect, should allow for the reality that now and then **** does indeed happen. But the wizards at LTCM, so the story goes, forgot about reality. They treated the statistical distributions found by their computers, based on data from a period when **** didn't happen, as if they represented the entire universe of possibilities.
As a result, they greatly understated the risk to which they were exposing both their investors and those who lent them money.
However, knowing the people who ran LTCM--who, to repeat, are as smart as they were supposed to be--it is kind of hard to believe that they were really that naive. These were experienced hands (not your typical 29-year-old traders, who don't remember anything before 1994). Anyone who has lived through energy crisis and debt crisis, inflation and disinflation, Reaganomics and Clintonomics, has to know that big surprises are part of life. Which brings us to the third, more sinister version of events: that LTCM knew exactly what it was doing.
Here's the way one investment industry correspondent--who prefers to be nameless--put it to me. Suppose, he says, that someone was willing to lend you a trillion dollars to invest as you like. What that lender has done is in effect to give you a "put option" on whatever you buy with that trillion dollars. That is, because you can always declare bankruptcy and walk away, it is as if you owned the right to sell those assets at a fixed price, whatever might happen in the market. And because the value of an option depends positively on "volatility"--the uncertainty about the future value of the underlying asset--the rational way to maximize the value of that option is to invest the money in the riskiest, most volatile assets you can find. After all, it's heads you become wealthy beyond the dreams of avarice, tails you get some bad press (and lose the money you yourself put in--but when you are allowed to make a trillion-dollar gamble with only $2.3 billion of your investors' capital, that hardly matters). And as my correspondent reminds us, the people who ran LTCM understood all about this sort of thing--indeed, those Nobel laureates got their prizes for, guess what, developing the modern theory of option pricing.
This "moral hazard" version of the story may seem a bit too stark to be believed. Did the managers really sit around saying, "Hey, let's gamble with the money those suckers have lent us"? Actually, it's a possibility: I don't know any of the LTCM players personally, but some of the hedge fund types I do know are, as my correspondent puts it, "about as moral as great white sharks." But anyway, never underestimate the power of hypocrisy. It is entirely possible for a man to act in a crudely cynical way without admitting it even to himself. Given their enormous incentive to take improper risks, it would actually be amazing if the managers at LTCM didn't respond in the normal way.
But we are still not quite there. For the remaining puzzle is why the world provided LTCM with so much money to lose. All those clever strategies depended on counterparts--on people and institutions who would provide cash now in return for the promise of German bonds, or whatever, later.
Why were those counterparts so willing to play along? (LTCM, as a matter of principle, refused to divulge its assets or strategy--so anyone who entered a contract with the firm was accepting an unknown risk.) Were these counterparts--mainly big banks and other institutional investors--simply naive?
Some of my correspondents say no. They think the big boys knew the risks but believed that if LTCM came to grief its creditors would be protected from loss by the government. In effect, they believe the LTCM story is mainly an updated version of what happened to the savings and loans, in which government guarantees underwrote an era of high-rolling risk-taking. True, there is no formal guarantee. But they believe that there was an implicit understanding that any major financial institution is simply "too big to fail."
But I don't buy it. Economists often make the working assumption that the private sector always knows what it is doing, that markets do stupid things only when the government gives them distorted incentives. It's a useful working assumption, but it is no more than that. In fact, everything I can see suggests that the big boys really were naive--that, star struck by LTCM's charismatic leader and his prestigious team, they failed to ask even the simplest questions (such as, "How much money have you borrowed from other people?")
Of course, if you believe that big, supposedly sophisticated
players can be that foolish--or, for that matter, if you believe that they
are not foolish but do foolish things because the government will always
bail them out--you start to wonder whether our whole financial structure
is as sound as we like to imagine. Did somebody say "crony capitalism"?
October 12, 1998
The big hedge-fund bailout helps some fat cats, but makes our
By Allan Sloan
The collapse and rescue of the biggest hedge fund in the United States
Then came the imminent collapse of Long-Term Capital Management
It may even be that the fund's managers outfaced a team led by Warren
How on earth can anyone justify bailing out rich managers and rich
And make no mistake about it: hedge funds are a nob's game. They're
When the government orchestrates a bailout of such an outfit, it's
Let's start with the offer faxed to Long-Term Capital on Sept. 23 by a
Buffett wasn't offering public charity. He was trying to do what he
The reason Long-Term Capital was in such dire straits was the financial
The enormous buying pressure on 30-year Treasuries made those bonds
If Long-Term Capital had not hocked itself to the eyeballs, it would have
We'll skip some of the gory details. Suffice it to say that Long-Term
By late September, the fund's lenders figured out something was wrong,
The new investors are also paying them a fee of 1 percent of assets a
Last week, for the first time in years, a Greenspan congressional