LTCM panic…

Panics are as old as markets, but derivatives were relatively new. Regulators had worried about the potential risks of these investive new securities, which linked the country’s financial institutions in a complex chain of reciprocal oligations. Officials had wondered what would happen if one big link in the chain should fail.

Ambitious target…

J. M.’s design was staggeringly ambitious. He wanted nothing less than to replicate the Arbitrage Group, with its Global reach and ability to take huge positions, but without the backing of Salomon’s billions in capital, credit lines, information networks, and 7000 emplyees. Having done so much for Salomon, he was bitter about having been forced into exile under a cloud and eager to be vindicated, perhaps by creating something better.

Start-up…

LTCM opened for business at the end of February 1994. Merilwether, Rosenfield, Hawkins and Leahy celebrated by purchasing a shipment of fine burgundies ample enough to last for years. In addition to its 11 partners, the fund had about 30 traders and clerks and $10 million with of SPARC workstations, the powerful Sun Microsystems machines favored by traders and engineers. Long Term’s fund raising blistz had netted !1.25 billion - well short of J. M’s goal but still the largest start-up ever.

odds of a Black monday…

The most obvious example was Black Monday, when, on no apparent news, the market plunged 23%. Economists later figures that on the basis of the market’s historic volatility, had the market been open every day since the creation of the Universe, the odds wold still have been against its failing that much on any single day. In fact, had the life of the universe been repeated 1 billion times, such a crash would still have been theoretically “unlikely”.

Philosophy…

A central tenet of the partner’s philosophy was that markets were steadily getting more efficient, more liquid, more “continuous” - more as Meton had envisioned them. With more investors hunting for mispriced securities and with market news traveling faster, it seemed logical that investors, would take less time to correct mistaken prices. And on most days, they probably did. An efficient market is a less volatile one (it has no Black Mondays) and from day to day, a less risky one.

Secrecy and leverage…

After the event, it was widely reported that Wall Street had somehow been ignorant of Long Term’s swollen total and leverage ratio. Merill Lynch would go so far as to state in a press release, “… this was the first time that we learned the overall size and scale of the positions and extent of leverage…”

bulging problem…

One could only say that it appeared to be growing very quickly - as were exposures up and down Wall Street. Almost imperceptibly, the Street had bought into a massive faith game, in which each bank had become knitted to its neighbor through a web of contractual obligations requiring little or no down payment.

Trust in modern finance and brains..

The supreme irony is that the professors were trying to deconstruct and ultimately to minimise risk, not - they believed - to speculate on overcoming it. In this, the fund was not unique. Long-Term was in fact the quintessential fund of the late 20th century - an experiment in harnessing the markets to the twin new disciplines of financial economics and computer programming. The belief that tomorrow’s risks can be inferred from yesterday’s prices and volatilities prevails at virtually every investment bank and trading desks. This was Long Term’s basic mistake, and its stunning losses betrayed the flaw at the very heart - the veyr brain - of moden finance.