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Buffett on LTCM
According to Warren Buffet the ill-fated Long Term Capital Management had made the right bets but didn't have the cash to stay solvent. Buffet wanted to step in and buy the firm but a holiday intervened. Thanks to Newmark's Door for the pointer.
...Warren wished that he had been able to buy LTCM’s positions when the Fed forced a resolution of the crisis that was crippling the government bond market.
The LTCM crisis was a ready-made example of Warren’s philosophy of buying firms when the economics was right, yet fear ruled the markets. He noted that “off-the-run” (non-benchmark) government bonds were selling to yield 30 basis points more than the “on-the-run” (benchmark) bonds that were maturing just six months later. He rightly claimed that this made no sense economically.
LTCM had taken a huge leveraged position in these bonds when the spreads were much smaller, but didn’t have the collateral to hold on to it when the spread widened. Buffett quoted John Maynard Keynes, who wrote in 1931 that “The market can stay irrational longer than you can stay solvent.” As the spread widened, Keynes’ dictum became devastatingly relevant for LTCM. But Berkshire, with its huge cash hoard, could withstand the pressure of even more market irrationality before the spread eventually returned to normal.
Unfortunately, Warren was never able to consummate the deal. He had been invited by Bill Gates to vacation in Alaska when the crisis broke and it was hard to negotiate such a deal on a cell phone... “Bill Gates cost me about $3 billion,” he shrugged.
Posted by Alex Tabarrok on April 4, 2007 at 07:04 AM in Economics | Permalink
Comments
surprising thing is that ltcm utilately didn't lose any money. it liquidated it's postions at profit or no loss. i read this in "when genuis failed". also puzzling is the fact that just how did the fed arrive at it's decision that an ltcm collapse would be a systemic risk. i have read many accounts of the ltcm saga but haven't found this point explained clearly.
Posted by: sa at Apr 4, 2007 7:58:00 AM
So, essentially, we can blame Bill Gates for the failure of LTCM?
Makes sense to me.
Posted by: Mike at Apr 4, 2007 8:26:15 AM
Isn't everything his fault?
Posted by: billb at Apr 4, 2007 9:00:49 AM
No mike, LTCM would have still failed. It is just that Buffet would have reaped the gain from buying the bonds rather then the NY banks that actually bought them. In either case LTCM was forced to sell the bonds at a loss. The difference between the discount that LTCM had to sell the bonds at because they did not have the liquidity to finance their position and the final price when the banks liquidated the portfolio is the profit the banks got and that Buffet desired.
LTCM still had the loses the "why genuis fail" article is in error.
Posted by: spencer at Apr 4, 2007 9:30:22 AM
It had the potential for systematic risk because LTCM was financing its leveraged position with bank loans. If LTCM had defaulted the banks would have had large loan loses that would have threatened their capital positions. Or at least others would have feared this and shut off the short term money market to these banks. The first market signal of bank liquidity problems almost always is an increase in short term money market spreads.
Posted by: spencer at Apr 4, 2007 9:36:47 AM
According to Roger Lowenstein's book, LTCM did approach Buffett about buying its risk arbitrage positions shortly before the fall, but Buffett turned them down, not because he didn't have time to consider it but because he said he no longer knew enough about those trades. The risk arbitrage positions were long positions that LTCM took in potential target companies--what Ivan Boesky traded in.
Obviously, these were much riskier than the spread trades.
Posted by: GMUSL Grad at Apr 4, 2007 9:37:02 AM
There's a reason the maxim "the market can stay irrational longer than you can stay solvent" exists. Because it's true. It happened to LTCM. Recently the same thing happened to Amaranth Advisors. Their trades worked out in the end, but they didn't have the capital to get to the "end". Being massively levered, in outsized positions, in deceptively illiquid markets, is a recipe for the mother of all margin calls. People extrapolate the abundant liquidity positions of today to tomorrow, and refuse or are unable to conceptualize a scenario where access to short term funding is cut off. Ultimately it's the margin clerks making that 3pm call each day that does in the levered speculator.
Posted by: joe at Apr 4, 2007 11:11:42 AM
Can someone explain what the risk was to the greater economy as a result of LTCM? What important
parts of the economy relied on LTCM's solvency?
Posted by: Person at Apr 4, 2007 11:36:48 AM
Can someone explain what the risk was to the greater economy as a result of LTCM? What important
parts of the economy relied on LTCM's solvency?
Posted by: Person at Apr 4, 2007 11:38:57 AM
And another mystery y'all can help me unravel is how to avoid double-posts.
Posted by: Person at Apr 4, 2007 11:50:07 AM
Person, I think its pretty much what Spencer said about the banking system.
LTCM's equity evaporates, then its the bank's capital at risk, then the
taxpayers. If a well functioning banking system is necessary for the
economy to function well then it was reasonable for the fed to conclude
that LTCM's meltdown posed a systematic risk.
I think that Joe has it right too. In the end traders were actively going
against LTCM's trades, even though the long-term fundamentals were on
LTCM's side. Well capitalized traders could bid up the price of already
overvalued "on the run" treasuries, for example, because they knew that LTCM
would soon be forced to buy them back regardless of the price. It was a
little like "buying the pot" in a no-limit poker game. Except you can't buy
the pot when Warren Buffet is at the table.
Posted by: Pat L at Apr 4, 2007 12:11:01 PM
Pat_L, what I'm not understanding is, I thought that the money for ordinary savings accounts had to be
in high-grade short-term loans (treasuries, CDs, commercial paper, etc.), i.e., not LTCM. The only
people investing in LTCM were people who could afford to lose, right?
Or not right?
Posted by: Person at Apr 4, 2007 12:16:10 PM
Person -- ordinary savings account are only a minor source of modern large scale bank capital.
The short term money market is much more important, at least at the margin.
Posted by: spencer at Apr 4, 2007 12:47:32 PM
spencer: Savings accounts are invested in the money market (which is the short-term high-grade loans).
Where is the capital for loans to hedge funds coming from? Who loses when they can't repay?
And if it's not immediately obvious in the answer to the previous question, why does that matter
for the broader economy?
Posted by: Person at Apr 4, 2007 12:58:35 PM
Person,
Read "When Genuis Failed" for the full version. It is an easy and informative read.
LTCM was leveraged 100 to 1 with the major Wall Street firms. If these firms would have gone under or perceived to be severely hobbled, there would have been a global liquidity crisis. Remember that there are only a few firms that are dealers for the U.S. government bond auctions. Without them, the U.S. government would not have been able to finance itself. That would be the worst of it, but they also provide liquidity for roughly 1/2 of the mortgage market, mergers and aquisitions, leveraged buyouts, IPOs etc. That is just in the U.S. I hope you get the idea.
Posted by: Patinator at Apr 4, 2007 1:20:46 PM
Because of their great reputations at the time and huge commissions, LTCM made very favorable financing arrangements with all the Wall Street firms, ie 100% leverage in certain cases. They also took a lot of steps to obfuscate their trading, trading with one bank and financing with another, so the bank that was financing might not know the status of the collateral.
It the assets go down in price and LTCM goes belly-up in a chaotic way, market participants might not know who which bank might get stuck with the bad collateral.
If you're a bank that did swaps with LTCM, you don't know if you should pay on a given day, not knowing if LTCM might go belly up and you won't get paid on your own leg. And of course LTCM probably needs that dough to pay someone else.
Now the rumors will start to fly that bank X got stuck with bad collateral and is not getting paid on its swaps and can't meet its obligations. Then people might not pay that bank until they get paid and that bank will not be able to finance its own positions and be forced to sell them at a loss, maybe even putting otherwise healthy institutions out of business, causing loss of faith in soundness of US markets and making it more costly for US companies to raise money (aka a market crash).
but of course panics are part of normally functioning of markets and governments have no business meddling in them :)
Posted by: curmudgeonly troll at Apr 4, 2007 1:29:43 PM
Patinator, I don't want to seem picky or obtuse, but what I'm hearing seems to be inconsistent, and your
last responses didn't answer my question. I asked: where is the capital for hedge fund loans coming from?
You say: Wall Street firms. I don't know what that means. There are many WS firms that do many things.
Surely you don't mean, when I tell my Schwab broker to buy 100 shares of XYZ, he takes the money, loans it
to Amaranth, and says, "Oh, Person won't know the difference, we'll patch it up in time, they're sure to
pay back and THEN maybe we'll get around to buying his XYZ." I think you mean that people put up capital,
specifically knowing it will go into risky loans. So, what does it matter if those people aren't repaid?
It's just like any other investment suffering a loss. No critical function is dependent on them being
repaid.
Your point about government bonds is, I'm afraid, laughable. You can buy bonds directly from the Treasury.
And even if not, do you really think the federal government would say, "Hm, our bond dealers are gone.
Guess we are incapable of borrowing money! Let's balance the budget." No. They'd find an easy workaround.
As for providing liquidity, again, I see an inconvenience, I don't see a crisis. They *currently* offer
the capital for M/A, mortgages, etc. So, people buying a house or considering a buyout have to wait a
little longer to come up with the money to be loaned. What difference does it make?
curmudgeonly_troll: same question. It doesn't matter that the bank is repaid; what matters is who is
ultimately extending the credit, and who relies on that person being repaid.
Posted by: Person at Apr 4, 2007 2:00:20 PM
So, instead of being a run on the bank, it was the bank on the run.
Posted by: Russ Nelson at Apr 4, 2007 2:16:00 PM
Person,
If you do not think that if the top firms on Wall Street each lost 90% of a large trade on their books (remember that we are talking about billions) all at the same time and there would not be a problem, you just won't get it.
Your knowledge of the way the Treasury works is laughable. Yes you can buy directly from the Fed, but please check out the following link for the purchasing limits for each security.
http://www.treasurydirect.gov/indiv/research/articles/res_invest_articles_purchaselimits_0406.htm
Do you think that China and Japan buy in $5 million increments per security each year? Laughable. Oh, the government will QUICKLY find a solution. Laughable.
Posted by: Patinator at Apr 4, 2007 2:57:22 PM
Person, regarding your question to me, I know that there are risk based capital guidelines for banks in the U.S, but I don't think that there is any regulation mandating that "safe" short-term money market instruments have to equal or exceed deposits. I think that deposits can be lent out as long as reserves and capital are adequate. Anyway, I don't know if the fed bailout of LTCM was a good thing or not. Maybe the cost in terms of creating moral moral hazard was too great. I just think that it was a tough call at the time when it looked liked a worldwide depression could be on its way. I'm not checking this thread again but feel free to e-mail if you like.
Regarding the second part of my earlier comment, I only used the treasury market as an example because it is mentioned in the post. That market is hard to move and I don't know whether traders went against LTCM in the treasury market. I have heard several credible sounding accounts of traders going against LTCM in other markets though.
Posted by: Pat L at Apr 4, 2007 3:11:18 PM
Savings accounts aren't especially invested in short term high quality stuff, they go into the usual pool of available cash that becomes all sorts of loans (commercial, real estate, Treasuries, ST stuff). They're backed by the overall assets of the bank.
Loans to LTCM came from big banks like Goldman, Citi, UBS etc. In addition they had swaps and similar net payment agreements with those banks, it's pretty similar to what occured with New Century last month, except the amounts were much larger (and the investment banks didn't know it at the time). Dollars to doughnuts LTCM (via repos) had AA or AAA credit before the panic hit.
In some sense you're correct Person, it shouldn't have been a crisis (after all the trades ultimatly worked out) but it was because in stress periods, assets aren't worth what they are under normal circumstances.
They had enough losses that I think one of the banks going to be stressed, and then you have the same run type behavior that results in other banks stoping trading with them, and they generally don't just let things wind down in that situation. The second half of the trader's axiom, "don't panic, but if you do panic, panic first!" would apply and suddenly the counterparties to that bank's other swaps would be demanding unwinding and more collateral (and then it sort of dominos from there).
Ultimately, the WS banks were the ones extending the credit, and almost every financial institution in the nation was depending on them being repaid because they were depending on other transactions with them.
Posted by: nelsonal at Apr 4, 2007 3:24:39 PM
Person,
I'm not trying to be glib, so excuse me if I'm oversimplifying here.
The way that LTCM threatened the financial system was the liquidity crisis that others have mentioned. This would happen if the LTCM went bankrupt, and the Wall St. banks were left holding the bag. What does this mean you ask? Imagine that Morgan Stanley has (these numbers are made up) 20B in equity (Assets - Liabilities) and that they have on the asset side of the books 10B in notional exposure, i.e. loans, to LTCM. Because LTCM negotiated such favorable financing rates with the brokers, collateral on hand against these loans would have been unimaginably small, we're talking basis points. So if LTCM goes down, Morgan sees a reduction in assets of 10B, no reduction in liabilities, and as a result, half their book value liquidated in a day. Now suppose that 20B in equity supported 540B in assets, a fairly typical leverage ratio for I-Banks. Well, now that 10B of equity has vaporized, and MS is supporting 530B in assets with just 10B in equity. It's now in violation of Fed capital requirements and will have to begin liquidating assets that it owns in order to raise capital and get back to a manageable level of risk. Now imagine that 10 of the largest financial institutions on the planet all saw their Shareholder's Equity cut in half (or some other large percent) and are all trying to liquidate assets at the same time. Where does the bid come from? Nowhere. Bonds quoted at par may now not be bid anything higher than 60-70. Not only will the banks all be selling at the same time to raise funds, but they sure as hell won't be providing liquidity into the marketplace; one of their chief functions in the capital markets. Warren Buffett calls it the daisy chain effect; effectively you are at the mercy of the weakest counterparty in a liquidity crisis.
Posted by: joe at Apr 4, 2007 3:31:00 PM
LTCM was a close call. That is exactly why the Fed arranged for private
institutions to buy the securities rather then doing it themselves. Technically,
the Fed did not bail out LTCM-- they just arranged it.
Posted by: spencer at Apr 4, 2007 3:31:11 PM
Joe,
What I first typed it out explaining it the way you did was just garbage. What I actually posted didn't give enought meat and probably confused people. You nailed it.
Posted by: Patinator at Apr 4, 2007 3:38:36 PM
joe, if what you've said is correct, I guess that clears up my confusion. I just didn't know that:
a) A low-yield savings account could, in effect, be so heavily leveraged.
b) Banks would put that much of their portfolio in one entity.
c) Bond prices could recede that far -- heck, if you had told me about a tripling of the effective yield
(or yield-to-maturity or whatever) on government securities, even I would have "helped out".
One final comment: People keep saying about how the yield spread on staggered securites is "stupid." But
it seems it can only be stupid if it can be arbitraged away. It seems that the answer to "why LTCM failed"
is the same as the answer to "why that spread exists".
Posted by: Person at Apr 4, 2007 4:03:03 PM
