Buffett on LTCM

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.

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.

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?

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.

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.

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.

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”.

Why the hell are these banks making these loans to LTCM anyway? Just because they know the Gmen will bail them out if they go bad? When our non-profit borrows a couple mill, the bank makes us sign a covenant about the way we’re going to manage our money going forward.

Lowenstein also wrote that LTCM was so aggressive in negotiating rates/fees with its banks that no Wall Street firm had much incentive to step up to help LTCM when it needed time. He suggests that had the banks had been making more money off LTCM — had there been bankers/traders earning 7-figure bonuses off the business LTCM did with their banks — there might have been pressure from inside these banks to give LTCM some breathing room.

Anyone know how credible Lowenstein’s claim is?

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