Buffett on LTCM

by on April 4, 2007 at 7:04 am in Economics | Permalink

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.

1 sa April 4, 2007 at 7:58 am

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.

2 billb April 4, 2007 at 9:00 am

Isn’t everything his fault?

3 spencer April 4, 2007 at 9:36 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.

4 joe April 4, 2007 at 11:11 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.

5 Person April 4, 2007 at 11:38 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?

6 Pat L April 4, 2007 at 12:11 pm

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.

7 spencer April 4, 2007 at 12:47 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.

8 Patinator April 4, 2007 at 1:20 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.

9 Person April 4, 2007 at 2:00 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.

10 Patinator April 4, 2007 at 2:57 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.

11 nelsonal April 4, 2007 at 3:24 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.

12 spencer April 4, 2007 at 3:31 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.

13 Person April 4, 2007 at 4:03 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”.

14 nelsonal April 4, 2007 at 4:33 pm

Person,
Reguarding the final comment. Most of the hedge fund returns (and uncorrallation with the rest of the markets)come from things that normally provide a relativly small consistent return, but on a rare occasion produce a large loss. Andrew Lo wrote a paper on why equity metrics (alpha and beta) aren’t good at describing hedge fund risk profiles) because alpha and beta both look very good in the years where you have the small consistent returns, but fail to capture the shock events that wipe out hedge funds pretty rapidly.

It is stupid that identical treasuries one issued 3 months ago is worth less than one issued yesterday, but profiting from that stupidity means that in a liquidity crisis you have to retain some excess capital (equity) to survive. Until the event happens, you look dumb relative to your peers (who are maximizing leverage).

15 Bill April 4, 2007 at 8:17 pm

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.

16 nelsonal April 4, 2007 at 11:08 pm

Buffett runs an insurance company, their job is to write derivatives (insurance contracts). When he speaks out against OTC derivatives he has one goal casting a suspect eye on the market that directly competes with his business. For example, there isn’t much difference between a CDS and an insurance contract he writes, but insurance regulators require he hold a certain amount of capital, while the CDS writers just have to meet collateral agreements with their banks. Guess which one costs more.

Buffett wanted to buy because he knew that off the run Treasury bet was a good one once things settled down they’d go back to making money. In part because the counter bet trades would dry up with a deeply capitalized partner backing them.

17 Auto April 5, 2007 at 4:14 pm

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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