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International Fixed Income

Topic 6B:LTCM

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(From last time)B. Peso Crisis

By the end of 1993, the MP traded at 3.1/$ and was overvalued by PPP measures (3.5-4.1). [Managed float].» Mexico’s international reserves surged towards 30bn by year-end.

» In March, these reserves dropped 10bn when presidential candidate Colosio was assassinated. Mexico’s reserves were almost completely depleted through November 1994.

» December 1, the new president, Zadillo, took office and shortly after devalued the peso, letting it float freely.

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Mexico’s International Reserves

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5

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15

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30

Jan-93

Mar-93

May-93

Jul-93

Sep-93

Nov-93

Jan-94

Mar-94

May-94

Jul-94

Sep-94

Nov-94

Jan-95

Mar-95

Reserves

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Mexican Peso

012345678

10/1

1/19

94

10/2

5/19

94

11/8

/199

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11/2

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1995

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1/31

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2/14

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2/28

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PESO

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Mexican Peso

012345678

10/1

1/19

94

10/2

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11/8

/199

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1995

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1/31

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2/28

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3/14

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3/28

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PESOBrady

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Cetes & Currency

0102030405060708090

0123456789

Cetes-91Cetes-182MP/$

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C. Russian Default

By June 1998, the stock market was at a two-year low; and the gov’t failed to collect enough funds from T-bill auctions to repay outstanding debt.

August was a bad month» 3-mth moratorium on debt payments» 50% devaluation of ruble» halting of FX trading» debt rescheduling that would lead to unprecedented losses

September» Liberal reformers resigned» Russian stock market dropped over 45%

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Ruble

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1/1/1998 1/1/1999 1/1/2000

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Russ. T-billsRuble/$

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Russia, $-denominated 3%, 2003

01020304050607080

4/3/

1996

10/3

/199

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4/3/

1997

10/3

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4/3/

1998

10/3

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1999

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4/3/

2000

Russia Bond

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Outline for LTCM lecture

Chronology of eventsReview one way of creating leverage in fixed income

marketsExamples

» Off-the-run versus on-the-run Trreasuries

» $ swaps versus Treasuries

» International government bonds

» International credit spreads

Summary

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Chronology

After being forced to leave Salomon in 1991, in wake of the Treasury auction rigging scandal, John Meriwether founded Long Term Capital Management in late 1993.

There was an exodus from Salomon during this period, giving LTCM (sometimes called Salomon North) a “dream team” of traders/researchers in the fixed income area.

LTCM’s “original” strategy was to take advantage of spreads between liquid and illiquid instruments in similar markets, and bank on a convergence of these securities - a so-called date with destiny. These strategies are highly levered because they are viewed as relatively riskless in the long run.

In their first (shortened) year (1994), LTCM earned 20%, with staggering returns of 43% and 41% (in 1995&1996). In 1997, their returns dropped to 19%, partly because they were getting to big to get the same levered returns. With amassed capital of $7 billion, they returned 2.7 billion to investors, leaving only the original investors and themselves. The size of their positions, however, were maintained.

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Chronology continued… Their trade positions had also ventured out of their usual “convergence” trades into other areas,

such as risk arbitrage, credit spread bets, emerging market debt, corporate bond spreads, etc… Also, in 1998, the partners bought an option from UBS, which in essence was structured such that

UBS got some equity but mostly provided a loan (which gave them temporary significant equity in LTCM, which would get bought out by the partners later). The motivation on LTCM’s part was tax driven.

In early summer,» LTCM reported its first losses to investors, primarily in the MBS area.» On July 17th, Salomon closed down its fixed income arbitrage group (to get out of that type of business);

this induced a price pressure effect which led to a further drop of around 10%.» On August 17, Russia defaulted on its debt, with an immediate flight to “quality”, i.e., to liquid instruments,

the opposite of LTCM’s trades.» On August 21, swap spreads moved 20 basis points (a normal move would be around 1-2bps). LTCM lost

$550 million.» On Sept. 2, Merriwether sent a letter stating the fund had lost $2.5 billion over the year (or 52% of its

value), with August producing $1.8 billion in losses.» Soon after that date, LTCM began to look for an infusion of capital, including meetings with Soros,

Robertson, Buffet, Goldman Sachs, etc...

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Chronology continued….

» In the third week of September, Bear Stearns (LTCM’s clearing agent) asked for $500 mm in collateral to continue clearing trades. On Friday, September 18th, with market conditions deteriorating, there was discussion about LTCM’s solvency.

» On Sunday, Sept. 20th,the NY Fed looked at LTCM’s portfolio and found that LTCM had over $50 billion of long-short positions in securities, notional amounts of futures contracts of $500 billion, notional swaps of $750 billion, and options over $150 billion. It was clear that LTCM failure would affect many counterparties.

» On Monday, Sept. 21st, they lost another $500 mm, half of it on short positions in long-term equity options. LTCM’s capital base was now only $600mm. In the evening, a consortium of banks and investment banks met to discuss what to do.

» On Tuesday, Sept. 22nd, Warren Buffet offered to buy the portfolio for $250mm, recapitalize it with $3 billion, with no management role for Meriwether. They had until 12:30pm to decide whether or not to do it. The offer was declined.

» That evening, an alternative plan was devised, which required 13 banks to put in about $250 mm each, and then to oversee the management of the portfolio. There would be no fire sale of assets. The existing investors, including the LTCM partners, would maintain a 10% ownership, or roughly $400 mm.

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Chronology continued… In the first two weeks after the bail-out, LTCM continued to lose money. There were even

rumors, false as it turns out, that the consortium was in trouble. By mid-November, markets had clamed down (e.g., Brazil did not default, the Asian crisis was diminishing, etc…), and the trades began to pay off.

By June, 1999, the fund was up 14.1%, net of fees, from the bailout date. Monies were gradually being paid back to the original investors and about $1 billion was returned to the consortium.

By December 1999, the fund was “officially” closed, with the consortium getting their money back, and Meriwether announcing a new fund, Relative Value, keeping just a few of the original Salomon Partners.

Who really lost ex-post?» The LTCM partners lost $1.3 billion, most of their stake in the fund.

» UBS lost $690 million, most of the value of their equity and the loan they had put in to the fund.

» Bank of Italy, Sumitomo Bank, and Dresdner Bank lost around $100mm.

» A number of investors lost money in the $25-50mm range, including Merill Lynch’s deferred compensation plan.

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The Repo Market

The repo market (along with bank debt) is the primary way institutions borrow/lend in fixed income markets. (we will discuss this market in depth in a few weeks).

Simultaneously borrow $X from the dealer to purchase securities, and then lend the same securities as collateral to the dealer.

Note that the haircut (i.e., margin) represents the dealer's protection against the collateral losing value.

Institution repays the dealer $X plus interest in return for the security. Institution bears market risk (credit risk aside).

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Example 1: Off- versus On-the-Run Treasuries

Consider the 6.125 11/15/2027 off-the-run Treasury versus the 5.5 08/15/28 on-the-run Treasury.

Characteristics of Bonds on 10/05/98

11/15/2027 08/15/2028

Yield 4.85 4.72

Duration 14.52 15.34

Convexity 317 347

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The Strategy

The basic idea of the strategy is to buy off-the-runs and short the on-the-runs. » Since their cash flows should be pretty similar, they should have similar

yields (because they are governed by the same discount rates). In fact, since the yield curve is upward sloping, the higher coupon bond (i.e., the off-the-run) should have a slightly lower yield as it relatively emphasizes earlier cash flows which are governed by lower rates.

This was one of the strategies of Long Term Capital Management, and, in fact, had been one for many years.

The coupon effect aside, the figure on the next page graphs the spread between the on-the-run and the closest off-the-run long-term treasury bond.

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Off- versus On-the-Run Spreads

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Basis Points

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Explanation

Historically, a 5 basis point spread was not unusual. The coupon effect aside, and assuming that any duration is hedged out in a portfolio context, this means that on every $1 mm invested, Long Term Capital was earning $5,000 for a .5% annualized return.» Now assume Long term Capital took a $1 billion dollar position on all the off-

the-run/on-the-run trades combined, but with only $10 mm of capital (i.e., 1% haircut).

» With $10mm capital, they expect to earn $5mm for a 50% annualized return.

What actually happened?» The spreads widened 12-14 basis points, perhaps a great long-term trade, but

giving a short-term mark-to-market loss of about 1% (after some calculations) of the $1 billion --- in other words, the entire $10mm capital invested.

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What happened after the bailout?

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Example 2: swap spreads

A plain vanilla interest rate swap is one in which you exchange fixed cash flows for floating-rate cash flows (often benchmarked against LIBOR (London Interbank Offer Rate, appropriate for A-rated London banks on their dollar deposits).

As we will learn about swaps later in the course, just realize for now that a swap has very little credit risk; so the fixed rate from a swap will reflect the par rate on Treasuries plus the curve of the LIBOR spread above Treasuries.

The figure graphs the swap spreads over the period.

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Swap Spreads

2yr 3yr 5yr 7yr 10yr 30yr0

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Maturity

Basis Points

8/148/2410/05

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The Strategy

One of Long-Term Capital's strategies was to be long swaps and short treasuries --- the thinking being that swaps spreads were going to tighten.

Over the weekend of August 21st-23rd, Russia essentially defaulted on its debt. The swap spread widened about 20 basis points during this period, which saddled Long Term Capital with substantial losses (as their positions were highly levered).

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What happened after the bailout?

2yr 3yr 5yr 7yr 10yr 30yr0

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Maturity

Basis Points

8/148/2410/0511/18

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Example 3: European convergence trade

With approach of European Monetary Union, one popular trade was to expect foreign gov't bonds to trade at similar yields, as their discount rates would eventually converge.

One popular one was to long Italian governments and short German government bonds, as Italian gov'ts were offering higher yields.

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Italian vs. German gov’t bonds

Term Structures on 8/14/98

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The Strategy

Rather than converging, the government bonds actually diverged in yields, leaving the highly levered Long Term Capital saddled with losses. In essence, their invested capital on these trades has disappeared.

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What happened after the bailout?

Term Structures on 11/18/98

1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr3

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Example 4: European credit spreads

As you’ll see later in the course, swap spreads represent the spread between future LIBOR (bank offer rates) and future T-bills. During the 1996-1997 period, UK swap spreads began to rise relative to German swap spreads. In other words, UK swaps (relative to their treasuries) were cheap compared to German swaps (relative to their treasuries).

LTCM went long UK swap spreads and short German swap spreads, betting they would eventually converge.

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Swap Spreads: UK & Germany

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UK spdGer. Spd

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Swap Spreads: UK & Germany

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Diff.

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Summary

In fact, we could have described relative trades in the Commercial Mortgage-Backed Securities market, the straight MBS market, the spread between corporate bonds and governments in various markets, Danish MBSs, risk arbitrage trades in the equity market, volatility trades (especially in the French stock market), etc... Nearly every one of the trades moved against Long Term Capital in the summer of 1998, with extreme moves in late August & September. As we have seen, leverage, while usually increasing the returns, can wipe out the capital quickly.