Unwinding LTCM’s positions was the toughest risk management task of 1999, if not the decade. The oversight committee appointed by the consortium that bailed out the troubled hedge fund rose to the challenge

Long-Term Capital Management will close down completely this month, following a final payment of $925 million to the 14-bank consortium which took control of it 15 months ago. This final chapter in the extraordinary story of LTCM was only made possible by the skill of the oversight committee that acted on the consortium’s behalf.

On the morning of Monday, September 28, 1998, the six-man oversight committee, appointed by the consortium that had just bailed out LTCM to the tune of $3.625 billion, arrived at the hedge fund’s headquarters in Greenwich, Connecticut.

The committee consisted of Connie Voldstad, co-head of global debt markets at Merrill Lynch; Richard Stuckey, head of fixed-income derivatives at Salomon Smith Barney; and John Fullerton, an adviser at JP Morgan. Then there was Michael Allen, head of US risk management at UBS; Brian Leach, head of risk management for Morgan Stanley’s global fixed-income division; and finally David Rogers, head of equity risk management at Goldman Sachs.

None of the six exactly welcomed the assignment. “At the time we didn’t know what this role could be,” says Rogers. “If we’d known it was going to be a 14 or 15-month thing, we might have thought about it differently.” Nor could they expect much direct support from their parent firms, as all six were now behind a Chinese wall that limited how much information they could disclose to the outside world.
The immediate priority was to motivate the demoralised principals and employees of LTCM, many of whom had lost their entire personal wealth. Leach explains: “When you’ve got people trying to cope from minute to minute, it was critical to establish a sense of stability for the organisation.”

The consortium imposed tough conditions on LTCM. Rogers says: “According to the deal that was struck that weekend, we could have fired all the principals if we wanted to. We could have fired John Meriwether. But we acknowledged that they understood the positions, certainly initially, better than we did. So we needed them, we asked them a lot of questions and they helped us understand what the best route was, and then collectively we would make the hard decisions.”

During their first weeks at LTCM, the oversight committee was in crisis management mode. According to Leach: “The most immediate concern was obviously to maintain the funding capability of the institution. You have to be able to do that or you can’t open the next day. The next critical thing was to change the perception in the market-place. When we arrived here, the market thought that LTCM was going under, and potentially was going to have to disgorge a huge amount of positions.”

As LTCM’s near-collapse had been hastened by speculation against the fund’s positions, notably long-dated index volatility, it was vital that traders at other firms stopped thinking they could front-run LTCM. “The primary goal was to disabuse people of that notion,” says Rogers. Leach adds: “Any trader that thought they might be able to buy or sell a particular security from LTCM in a day or a month, in reality was going to have to wait much longer than that.”

It was a close-run thing. The oversight committee realised that it had less than two months until markets – at least those that were still trading – began to wind down for the holiday period at the end of 1998. According to Leach: “What we wanted to do was identify positions that were the most vulnerable from an overall risk standpoint, and try and make a reasonable dent in those risk parameters quickly.”

They almost didn’t make it. “We still had the bulk of the risk,” says Leach. “We obviously began cutting things as soon as we got on site and delved into things. But the position was still huge. And there was a lot of volatility based on us. People moving things around because they didn’t know if LTCM had a position in something.” Indeed, the capital provided by the consortium almost ran out completely. “We certainly had extreme swings in P&L during the entire month of October,” Rogers concedes. “We spent time thinking about whether we were properly capitalised. That issue was a strong incentive for us to keep focused on risk reduction.”

According to Leach, the committee realised that the sheer size of LTCM’s portfolio could work to their advantage: “We had a little bit of everything. So as long as something in the world was attractive we actually could be active that day.”

Two of LTCM’s positions were especially toxic to its risk levels: sterling swap spreads and short long-dated index volatility. Because LTCM had cornered the market in both areas, there was an acute liquidity problem. The solution was to hold regular public auctions to unwind the two positions. Leach explains: “Our thought was to provide disclosure, uniformity and regularity. The market already knew a lot about these positions, which were large, but the rumour mill thought they were probably even larger. So the way we could deal with that was to try and show a very orderly process, and hopefully the market could re-evaluate and re-price based on that information.”

Rumour mill
The intense level of gossip and rumour surrounding LTCM was a bugbear for the committee. For example, there was never any gold (or gold derivatives) held on LTCM’s books, but the committee had a hard time convincing the market. “We actually had somebody who said they knew we were lying,” chuckles Rogers.

There were many less-liquid securities in LTCM’s portfolio that didn’t lend themselves to the auction approach; in particular, single stocks (used for risk arbitrage and pair trades) and convertible bonds. Here, a case-by-case approach was used. “Most of the world’s securities industry was trying to call us and find out if there was something in the portfolio that might help them do their job,” says Leach. “There were times when we were able to agree on a trade that was very discreet.”

Apart from index volatility and sterling swap spreads, perhaps the largest single trade held by LTCM was its shorting of dollar swap spreads. Here, liquidity was not such a problem, says Leach. “Swaps are a core hedging vehicle for every fixed-income security in the US. It’s a very liquid market, so that’s an example of where we just chipped away and chipped away.”

However, LTCM’s swap positions – dollar-denominated and otherwise – had another feature that increased risk. To maintain secrecy, LTCM’s principals had always farmed different legs of a trade among different firms. As a result, when the consortium took over, LTCM had more than 60,000 individual positions on its books, of which 10,000 were swaps.

Much has been said about the fund’s $1.25 trillion off-balance-sheet notional derivatives positions. What does that number mean in terms of leverage? For corporate end-user transactions, which usually match some form of borrowing, swap notionals do not contribute to leverage at all. That is because the nature of the end-user indicates clearly to the dealer what the purpose of the swap is. In economics language, this is called signalling, and reduces risk.

Leach explains: “There is more signalling in a traditional corporate. Even in a bankruptcy, the corporate entity also shows directly what it’s managing. The swap notional is revealing in both cases. The notional in LTCM’s situation was probably not an issue as long as mark-to-market was being observed, but in a crisis situation, that changed dramatically.”

Why was LTCM so different? The splitting up of transactions gave individual counterparties a very distorted idea of what LTCM was doing, continues Leach. “One counterparty may have been nothing but long five-year swaps and another might have been nothing but short seven-year swaps, and that curve trade was unsettling to both of them.”

Leach believes that this surfeit of contracts greatly increased the perception of LTCM’s risk. “It may not add to the leverage of the overall fund, but I think it added to the leverage by counterparty,” he says. “The longs see only long exposure between them, the shorts see only short exposure between them. Everybody wanted a haircut because they only saw gross exposure, while internally we saw it as a net exposure. The leverage of LTCM overall was not the same as the leverage per counterparty. These aren’t additive.”

This perception was exacerbated by another habit of LTCM’s traders, which followed standard practice on the interbank market. When the fund chose to close out a swap position, rather than cancel the swap or sell it back to the dealer, it would instead enter into a reverse swap transaction that served the same purpose. Leach explains: “In a five-year swap example, the counterparty might have long five years, short five years and long five years, so net they were still long five years. In this way, LTCM still had thousands of other contracts that had nothing to do with the primary risk any more, but were still clogging the books.” Finding a solution to this problem came to be known as the swap project.

But it was no less urgent than other kinds of risk reduction done by the committee, explains Leach: “The day before the bailout, the individual counterparties looked at the leverage and were extremely concerned. The day after the capital came in, we had to be able to convince them we would try to get them to a better netted position. It doesn’t sound like a traditional risk management issue, but you can’t get from the portfolio LTCM then had to the portfolio we currently have without reducing that mountain of paper.”

Simply unwinding all the superfluous swaps in LTCM’s $1.25 trillion portfolio was not an option because of transaction costs, explains Rogers. “The bid/ask spread on 10,000 swaps could have cost a lot of money. It would have been very onerous to the fund.”

Counterparties
Instead, the committee embarked on a massive exercise. Most of the fund’s largest counterparties were also swap counterparties with each other, often with significant exposures. If such exposure could be paired up with an opposing trade that went via LTCM, and that opposing trade was then transferred away from LTCM into one directly between the counterparties, risk would be greatly reduced.

Leach explains why. “Pairing counterparties up obviously replaces LTCM with a different entity, and if they were happy with that entity, it would be a positive item. The perception of reduced risk helped the overall portfolio, because then people figured that if exposure had dropped in half, then maybe that meant we had half the position of something that had nothing to do with the swap project. They then saw the overall risk dropping.”

The advantage of this was that all the superfluous swaps in LTCM’s portfolio could be lumped together into single giant swaps that offset the exposure between pairs of counterparties. The result? Some of the largest individual swaps ever traded in the capital markets, with notionals of several hundred billion dollars. By December 1999, when the final repayment was made to the consortium, the 10,000 swaps on LTCM’s books had been reduced to just 50.

David Rogers (left) and Brian Leach of the
LTCM oversight committee

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