Chapter 8
“The Fall”
The chapter begins with Russia declaring debt moratorium on
August 17th. The government basically decided to pay its own workers
rather than paying debt holders in the US. Several days after this, the rest of
the world started to feel its effects, turning investors to a panic and them
running from any sort of investment risk wherever it was. Swap spreads began to
rise sharply, and the surge in volatility cost Long Term tens of millions of
dollars. People were buying safe, low-yielding bonds and selling risky,
high-yielding bonds, and this pushed the spreads between these bonds even
wider.
Swap spreads reached records ranges, widening to ranges like
76 in May. The models Long Term were using assumed this could only happen once
like in 1987, but it was happening again. Because of Long Term’s level of leverage,
it was losing money wherever it looked. Nothing was going right, as even Long
Term’s safer bonds in Russia and Brazil were down. Long Term had calculated
with great mathematical certainty that it would not lose more than $35 million
on any single day, however it had just dropped $553 million, 15% of its
capital, on one day. In less than three months, it had lost a third of its
total capital.
Because of all these losses, Long Term’s leverage was
dangerously high. To reduce the risk, the partners had to sell something, and
now the question was what that something would be. Meriwether reached out to
George Soros to talk strategy. Soros agreed to invest $500 million at the end
of August if Long Term could raise an additional $500 million in time. Long Term
also turned to JP Morgan about strategies to salvage some of Long Term’s
positions. Mendoza, the Morgan vice chairman, offered another $200 million.
Something the models Long Term had been using had missed was
the liquidity in the credit markets. With everyone trying to get out at the
same time, there was no liquidity. Because of Long Term’s extreme leverage, it
was forced to sell. However, without buyers, prices run to the extremes beyond
the bell curve.
With few days to come up with the remaining $300 million to
match Soros’ investment, the partners persistently tried to meet with Buffett
who persistently declined to invest in Long Term. Aside from the fund, the
partners realized another problem was on their hands; LTCM’s cash flow. The
management company owed $165 million to a group of banks, and when they heard
of the fund’s poor performance, they thought they were entitled to demand
repayment. The management company didn’t have the cash, and was close to being
insolvent. If this became public, the firm and the fund would face a lot of
trouble.
The Long Term fund was also facing cash flow troubles. Bear
Stearns, the funds clearing broker, never signed an agreement so could stop
clearing trades whenever he pleased. Long Term was now at the mercy of Bear.
By the end of August, the fund came up short to meet Soros’
investment, and was left with only $2.28 billion after losing 45% of its
capital. The month experienced a kind of volatility that mathematicians thought
was unlikely to occur in the life of the Universe. Every bet for Long Term was
losing simultaneously and the fund was in terrible shape.
Questions
Ch. 8
- -How were Meriwether and Soros different in
strategizing?
- -In August, how did banks respond to their
clients’ mounting losses when bond trading all but vanished? What did the flow
of capital look like in this time?
- -What was unique about Vinny Mattone, the fund’s
first contact at Bear Stearns, and the way he saw the markets?
- -What was the relationship in this period between
the fund and banks?
- -How was this crash referenced in media outlets
and news?
- -How did the month of August end for the fund and
for the bond market as a whole?
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