Of LTCM and LOR...

Dad and Mum, got back my equity derivatives midterm today. I did well. So, don't worry, I'm not wasting your $$$ here. Hahaha! Anyway, been wanting to blog down one lesson I learnt from the market crashes of 1987 and 1998. Being a lazy bum, I'm just gonna post my answer to one of the midterm questions.

Zhaobin and David: Thanks so much for understanding when I had to cancel my trip to Penn because of this damn midterm. My good grade in this goes out to you dudes! Booyah! =) Good luck for applications! You guys deserve the good stuff.

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What can we learn from the experiences of LOR during 1987 and LTCM in 1998 about the behaviour of strategies that depended on liquidity during periods of market stress? Have other hedge funds experienced similar outcomes in the past 2 months? Be as specific as you can.

Strategies that depend heavily on liquidity during periods of market stress have shown to spark a vicious cycle of asset sell-offs and declining asset prices in the face of market illiquidity. Both LOR and LTCM were pioneers in the strategies they promoted to clients and investors respectively. While based on academically sound assumptions, it was recognized that both strategies required liquid markets to function properly. However, the issue of liquidity (or rather, the lack of it) was swept under the carpet as everyone was eagerly amassing fortunes through these “sexy” ideas. Unsurprisingly, their continued profitability soon attracted competitors who were eager to grab a slice of the pie.

Numerous firms running portfolio insurance programs utilized the same type of dynamic hedging strategies used by LOR, albeit with different clients. In LTCM’s case, hedge funds were set up to replicate their trading strategies, taking up identical positions as the revered fund. Both strategies were severely tested when faced with a plunge in investor confidence due to various events. The downturn in the market required portfolio insurers to short more futures in order to dynamically create a hedge against the drop in markets; while hedge funds in the vein of LTCM were required to stomach losses on a daily basis which led to them liquidating their positions in order to satisfy fund redemptions or settle the losses on their trades.

If one small portfolio uses a particular strategy, liquidity would not be an issue. However, there were many portfolio insurers and LTCM-like funds. Upon having to liquidate, they all had to offer lower prices in order to attract buyers. This resulted in potential liquidity suppliers (buyers) and investors being scared off by the higher volatility and wider spreads. When perceptions change, liquidity evaporates quickly. Indeed, the belief that one can safely get out of a “liquid” market is one of the great fallacies of investing.

This lesson went unlearnt. Banks like Citigroup and Merrill Lynch felt comfortable owning mortgage securities not because they knew anything about the underlying properties, but because the market for mortgages was supposedly “liquid.” (Each firm went on to write down the value of its mortgage investments by more than $40 billion)

More recently, illiquidity found a new victim in US hedgefund Ospraie Management LLC. Ospraie suffered due to a market sell-off and closed its flagship fund after suffering 38.59% losses this year. In a letter sent to investors the fund’s management said that the losses were primarily caused by a substantial selloff in a number of their energy, mining and resource equity holdings during a six-week period characterized by some of the sharpest declines in these sectors in the past ten to twenty years.