Posted on 01/05/2010 8:17:42 AM PST by FromLori
We agree!
Kind of pathetic ain’t it
And to make big money by handling money you often need a million dollars to make something decent off a small spread. Of course you borrow the money to do it
The Warning
At the time it was founded, LTCM was the biggest, most prestigious hedge fund ever created. The brainchild of John Meriwether, former head of bond trading at Salomon Brothers, it had two future Nobel Prize winners as partners, a staff of virtuoso traders and brilliant mathematicians, $10 million worth of fancy engineering workstations, and an initial capitalization somewhere north of $1 billion. It was the largest start-up hedge fund in history.
It was also one of the most successful. But LTCM didn't make its money by doing anything so crude as betting on things like the rise and fall of the stock market. In fact, like most big hedge funds, LTCM paid very little attention to stocks. The Dow Jones average might get all the attention, but Wall Street pros know two things: The market for debt is far larger than the market for equities, and it provides far more fertile ground for mathematical manipulation and epic profits.
But clever mathematics alone isn't enough to make Gatsbyesque fortunes. For that, you need to use leverage. You need to borrow other people's money. Lots of it.
It's easy to see why. A typical LTCM bet would start when someone noticed a spread that seemed a little out of whack. For example, two bonds might trade for slightly different prices even though they were nearly identical. So LTCM would go long in one bond and short in the other, essentially betting that the spread would narrow. Bond traders deal in basis pointshundredths of a percentage pointand a bet like this might depend on a spread of, say, 20 basis points narrowing to 10. That's a nearly invisible movement, and on a million-dollar trade it nets you a grand total of $1,000. Hardly worth bothering with unless you make it a billion-dollar bet instead. That's what LTCM did: It mastered a method that let it borrow huge sums of money practically for free and that turned thousand-dollar profits into million-dollar profits. Do that a few hundred times a year and you're talking real money.
But leverage is a harsh mistress: It allows you to make lots of money when things go right, but it also allows you to lose lots of money very quickly when they don't. And in 1998 things didn't go right. Spreads that were supposed to narrow kept widening, and LTCM was forced to dip into its own capital to pay back the huge short-term loans it had taken out to leverage its bets. Losses kept mounting, creditors called in their loans, and eventually everything came crashing down.
But a funny thing happened on the way to the crash: The New York Fed stepped in and arranged a bailout. Almost all of Wall Street's biggest firms participated, and they did so for one reason: The Fed convinced them that LTCM was too big to fail. An uncontrolled bankruptcy might set off a domino effect that could bring down dozens of banks. A few months later, an interagency report concluded, "The near collapse of LTCM illustrates the need for all participants in our financial system, not only hedge funds, to face constraints on the amount of leverage they assume." It was a bipartisan judgment, signed by Fed Chairman Alan Greenspan and by Robert Rubin, Bill Clinton's treasury secretary.
Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.