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Be Careful about Leveraging!

Long Term Capital Management (LTCM) is one of the most fascinating hedge-funds in the annals of finance. The hedge fund rose like a rocket before crashing back down to earth – with the impact of its collapse almost bringing down the entire financial system in the USA. $1 invested in LTCM at its inception on Feb 1994 would have turned into $4 by April 1998 before collapsing to almost $0.30 by Sep 1998.

How did the fund achieve such superhuman returns and then give it all back and more in a blink? The short answer: Leverage.

LTCM was founded by John Meriwether, a former vice-chairman of the investment bank Salomon Brothers that became part of American banking giant Citigroup. To bolster LTCM’s reputation, Meriwether got Robert C. Merton and Myron Scholes to join as partners. Merton and Scholes were Nobel prize winners and the Black-Scholes model for options pricing was actually named after Scholes, who helped derive the famous model.

The fund’s main trading strategy was arbitrage – taking advantage of price differentials between similar financial securities and derivatives that are trading at different prices. LTCM believed that the price differentials between similar instruments would eventually converge and they set up complex trades to take advantage of that convergence. Scholes’s and Merton’s academic training in the efficient market hypothesis also convinced them that these price differentials can only diverge up to a certain point before converging. .

Because of the minute nature of the price differentials, LTCM had to take on enormous leverage in order to make substantial profits from their arbitrage trading activities. According to Roger Lowenstein’s account of the LTCM saga, the hedge fund was levered 100-to-1 at its peak. LTCM had borrowed $100 for every dollar of asset it had!

LTCM became the envy of many financial institutions on New York’s fabled Wall Street from the day it started trading. Its meteoric rise and huge trade volumes made many banks willing to offer lucrative terms to LTCM for the fund to trade with them. This spawned an intertwined mess of complex financial contracts between the hedge fund and Wall Street.

All looked great for LTCM until May 1998 when it started suffering losses. The bleeding continued and peaked when Russia defaulted on its debt in August 1998. Many of LTCM’s trades unravelled around that period as the price differentials between the securities and derivatives widened, to levels that the fund thought were impossible. LTCM had to post collateral to keep their trades going but because of the extreme leverage they had, eventually found it impossible to do so. Ultimately, it was leverage that killed LTCM.

Because of the complex dealings that the fund had with banks such as Goldman Sachs and J.P Morgan, a bail-out of LTCM had to be orchestrated by the Federal Reserve Bank of New York to prevent a collapse of the financial system.

The story of LTCM is a reminder of how pride and leverage can combine into a toxic cocktail of financial destruction. It was a sad deja-vu for investors world-wide in 2007-2009 as the Global Financial Crisis was also largely brought about by highly leveraged financial institutions.

Closer to home, in Singapore, we see our banks like DBS Group Holdings (SGX: D05), Overseas-Chinese Banking Corporation (SGX: O39) and United Overseas Bank (SGX: U11) being prudent with leveraging their capital. These banks have Capital Adequacy Ratios (CAR) at least twice that of the Basel III minimum requirements of 8%. The CAR is a measure of the ‘cushion’ that a bank has for potential losses and the higher the ratio, the thicker the cushion. This also means that banks with a high CAR are leveraged by a smaller amount compared to those with lower CARs.

The local banks escaped the Global Financial Crisis of 2007/2009 relatively unscathed and even managed to post profits even as many of their western counterparts were deeply mired in red. Their experience showed investors they were generally leery of excessive leverage and overly-complex financial dealings – that’s the difference a relative lack of leverage and hubris can do.

Besides financial institutions, companies of all sorts can also run into trouble when their balance sheet becomes bloated with debt – just look at the experience of General Motors in 2007/2009, when they had to file for bankruptcy. Individuals pursuing risky investing strategies by taking on excessive leverage have also flipped belly up. Andy Zaky, an ex-hedge fund manager who invested in leveraged financial derivatives linked to Apple’s stock, is a good example.

Seth Klarman, president of Baupost Group – one of the best value investing firms out there with annualised returns of 20% per year since 1983 – once said, “Almost every financial blow up is because of leverage”. Leverage does not make a mediocre investment strategy good, all it does is to amplify its swings. Handle it with care.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.