In the mid 1990’s one firm was dominating Wall Street with its great profits and Wall Street was jealous and wanted a piece of it. At the time the firm was called Long Term Capital Management and was one of the most successful hedge funds in the world. The firm has risen from a medium sized money management firm to controlling over $1 trillion in assets and for 3 years almost everything they did was profitable. A book written about the firm is When Genius Failed – The Rise and Fall of Long-Term Capital Management by Roger Lowenstien, Random House, NY, 200. In 1997 the firm had to force their original investors to take $2.7 billion or for every $1 someone invested they received $1.82 and still had their original investment. The firm was making a minimum yearly return of 25% and most years were better. The partners were on paper almost billionaires themselves.

After having winning days for four years and all that implies,  in 5 weeks starting in mid August of 1998 the money was gone, partly it was because the fundamental belief of the firm was markets are efficient machines. If they are efficient then they eventually return to normal and along the way securities are mispriced. If the models see the mispricing, options can used to make money when the securities go back to normal. The firm was one of the greatest users of options which implies a leverage and implies a method to calculate what level of volatility the market is was expecting. Long Term Capital Management used the Black-Scholes formula and the key element in pricing an option is the expected volatility of the underlying asset.

For years, Wall Street had loved leveraged, then when Russia defaulted on its bonds everyone ran to safety and while spreads did and always come back, the issue is when. Every flight to safety increased spreads which increased losses at Long Term. The model makers has missed the fact there was no liquidity in credit markets. When losses mount, leveraged firms must sell lest their losses overwhelm them. When a firm has to sell without buyers, prices run to the extremes of the bell curve. And rational people have to sell, they protect themselves at wait till the next time around.

Long Term Management rose similar to other firms people were dazzled by the partners’ reputation, degrees, celebrity and their very profitable performance. The firm tried to keep all its secrets and Wall Street allowed them access to credit so Long Term could leverage itself 30 plus to 1. The easy credit and the early days of making money in mispriced assets led to many others in the field doing similar things. Long Term leveraged itself so much it became the only player in the market and when that happens its it illiquid or can not sell. If the company is highly leveraged and illiquid it is playing Russian roulette for it must be right every single day or it is bankruptcy around the corner.

Another aspect the models did not take into account are traders are generally rational, they are impressionable and imitative; they run in flocks and retreat in hordes.

There was a belief that tomorrow’s risks can be inferred from yesterday’s prices and volatilities. Risk Management is an art not a science.

Linking to dividend paying stocks,  one aspect is the lack of leverage is expected. When you buy the companies you are expecting your dividends and over time the capital gains will increase your wealth but you have time on your side. With leverage sometimes it is very good and sometimes it is very bad particularly when you need money. Try to keep your leverage low, think longer term paybacks and read about leverage companies and try not to invest in them.

There are more questions than answers, till the next time – to raising questions.