The LTCM Crisis: Death by Derivatives
One issue we can look at that illustrates how such risks can congregate in a dangerous manner, is the Long-Term Capital Management (LTCM) crisis. This excerpt is from the Wizards of Money podcast series that came in the 2000s to assist activists decipher the world of finance.
It was published in the early 2000s (a few years before the Financial Crisis) and was a great series that was put out there to help the average person make sense of the Capitalist financial system.
“By mid 1998 LTCM had about $4 billion in equity capital and borrowed funds of about $120 billion, a hefty leverage of about 30 times. But, amazingly, that leverage was compounded further by another TENFOLD, by LTCM's off-balance sheet derivatives exposures whose notional principle amounted to more than another $ 1Trillion! To be clear, this notional principle does not represent the full amount owed to anyone but rather the full value of assets underlying various derivatives transactions. The biggest bet that LTCM had on its books in the summer of 1998 was to do with interest rates on underlying bonds. The biggest bet that LTCM had its money on was predicting that the difference between interest rates on risky bonds and interest rates on the safest of all bonds, US Treasury Securities, would go down in the near future.
But in August 1998 Russia unexpectedly defaulted in its domestic debt, causing the market to panic, sell off risky assets and rush into the safest investment - US Treasuries. This pushed up the price of US Treasuries and pushed down the price of riskier bonds which is the same as saying that interest rates on US Treasuries went down while rates on riskier bonds went up. That is, the spread between risky bonds and US Treasuries widened - exactly the opposite of the LTCM bets.
When you trade in derivatives and gamble that the price or rate on an underlying asset will move in a certain direction you are said to be "in-the-money" when the price of that asset is in line with the
direction of your bet. You are "out-of-the-money" when the price moves against the direction of your bet. Counter-parties see how much they are in or out of the money by marking their positions to market on a regular basis. If you are out-of-the-money your betting counter-party to your derivatives transaction, or your derivatives clearing agent, will call on you to deposit some type of collateral with them in line with the amount your bet is wrong or "out-of-the-money". This deposit serves as security toward you being able to settle the full transaction on the agreed upon date in the derivatives trade.
When the real world went in the opposite direction to the massive LTCM bets, LTCM counter-parties were getting worried about getting their money from LTCM, especially since LTCM was so highly leveraged. LTCM might be forced to liquidate its assets in a fire sale in order to meet margin calls triggered by their sudden slide out-of-the-money. Either they would have to sell off a massive amount of assets quickly to meet these large calls, or, if they couldn't do this they would default. Either way a chain reaction of panic would ripple through the markets.
Soon after the Russian default it became clear that LTCM's positions were such that it had now lost most of its equity capital in just a few days. Not only were its bank loans now at risk but if LTCM defaulted on meeting its margin requirements with derivatives counter-parties, all counterparties would have immediate claims on LTCM and its many derivatives positions would be shut down. This would
have sent a wave a panic through the derivatives markets because LTCM was such a big player, and this would probably bleed into most other major financial markets.
If LTCM had to liquidate assets to meet margin calls then, because of the size of the assets that needed to be sold, this massive sell-off would have depressed prices and caused panic, pushing asset prices down even further. In turn, this would have hampered LTCM's ability to meet its margin requirements, as well as its ability to repay the banks they borrowed their gambling funds from. Compounding these problems was the realization that many market players, including major banks and securities firms, made "copy-cat" bets and their positions would be further harmed by an LTCM fire sale.
The Federal Reserve Bank of New York intervened and called together a consortium of banks who were complicit in this hedge fund madness by both lending to LTCM for their gambling needs and by being major players in the unregulated OTC market themselves.
It was decided that the bank consortium would lend MORE to LTCM, by lending them the funds necessary to meet margin calls and prevent the massive panic that default and/or massive asset sales would have caused. The thinking was that these loans would tide over LTCM until its betting positions turned around, so the banks were thereby also participating in the gamble (even more!). And therefore, unbeknown to all of us, the public was also participating in the gamble. Who knows what would have happened if the betting positions continued to get worse? The banks, and therefore their depositors, would have been more and more on the hook for the LTCM gambles. But as things turned out, LTCM gradually came back into the black and, through the combined management of LTCM and the bankers, the LTCM gambles were eventually wound down in an orderly fashion and a financial catastrophe averted.
Interestingly the LTCM founders and some of its investors and creditors blamed the whole thing on a "distorted market".
Apparently their gambling was perfect except for these external forces.”