How LTCM Enabled The Sub Prime Meltdown.

When Long Term Capital Management (LTCM) was bailed out by a consortium of Wall Street Investment Banks, most notably Lehman Brothers in 1998, was there ever any idea that singular bailout would set the stage for the biggest global market collapse just 10 years later? Would Lehman Brothers & Bear Stearns still be around? Would AIG be in its mess today? Would we have sidestepped the sub prime mess? Would we have controlled obscene risky behavior and over leverage if this hedge fund would have been allowed to fail? Was the bailout and rescue of this intertwined hedge fund coupled with its incestuous relationship with Wall Street one of the biggest undiscovered reasons for the current crisis we are in? Well First...some background.

LTCM was a Quantitative/Bond Arbitrage/Pairs Trading hedge fund founded by Former Salomon Brothers "Super Star' trader John Meriwether. Meriwether along with Michael Milken was the King of Bond Trading back in the 80's and 90's. He was a mathematical genius, a man who was able to figure out complex financial calculations (convexity/concavity/duration) in his mind. One of the reasons I choose the trader profession was because of this man. In short he was an absolute brilliant thinker and trader. Also employed at LTCM were Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences. They were enormously successful in their bond arbitrage/pairs trading strategy, racking up 40% annual gains even after fees, with out much risk at all except for the leverage. I was a young trader at Salomon Smith Barney's Mortgage Desk, and I executed trades for LTCM, personally speaking to Meriwether on occasion. They were always ahead of the curve, thinking 3-4 moves ahead of the general market. We all used to say, follow Meriwether then wait for bonus time. But the bottom fell out when Russia defaulted on their loan obligations and the subsequent fall out destroyed all of LTCM's exotic hedges and strategies. The company used complex mathematical models to take advantage of fixed income arbitrage deals (convergence trades) usually with U.S., Japanese, and European government bonds, as well as various interest rate swap and derivative trades. They used incredible leverage sometimes 100-1 to execute these strategies, when Russia defaulted, these trades/hedges were obliterated, causing the fund to lose much of its assets. But the potential backlash was much greater because of the excessive leverage, thus Alan Greenspan and the FRB negotiated the takeover of LTCM by a slew of Wall Street Investment houses. The total losses the fund reported was in the neighborhood of $4.6 Billion.

But how did this event lead or enable the current mess? The answer is Wall Street never learned from its mistakes in the LTCM debacle. They never curtailed their risk and leverage exposure. This entire sub prime mess had nothing to do with bad mortgages or people who couldn't pay their mortgages. The U.S. economy could have handled the mortgage mess on its own. It was the over leverage and side bets (CDO/CDS/SWAPS) that screwed things up. This was entirely a US Problem, the global economy would not have been hurt if it wasn't for the ludicrous securitization and reckless side bets that were made. The same exact behavior that was exhibited by LTCM in regards to leverage back in 1998. The subsequent bailout proved that in the end you can screw up how ever many times, show total reckless disregard for any type of fiduciary responsibility. If our strategy worked, we are truly great traders so pay us millions, if we are wrong, just bail us out. That is basically what Meriwether and LTCM ended up doing. That is the same greedy attitude on Wall Street today, with exponentially more leverage and far more catastrophic losses.

If LTCM had been allowed to fail, Lehman and the rest of the investment houses would've lost billions of dollars, severely hurting their stock prices, their capital would've been impaired, and it would've put a terrible crimp on Wall Street in regards to leverage and risk. It would've slowed them down for years. They would have learned that risk management and proper risk strategies would need to be implemented in the future so that something like LTCM would never happen again Instead of losing capital, losing assets, and losing incompetent people, they hired more incompetent people, increased the leverage exponentially, risk management went out the window. They learned that profits are earned in the private sector, but losses are subsidized by the public sector. They had a great strategy because the precedent had been set 10 years earlier. If the precedent of inflicting pain after incompetence was set previously, it would have greatly diminished the chances of bad choices later.

That is where we are and why we are here today because of the terrible short term and short sighted policies of always looking at short term trading profits.

The system cant keep on bailing insolvent institutions out, but there really is no alternative as the precedent has already been set time in and time out.