19 Years-Long Term Capital Management

In the late 90's it seemed that almost nothing could derail the stock market locomotive. Even the Kosovo War fought between NATO and what remained of Yugoslavia failed to put a dent in the market's money machine. The advances in productivity and creativity as then promised by the internet had become that era's golden goose. Whole industries and companies that had started for almost nothing {businesses which had been tracked out on the blackboards and spreadsheets in the back alleys of Silicon Valley} were brought public with market caps in the billions of dollars, making instant millionaires out of those that spawned them. Corporate America was on a mad spending binge to outfit itself with this latest technology and to prepare for what was widely feared to be a computer meltdown on January 1, 2000.

I left William Blair in May of 1998 for the opportunity to join Alex Brown (one of the oldest brokerage firms in the country which had recently been purchased by Banker's Trust). At that time the S&P 500 (SPX) traded around 1111. People even then were beginning to worry about how far and how fast the market had moved up (it was up over 140% since 1985).

By the midpoint of the year investors had other concerns because the market had taken on a different character. Stocks experienced their first valuation correction in almost 3 years. This and the raising of interest rates caused some real stress in the financial system. Then in October of that year a major financial hemorrhage occurred owing to the stresses induced when the hedge fund Long Term Capital Management {LTCM} suffered a string of catastrophic losses. The downfall of the fund actually started in the spring as LTCM started to see negative returns for an investment strategy {Bond Arbitrage} that in theory was not supposed to ever lose large amounts of money.

There is an old expression amongst traders that "the market holds in reserve a bullet with your name on it". That bullet found LTCM in the late summer of 1998. What ultimately did in LTCM occurred when the Russian Government defaulted on its sovereign debt. This was money in the billions of dollars Russia had borrowed from Western financial institutions since the fall of the USSR in the early 90's. This is again something in the world of finance that theoretically isn't supposed to happen. Reason has always held that governments can tax or borrow more money to pay off bondholders. Unfortunately such defaults occur often enough that this theory should be scrapped. Now the Russians were saying NYET on repayment. As a result panicked investors sold most of their other bonds, particularly those of less credit worthy foreign governments, to buy U.S. treasury securities. LTCM found itself on the wrong side of this trade and by early September had lost almost 2 billion in capital.

One of the problems that occurred was LTCM's extensive use of leverage {borrowed funds} and it was on the hook to the banking world to the tune of billions which nobody was sure could be recovered. LTCM experienced a "flight to liquidity". It's investors, fearing the fund's solvency, wanted their money back right away. Unfortunately there wasn't enough in the kitty to pay everybody out. This prompted a bail-out by many of the top international banks organized by the Federal Reserve in New York. The motivating fear was a vicious chain reaction as LTCM sold its securities to cover its debt and redemptions. Investors worried that a further drop in prices would force other institutions to liquidate their own debt, spreading a downward price spiral which might wipe out the financial world as it then existed.

LTCM was the worst financial crisis witnessed since the stock market crash in 1987 and it is impossible to do justice to this complex story in a few paragraphs. The SPX lost about 18% from July to mid-October. Some financial institutions never recovered. Banker's Trust itself was weakened by the ordeal and sold itself to Deutsche Bank later in the year.

The markets rebounded once it became apparent that the banks were in the process of stabilizing the situation. The SPX recovered most of its summer decline in about 30 trading days, It added about 20% in that time period, once again illustrating that stocks often have very large explosive moves in relatively short periods of time.

The SPX traded as high as 1230 by the end of the year. Even though the market had witnessed and survived a major financial crisis, stocks still managed to tack on another 26% in 1998 (more if you add in dividends). But the underlying tone had changed in new and subtle ways.....To be continued.