Long Term Capital Management: The Roots of Lehman’s Fall?
The fall of LTCM (Long Term Capital Management) and Lehman Brothers remain some of the most debated topics in modern financial history.
Following the Russian financial crisis of 1998, LTCM, a new but prominent hedge fund, found itself on the edge of bankruptcy. However, the firm was saved, establishing the first instance in which a non-insured depository was bailed out by the Federal Reserve.
Nearly a decade later, with an excessively leveraged balance sheet on the verge of collapse due to the 2008 subprime mortgage crisis, Lehman Brothers found themselves in nearly the same position as LTCM.
However, Lehman did not receive a bailout by the Federal Reserve despite having a larger presence in the financial sector and thus more risk of contagion. Although the outcomes differed, the downfalls of Lehman and LTCM are strikingly similar in cause and possibly even related.
The Federal Reserve maintains that there were legal issues with bailing out Lehman’s sizable loss, the decision may have been made to avoid political scrutiny regarding the idea of “too big to fall” stemming from the LTCM save 10 years prior.
Background
LTCM, founded in 1994, amassed assets valued up to 120 billion dollars before their near-collapse in 1998 [4]. The hedge fund was founded by John Meriwether, a highly accomplished trader from Solomon brothers, alongside David Mullins, a former vice chairman of the federal reserve, and Nobel peace prize winning economists Myron Scholes and Robert Merton [4].
This high-profile management team generated massive hype behind LTCM leading to an initial investment of 1.3 billion dollars from various banks and other private funds [4]. LTCM provided impressive yields for investors with annual return rates up to 42.8 percent, growing to roughly 7.3 billion in capital and 120 billion in assets by the end of 1997 [6].
However, LTCM’s success didn't last long and blew up in one of the most spectacular fashions in August of 1998.
LTCM primarily invested in convergence trades amongst various countries' bonds [3]. The fund compared government bonds that were slightly mispriced relative to each other and took corresponding long or short positions. As such, LTCM had a large stake in global markets.
The devaluation of the Russian ruble and declared moratorium on Russian debts caused significant liquidity issues in several Asian economies which yielded a massive loss for LTCM. With equity dropping to 600 million and an astronomical leverage ratio over 100 to 1, failure seemed imminent for LTCM and bailout procedures were underway [3].
LTCM initially received a private buyout offer by a group made up of Berkshire Hathaway, Goldman Sachs, and AIG [4]. The group proposed to buy out shareholders for 250 million and inject 3.75 billion in capital into LTCM [4].
But, LTCM refused the offer and eventually received a better rescue package from the Federal Reserve: 14 high-value banks invest 3.65 billion in capital for 90 percent of LTCM’s equity with shareholders retaining the other 10 percent [4]. The Fed’s package was ultimately better for both existing shareholders and management, but the necessity of Federal involvement is questionable, given the existence of a previous buyout offer.
A decade later saw one of the most harrowing financial collapses in modern history, the 2008 subprime mortgage crisis and the fall of Lehman Brothers. The firm was originally founded in 1844 as a dry goods store by brothers Mayer, Emanuel, and Henry Lehman before its expansion into commodities trading and brokerage services [9].
Unlike LTCM, Lehman Brothers was a firm with decades of experience, overcoming some of the world's worst financial situations including the Great Depression. In the early 2000’s, Lehman invested in mortgage backed securities, acquiring multiple prominent mortgage lenders.
As a large player in the mortgage industry, Lehman incurred significant losses due to the 2007 credit crisis and subsequent collapse of mortgage backed securities. Unable to finance its losses, Lehman's stock plummeted and the firm was headed for bankruptcy [9].
The weekend before the bankruptcy, Bank of America and Barclays attempted to settle a takeover with Lehman, but talks ultimately fell through [9]. The Federal Reserve refused to assist Lehman on the basis of legality and consequently forced the firm into bankruptcy.
However, the Fed had just bailed several large financial institutions including Bear Stearns, Freddie Mac, and Fannie Mae [7]. The case of Lehman Brothers is by no means cut and dry with economists and financial experts arguing for both sides of the lack of federal intervention.
Causes of Failure
Although LTCM and Lehman Brothers suffered problems with different financial assets, issues with risk management and over leveraging were consistent with both firms' downfalls. Several of the mistakes made by LTCM were replicated in 2008 by Lehman Brothers and other financial entities.
Perhaps the biggest takeaway from LTCM’s near fall is how dangerous over leveraged assets can be. LTCM’s high leverage ratio of over 25 to 1 is seen as a significant cause of its downfall [8]. The same pattern was observed with Lehman which had a leverage ratio of 30 to 1 before its bankruptcy [9].
However, over leveraging is a commonly observed trend in the financial industry. From before LTCM’s rescue to after Lehman's fall, many banks and hedge funds created a culture of over leveraging by pursuing a high-leverage, high-risk, but high-reward strategy.
Another factor consistent with each firm's downfall lies in extensive investment of unregulated OTC’s (over the counter derivatives). LTCM had OTC derivatives worth an estimated one trillion dollars [6]. OTC trades are set in a way that they offset each other for the purpose of hedging and risk management [6]. While the purpose of derivatives lies in risk management and hedging, when used for speculation, they have an enormous amount of risk. [6].
Lehman Brothers and other prominent brokers involved in the 2008 crisis also invested in a large amount of OTC’s, specifically credit default swaps, which were inadequately hedged and thus contributed to significant losses [6]. If regulation occurred on overexposure in derivatives following 1998, perhaps Lehman’s losses could have been limited in 2008.
“Too big to Fail” & Politics
The saving of LTCM—which created the “too big to fall” ideology in non-insured financial entities—is partially responsible for the fall of Lehman. Despite receiving a private buyout offer, the Federal Reserve intervened and facilitated a more generous bailout package for LTCM.
While this action may have prevented contagion in the short run, it strongly implied that large financial institutions are supported by the Fed. This action encouraged extreme risk taking and over leveraging in large hedge funds.
Perhaps if the 1998 crisis was taken as an example to define more explicit policy and good practice, Lehman and other banks would have been on better footing to deal with 2008.
Lehmans’s fall remains one of the most controversial decisions in Wall Street history. The decision to let Lehman collapse was supposedly based on limitations of the law.
But, according to Phil Angledies, the crisis commission chairman, the Fed did not provide any notes on analysis stating that “if you look at the record, there is no legal stopper” [7].
Furthermore, Henry Paulson, the secretary of the treasury, is quoted in emails as saying “I can’t do it again. I can’t be Mr. Bailout” after heavy scrutiny for bailing Bear Stearns months prior [2]. However, Paulson and the Fed bailed out AIG just a week after Lehman's fall [7].
How does this relate to LTCM?
Lehman Brothers was actually one of the few Wall Street goliaths to not participate in LTCM’s bailout.
Paulson, who was the CEO of Goldman Sachs at the time of LTCM’s fall, played a significant part in the bailout and may have expected Dick Fuld, CEO of Lehman, to do the same. If Paulson was willing to take negative press on AIG, perhaps other factors influenced the decision against Lehman.
While it’s largely speculative, Paulson and Fuld’s rivalry going back to LTCM may have played a part in the Fed’s decision. However the contagion effects from AIG were perceived to be much worse, thus necessitating the bailout with Lehman brothers. Bailing out Lehman was the rational move, yet Paulson declined.
Similarities and differences aside, the cases of LTCM and Lehman combined, ultimately reveal misguided judgement on the part of the Federal Reserve. Not bailing out Lehman resulted in contagion which amplified the 2008 crisis.
On the other hand, LTCM may not have needed a bailout at all considering they had received a private buyout offer. By forcing LTCM to go with Berkshire’s offer, the Federal Reserve might have avoided extending the “too big to fall” ideology to hedge funds. While each case is indeed different, analysis of Lehman and LTCM suggests a need for more consistency in Federal Reserve bailout procedures.
Wrtitten by Amrith Kumaar
Sources:
[1] Amadeo, Kimberly. “How a 1998 Bailout Led to the 2008 Financial Crisis.” The Balance, December 26, 2020. https://www.thebalance.com/long-term-capital-crisis-3306240#:~:text=That%20was%20after%20management%20took,a%2017.1%25%20return%20that%20year.
[2] Ball, Laurence M. “Ten Years on, the Fed's Failings on Lehman Brothers Are All Too Clear | Laurence M Ball.” The Guardian. Guardian News and Media, September 3, 2018. https://www.theguardian.com/commentisfree/2018/sep/03/federal-reserve-lehman-brothers-collapse.
[3] C. T. Bauer College of Business at the University of Houston. Accessed February 2, 2021. https://www.bauer.uh.edu/rsusmel/7386/ltcm-2.htm.
[4] Dowad, Kevin. “Too Big to Fail? Long-Term Capital Management and the Federal Reserve.” Cato.org, September 23, 1999. https://www.cato.org/sites/cato.org/files/pubs/pdf/bp52.pdf.
[5] Doren, Peter Van, About the Author Peter Van Doren Senior Fellow and Editor, Peter Van Doren Senior Fellow and Editor, and Senior Fellow and Editor. “Lehman Brothers and Bear Stearns: What's the Difference?” Cato Institute, January 22, 2021. https://www.cato.org/commentary/lehman-brothers-bear-stearns-whats-difference.
[6] Investments, ABC. “Long Term Capital Management: A Precursor to the Global Financial Crisis.” Medium. Medium, August 14, 2019. https://medium.com/@abc_40376/long-term-capital-management-a-precursor-to-the-global-financial-crisis-9cbc5436c01f.