Long Term Capital Management case study: The role of communication in its collapse Jennie Butler Elizabeth Lee Christina Prevalsky Jack Zhao Operations Research & Information Engineering Cornell University, Ithaca, NY October 19 th, 2007 Introduction Imagine a group comprised of physicists, mathematicians and even Nobel Laureates. Now imagine if these people worked together and offered to manage your money. Would you trust them? In fact, Long Term Capital Management (LTCM) was a hedge fund headed by such a group of geniuses deemed by everyone as a can t miss, a sure thing. In its first three years, LTCM experienced returns on capital of over 40%, but in the summer of 1998, things took a turn for the worse, and in just four months LTCM lost over $4.6 billion (Lewis 1999 p. 7). Numerous theories have been proposed about the cause of this collapse, but rarely is the role of communication discussed, and that is exactly what we intend to consider in this project. This case study examines the role of communication in the rise and fall of LTCM. Specifically, we will analyze particular events that show how communication models changed as the firm became distressed. In this setting, communication takes place primarily between the firm and its investors and the banks that support their operations. The objective is not to argue that communication caused the demise of the fund but rather to identify the situations where miscommunication, lack of communication, or excessive communication contributed to its downfall. The membership of the team is quite suitable for attaining this goal. It is clear that the combination of analytical ability, fundamental understanding of economics and industry exposure will ensure a rigorous analysis. The procedure describes the collaborative efforts of the group and a Gantt chart is provided outlining the timing of various deliverables. Allocations of initial tasks were determined, and strategies for working well in the group were discussed and agreed upon, including guidelines for meeting attendance, agendas as well as a process for communicating between meetings.
J. Butler, E. Lee, C. Prevalsky, J. Zhao LTCM1 Proposal v. 4 2 Background John Meriwether and other founding principals Before diving into the set of events that contribute to the rise and fall of Long Term Capital Management, it is helpful to gain some insight into the backgrounds of the people involved in the process. The most notable figure is founder John Meriwether, an established pioneer of fixed income arbitrage at Salomon Brothers in the early 1980s. During this time, Meriwether recruited some of the most talented economists, mathematicians and physicists to this business who would later become principal founders of LTCM. Amongst these academics were Nobel Laureates in economics Robert Merton and Myron Scholes. At Salomon, Meriwether and his team developed and implemented mathematical models largely based on the assumption of convergence of spreads. For example, he would bet that the different between the price of a 30 year bond and the price of a 29½ year bond would converge to a negligible amount as the bonds go to maturity, since they are nearly identical so investors shouldn t pay a premium for one bond over the other. This is the fundamental idea behind the strategy that made Meriwether the reputable star trader at Salomon. Meriwether left the firm in 1991 due to a scandal that involved most of Salomon s top executives and established Long Term Capital Management, taking with him the strategies that had made Salomon so profitable as well as most of the team from the Fixed Income Arbitrage group (Lewis 1999). The rise of LTCM Clearly, the structure and strategies used by LTCM had their origins long before the fund s inception in the early 1990 s. In fact, Meriwether and his team carried their trading strategy directly from Salomon to LTCM. His proven track record at Salomon was a key factor in the enormously successful initial fundraising efforts of LTCM. The bank attracted a wide variety of qualified investors that included other banks, pension funds, international firms as well as high net worth individuals. At the end of February 1994, the fund had raised $1.25 billion of capital (Lowenstein 2000), the largest start up ever. Once the initial funding was obtained, LTCM needed to set up several trading mechanisms. Their partners included Merrill Lynch, who was primarily responsible for fundraising, Bear Stearns, who executed the majority of the firm s trades, and a vast array of investment banks that provided relatively cheap financing (Lewis 1999). In the process of executing their seemingly successful trading strategy, they developed an extremely complex set of relationships and dependencies. The fall of LTCM It was this set of relationships that allowed LTCM to achieve their early success, but in the summer of 1998, when the spreads began to widen much like they had in 1978, these same relationships contributed heavily to their collapse. During this period, Russia defaulted on its debt, causing a devaluation of many of LTCMʹs investments. As bits and pieces of LTCM s trading strategy had been discovered, most of Wall Street had actually made similar trades that were also negatively affected by the Russian collapse. As other investors fled toward liquid assets such as short term bonds and shied away from longer term bonds, spreads further increased, causing sharp decreases in the value of LTCM s portfolio. This wouldn t have
J. Butler, E. Lee, C. Prevalsky, J. Zhao LTCM1 Proposal v. 4 3 been a problem if LTCM had an endless supply of cash (like they had access to before Wall Street began to panic). However, the banks increasingly demanded that LTCM give them more information and put up more collateral for their trades. Through Meriwether s personal relationship with other banks, LTCM had managed to borrow much more capital than normally excepted for nearly no collateral, meaning the banks were taking the bulk of the risk should LTCM s trading strategy fail. As the spreads widened, banks began to demand more and more collateral for LTCM s trades collateral they did not have. Since they could not meet all of their cash obligations, the pressure was on to sell off trades and realize losses. Eventually, as LTCM reached the brink of being forced to sell off all of their investments, they were forced to divulge all of the information of their trades and seek help from the other banks. As information became available, others who held similar investments started unwinding their positions or selling them off. At first this was done as an attempt to cut losses, but later this was used as an actual attack on LTCM intended to devalue the fund further and make it an easier acquisition target. The demise of LTCM ended with the intervention of the United States Federal Reserve, who elicited capital from top investment banks to bail out the fund to avoid further blows to the market. Research Agenda Our analysis will focus on the role of communication and it changed throughout the rise and fall of LTCM. We will explore the evolution of the communication between LTCM and their investors and the banks that supported their operations, relating them to concepts learned in class. Drawing from Eisenberg s (2007) models of communication, we expect to find evidence of the use of strategic control 1 primarily during the rise and success of LTCM. We will examine how this model of communication contributed to their initial success and analyze how it affected their eventual downfall. As investors and banks began exerting pressure on the LTCM due to their declining performance, we will examine the forced more open, transactional process 2 model of communication that occurred over the course of its collapse and how that affected the progression of these events and the eventual outcome. Team Qualifications Jennie Butler Jennie is a senior completing a Bachelor s degree in Operations Research. Her coursework load has focused primarily on the economic implications of Operations Research and includes with an additional six strictly Economics courses. This gives Jennie a good background in the workings of financial markets. Last summer she worked in the technology department of J.P. Morgan Chase, and received a first hand 1 Communication is viewed as a tool used by individuals to gain control of their environment (Eisenberg, Goodall, and Tretheway 2007). 2 All participants in the process are constantly engaged in both sending and receiving information simultaneously (Eisenberg, Goodall, and Tretheway 2007).
J. Butler, E. Lee, C. Prevalsky, J. Zhao LTCM1 Proposal v. 4 4 look at a bank on Wall Streetʹs culture. This experience gives Jennie a good understanding of the communication models commonly used by the sales and trading culture. Elizabeth Lee Liz is a senior and Master of Engineering student majoring in Operations Research concentrating in Financial Engineering. Her courses have included finance, accounting, derivatives, fixed income securities and other interest rate product. This past summer, she worked as an analyst in the Investment Banking Division at Credit Suisse. Within the Financial Institutions Group, her work focused primarily on the asset management industry, with a client list including banks, hedge funds and private equity firms. In this process, she has gained knowledge regarding the relationships between financial institutions. Christina Prevalsky Christina is a senior completing a bachelor s degree in Operations Research. Her coursework has included accounting, microeconomics, derivatives and interest rate securities, providing a good background in the theory (and quantitative aspects) behind various investment strategies. In addition, she has had internships at Goldman Sachs Technology and Merrill Lynch Private Wealth Management, which have given her an insight into the culture at Wall Street firms and at smaller financial services companies. Jack Zhao Jack is a senior completing a dual degree in Economics and Operations Research. He has superior analytical skills mixed with excellent economic intuition and is overall competent socially. This can be attributed to his dual degree background, his recent classes in finance and case studies, and his job as a financial analyst. The engineering background provides him with the wide array of quantitative tools and problem solving skills necessary for analysis. The economics background gives him a general know how on markets work and how firms think (read business intuition). The interplay between these two backgrounds gives Jack the foundation for understanding LTCM. Along with his technical skills, Jack has a great deal of teamwork skills from classes, clubs, and jobs. Overall, Jack will be a versatile contributor to the team. The group is similar, yet the group remains diverse. In one respect, all members are at least Operations Research majoring who have had enough exposure to the finance industry to understand the technicalities of the case. On the other hand, each person contributes something unique to that individual. Jennie has significant experience working in teams and understands the collaborative process involved. Through her internship at J.P. Morgan Chase, she became familiar with the culture at such financial institutions, which may play a key part in their relationships and communication with other institutions. From her work in the Financial Institutions Group, Liz is knowledgeable about the relationships between banks, investment banks, investment managers (hedge funds and mutual funds), institutional investors, retail investors and the government. Christina s client exposure provides a good understanding of investor mentality and behavior. Jack s academic focus in Operations Research and Economics gives him the ability to understand the fundamental ideas of the firm s investment strategy as well as the technical proficiency to understand complicated trading mechanics.
J. Butler, E. Lee, C. Prevalsky, J. Zhao LTCM1 Proposal v. 4 5 Allocation of tasks Proposal The proposal was produced as a team effort. This planning stage is the most crucial aspect of this process, as members learn to share goals and acknowledge the tasks required in the process. In the first meeting, the group discussed the case study generally and planned out the first stages of the project. Drawing from the introductory readings that included Gladwell (2002), Lewis (1999) and portions of Lowenstein (2000), the team members tried to achieve a common understanding of the case through exchanging individual understandings as perceived through our respective object worlds. Once we agreed on the focus of the case, specific tasks were assigned. Each member was responsible for writing a description of him or herself. Based on the notes from our meeting, Christina summarized a description of the case study, Liz wrote write the procedure, and Jack wrote the introduction and created a Gantt chart of the various deliverables and their timelines. Jennie compiled these pieces into a coherent document, organizing and making edits/revisions as was necessary. Individual Case Study Reports The set of assigned readings (in addition to the introductory readings) include Lowenstein (2000), MacKenzie (2003), and the report from the United States Department of Treasury (1999). MacKenzie (2003) will serve as an optional source that would be consulted as the analysis later deems necessary. All group members have relatively similar financial background and other competencies. Thus, readings and reports were negotiated based on members schedules in the upcoming month. Christina will read the first 6 chapters of Lowenstein (2000) on the Rise of LTCM, writing specifically on chapters 3 and 4. Liz will complete the remaining readings from Lowenstein on the Fall of LTCM, reporting on chapters 8, 9 and 10. Both reports will have a rough draft due on October 26 th and a final draft due on October 29 th. Our analysis will focus on the role of communication throughout this process. The Lowenstein readings will provide an in depth background on the entire case as well as how communication changes as the firm becomes distressed. Christina and Liz will focus on the modes of communication used by LTCM with other banks and their investors. Jack is responsible for reading and reporting on MacKenzie (2003), and will focus on how LTCM s portfolio was communicated to other banks and hedge funds, which may have played an important factor in its demise. Jennie is responsible for the report from the United States Department of Treasury (1999). She will focus on communication strategies during the collapse of the fund. This reading load is lighter so that she can focus on portions of the analysis that were neglected in previous reports. A similar schedule was negotiated so that two rough drafts are due on October 31 st and the final drafts due on November 2 nd. The reports will build on the prior reports. All team members will provide comments on the rough draft. However, these are not formal critiques and are likely to be given verbally or via email. Team Executive Summary and Presentation
J. Butler, E. Lee, C. Prevalsky, J. Zhao LTCM1 Proposal v. 4 6 The team executive summary will be a collaborative effort based on a synthesis of individual findings. Currently, the specifics of the analysis are unknown so specific tasks have not been assigned. However, it is expected that each member will focus on the materials from their assigned readings in writing the executive summary and making the presentation. Scheduling The following Gantt chart provides the timeline for completing each deliverable, showing both individual tasks and group efforts. This chart is helpful for team members to remember important dates and be aware of what their responsibilities are and what everyone else is doing. Deliverable Step Due Date Proposal Rough Draft 15 Oct Edit 18 Oct 19 Oct Individual Case Study 1 Rough Draft 26 Oct (C. Prevalsky) Edit 28 Oct 29 Oct Individual Case Study 2 Rough Draft 26 Oct (E. Lee) Edit 28 Oct 29 Oct Individual Case Study 3 Rough Draft 31 Oct (J. Zhao) Edit 1 Nov 2 Nov Individual Case Study 4 Rough Draft 31 Oct (J. Butler) Edit 1 Nov 2 Nov Team Executive Rough Draft 12 Nov Summary Edit 13 Nov 14 Nov Team Slides Rough Copy 14 Nov Edit Final Copy 17 Nov 19 Nov Presentation Talk Script 16 Nov Rehearsal 1 Rehearsal 2 (w/ Slides) Final Presentation 17 Nov 18 Nov 19 Nov 7 Oct 14 Oct 21 Oct Week of 28 Oct 4 Nov 11 Nov 18 Nov
J. Butler, E. Lee, C. Prevalsky, J. Zhao LTCM1 Proposal v. 4 7 Team strategies Our team strategy is focused heavily on the efficient use of team meetings and outside communication. We have established a set of norms regarding meeting attendance, meeting agendas, and communication between meetings. Meeting attendance We expect that each member will be present and on time for every team meeting or have notified the other team members of his or her absence prior to the meeting. This way, if we must get information from that person to be able to go on the next aspect of the project, we can arrange a different meeting time or get the information before the meeting so that we will not be delayed due to the absence. Meeting agendas All meetings will be conducted according to a general outline. First, we will briefly recap the highlights of the last meeting and resolve any unsettled issues. Second, we will proceed with the task at hand. For example, if we are discussing a case study report, the writer will present the key points from the readings. The group will discuss how these issues could be incorporated into the team analysis. In the event that there is a disagreement, we will discuss the issue until we reach a unanimous decision. A unanimous decision process ensures that all members agree on the focus and the analysis, which allows for a consistent report and presentation. Finally, we will allocate tasks as necessary and set the agenda for the next meeting. Communication between meetings After the meeting, the notes compiled summarizing the meetings discussion and any assigned tasks for the next will be emailed out to each member. If the tasks involve a writing assignment or a revision of any sort, the documents will be emailed out to each team member. This allows us to make suggestions or continually revise the documents as a team without having to wait for the next meeting.
J. Butler, E. Lee, C. Prevalsky, J. Zhao LTCM1 Proposal v. 4 8 References Eisenberg, Eric M., Goodall, H.L. Jr, and Angela Trethewey. 2007. Organizational communication: Balancing creativity and constraint. Boston: New York: Bedford / St. Martin s. Gladwell, Malcolm. 2002. Blowing up: How Nassim Taleb turned the inevitability of disaster into an investment strategy. (April 22 & 29): 162 165, 167 168, 170 173. Lewis, Michael. 1999. How the eggheads cracked. New York Times Magazine (January 24): 24 31, 42, 67, 71, 77. Lowenstein, Roger. 2000. When genius failed: The rise and fall of Long Term Capital Management. New York: Random House. MacKenzie, Donald. 2003. Long Term Capital Management and the sociology of arbitrage. Economy and Society. 32 (3): 349 380. MacKenzie, Donald. 2006. An engine, not a camera: How financial models shape markets. Cambridge: MIT Press. United States Department of the Treasury. The President s Working Group on Financial Markets. 1999. Hedge funds, leverage, and the lessons of Long Term Capital Management.