International Fixed Income

International Fixed Income
Topic 6B:LTCM
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(From last time) B. Peso Crisis
By the end of 1993, the MP traded at 3.1/$ and was overvalued by PPP measures (3.5-4.1). [Managed float].
that type of business); this induced a price pressure effect which led to a further drop of around 10%. » On August 17, Russia defaulted on its debt, with an immediate flight to “quality”, i.e., to liquid instruments, the opposite of LTCM’s trades. » On August 21, swap spreads moved 20 basis points (a normal move would be around 1-2bps). LTCM lost $550 million. » On Sept. 2, Merriwether sent a letter stating the fund had lost $2.5 billion over the year (or 52% of its value), with August producing $1.8 billion in losses. » Soon after that date, LTCM began to look for an infusion of capital, including meetings with Soros, Robertson, Buffet, Goldman Sachs, etc...
» Mexico’s international reserves surged towards 30bn by year-end. » In March, these reserves dropped 10bn when presidential candidate
Colosio was assassinated. Mexico’s reserves were almost completely depleted through November 1994. » December 1, the new president, Zadillo, took office and shortly after devalued the peso, letting it float freely.
» LTCM reported its first losses to investors, primarily in the MBS area. » On July 17th, Salomon closed down its fixed income arbitrage group (to get out of
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Chronology continued….
» In the third week of September, Bear Stearns (LTCM’s clearing agent) asked for $500 mm in collateral to continue clearing trades. On Friday, September 18th, with market conditions deteriorating, there was discussion about LTCM’s solvency.
» Liberal reformers resigned » Russian stock market dropped over 45%
7
1400 1200 1000
800 600 400 200
0 1/1/1998
Ruble
1/1/1999
35 30 25 20 15 10 5 0 1/1/2000
» On Sunday, Sept. 20th,the NY Fed looked at LTCM’s portfolio and found that LTCM had over $50 billion of long-short positions in securities, notional amounts of futures contracts of $500 billion, notional swaps of $750 billion, and options over $150 billion. It was clear that LTCM failure would affect many counterparties.
Russ. T-bills Ruble/$
8
Russia, $-denominated 3%, 2003
80
70
60
50
40
30
20
10
0
4/3/1996 10/3/1996 4/3/1997 10/3/1997 4/3/1998 10/3/1998 4/3/1999 10/3/1999 4/3/2000
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Chronology continued…
Their trade positions had also ventured out of their usual “convergence” trades into other areas, such as risk arbitrage, credit spread bets, emerging market debt, corporate bond spreads, etc… Also, in 1998, the partners bought an option from UBS, which in essence was structured such that UBS got some equity but mostly provided a loan (which gave them temporary significant equity in LTCM, which would get bought out by the partners later). The motivation on LTCM’s part was tax driven. In early summer,
PESO
4
8
7
6
5 4
3
2
1
0
Mexican Peso
10/11/1994 10/25/1994 11/8/1994 11/22/1994 12/6/1994 12/20/1994
1/3/1995 1/17/1995 1/31/1995 2/14/1995 2/28/1995 3/14/1995 3/28/1995
Summary
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Chronology
After being forced to leave Salomon in 1991, in wake of the Treasury auction rigging scandal, John Meriwether founded Long Term Capital Management in late 1993. There was an exodus from Salomon during this period, giving LTCM (sometimes called Salomon North) a “dream team” of traders/researchers in the fixed income area. LTCM’s “original” strategy was to take advantage of spreads between liquid and illiquid instruments in similar markets, and bank on a convergence of these securities - a so-called date with destiny. These strategies are highly levered because they are viewed as relatively riskless in the long run. In their first (shortened) year (1994), LTCM earned 20%, with staggering returns of 43% and 41% (in 1995&1996). In 1997, their returns dropped to 19%, partly because they were getting to big to get the same levered returns. With amassed capital of $7 billion, they returned 2.7 billion to investors, leaving only the original investors and themselves. The size of their positions, however, were maintained.
Reserves
3
8
7Hale Waihona Puke 6543
2
1
0
Mexican Peso
10/11/1994 10/25/1994 11/8/1994 11/22/1994 12/6/1994 12/20/1994
1/3/1995 1/17/1995 1/31/1995 2/14/1995 2/28/1995 3/14/1995 3/28/1995
» 3-mth moratorium on debt payments » 50% devaluation of ruble » halting of FX trading » debt rescheduling that would lead to unprecedented losses
September
By June 1998, the stock market was at a two-year low; and the gov’t failed to collect enough funds from T-bill auctions to repay outstanding debt. August was a bad month
Russia Bond
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Outline for LTCM lecture
Chronology of events Review one way of creating leverage in fixed income markets Examples
» Off-the-run versus on-the-run Trreasuries » $ swaps versus Treasuries » International government bonds » International credit spreads
2
Mexico’s International Reserves
30 25
20 15 10
5 0
Ja M M J Se No Ja M M J Se No Ja M n- ar- ay- ul- p- v- n- ar- ay- ul- p- v- n- ar93 93 93 93 93 93 94 94 94 94 94 94 95 95
70
60
50
40 PESO
30 Brady
20
10
0
5
Cetes & Currency
90
9
80
8
70
7
60
6
50
5
40
4
30
3
20
2
10
1
0
0
Nov-94
Jan-95
ar-95 M
May-95
Jul-95 Sep-95 Nov-95 Jan-96
Cetes-91 Cetes-182 MP/$
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C. Russian Default