The levels of risk and leverage at hedge fund Long Term Capital Management (LTCM) created an unsustainable business and made its collapse in 1998 far more likely than markets recognised at the time, according to a top quantitative analyst who worked at the fund.
Myron Scholes, emeritus professor of finance at Stanford University and economics Nobel laureate, was a board member at LTCM, whose recruitment prior to the start of trading in 1994 helped lend it intellectual heft when raising capital from high-net-worth investors. In an interview with Risk, Scholes says the firm had insufficient capital for the risk on its books, and that the experience shows the danger of relying too heavily on classical portfolio theory.
"LTCM ran leveraged positions at too-high risk levels. It was not a sustainable business in the longer run if you have to reduce leverage and seek extra capital at a time when risk transfer costs are high," he says.
After four years of stellar returns, the fund was left scrambling for cash following Russia's debt default and the resulting turmoil in sovereign bond markets. The Federal Reserve had to organise a bank-financed bail-out to manage the fund and prevent losses spilling over to its numerous counterparties – the eventual realised loss totalled $4.6 billion.
"If you are running an interconnected, leveraged business then you have to run it very differently from running an unleveraged business. Capital models should give levels that are required to sustain the business at times of shock, and this is different for leveraged hedge funds because they can't call for additional capital from investors," says Scholes.
LTCM ran leveraged positions at too high risk levels. It was not a sustainable business in the longer run
"I believe capital models should not rely on portfolio theory, because the correlation structure is just not constant – in a crisis you have intermediaries reducing risk simultaneously, so things that appeared to be independent clusters in the past become correlated, and diversification against those clusters does not provide staying power."
Although the collapse of the fund is generally seen as highlighting the impact of low probability events on systemic risk (Risk July 2011, pages 68-71), Scholes argues the chances of collapse were much higher than market participants realised at the time.
"It was a much higher-probability event than people thought, because it told people they were going to make 40% a year at 20% volatility – a high risk level. The problem comes because, as a hedge fund, you don't really have deep pockets, so it's hard to run at a high risk for a long time," he says.
"I would have done many things differently. The people who experienced the crisis we are now in will learn a heck of a lot because they experienced it. But people who didn't experience it can't understand because they weren't there."
Scholes has recently been more prominent in warning excessive capital requirements will lead to more volatile markets.
An interview with the renowned quant and co-creator of the Black-Scholes option pricing formula will appear in the September issue of Risk.