Risk Management- A vital Organ of Financial Services

Introduction:

Risk Management is at the bedrock of successful operation within the Financial Services space. In more careless times it was heralded as a mere surplus function which brought little value to the firm. Now, it is abundantly clear that it is a necessity.

The Long-Term Capital Management (LTCM) disaster stands out, in my opinion, as the most egregious disregard for proper risk management by a financial institution. Its effects were so damaging that FED chairman Alan Greenspan remarked “had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own”. This event had drastic impacts on both the financial community as well as U.S politics. Therefore, given the fact that Risk Management failures in one firm could potentially destabilise the entire global economy, I would be remiss to not write a Financial Risk article on the LTCM crisis.

Background of the firm:

To begin, it is necessary to provide a brief background on LTCM. Long-Term Capital Management (LTCM) was established by bond trader John Merriweather and several distinguished academics including Nobel Prize winning academic economists Robert Merton and Myron Scholes. The LTCM crisis can be surmised as follows. The firm started and gained traction immediately given the credentials of its board. It had secured $1 billion in capital very quickly. The fund generated Super Normal Profits. They proclaimed to have exploited arbitrage opportunities and led to risk levels of effectively zero. However, in 1997 the Asian Financial crisis struck. Moreover, in August 1998, Russia defaulted on their debt and LTCM were thrown into disarray because they held a significant stake in Russian bonds. LTCM’s empirical approach to the stock market led to them having poor intuition and they held their positions. This led to debt ballooning to $4 billion. The fund was in ruins and to avert a financial crisis, the U.S government and Fed organised a bail out (and backed by a group of 14 banks) because they were about to default on their loans. Throughout this report, I will forensically examine two of these failures (market risk and credit risk) and conclude what if anything can be done to ensure that this does not happen in the future. I will then reflect on my overall understanding of the effect of this failure for the market and how exactly firms can go about making sure risk management is never disregarded going forward.

Rationale that led to the incident:

The rationale for this failure was that LTCM took a wholly empirical approach to their positions. LTCM. The primary strategy employed by LTCM was convergence trades. This relies on identifying shares which are mispriced and taking long on the low-price shares and short on the highly priced shares. As the differences in price were small, the firm had to take large, highly leveraged (mostly debt) positions to generate a notable profit. At the beginning of 1998, they had a leverage factor of roughly 30:1. They maintained that the risk levels were managed so effectively that they could ignore this drastic leverage.

Losses the firm had to incur:

The losses the firm incurred were colossal. In less than one year they had lost $4.4 billion of the $4.7 billion in capital (a gargantuan sum for 1998 remember). This included $533 million in a single day. The firm eventually had to be bailed out by the U.S Government in September 1998. This is expressed in the graph below. The equity of the firm rose steadily until a stark plummet in 1998 where they were at its lowest point (Warren Buffet lead a team trying to buy the fund for $250 million) and they refused leading to their bailout.

Incidence of Risk Management failure:

The incidence of Risk Management failure is extremely stark here. The first major risk management failure was credit risk. Credit (Default) risk simply refers to the risk that one party will not be able to meet their loan obligations and cannot pay the amount back in full or in part. When the Asian Financial crisis began, few scholars would have predicted the collapse of the Thai Baht. Furthermore, this was compounded when Russia defaulted on their bonds, throwing the firm into the abyss. This was the catalyst for the demise of LTCM. Had they not taken such a stark position on Russian backed bonds, then they may have been saved. However, they callously took an extremely large position here which hindered the overall diversification of their fund. In turn, this folly resulted in an immense loss of capital and set in motion the eventual collapse of the fund. They should have taken a more intuitive approach. To think that a country which exited the Soviet Union just seven years prior, would be so reliable to pay its debts that you would not hedge this risk is a prime example of the risk management failure which bankrupted LTCM. A more balanced approach would have been to spread the risk out and instead look to invest in other areas to negate this potential consequence. They should have hedged against the risk that a country would default on payment rather than naively presuming the Boris Yeltsin government would meet their obligations. However, LTCM gave little to no consideration for Credit risk and the results proved fatal.

Next, the other colossal risk management failure which facilitated the LTCM collapse was their lackadaisical attitude towards market risk. Market risk is defined as the risk that an entity will incur a loss due to factors affecting the overall financial markets. It can be hedged against to some degree, but it cannot be eliminated by diversification. Firstly, let us define our parameters. According to prominent academic Freidun “Value-at-Risk models are the primary means through which financial institutions measure the magnitude of their exposure to market risk”. These were used prominently by LTCM. Therefore, we can assess the LTCM situation from the lens of their Value at Risk models. These models are designed to measure the level of risk that a certain financial institution could lose over a specified time horizon at a given probability. Value at risk is calculated via three methods (Monte Carlo approach, Historic simulation, and the Delta Normal approach). All aim to compute a numerical value to represent market risk. LTCM prided themselves on holding a daily volatility of $45 million. This was compared with the S&P daily volatility of $44 million, which was regarded as rock solid. This paper, which has been cited 5695 times presents a very objective view of the risk management and enables us to quantify risk for LTCM. However, taking this as gospel was the ruin of LTCM. Ron Rimkus CFA writes that the Value at Risk model is an inherently flawed one. It is based off historic returns. Moreover, bias exists because the model discounts the use of outliers, which need to be considered in real life scenarios. Therefore, un-predictable and rare events such as the 1997 Asian Financial crisis and the 1998 Russian default were anomalies which were not factored into their calculations. Hence, LTCM were too trusting and over-reliant on an inaccurate model for their market risk management. This proved a lethal error to make.

Outcome of the failure and effects on stakeholders:

LTCM had to be liquidated. The firm required a $3.6 billion bailout organised by the U.S government. This led to a large political strife. Politicians such as Bernie Sanders slammed this move. But Alan Greenspan felt it necessary to bail out the firm. Moreover, several prominent investors in LTCM had their careers destroyed. The Chairman of Union Bank of Switzerland was even forced to resign after losing $780 million in an ill-fated position on short puts. Within the firm, the reputations of its leaders were also sullied forever more. In fact, David Mullins, who many believe was preparing to mount an attempt at FED Chairman was disgraced and impeded from ever entering public finance again. These cases act as a microcosm of the countless careers and reputations of stakeholders which were irreparably damaged by the LTCM crisis.

Personal take on the failure and how it could have been averted:

I personally believe that the major error here comes from a lack of diversity. The fact that it was led primarily by academics may well have been their undoing. I have no doubt an element of group think prevailed here. Hence, a means of combatting this in future is to employ greater diversity at the decision-making level. What I mean by this is that firms should look to have decision makers from a broad range of backgrounds with an array of skillsets so that decisions are made on a holistic basis. Otherwise, according to “Why diverse teams are smarter” a Harvard Business Review article by Rock and Grant, it is very easy to have the same opinions (such as on Russian bonds) not being challenged and problems multiply before they can be tackled effectively. With greater diversity, there would be an informal series of checks and balances where the ideas of others would be debated and questioned further before being put into practice. Therefore, the failure could have been averted or at the very least mitigated by the employment of a more diverse workforce. This has been a very prominent contemporary corporate tactic and its results have been very fruitful for firms.

My personal take extends further. I would also recommend financial institutions tread carefully regarding arbitrage in finance. I believe that arbitrage in finance can never truly be guaranteed. The Efficient Market Hypothesis states that the markets reflect all available public information. Therefore, there is no way to exploit a riskless opportunity and take advantage of market inaccuracies. The widely acclaimed paper in the Journal of Financial Economics “The limits to arbitrage” from academics Shleifer and Vishny states that even if sound statistical inferences are adopted by a firm, LTCM displays that, unpredictable events and the noise traders that follow them can destabilise any position of arbitrage. After reading this case study, my regard for the Efficient Market Hypothesis has increased. With that in mind, I believe that a crisis like this can only be averted via the use of dynamic trading strategies and not believing that a wholly mathematical model can be employed to repeatedly take advantage of market discrepancies. While statistically sound, this would not work. This is because according to John Maynard Keynes “The markets can remain irrational longer than you can remain solvent”.

Conclusion

As with every article in the Avant-Garde Analyst, the theme of optimism perforates through. When I reflect on the LTCM disaster, I am reminded of numerous regulations put in by the executive branch of countries and financial regulators such as the Basel 2 principles which eliminate room for malpractice. Furthermore, with the increased growth in talented individuals pursuing a career in Financial Risk and an altruistic group of young people pursuing a career in finance, a brighter future seems to be on the horizon.