The real culprit in 1994 was leverage. If you aren’t in debt, you can’t go broke and can’t be made to sell, in which case “liquidity” is irrelevant. but, a leveraged firm may be forced to sell, lest fast accumulating losses put it out of business. Leverage always gives rise to this same brutal dynamic, and its dangers cannot be stressed too often…
One of LTCM‘s first trades involved the thirty-year Treasury bond, which are issued by the US Government to finance the federal budget. Some $170 billion of them trade everyday, and are considered the least risky investments in the world. but a funny thing happens to thirty-year Treasurys six months or so after they are issued: they are kept in safes and drawers for long-term keeps. with fewer left in the circulation, the bonds become harder to trade. Meanwhile, the Treasury issues new thirty-year bond, which has its day in the sun. On Wall Street, the older bond, which has about 29-and-a-half years left to mature, is known as off the run; while the shiny new one is on the run. Being less liquid, the older one is considered less desirable, and begins to trade at a slight discount. And as arbitrageurs would say, a spread opens.
LTCM with its trademark precision calculated that owning one bond and shorting another was twenty-fifth as risky as owning either outright. Thus, it reckoned, it would prudently leverage this long/short arbitrage twenty-five times. This multiplied its potential for profit, but also its potential for loss. In any case, borrow it did. It paid for the cheaper off the run bonds with money it had borrowed from a Wall Street bank, or from several banks. And the other bonds, the ones it sold short, it obtained through a loan, as well. Actually, the transaction was more involved, though it was among the simplest in LTCM’s repertoire. No sooner than LTCM buy off the run bonds than it loaned them to some other Wall street firm, which then wired cash to LTCM as collateral. Then LTCM turned around and used this cash as a collateral on the bonds it borrowed. On Wall street, such short-term, collateralized loans are known as “repo financing”. The beauty of the trade was that LTCM’s cash transactions were in perfect balance. The money that LTCM spent going long matched the money that it collected going short. The collateral it paid equalled the collateral it collected. In other words, LTCM pulled off the entire transaction without using a single dime of its own cash. Maintaining the position wasn’t completely cost free, however. Though, a simple trade, it actually entailed four different payment streams. LTCM collected interest on the collateral it paid out and paid interest at a slightly higher-rate on the collateral it took in. It made some of this deficit back because of the difference in the initial margin, or the slightly higher coupon on the bond it owned as compared to the bond it shorted. This, overall cost a few basis points to LTCM each month.