Financial Fragility in the Margins. Thought of the Day 114.0

If micro-economic crisis is caused by the draining of liquidity from an individual company (or household), macro-economic crisis or instability, in the sense of a reduction in the level of activity in the economy as a whole, is usually associated with an involuntary outflow of funds from companies (or households) as a whole. Macro-economic instability is a ‘real’ economic phenomenon, rather than a monetary contrivance, the sense in which it is used, for example, by the International Monetary Fund to mean price inflation in the non-financial economy. Neo-classical economics has a methodological predilection for attributing all changes in economic activity to relative price changes, specifically the price changes that undoubtedly accompany economic fluctuations. But there is sufficient evidence to indicate that falls in economic activity follow outflows of liquidity from the industrial and commercial company sector. Such outflows then lead to the deflation of economic activity that is the signal feature of economic recession and depression.

Let us start with a consideration of how vulnerable financial futures market themselves are to illiquidity, since this would indicate whether the firms operating in the market are ever likely to need to realize claims elsewhere in order to meet their liabilities to the market. Paradoxically, the very high level of intra-broker trading is a safety mechanism for the market, since it raises the velocity of circulation of whatever liquidity there is in the market: traders with liabilities outside the market are much more likely to have claims against other traders to set against those claims. This may be illustrated by considering the most extreme case of a futures market dominated by intra-broker trading, namely a market in which there are only two dealers who buy and sell financial futures contracts only between each other as rentiers, in other words for a profit which may include their premium or commission. On the expiry date of the contracts, conventionally set at three-monthly intervals in actual financial futures markets, some of these contracts will be profitable, some will be loss-making. Margin trading, however, requires all the profitable contracts to be fully paid up in order for their profit to be realized. The trader whose contracts are on balance profitable therefore cannot realize his profits until he has paid up his contracts with the other broker. The other broker will return the money in paying up his contracts, leaving only his losses to be raised by an inflow of money. Thus the only net inflow of money that is required is the amount of profit (or loss) made by the traders. However, an accommodating gross inflow is needed in the first instance in order to make the initial margin payments and settle contracts so that the net profit or loss may be realized.

The existence of more traders, and the system for avoiding counterparty risk commonly found in most futures market, whereby contracts are made with a central clearing house, introduce sequencing complications which may cause problems: having a central clearing house avoids the possibility that one trader’s default will cause other traders to default on their obligations. But it also denies traders the facility of giving each other credit, and thereby reduces the velocity of circulation of whatever liquidity is in the market. Having to pay all obligations in full to the central clearing house increases the money (or gross inflow) that broking firms and investors have to put into the market as margin payments or on settlement days. This increases the risk that a firm with large net liabilities in the financial futures market will be obliged to realize assets in other markets to meet those liabilities. In this way, the integrity of the market is protected by increasing the effective obligations of all traders, at the expense of potentially unsettling claims on other markets.

This risk is enhanced by the trading of rentiers, or banks and entrepreneurs operating as rentiers, hedging their futures contracts in other financial markets. However, while such incidents generate considerable excitement around the markets at the time of their occurrence, there is little evidence that they could cause involuntary outflows from the corporate sector on such a scale as to produce recession in the real economy. This is because financial futures are still used by few industrial and commercial companies, and their demand for financial derivatives instruments is limited by the relative expense of these instruments and their own exposure to changes in financial parameters (which may more easily be accommodated by holding appropriate stocks of liquid assets, i.e., liquidity preference). Therefore, the future of financial futures depends largely on the interest in them of the contemporary rentiers in pension, insurance and various other forms of investment funds. Their interest, in turn, depends on how those funds approach their ‘maturity’.

However, the decline of pension fund surpluses poses important problems for the main securities markets of the world where insurance and pension funds are now the dominant investors, as well as for more peripheral markets like emerging markets, venture capital and financial futures. A contraction in the net cash inflow of investment funds will be reflected in a reduction in the funds that they are investing, and a greater need to realize assets when a change in investment strategy is undertaken. In the main securities markets of the world, a reduction in the ‘new money’ that pension and insurance funds are putting into those securities markets will slow down the rate of growth of the prices in those markets. How such a fall in the institutions’ net cash inflow will affect the more marginal markets, such as emerging markets, venture capital and financial futures, depends on how institutional portfolios are managed in the period of declining net contributions inflows.

In general, investment managers in their own firms, or as employees of merchant or investment banks, compete to manage institutions’ funds. Such competition is likely to increase as investment funds approach ‘maturity’, i.e., as their cash outflows to investors, pensioners or insurance policyholders, rises faster than their cash inflow from contributions and premiums, so that there are less additional funds to be managed. In principle, this should not affect financial futures markets, in the first instance, since, as argued above, the short-term nature of their instruments and the large proportion in their business of intra-market trade makes them much less dependent on institutional cash inflows. However, this does not mean that they would be unaffected by changes in the portfolio preferences of investment funds in response to lower returns from the main securities markets. Such lower returns make financial investments like financial futures, venture capital and emerging markets, which are more marginal because they are so hazardous, more attractive to normally conservative fund managers. Investment funds typically put out sections of portfolios to specialist fund managers who are awarded contracts to manage a section according to the soundness of their reputation and the returns that they have made hitherto in portfolios under their management. A specialist fund manager reporting high, but not abnormal, profits in a fund devoted to financial futures, is likely to attract correspondingly more funds to manage when returns are lower in the main markets’ securities, even if other investors in financial futures experienced large losses. In this way, the maturing of investment funds could cause an increased inflow of rentier funds into financial futures markets.

An inflow of funds into a financial market entails an increase in liabilities to the rentiers outside the market supplying those funds. Even if profits made in the market as a whole also increase, so too will losses. While brokers commonly seek to hedge their positions within the futures market, rentiers have much greater possibilities of hedging their contracts in another market, where they have assets. An inflow into futures markets means that on any settlement day there will therefore be larger net outstanding claims against individual banks or investment funds in respect of their financial derivatives contracts. With margin trading, much larger gross financial inflows into financial futures markets will be required to settle maturing contracts. Some proportion of this will require the sale of securities in other markets. But if liquidity in integrated cash markets for securities is reduced by declining net inflows into pension funds, a failure to meet settlement obligations in futures markets is the alternative to forced liquidation of other assets. In this way futures markets will become more fragile.

Moreover, because of the hazardous nature of financial futures, high returns for an individual firm are difficult to sustain. Disappointment is more likely to be followed by the transfer of funds to management in some other peripheral market that shows a temporary high profit. While this should not affect capacity utilization in the futures market, because of intra-market trade, it is likely to cause much more volatile trading, and an increase in the pace at which new instruments are introduced (to attract investors) and fall into disuse. Pension funds whose returns fall below those required to meet future liabilities because of such instability would normally be required to obtain additional contributions from employers and employees. The resulting drain on the liquidity of the companies affected would cause a reduction in their fixed capital investment. This would be a plausible mechanism for transmitting fragility in the financial system into full-scale decline in the real economy.

The proliferation of financial futures markets has only had been marginally successful in substituting futures contracts for Keynesian liquidity preference as a means of accommodating uncertainty. A closer look at the agents in those markets and their market mechanisms indicates that the price system in them is flawed and trading hazardous risks in them adds to uncertainty rather than reducing it. The hedging of financial futures contracts in other financial markets means that the resulting forced liquidations elsewhere in the financial system are a real source of financial instability that is likely to worsen as slower growth in stock markets makes speculative financial investments appear more attractive. Capital-adequacy regulations are unlikely to reduce such instability, and may even increase it by increasing the capital committed to trading in financial futures. Such regulations can also create an atmosphere of financial security around these markets that may increase unstable speculative flows of liquidity into the markets. For the economy as a whole, the real problems are posed by the involvement of non-financial companies in financial futures markets. With the exception of a few spectacular scandals, non-financial companies have been wary of using financial futures, and it is important that they should continue to limit their interest in financial futures markets. Industrial and commercial companies, which generate their own liquidity through trade and production and hence have more limited financial assets to realize in order to meet financial futures liabilities in times of distress, are more vulnerable to unexpected outflows of liquidity in proportion to their increased exposure to financial markets. The liquidity which they need to set aside to meet such unexpected liabilities inevitably means a reduced commitment to investment in fixed capital and new technology.

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Long Term Capital Management. Note Quote.

Long Term Capital Management, or LTCM, was a hedge fund founded in 1994 by John Meriwether, the former head of Salomon Brothers’s domestic fixed-income arbitrage group. Meriwether had grown the arbitrage group to become Salomon’s most profitable group by 1991, when it was revealed that one of the traders under his purview had astonishingly submitted a false bid in a U.S. Treasury bond auction. Despite reporting the trade immediately to CEO John Gutfreund, the outcry from the scandal forced Meriwether to resign.

Meriwether revived his career several years later with the founding of LTCM. Amidst the beginning of one of the greatest bull markets the global markets had ever seen, Meriwether assembled a team of some of the world’s most respected economic theorists to join other refugees from the arbitrage group at Salomon. The board of directors included Myron Scholes, a coauthor of the famous Black-Scholes formula used to price option contracts, and MIT Sloan professor Robert Merton, both of whom would later share the 1997 Nobel Prize for Economics. The firm’s impressive brain trust, collectively considered geniuses by most of the financial world, set out to raise a $1 billion fund by explaining to investors that their profoundly complex computer models allowed them to price securities according to risk more accurately than the rest of the market, in effect “vacuuming up nickels that others couldn’t see.”

One typical LTCM trade concerned the divergence in price between long-term U.S. Treasury bonds. Despite offering fundamentally the same (minimal) default risk, those issued more recently – known as “on-the-run” securities – traded more heavily than those “off-the-run” securities issued just months previously. Heavier trading meant greater liquidity, which in turn resulted in ever-so-slightly higher prices. As “on-the-run” securities become “off-the-run” upon the issuance of a new tranche of Treasury bonds, the price discrepancy generally disappears with time. LTCM sought to exploit that price convergence by shorting the more expensive “on-the-run” bond while purchasing the “off- the-run” security.

By early 1998 the intellectual firepower of its board members and the aggressive trading practices that had made the arbitrage group at Salomon so successful had allowed LTCM to flourish, growing its initial $1 billion of investor equity to $4.72 billion. However, the miniscule spreads earned on arbitrage trades could not provide the type of returns sought by hedge fund investors. In order to make transactions such as these worth their while, LTCM had to employ massive leverage in order to magnify its returns. Ultimately, the fund’s equity component sat atop more than $124.5 billion in borrowings for total assets of more than $129 billion. These borrowings were merely the tip of the ice-berg; LTCM also held off-balance-sheet derivative positions with a notional value of more than $1.25 trillion.

The fund’s success began to pose its own problems. The market lacked sufficient capacity to absorb LTCM’s bloated size, as trades that had been profitable initially became impossible to conduct on a massive scale. Moreover, a flood of arbitrage imitators tightened the spreads on LTCM’s “bread-and-butter” trades even further. The pressure to continue delivering returns forced LTCM to find new arbitrage opportunities, and the fund diversified into areas where it could not pair its theoretical insights with trading experience. Soon LTCM had made large bets in Russia and in other emerging markets, on S&P futures, and in yield curve, junk bond, merger, and dual-listed securities arbitrage.

Combined with its style drift, the fund’s more than 26 leverage put LTCM in an increasingly precarious bubble, which was eventually burst by a combination of factors that forced the fund into a liquidity crisis. In contrast to Scholes’s comments about plucking invisible, riskless nickels from the sky, financial theorist Nassim Taleb later compared the fund’s aggressive risk taking to “picking up pennies in front of a steamroller,” a steamroller that finally came in the form of 1998’s market panic. The departure of frequent LTCM counterparty Salomon Brothers from the arbitrage market that summer put downward pressure on many of the fund’s positions, and Russia’s default on its government-issued bonds threw international credit markets into a downward spiral. Panicked investors around the globe demonstrated a “flight to quality,” selling the risky securities in which LTCM traded and purchasing U.S. Treasury securities, further driving up their price and preventing a price convergence upon which the fund had bet so heavily.

None of LTCM’s sophisticated theoretical models had contemplated such an internationally correlated credit market collapse, and the fund began hemorrhaging money, losing nearly 20% of its equity in May and June alone. Day after day, every market in which LTCM traded turned against it. Its powerless brain trust watched in horror as its equity shrank to $600 million in early September without any reduction in borrowing, resulting in an unfathomable 200 leverage ratio. Sensing the fund’s liquidity crunch, Bear Stearns refused to continue acting as a clearinghouse for the fund’s trades, throwing LTCM into a panic. Without the short-term credit that enabled its entire trading operations, the fund could not continue and its longer-term securities grew more illiquid by the day.

Obstinate in their refusal to unwind what they still considered profitable trades hammered by short-term market irrationality, LTCM’s partners refused a buyout offer of $250 million by Goldman Sachs, ING Barings, and Warren Buffet’s Berkshire Hathaway. However, LTCM’s role as a counterparty in thousands of derivatives trades that touched investment firms around the world threatened to provoke a wider collapse in international securities markets if the fund went under, so the U.S. Federal Reserve stepped in to maintain order. Wishing to avoid the precedent of a government bailout of a hedge fund and the moral hazard it could subsequently encourage, the Fed invited every major investment bank on Wall Street to an emergency meeting in New York and dictated the terms of the $3.625 billion bailout that would preserve market liquidity. The Fed convinced Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P. Morgan, Morgan Stanley, Salomon Smith Barney, and UBS – many of whom were investors in the fund – to contribute $300 million apiece, with $125 million coming from Société Générale and $100 million from Lehman Brothers and Paribas. Eventually the market crisis passed, and each bank managed to liquidate its position at a slight profit. Only one bank contacted by the Fed refused to join the syndicate and share the burden in the name of preserving market integrity.

That bank was Bear Stearns.

Bear’s dominant trading position in bonds and derivatives had won it the profitable business of acting as a settlement house for nearly all of LTCM’s trading in those markets. On September 22, 1998, just days before the Fed-organized bailout, Bear put the final nail in the LTCM coffin by calling in a short-term debt in the amount of $500 million in an attempt to limit its own exposure to the failing hedge fund, rendering it insolvent in the process. Ever the maverick in investment banking circles, Bear stubbornly refused to contribute to the eventual buyout, even in the face of a potentially apocalyptic market crash and despite the millions in profits it had earned as LTCM’s prime broker. In typical Bear fashion, James Cayne ignored the howls from other banks that failure to preserve confidence in the markets through a bailout would bring them all down in flames, famously growling through a chewed cigar as the Fed solicited contributions for the emergency financing, “Don’t go alphabetically if you want this to work.”

Market analysts were nearly unanimous in describing the lessons learned from LTCM’s implosion; in effect, the fund’s profound leverage had placed it in such a precarious position that it could not wait for its positions to turn profitable. While its trades were sound in principal, LTCM’s predicted price convergence was not realized until long after its equity had been wiped out completely. A less leveraged firm, they explained, might have realized lower profits than the 40% annual return LTCM had offered investors up until the 1998 crisis, but could have weathered the storm once the market turned against it. In the words of economist John Maynard Keynes, the market had remained irrational longer than LTCM could remain solvent. The crisis further illustrated the importance not merely of liquidity but of perception in the less regulated derivatives markets. Once LTCM’s ability to meet its obligations was called into question, its demise became inevitable, as it could no longer find counterparties with whom to trade and from whom it could borrow to continue operating.

The thornier question of the Fed’s role in bailing out an overly aggressive investment fund in the name of market stability remained unresolved, despite the Fed’s insistence on private funding for the actual buyout. Though impossible to foresee at the time, the issue would be revisited anew less than ten years later, and it would haunt Bear Stearns. With negative publicity from Bear’s $38.5 million settlement with the SEC regarding charges that it had ignored fraudulent behavior by a client for whom it cleared trades and LTCM’s collapse behind it, Bear Stearns continued to grow under Cayne’s leadership, with its stock price appreciating some 600% from his assumption of control in 1993 until 2008. However, a rapid-fire sequence of negative events began to unfurl in the summer of 2007 that would push Bear into a liquidity crunch eerily similar to the one that felled LTCM.