Remembering LTCM
Doug Nolan
The 25-year anniversary of the Russia/LTCM collapse offers a timely reminder of the perils of leveraged speculation.
A series of Wall Street Journal articles touched on key issues.
“Naturally things are completely different today.
Back in 1998 there was a massive auto worker strike, Russia was a financial pariah, America's unemployment rate was at a historic low, tech stocks were the only game in town, the Federal Reserve had raised rates for the first time in years the previous March, House Republicans wanted to impeach the president and the New York Yankees were in first place.
Today, by contrast, the Yanks couldn’t win to save their lives. In all seriousness, though, there is a fair bit of late 1990s style irrational exuberance present today.”
- (Heard on the Street, September 22, 2023)
The first of the Journal’s three-part series underscored a critical issue:
“Even 25 years later, the effects are with us.
If there was a time when the ‘Fed put’ was born, it was during the LTCM crisis…
The Fed's first rate cut in 1998 came on Sept. 29, just six days after the Federal Reserve Bank of New York helped arrange a $3.5 billion bailout of LTCM by a consortium of financial firms.
Judging from economic reports from the time, the cut didn’t make much sense.”
Yet a critical facet of the “Fed put” significantly predates September/October 1998.
I’ve seen no mention of the critical roles played by Mexico’s “Tequila crisis” and the collapse of the Asian Tiger Bubbles.
The 1994/95 peso crisis and yield spike (tesobonos collapse) unfolded in the wake of Fed tightening and problematic U.S. bond market deleveraging, revealing how years of monetary stimulus had promoted leveraged speculation throughout the emerging markets.
Importantly, the $50 billion U.S. bailout package (in concert with IMF assistance) for Mexico was instrumental in stoking 1996 Asian Tiger Bubble “Terminal Phase Excess.”
The following year, Bubbles burst in South Korea and Indonesia (along with Malaysia, Philippines, and Thailand) with catastrophic consequences.
The IMF led a group of global institutions in formulating bailout packages of over $100 billion.
If not for the Mexican and Asian bailouts, I seriously doubt there would have been such enthusiasm for leveraging Russian, Italian and other bonds.
The LTCM Nobel laureates would have been humbled before accumulating $1 TN notional of derivative contracts within a highly levered $7 billion hedge fund.
In general, the bailouts, along with the activist Greenspan Fed’s keen market focus, were instrumental in rapid hedge fund industry expansion and the surge in global leveraged speculation.
Another critical aspect of the analysis is missing from conventional accounts: The LTCM bailout pushed the nineties “tech” Bubble into “Terminal Phase Excess.”
From its October 9th, 1998, low of 1,492, the Nasdaq Composite surged 155% to the March 10, 2020, record high of 5,133 (a high that stood for 15 years).
The Nasdaq Composite rose a manic 86% in 1999.
And as the Fed gathered the heads of the Wall Street firms in a room to negotiate the LTCM bailout, the GSE’s were hard at work orchestrating a market liquidity bailout.
GSE assets expanded an unprecedented $136 billion during Q4 1998 – surpassing the previous Q4 1994 (Mexican crisis) record of $60 billion.
For year 1998, GSE assets expanded an unprecedented $305 billion, or 28%, to a record $1.406 TN.
The LTCM crisis unleashed reckless Fannie and Freddie expansions and market operations.
GSE assets would expand another $317 billion in 1999, $242 billion in 2000, $345 billion in 2001, $242 billion 2002, and $245 billion in 2003.
If not for the LTCM bailout and resulting terminal tech Bubble excess, there would have been less desperation for Fed easing and the accommodation of mortgage finance excesses.
Household mortgage debt was already expanding at a 9% rate in 1998.
Mortgage Credit Bubble inflation then saw growth increase to 10.8% in 2001, 13.3% in 2002, 12.8% in 2003, 14.2% in 2004, 13.9% in 2005, and 11.5% in 2006.
And if not for the mortgage finance Bubble, surely there would not have been the $26 TN, or almost 200%, surge in Treasury and Agency Securities since 2007.
There are today eerie parallels to the period leading up to the Russia/LTCM crisis.
After all the 1994-1997 period global instability, the global leveraged speculating community should have been cautious.
They had instead been emboldened by the Fed, “the committee to save the world” (Greenspan, Rubin and Summers), the GSEs, the IMF, and the global central bank community.
Pandemic policy measures (and the March bailout) again emboldened.
“The West will never allow the Russian ruble to collapse” was part of the bullish narrative, as the S&P500 (and bank stocks!) surged to record highs in July 1998.
No one recognized the interconnectedness of the Russian bond market and currency derivatives to global debt markets.
Not many years later, it was “Washington will never allow a housing bust.”
There is today even more confidence that Beijing has all the financial resources and ingenuity to ensure renminbi stability.
And it’s always such cavalier attitudes that ensure the accumulation of precarious speculative leverage, risky lending, and other financial excesses.
De-risking/deleveraging gained important momentum this week.
The global yield spike ran unabated, with notable pain for the European periphery.
At Thursday’s highs, Italian 10-year yields traded to 4.95%, up 35 bps w-t-d to the high back to the 2012 European bond crisis.
Greek yields were up 33 bps w-t-d (4.52%) at Thursday’s highs, with Portuguese (3.75%) and Spanish yields (4.08%) 25 bps higher.
The spread between German and Italian 10-year yields widened nine this week to 194 bps, the widest level since the March banking crisis period.
Emerging markets remain under de-risking pressure.
The Colombian peso declined 2.19%, the Brazilian real 1.93%, the Russian ruble 1.82%, the Mexican peso 1.27%, and the Polish zloty 1.15%.
For September, the Polish zloty dropped 5.68%, the Hungarian forint 4.60%, the Chilean peso 4.40%, the Czech koruna 3.93%, and the Thai Baht 3.88%.
EM bonds remain under significant pressure.
Local yields surged 145 bps this week in Turkey (25.91%), 27 bps in Peru (7.32%), 23 bps in Hungary (7.49%), 14 bps in Indonesia (6.88%), and 11 bps in Brazil (11.66%).
EM dollar bond yields spiked higher.
Yields jumped 21 bps in Colombia (8.21%), 18 bps in Panama (6.76%), 16 bps in Turkey (8.56%), 14 bps in Indonesia (5.82%), 13 bps in Saudi Arabia (5.47%), 12 bps Mexico (6.34%), 12 bps in Peru (5.95%), and 11 bps in the Philippines (5.46%).
Global “risk off” was not contained within the “periphery.”
Ten-year Treasury yields jumped 14 bps this week to 4.57%, the high back to October 2007.
Benchmark MBS yields surged 18 bps to 6.36%, trading Thursday at 6.50% for the first time since April 2002.
High yield CDS surged 35 to 481 bps, trading this week at highs since May.
Curiously, U.S. bank CDS prices were at the top of the week’s global leaderboard.
Bank of America CDS jumped 9.5 to a four-month high 96 bps.
Citigroup CDS gained seven to a four-month high 86 bps, while JPMorgan CDS increased four to a four-month high 65 bps.
The Dollar Index traded to 106.8 in Thursday trading, the high back to November 2022.
The euro traded below 1.05 versus the dollar for the first time since early January (before closing the week at 1.0573).
The dollar/yen traded up to 149.70, almost breaching the 150 level for the second time (October 2022 the first) since 1990.
Japan’s TOPIX Bank Index was slammed 5.3%, the largest decline since March.
A Thursday Bloomberg headline:
“Biggest Selloff in 25 years Hits Japan Bonds as BOJ Loosens Grip.”
September 25 – Dow Jones (Megumi Fujikawa):
“Bank of Japan Gov. Kazuo Ueda said… he has seen some positive signs of sustainable inflation, but he isn't ready to unwind monetary easing yet.
‘Japan's economy has entered a critical phase in terms of realizing a virtuous cycle between wages and prices, and what is important at this phase is to carefully nurture the buds of change in the economy,’ Ueda told business leaders…”
September 28 – Bloomberg (Yumi Teso and Masaki Kondo):
“The Bank of Japan announced an unscheduled bond-purchase operation Friday in a reminder to the market of its determination to manage the upward momentum in sovereign yields.
The buying clipped half a basis point off the benchmark 10-year yield…
Japan’s 30-year yields reached a peak last seen in 2013 and the 20-year maturity touched the highest since 2014 on Thursday amid a selloff that’s hitting bonds around the world.”
While the renminbi held steady, Chinese sovereign and bank CDS rose again this week.
Things took a dramatic turn for the worse at Evergrande (See China Watch), with no end in sight for the great deflating Chinese apartment Bubble.
September 25 – Bloomberg:
“Fresh drama at property developers including China Evergrande Group is jeopardizing President Xi Jinping’s latest efforts to end the housing crisis.
Just as China enters a key holiday sales season, a raft of headlines are weighing on already-frail confidence in the property market.
Evergrande said it has to revisit its debt restructuring plan and a unit missed a yuan bond payment.
Former executives at the defaulted real estate giant have been detained...
Meanwhile, China Oceanwide Holdings Ltd. said it is facing liquidation and Country Garden Holdings Co. is still trying to avoid a potential default.”
The Wall Street Journal ran what is surely a prescient headline: “LTCM Crisis Took One Bailout. We Should Be So Lucky Next Time.”
The world is not prepared for globalized de-risking/deleveraging.
The Fed/FHLB March banking bailout unleashed a six-month speculative cycle, emboldening market speculation.
Not only was the Fed liquidity backstop further validated, but the “Fed put” arrived before “risk off” even had a chance to get going.
The unfolding crisis will be so much more problematic.
A synchronized global de-risking/deleveraging will snare scores of levered funds across markets.
It’s worth noting that this week had inklings of trouble for multiple popular strategies, including 60/40, risk parity, quant strategies, and long/short (Goldman Sachs short index up 2.1%).
There will be no easy fix for systemic de-risking/deleveraging.
We witnessed in March 2020 how the massive growth in levered speculation had created the need for Trillions of central bank support to reverse speculative deleveraging.
But that was before inflation had become a major issue – and prior to the spike in global bond yields.
The next big central bank market bailout will present quite a test.
How destabilizing will de-risking/deleveraging become before central bankers are compelled to act?
Are central bankers prepared to orchestrate another massive liquidity injection?
Would this liquidity onslaught stoke bond market inflation fears?
Would global currency markets, already at the cusp of disorderly trading, turn chaotic?
It doesn’t take much to imagine wild instability taking hold across global markets.
September 27 – Bloomberg (Marc Rubinstein):
“After the fact, one of the LTCM partners summed it up well: ‘The hurricane is not more or less likely to hit because more hurricane insurance has been written.
In the financial markets this is not true.
The more people write financial insurance, the more likely it is that a disaster will happen, because the people who know you have sold the insurance can make it happen.
So you have to monitor what other people are doing.’”
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