Thursday, August 18, 2011

LTCM Co-Founder, Nobel Laureate, Scholes Says the Fund Was Doomed From the Start (we are still using 1998 as a mental map for 2011)

From FINalternatives:

LTCM Founder Says Leverage, Portfolio Theory Doomed Firm
A co-founder of Long-Term Capital Management said that the legendary collapsed hedge fund’s leverage ensured its fate.

LTCM collapsed in 1998—a year after Myron Scholes won the Nobel Prize in economics—forcing the Federal Reserve to arrange a bailout. At the time, it was the largest-ever hedge fund failure.

Scholes, who went on to found hedge fund Platinum Grove Asset Management, now says that the firm’s leverage doomed it in the wake of Russia’s sovereign debt default.

“LTCM ran leveraged positions at too-high risk levels,” Scholes told Risk. “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.”

And this [sic] risks inherent in LTCM’s portfolio were higher than anyone realized 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,” Scholes said of LTCM’s demise. “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.”
Scholes also blamed an over-reliance on classic portfolio theory....MORE
HT: Economic Policy Journal who titled his post "Now He Tells Us: Noble Prize Winner Says LTCM Was Doomed to Fail" and goes on to rail that Scholes' apologia should be a mea culpa.

Here's what the DJIA did in that that long ago summer of 1998:

We are using this pattern as a guide to this year's action. So far it's close enough for modeling.
One difference, in 2011 the April-May high rather than the July set the interim top.
We should be able to get to a 21% top-to-bottom decline easily enough.
See also:
Equities 2011: More Like 1987 than 2008 (or is it 1903? 1998? 1873 was pretty bad...)
1998 As a Template For 2011's Market Action (DIA; SPY; VIX)