Thursday, April 05, 2007

Buffet and LTCM

Interesting tidbit for students of the LTCM meltdown, as relayed by Wharton professor Jeremy Siegel.

Apologies to people who believe in efficient markets and similar orthodoxy ;-)

Long Term Capital Management

One student asked about Berkshire’s role in the Long-Term Capital Management (LTCM) crisis that rocked the financial markets in 1998. It was obvious that Warren wished that he had been able to buy LTCM’s positions when the Fed forced a resolution of the crisis that was crippling the government bond market.

The LTCM crisis was a ready-made example of Warren’s philosophy of buying firms when the economics was right, yet fear ruled the markets. He noted that “off-the-run” (non-benchmark) government bonds were selling to yield 30 basis points more than the “on-the-run” (benchmark) bonds that were maturing just six months later. He rightly claimed that this made no sense economically.

LTCM had taken a huge leveraged position in these bonds when the spreads were much smaller, but didn’t have the collateral to hold on to it when the spread widened. Buffett quoted John Maynard Keynes, who wrote in 1931 that “The market can stay irrational longer than you can stay solvent.” As the spread widened, Keynes’ dictum became devastatingly relevant for LTCM. But Berkshire, with its huge cash hoard, could withstand the pressure of even more market irrationality before the spread eventually returned to normal.

Unfortunately, Warren was never able to consummate the deal. He had been invited by Bill Gates to vacation in Alaska when the crisis broke and it was hard to negotiate such a deal on a cell phone. Eventually the banks holding the collateral made a deal with LTCM and Berkshire didn’t have a chance to top their offer.

Warren is philosophical about the loss of this opportunity, noting it was the most expensive vacation he ever took. “Bill Gates cost me about $3 billion,” he shrugged. But that incident certainly has not soured their friendship and didn’t prevent him from giving the Bill and Melinda Gates Foundation the lion’s share of his wealth.

5 comments:

Dave Bacon said...

What's a few billion among friends, eh?

J said...

This whole episode is discussed in 'When Genius Failed', including Buffet's fishing trip. From the book, it seems like he had plenty of chances to make a deal for LTCM, but that he couldn't do a deal with LTCM under the terms he wanted.

steve said...

The impression I got from WGF is that Buffet couldn't get the deal he wanted. In this anecdote he blames the fact that he was in Alaska...

Anonymous said...

Regarding your earlier post

http://infoproc.blogspot.com/2005/02/ltcm-and-real-smart-guys.html,

you should read

MacKenzie, D. (2003), "Long-Term Capital Management and the Sociology of Arbitrage", Economy and Society, 32, 349-380.

It is the best article written about the topic.

steve said...

I just tried to find a copy on the web, but they all seem to be behind copyright protection. Can you send me a copy?

I think I read some related work by MacKenzie -- a paper discussing the Black-Scholes equation and arbitrage.

Does he actually discuss LTCM's positions? I knew people there and it seems very few knew the whole picture of what their portfolio looked like. There was a lot of rumor and speculation...

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