The So-Called ‘Masters of the Universe’

October 5, 1998 – Long-Term Capital Management was supposed to have been run by some of the best minds on Wall Street. Its management boasted that two Nobel laureates and a former Federal Reserve governor were among the glitterati that adorned its high-powered Board of Directors. Its state-of-the-art ‘black-box’ computer models were supposedly developed and operated by some of the best mathematicians available, using the latest techniques, proprietary software and computing power to generate low-risk, but high rates of return. Until last month, LTCM was considered by others and by themselves to be ‘masters of the universe’. We all know now that it didn’t quite work out that way.

Nevertheless, this all-star team enabled John Meriwether, the principal behind the firm, to develop some of the best contacts throughout the financial world. In short, he comfortably traveled in central-banker circles, so it is not too surprising to me that the central bank of Italy lost $250 million after LTCM collapsed. More central bank losses will be reported in due course, unless of course the more secretive central banks are too embarrassed to report their losses to the public whom they supposedly serve, and then disingenuously hide those losses in arcane ways. No, the central bank involvement is not surprising. What is surprising though is that the implications of the LTCM collapse do not yet appear to have been fully grasped by the media nor the general public.

One obvious implication is that the prestige of hedge funds peaked coincidentally with the stock market, much like the infamous investment trusts did in 1929. The hedge funds have had their moment in the sun, and now the heyday of hedge funds has passed. But it is the less obvious implication which is of greater interest to me because of its potential bullish impact on the Gold market going forward from here. Because I view this impact to be so important, I would like to review what so far has largely been ignored.

Long-Term Capital Management’s balance sheet was a disaster waiting to happen, and with the benefit of hindsight, we now know why they were so secretive about their operation and financial position. Even many of the banks that loaned money to LTCM supposedly did not fully know or understand the extent to which this hedge fund was leveraged (yes, some bankers are really that dimwitted that they don’t spend the time and effort to fully examine the risks before they lend billions).

At its peak, LTCM owned $134 billion of assets, and much of this was comprised of Third World debt. This total by any measure is huge, but the real surprise is on the right-side of the balance sheet – its liabilities and equity. Only $4 billion of equity supported a pyramid of $130 billion of debt. Therefore, a 3% decline in asset value could wipe out the firm’s equity, leaving a mountain of debt to be serviced. And that’s exactly what happened; the value of its assets dropped more than 3%. This analysis excludes LTCM’s $1.25 trillion book of derivative exposure, which is reported off the balance sheet. Who knows what losses lurk in there and are yet to be reported?

Although it wasn’t supposed to happen according to their ‘black-box’ computer models, the value of LTCM’s assets dropped. Partner equity in the hedge fund was wiped out, leaving the debtors with staggering losses because the liabilities far exceed the market value of LTCM’s assets. Therefore, under the supervision of the Federal Reserve, the creditor banks engineered a bail-out rather than have an asset fire-sale which would force these banks to recognize losses probably as large as $25 billion if attempts were made to liquidate the remaining assets.

To buy time, $3 billion of new money was pumped into LTCM by the banks to provide the now defunct hedge fund with some liquidity while the banks try to unload LTCM’s assets in a more orderly fashion over a long period of time. I doubt they will be successful in this regard, but that is their hope to avoid realizing these big losses.

Now here is where this story really gets interesting. In their rush to deal with the assets on the left-side of the balance sheet, the banks have so far largely ignored the nature of the liabilities on the right-side of LTCM’s balance sheet. Specifically, I understand that LTCM presently has about $90 billion of liabilities remaining and assets with a nominal value of $90 billion, ignoring the new bank equity and assuming that the market value of its assets have not deteriorated (which of course they have). In any case, if one looks at the $90 billion of debt, not all of it is denominated in Dollars. Much of it is denominated in foreign currencies, and $4 billion is denominated in Gold ounces. Gold ounces? Yes, here’s what happened.

LTCM borrowed Gold from central banks (some 400 tonnes, which is about 13 million ounces) to provide funding for some of its assets. The process, which is frequently used by mining companies hedging future production, works like this. LTCM borrows the Gold, and then immediately sells it to obtain Dollars or some other national currency, which is then used to buy some asset, mainly bonds of different sovereign debtors (US, Japan, Germany, Russia, etc.). The result is that LTCM is short Gold.

Hedge funds like LTCM borrowed Gold because the volatility was low and because of the perceived central bank overhang, namely, that central banks were going to dishoard their Gold, a process which would take next to forever to complete. Borrowing Gold to fund assets was seen as a low risk play, which it has been for the past 2-1/2 years as Gold declined. Also, option volatility on Gold had been dropping for years, confirming LTCM’s mathematically derived perception of low risk. So borrowing Gold seemed like a low risk funding technique, which I guess it was until Gold hit $274 at the end of August, at which point LTCM started to unravel.

At the moment, everyone is still focusing on LTCM’s assets, not its liabilities. The 400 tonne liability at the end of August was $3.6 billion in Dollar terms, with the Gold price at $274. Relative to $90 billion of liabilities, this $3.6 billion was hardly on the radar screen of the people overseeing LTCM. Soon it will be because the 8% rise in the Gold price in September increased LTCM’s liabilities in Dollar terms by $286 million. The September 30th $3.8 billion Gold liability marked-to-market at $296 per ounce should increase the awareness by LTCM’s overseers of this Gold problem because of the big change in the liability from the August 31 valuation when Gold was $274.

Even more important, the magnitude of this problem is underestimated because few people realize that it is probably impossible to buy 400 tonnes of Gold anywhere near present prices. It may take a price something north of $350 (maybe very far north) to entice enough people to accept Dollars in return for parting with their Gold.

Remember, LTCM needs 400 tonnes to repay its Gold loan, and at the moment, there is a shortage of physical Gold, not a surplus. To prove this point, ask any coin dealer whether or not he is able to acquire a sufficient amount of inventory. They can’t, so quickly are coins and bars moving off the shelves of dealers.

Clearly, LTCM is going to remain on the front pages for weeks, if not months. It will have a big and untold knock-on effect, with both short-term and long-term implications.

In the short-term the hedge funds that borrowed Gold like LTCM did (short Gold, long Russian bonds, now there’s a wise trade only two Noble laureate college professors could put together!) will soon have to begin repaying those loans because many lenders of Gold will be unwilling to accept the credit risk. Consequently, we’ll see a contraction in Gold lending much like after the Drexel collapse, which owed and failed to repay the Bank of Portugal 17 tonnes of Gold (central bankers aren’t much smarter than Nobel laureates!).

But the big question remains – where will the hedge funds find the 1300 tonnes (400 tonnes borrowed by LTCM alone) they need to repay their debts? [This 1300 tonne estimate comes from The 1998 Gold Book Annual written by Frank Veneroso, which in my view is one of the best analyses available of the supply, demand and movement of Gold bullion. It is available for purchase for $295 from Jefferson Financial (800) 877-8847, or fax (504) 837-4885].

At $290 per ounce, it is likely that the hedge funds will not be able to acquire the weight of Gold they need to repay their loans. It is logical to assume that no central bank stands ready to part with that weight of Gold, so the hedge funds will have to go into the market to cover, an action which should drive the Gold price considerably higher. At $380-$400, maybe they will be able to cover, namely, if a sufficient number of Gold owners are enticed to part with their hoard. But in reality, it may take a much higher price for LTCM alone (forgetting about the other hedge funds for the moment) to acquire the bullion it needs to repay its loan.

It seems more likely that LTCM will declare bankruptcy, leaving the central banks who loaned the 400 tonnes with big losses, which has an important implication for the long-term. The big short positions in Gold by the hedge funds are a thing of the past – like big tail-fins on 1950’s Cadillacs. An era has passed.

Over the past few years, the Gold market has absorbed not only new production, but the Gold borrowed from central banks by hedge funds and others and then sold into the market to raise national currencies. With this onslaught of metal, it is no wonder that Gold is under $300, given the magnitude of the sales by hedge funds. But no longer, and I expect that the Gold price will continue to rise from here as a reflection of this new reality.