Evergrande vs. Lehman and Long Term Capital Management (LTCM)

Evergrande hysteria seems to have been a one-day wonder on Wall Street, as investors began to look deeper than over-the-top media coverage to realize that, while a big deal for China, it’s really only a worry for the rest of the world to the extent they’re Evergrande creditors.

The comparisons being made with Lehman and LTCM were headline-grabbing (which I guess was the intent) but way off the mark. I thought I’d write a brief recap of my take on both of these.

LTCM is easier. The important thing to realize is that while there’s tons of liquidity in the trading of the Treasury bonds that are selected to be the constituents of T-bond derivatives (called “on the run”), there isn’t in very similar bonds that aren’t (called “off the run”). Because of this, off the run bonds trade at slightly higher yields than virtually identical ones that are lucky enough to be on the run. For years, investors of all stripes–banks, brokerage houses, wealthy individuals–have shorted on the run bonds, used the money to buy nearly identical off the run ones and held to maturity. Under normal circumstances, this was like picking up $100 bills on the street.

In 1994, a famous Salomon Brother bond trader decided to execute this bread-and-butter strategy on an heroic scale. He founded LTCM, put a couple of Nobel Prize-winning financial academics on the board to enhance the brand, and raised a ton of capital.

Investors more than tripled their money in the first three years. Then came the implosion of the Russian economy in 1998, which triggered a flight to safety–meaning on the run bonds went up in price while off the run went down. Suddenly, LTCM, which was reported to be borrowing as much as 25x it’s equity, was bankrupt.

The “crisis” wasn’t about rich people losing money. It was about how to sell tons of highly illiquid securities that LTCM had (incredibly recklessly, in my view) bought, with nary a peep–that I heard anyway–from its eminent directors. The Fed cobbled together a consortium of banks to hold them and gradually sell them off.

Lehman tomorrow.

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