According to some, America’s bailout culture started long before the 2008 global financial crisis, with Wall Street’s bailout of Long-Term Capital Management, an iconic hedge fund whose employee roster included a “who is who” of Nobel prize winners and financial luminaries, and whose core business model was, for lack of a better word, collecting pennies in front of a steamroller: one of the fund’s most popular trades was in the arena of fixed-income arbitrage, where the fund would take advantage of tiny mispricing between more expensive “on the run” treauries and cheaper “old benchmark” notes, capitalizing on a tiny spread which was at most a few basis points, betting that over the long run this spread would collapse. To make this trade economic, the fund employed massive leverage: at the beginning of 1998, the firm had equity of only $4.72 billion against which it had borrowed over $124.5 billion resulting in “regulatory assets” of around $129 billion, for a debt-to-equity ratio of over 25 to 1 (the fund also had off-balance sheet interest rate derivatives with a notional value of approximately $1.25 trillion).
For a while, the fund’s massively leverage trades worked as expected, with the fund returning 21%, 43% and 41% in its first three years, respectively, however in year four things turned ugly when first the Asian Financial Crisis struck in 1997 followed by the 1998 Russian Financial Crisis. At that point the fund lost $4.6 billion in just weeks, wiping out its entire equity stack, and prompting the first official “intervention” by the Federal Reserve alongside a consortium of 16 banks, which stepped in to help an orderly unwind of the fund whose implosion was rocking the market.
We bring this iconic hedge fund blow up – which was entirely due to far too much leverage – because it appears that we may be returning to the good old days of stratospherically insane hedge fund leverage. Case in point, Michael Gelband’s new hedge – just a few months old – which may not have quite the leverage of LTCM just yet, appears to be giving it the old college try; in fact, as Bloomberg notes, Gelband is already already using more leverage than his former boss, Israel Englander.
ExodusPoint Capital Management, one of the industry’s highest-profile launches in recent history, had $82.3 billion of regulatory assets as of Dec. 31, or almost 10 times the $8.4 billion of investor capital the firm had under management, resulting in roughly 10x leverage according to a the fund’s Form ADV.