The most surprising news to come out of the Long-Term Capital bailout was that John Meriwether’s hedge fund was taking large gambles in the field of equity arbitrage. Because announced mergers sometimes never take place, the stock prices of companies involved in a merger rarely converge right away. Even if Company Y agrees to buy Company X at a stock price that’s $10 above Company X’s current price, investors’ uncertainty about whether the deal will go through keeps Company X’s stock price from jumping that $10 right away. As a result, there’s potentially money to be made if you bet that the deal will go through and that Company X is therefore worth $10 more a share.
Of course, there’s also a great deal of money to be lost if the deal doesn’t go through and Company X’s stock price plummets, or, in the case of a stock swap, if Company Y’s shares fall, thereby making Company X’s shares less valuable. Something like this appears to have happened to Long-Term Capital, which reportedly made a huge bet on the proposed Tellabs-Ciena merger. That deal collapsed after Ciena lost an important contract and then had AT&T publicly announce that Ciena wasn’t in the running for a crucial chunk of business. The stock fell from $90 to below $13 a share, and Tellabs–which also saw its stock tank–called off the deal.
What’s surprising about Long-Term’s bet is that it doesn’t fit into the quantification model that was supposedly behind all of the fund’s investments. There’s no historical precedent that lets you know what the likelihood of a Tellabs-Ciena merger being consummated is, nor is there a convincing way of quantitatively modeling the risk-to-return ratio on that merger without some serious spadework into the financials of the two companies. And that’s investing of a very different sort than the kind that Long-Term advertised itself as doing. Its reliance on computer models was supposed to create essentially risk-free investments. But a proposed telecom merger seems like one good definition of a risk-full investment, particularly in this climate.
In other words, it’s not really accurate to say that Long-Term was just victimized by world events that even the most sophisticated quantitative models could not have predicted. The fund was also just making bad bets with leveraged money. And you don’t need Nobel Prize winners to do that.
THE DEATH OF RISK TOLERANCE: Speaking of risks, apparently no one believes in taking them anymore. The drop in 30-year interest rates to below 4.80 percent, the rapid rise in the spread between junk-bond yields and Treasury yields, the collapse of the market for emerging-market bonds, and the continued sell-off of U.S. equities all reflect one overarching fact: Investors are now willing to pay a premium for safety, where until July they were willing to pay a premium for growth. As Alan Greenspan remarked last week, the debacle in Russia, coupled with the continued turbulence in Asia and Latin America, has turned investors everywhere into nervous Nellies (well, he didn’t call them that, but that’s what he meant). If investors were willing to take risk X for yield Y in June, today they’re demanding yield 2Y, if they’re willing to take the risk at all.
Presumably this creates a huge opportunity to make money for anyone brave enough to invest in things other than U.S. treasuries. Junk bonds, for instance, still have a default rate of just 3 percent, but the spread between their yields and those of treasuries have doubled in the past year. The same might be said of small-cap U.S. stocks, which have been wiped off the map in 1998, even though many of those companies are growing as fast as ever. If the market is efficient, buyers should emerge to take advantage of these opportunities.
Of course, the looming fear is that the market is efficient, and that it’s appropriately discounting an impending recession, which could send the junk-bond default rate skyrocketing and which would make emerging markets places you definitely would not want to be. If investors were crazily optimistic as late as June, they may very well be too pessimistic now (though not about U.S. large-cap stocks, which still have too much good news priced into them). But once bitten, twice shy, I guess.