New on FinoLib · Volume II: Capital Markets
My latest article is now live on FinoLib, the free finance library I write: Asian Financial Crisis of 1997 and the LTCM Collapse of 1998, from Volume II: Capital Markets. Read the summary below for the substance of the topic, then continue to FinoLib for the complete treatment.
10.3 The 1997 Asian Financial Crisis
The idea in plain words
The 1997 Asian crisis began when Thailand let its currency, the baht, float on July 2, 1997. It fell from 24.52 to 56.10 per dollar by January 1998. Companies and banks that had borrowed in dollars but earned in local currency saw their debts more than double in local terms. That triggered IMF programs for Thailand, Indonesia and Korea.
Key points
■A Thai firm with $100 million of debt and 1 billion baht of EBITDA went from 2.45× to 5.61× debt to EBITDA without any change in its business.
■A 4.0× covenant broke at 40 baht per dollar, a 38.7% fall; the actual fall was 56.3%.
■The Korean won fell from 890 to 1,960 per dollar in 1997, raising dollar debt in won by 120.2%.
A closer look
Through the mid-1990s, several fast-growing Southeast Asian economies (Thailand, Indonesia, South Korea, and others) had borrowed heavily in foreign currency (largely US dollars) while maintaining currencies pegged, or closely managed, against the dollar (Volume I’s Part 1 on exchange rate regimes). When Thailand was forced to abandon its currency peg in July 1997 under speculative pressure, the baht collapsed in value — and because so much corporate and bank debt across the region was denominated in dollars while revenues were earned in local currency, the devaluation instantly and dramatically inflated the real cost of repaying that debt, triggering a cascading regional crisis and IMF interventions across several countries.
Decision rule
If a borrower earns in one currency and owes in another, compute the exchange rate at which its covenants break: covenant multiple × local-currency EBITDA ÷ foreign-currency debt. If that rate is within one past crisis-size move of today’s (the baht lost 56% of its value in six months), require a hedge, natural or financial, or price the loan as if the breach were likely. The rule does not apply when revenues are themselves in dollars, as for exporters priced in dollars.
The costliest mistake
Trusting a peg as if it were a hedge. A peg holds until the central bank runs short of reserves, then breaks in a day: the baht moved from 24.52 to 30.18 overnight on July 2, 1997. In the example, the company’s dollar debt rose by 5.61 − 2.45 = 3.16 billion baht, more than three years of its EBITDA, with no change in its business. Hedge the currency or borrow in the currency you earn.
10.4 LTCM’s 1998 Collapse
The idea in plain words
Long-Term Capital Management was a hedge fund founded in 1994 by John Meriwether, with Robert Merton and Myron Scholes as partners. It made leveraged convergence trades, betting that prices that had drifted apart would come back together. After Russia’s default in August 1998, its capital fell to $2.3 billion against over $125 billion of assets. On September 23, 1998, fourteen firms put in about $3.6 billion, organized by the New York Fed without public money.
Key points
■Leverage was over 25 to 1 on January capital and about 54 to 1 after August’s $1.8 billion loss.
■The asset fall that wipes out capital is 1 ÷ leverage: 3.84% at 26×, 1.84% at 54×.
■A 2% adverse move erases all capital above 50× leverage.
Decision rule
Before sizing any leveraged relative-value position, compute the adverse move that wipes out capital: 1 ÷ leverage (assets ÷ capital). If a move of that size has occurred even once in the history you can find, including crisis periods, cut leverage until the wipe-out move is at least twice the worst move on record, and hold enough unencumbered cash to meet margin calls through it. If many other funds hold the same trade, assume the exit price will be worse than any model says.
The costliest mistake
Letting leverage rise through losses. LTCM’s capital fell from $4.1 billion at the end of July 1998 to $2.3 billion after August’s $1.8 billion loss, a 1.8 ÷ 4.1 = 43.9% drop in one month, while its assets stayed above $125 billion: on that asset base leverage went from 125 ÷ 4.1 = 30× to 125 ÷ 2.3 = 54× without a single new trade. Rebalance leverage after losses, not only after gains, and set a hard ceiling that forces selling early, while markets are still open to you.
What the full article covers
In the full article I take you through these sections:
■10.3 The 1997 Asian Financial Crisis
■10.4 LTCM’s 1998 Collapse
It includes worked examples, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, Asian Financial Crisis of 1997 and the LTCM Collapse of 1998, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
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