LTCM’s superportfolio unraveling, not just flight to quality, drove 1998 price movements.

Evidence

Swap spreads encompass two “type two” cases (France and Germany) and also an overall “type one” comparison. Because the market in swaps is less liquid than that in government bonds, and because a crisis may prompt fears of bank failures (and did so in 1998), a flight to quality should increase swap spreads. Table 8.2 contrasts the behavior of swap spreads in four countries. In France, LTCM was “long” the swap spread in 1998 (that is, had a position, akin to that described in the swap spread example in appendix G, which would increase in value if the spread rose). That makes France a “type two” case, one in which the effect of the superportfolio unraveling (downward pressure on the swap spread) would be opposite in direction to the effect of a flight to quality (upward pressure). … As table 8.2 shows, spreads widened markedly in the United States and the United Kingdom. (The same happened in Sweden, where arbitrageurs were also short the swap spread.) In contrast, in France and Japan, swap spreads widened only more modestly during the crisis; that was also the case in Germany, another type two case in which LTCM had a long position in the swap spread akin to that in France. I know of no plausible flight-to-quality explanation of these international contrasts, while they are broadly consistent with the superportfolio explanation. … A flight to quality did take place in August and September 1998, but these data do indeed suggest that overlaying it (and sometimes acting in contradiction to it) was an unraveling superportfolio. — Donald MacKenzie, An Engine, Not a Camera, 1080

Categorization

• XREF: The type one vs type two distinction in discriminating competing explanations connects to quasi-experimental causal inference methods used across social science. — connects to: The superportfolio effect predicts price declines in assets believed to be held by LTCM. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1075; Flight-to-quality and superportfolio unwinding produce indistinguishable price movements in most cases. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1076; Imitation of LTCM created new correlations between unrelated arbitrage positions in 1998. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1228

Broader Connections

• Imitation of LTCM created new correlations between unrelated arbitrage positions in 1998. #expands (0.82) — Donald MacKenzie, An Engine, Not a Camera, 1228