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Long Term Capital Management (LTCM) was a hedge fund established in 1994 by John Meriwether, a very successful bond broker at Salomon Brothers. At Salomon, Meriwether was one of the first on Wall Street to hire the best academics and professors. Meriwether established a team of scholars who applied models based on financial theories to trading. At Salomon, Meriwether’s group of geniuses generated amazing returns and demonstrated an unprecedented ability to accurately calculate risk and other market factors.
In 1994, Meriwether left Salomon and founded LTCM. The partners included two Nobel Prize-winning economists, a former Vice Chairman of the Federal Reserve Board of Governors, a Harvard University professor, and other successful bond traders. This elite group of traders and academics attracted an initial investment of around $1.3 billion from many major institutional clients.
Strategy
LTCM’s strategy was simple in concept but difficult to implement. LTCM used computer models to find arbitrage opportunities between markets. LTCM’s core strategy was convergence trading where securities were mispriced relative to each other. LTCM would go long on the undervalued security and short on the overvalued security.
LTCM participated in this strategy in international bond markets, emerging markets, US government bonds and other markets. LTCM would make money when these spreads narrowed and returned to fair value. Subsequently, as LTCM’s capital base increased, the fund engaged in strategies outside its expertise, such as merger arbitrage and S&P 500 volatility.
These strategies, however, focused on small price differences. Myron Scholes, one of the partners, stated that “LTCM would work like a giant vacuum cleaner sucking up nickels that everyone else had missed.” In order to make a significant profit on small differences in value, the hedge fund took highly leveraged positions. At the beginning of 1998, the fund had assets of about $5 billion and had borrowed about $125 billion.
Results
LTCM achieved outstanding returns initially. Before fees, the fund returned 28% in 1994, 59% in 1995, 57% in 1996 and 27% in 1997. LTCM returned these returns with surprisingly little downward volatility. Through April 1998, the value of an invested dollar initially increased to $4.11.
However, in mid-1998 the fund began to experience losses. These losses were further compounded when Salomon Brothers got out of the arbitration business. Later in the year, Russia defaulted on government bonds, an LTCM holding. Investors panicked, selling Japanese and European bonds and buying US Treasuries. Therefore, the spreads between LTCM holdings widened, causing arbitrage trades to lose huge amounts. LTCM lost $1.85 billion in capital at the end of August 1998.
Spreads between LTCM arbitrage trades continued to widen and the fund experienced a liquidity drain causing assets to shrink in the first 3 weeks of September from $2.3bn to $600m. Although the assets decreased, due to the use of leverage, the value of the portfolio did not decrease. However, the decline in assets raised the fund’s leverage. Ultimately, the Federal Reserve Bank of New York catalyzed a $3.625 billion bailout by major institutional creditors to prevent a broader collapse in financial markets that caused LTCM’s dramatic leverage and huge derivatives positions. . At the end of September 1998, the value of an initially invested dollar fell to $.33 before fees.
Lessons from the failure of LTCM
1. Limitation of excessive use of leverage
By engaging in value-based investment strategies that converge from the market price to an estimated fair price, managers must be able to have a long-term time frame and be able to withstand unfavorable price changes. When dramatic leverage is used, the ability of capital to be invested for the long term during unfavorable price changes is limited by the patience of creditors. Typically, lenders lose patience during market downturns, when borrowers need capital. If forced to sell securities during an illiquid market crisis, the fund will go bankrupt.
LTCM’s use of leverage also highlighted the lack of regulation in the OTC derivatives market. Many of the lending and reporting requirements established in other markets, such as futures, were not present in the OTC derivatives market. This lack of transparency meant that the risks of LTCM’s dramatic leverage were not fully recognized.
The failure of LTCM does not mean that any use of leverage is bad, but it does highlight the possible negative consequences of using excessive leverage.
2.Importance of Risk Management
LTCM failed to manage multiple aspects of risk internally. The managers focused mainly on theoretical models and not enough on liquid risk, spread risk and stress tests.
With such large positions, LTCM should have focused more on liquidity risk. The LTCM model underestimated the probability of a market crisis and the potential for a flight to liquidity.
The LTCM models also assumed that long and short positions were highly correlated. This assumption had a historical basis. Past results do not guarantee future results. By stress testing the model for the potential for lower correlations, the risk could have been better managed.
In addition to LTCM, the hedge fund’s large institutional creditors failed to adequately manage risk. Impressed by the fund’s stellar operators and large number of assets, many creditors offered very generous credit terms, even though the creditors were involved in significant risk. Furthermore, many creditors failed to understand their full exposure to specific markets. During a crisis, exposure in multiple areas of a business to specific risks can cause dramatic damage.
3. Supervision
LTCM was unable to have truly independent control over the traders. Without this oversight, traders were able to create positions that were too risky.
LTCM demonstrates an interesting case for the limitations of predictions based on historical data and the importance of recognizing potential model failure. Furthermore, the LTCM story illustrates the risk of limited transparency in the OTC derivatives market.
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