Long-Term Capital Management
From Invertopedia, the encyclopedia of how things fail
Long-Term Capital Management (LTCM) was a hedge fund started by former Salomon Brothers bond trader John Meriwether, with future Nobel laureates Myron Scholes and Robert Merton as partners[1]. It began 1998 with $4.8 billion of capital, and by the end of August it held more than 25 dollars of assets for every dollar of that[3]. After Russia defaulted on August 17, 1998[1], the fund lost 44 percent of its value in that month alone[2]. On September 23 the New York Fed brought 14 banks and brokers together to put in about $3.6 billion for 90 percent of the fund[2][1].
Contents
The bet
LTCM looked for prices of closely related bonds that had drifted apart and bet they would come back together[1]. Each gap was tiny, so the trades only paid if they were huge, and the fund borrowed heavily to make them so[1][2]. Its models treated a sudden rush by everyone into the safest assets as a rare event[1].
It worked for years. The fund returned 43 percent in 1995 and 41 percent in 1996[2]. At the end of 1997 it handed about $2.75 billion back to investors[4] without shrinking its positions, which pushed its leverage even higher[2].
What happened
| 1993 – 1994 | John Meriwether starts LTCM. It begins trading in February 1994 with $1.25 billion from investors, plus $100 million from the partners.[1][2] |
|---|---|
| 1995 – 1996 | Returns of 43 and 41 percent.[2] |
| 1997 | Partners Myron Scholes and Robert Merton win the Nobel Prize in Economics.[1] |
| End of 1997 | LTCM returns about $2.75 billion of capital but keeps its positions. Leverage is about 30 to 1.[4][2] |
| Jun 1998 | A 10 percent loss, its worst month so far.[1] |
| Aug 17, 1998 | Russia defaults on its debt. Investors rush into safe bonds, and the spreads LTCM bet would narrow widen instead.[1] |
| Aug 21, 1998 | The fund loses $553 million in one day. Its models had said it was unlikely to lose more than $35 million on any single day.[1][2] |
| Sep 2, 1998 | A letter to investors discloses the losses: 44 percent of the fund's value gone in August.[2] |
| Sep 23, 1998 | Meriwether turns down an offer from Warren Buffett's group to buy out the partners for $250 million. By that evening 14 firms agree to put in about $3.6 billion for 90 percent of LTCM, in talks brokered by the New York Fed.[1][2] |
| End of 1999 | The positions are sold off and the consortium gets its money back.[2] |
The kill shot
The trades were small bets made enormous with borrowed money, and they all depended on markets staying calm. When Russia defaulted, every spread moved the wrong way at once and there was nobody to sell to.
At the end of August 1998 LTCM had over $125 billion of assets on its balance sheet against capital that was shrinking fast, and derivatives contracts with a gross notional value of well over $1 trillion[3]. It dealt with about 75 repo counterparties and about 50 derivatives counterparties[3]. No single one of them was necessarily aware how deep LTCM's liquidity problems ran[3].
The models were built on how bond spreads had behaved in the past[1]. In a flight to safety they all moved together, and the size of the fund's positions meant it could not get out without moving prices against itself. The Fed's fear was a forced fire sale that would dry up liquidity across markets[4].
Red flags ignored
- Leverage on leverage. More than 25 to 1 on the balance sheet, plus derivatives with well over $1 trillion of gross notional value.[3]
- Giving capital back, keeping the bets. Returning about $2.75 billion at the end of 1997 left the same positions on a smaller cushion.[4][2]
- A model's worst day. The models put a bad day at $35 million. The fund lost $553 million on August 21.[1][2]
- Drifting out of its lane. In 1997 it moved into emerging-market debt and currencies; on one big currency bet Scholes warned it had no informational advantage.[1]
- Too big to sell. Profits had come from being the largest player in crowded trades; that same size made it impossible to exit quietly.
The cost
LTCM started 1998 with $4.8 billion of capital and had $2.3 billion left at the end of August, after losing $1.8 billion in that month alone[3]. The partners' remaining 10 percent stake after the deal was worth about $400 million[1].
No Federal Reserve money went in[4][2]. Fourteen firms put in about $3.6 billion between them; two others in the talks declined to take part[2].
The inversion
Your model's worst case is not the market's worst case. Size every position for the day when everything you assumed was unrelated moves together, and keep enough cash to survive it without selling.
What survived
The fund itself, briefly. Its partners ran it under an oversight committee for the consortium, sold off the positions and returned the last of the $3.6 billion by the end of 1999[2]. Greenspan told Congress the deal "was not a government bailout"[4], but it set a precedent that is still argued over: whether the Fed should help organize a rescue of a firm that is too interconnected to fail[1].
A presidential working group concluded that the main lesson was how to limit excessive leverage[3].
References
- ^ “Too Interconnected to Fail? The Rescue of Long-Term Capital Management”. Stephen Slivinski, Region Focus, Federal Reserve Bank of Richmond, Summer 2009. Meriwether's 1993 start, $1.25 billion of startup capital in 1994, Merton and Scholes and their 1997 Nobel, 1995-96 returns, the June 1998 loss, Russia's August 17 default, the $553 million day against a $35 million model limit (quoting Lowenstein), the Buffett offer, the New York Fed meetings, and the $3.65 billion, 14-firm, 90 percent deal.
- ^ “Near Failure of Long-Term Capital Management”. Michael Fleming and Weiling Liu, Federal Reserve History, November 22, 2013. February 1994 start, yearly returns of 20, 43, 41 and 17 percent, about 30 to 1 leverage at the end of 1997, capital returned without shrinking positions, the 44 percent loss in August 1998, the August 21 losses, the September 2 letter, the New York Fed's role with no Fed money at risk, the $3.6 billion from 14 firms, and repayment by the end of 1999.
- ^ “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management”. Report of the President's Working Group on Financial Markets, April 1999 (CFTC copy). Capital of $4.8 billion at the start of 1998, over $125 billion of assets, leverage of more than 25 to 1, over $1 trillion of gross derivatives notional at the end of August 1998, about 75 repo and 50 derivatives counterparties, $1.8 billion lost in August, $2.3 billion left before the rescue, and the conclusion on excessive leverage.
- ^ “Testimony of Chairman Alan Greenspan: Private-sector refinancing of the large hedge fund, Long-Term Capital Management”. Board of Governors of the Federal Reserve System, October 1, 1998. About $2.75 billion returned to investors at the end of 1997, half the capital gone by the end of August, the fire-sale risk, no Federal Reserve funds put at risk, and "not a government bailout".