Long Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether, a very successful bond trader at Salomon Brothers. In Salomon, Meriwether was one of the first on Wall Street to employ top academics and professors. Meriwether founded a team of academics who applied models based on financial theories in trading. In Solomon, Meriwether’s group of geniuses achieved incredible returns and demonstrated an incomparable ability to accurately calculate risk and other market factors.
In 1994, Meriwether left Solomon and founded the LTCM. Among the partners were two Nobel Prize-winning economists, a former vice chairman of the Federal Reserve Board of Governors, a professor at Harvard University and other successful bond traders. This elite group of retailers and academics has attracted initial investments of about $ 1.3 billion from many large institutional clients.
The LTCM strategy was simple in concept but difficult to implement. LTCM used computer models to find opportunities for arbitrage between markets. The central strategy of the LTCM was convergence trading in which securities were misjudged against each other. LTCM would occupy long positions on a lower priced security and short positions on an overvalued security.
LTCM has addressed this strategy in international bond markets, emerging markets, U.S. government bonds, and other markets. LTCM would make money if these ranges were reduced and returned to fair value. Later, as LTCM’s capital base increased, the fund engaged in strategies beyond their expertise, such as merger arbitrage and the instability of the S&P 500.
These strategies, however, focused on small price differences. Myron Scholes, one of the partners, said “LTCM would function as a giant vacuum cleaner that sucks up coins that everyone else overlooked.” In order to make a significant profit on small differences in value, the hedge fund took positions with high leverage. In early 1998, the fund had assets of about $ 5 billion and borrowed about $ 125 billion.
LTCM initially achieved outstanding returns. Prior to benefits, the fund earned 28% in 1994, 59% in 1995, 57% in 1996, and 27% in 1997. LTCM earned these returns with surprisingly little volatility. By April 1998, the value of one initially invested dollar had risen to $ 4.11.
However, in mid-1998, the fund began to experience losses. These losses were further exacerbated when the Salomon Brothers left the arbitration business. Later in the year, Russia paid for government bonds, owned by LTCM. In a panic, investors sold Japanese and European bonds and bought American government bonds. As a result, the spreads between LTCM’s holding have widened, causing arbitrage trades to lose huge amounts. LTCM lost $ 1.85 billion in capital by the end of August 1998.
Differences between LTCM’s arbitrage transactions continued to widen and the fund experienced a drop in liquidity leading to a reduction in assets in the first 3 weeks of September from $ 2.3 billion to $ 600 million. Although assets were reduced, the value of the portfolio did not decrease due to the use of leverage. However, the reduction in assets increased the financial leverage of the fund. Finally, the Federal Reserve Bank of New York catalyzed a $ 3.625 billion bailout by major institutional lenders to avoid a wider collapse in financial markets causing a dramatic LTCM leverage and huge derivative positions. In late September 1998, the value of one initially invested dollar fell to $ 0.33 before fees.
Lessons from LTCM’s failure
1. Limit the use of excess leverage
When dealing with investment strategies based on securities that converge from the market price to the estimated fair price, managers must be able to have a long-term time frame and be able to withstand adverse price changes. When dramatic leverage is used, the possibility of long-term capital investment during adverse price changes is limited by the patience of creditors. Lenders usually lose patience during a market crisis, when borrowers need capital. If it is forced into securities during the illiquid market crisis, the fund will fail.
The use of leverage by the LTCM has also highlighted the lack of regulation in the OTC derivatives market. Many lending and reporting requirements established in other markets, such as futures, were not present in the OTC derivatives market. This lack of transparency has led to the risks of the dramatic leverage of LTCM not being fully recognized.
The failure of the LTCM does not mean that any use of leverage is bad, but it highlights the potential negative consequences of using excessive leverage.
2. The importance of risk management
LTCM has failed to internally manage multiple aspects of risk. Managers focused mainly on theoretical models and not enough on liquidity risk, gap risk and stress testing.
With such large positions, LTCM should have focused more on liquidity risk. The LTCM model underestimated the likelihood of a market crisis and the potential for liquidity escapes.
LTCM models also hypothesized that long and short positions were highly correlated. This assumption is historically based. Past results do not guarantee future results. By testing stress models for the potential for lower correlations, risk could be better managed.
In addition to the LTCM, large hedge fund institutional creditors have failed to properly manage risk. Impressed by the fund’s top traders and the large amount of assets, many lenders provided very generous loan terms, although creditors were involved in significant risk. Also, many creditors did not understand their overall exposure to certain markets. During a crisis, exposure in multiple areas of business to specific risks can cause dramatic damage.
LTCM failed to have a truly independent vendor check. Without this oversight, traders could create positions that were too risky.
LTCM shows an interesting case of limiting predictions based on historical information and the importance of recognizing potential model failures. In addition, the story of LTCM illustrates the risk of limited transparency in the OTC derivatives market.
To learn more about finance and investing, visit the Sharpe Investing blog.