Background
Long Term Capital Management (LTCM) was a hedge fund established in 1994 by John Meriwether, a highly successful bond trader at Salomon Brothers. At Salomon, Meriwether was one of the first on Wall Street to hire top academics and professors. Meriwether established a team of academics who applied models based on financial theories to trading. At Salomon, Meriwether’s group of geniuses generated amazing returns and demonstrated an unparalleled ability to accurately calculate risk and other market factors.
In 1994, Meriwether left Salomon and founded LTCM. 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 cross-market arbitrage opportunities. LTCM’s core strategy was convergence trades in which securities were incorrectly priced relative to each other. LTCM would take long positions on the undervalued security and short positions on the overvalued security.
LTCM participated in this strategy in the international bond markets, emerging markets, US government bonds and other markets. LTCM would make money when these spreads narrowed and returned to fair value. Later, as LTCM’s capital base increased, the fund became involved in strategies outside of 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 overlooked.” To make a significant profit on the small differences in value, the hedge fund took high leverage positions. As of early 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 achieved these returns with surprisingly little downward volatility. Through April 1998, the value of one dollar initially invested increased to $4.11.
However, in mid-1998 the fund began to experience losses. These losses were further compounded when Salomon Brothers exited the arbitration business. Later in the year, Russia defaulted on government bonds, a holding of LTCM. Investors panicked and sold Japanese and European bonds and bought US Treasuries. Therefore, spreads between LTCM holdings increased, causing arbitrage trades to lose huge amounts. LTCM lost $1.85 billion in equity at the end of August 1998.
Spreads between LTCM arbitrage trades continued to widen and the fund experienced a liquidity drain which caused 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 from major institutional creditors to prevent a broader collapse in financial markets that led to LTCM’s dramatic leverage and huge positions in derivatives. As of the end of September 1998, the value of one dollar initially invested decreased to $.33 before fees.
Lessons from LTCM’s failure
1. Limiting the excessive use of leverage
When engaging in security-based investment strategies that converge from 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 you are forced to buy stocks during an illiquid market crisis, the fund will fail.
LTCM’s use of leverage also highlighted the lack of regulation in the over-the-counter (OTC) derivatives market. Many of the reporting and lending requirements established in other markets, such as futures markets, 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 potential negative consequences of using excessive leverage.
2. Importance of Risk Management
LTCM failed to manage multiple aspects of risk internally. 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 merchants. Without this supervision, 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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