Long Term Capital Management (LTCM)

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The demise of Long Term Capital Management (LTCM) in August and September of 1998 was notable due to the size of the fund's exposures and the pedigree of the individuals involved. Founded in 1994 by John Meriwether, LTCM's principals included former Federal Reserve Board Vice-Chairman David Mullins, Nobel laureates Robert Merton and Myron Scholes, several world-renowned academics, and experienced traders from the famous Salomon Brothers' bond arbitrage desk. Before its failure, LTCM had USD 4.8 billion in equity and USD 125 billion in assets, making for a 25-to-1 leverage ratio.

 

LTCM's downfall was triggered in August of 1998, when the government of Russia declared a moratorium on its debt and devalued its currency (i.e., the ruble). These actions caused the value of LTCM's holdings to fall over 40%, a loss of nearly USD 2 billion. Concerned about a potential systemic crisis, the Federal Reserve Bank of New York brokered the rescue of LTCM by a group of banks that agreed to inject USD 3.5 billion into the fund in exchange for a 90% equity stake and control of its management. How could LTCM have been so adversely affected by a single market event? The reason lay in an arbitrage strategy the fund employed that was based on market-neutral trading (also known as relative-value trading). These strategies typically involve the purchase of one asset and the simultaneous sale of another and are designed to exploit relative mispricings between the assets. As a result, they generate profits when the price spread between assets moves in the anticipated direction, regardless of directional movements in the overall market.

 

Many of LTCM's strategies, based on extensive and intensive empirical research by top-level academics and practitioners at the firm, appeared safe at first glance. The firm made its trades based on the assumption that the spreads between sovereign and corporate bonds in various countries were too wide and would eventually revert to their "normal" levels. For instance, LTCM would purchase UK corporate bonds and sell (or "short") appropriate UK government bonds to capture a perceived relative-value opportunity. Other trades were motivated by the fact that several European countries were scheduled to join the European Economic and Monetary Union (EMU) and convergence of sovereign bond yields was anticipated. Trades of this type might involve, for instance, buying Spanish or Italian government debt and selling German bunds.

 

As long as the yield spread narrowed, these positions would make money regardless of movements in absolute prices.14 The limited returns from these low-risk strategies came under increasing pressure as more traders entered the market to take advantage of the same perceived opportunities. To boost performance (measure by return on equity), LTCM used leverage. With a 25-to-1 leverage ratio, for example, LTCM could turn a 1% return on assets into a 25% return. This was aided by LTCM's ability to obtain large amounts of financing, collateralized by the bonds it invested in. Part of the fund's ability to access such large loans was due to its strategies being widely perceived as low-risk in nature. LTCM's failure reflected its inability to anticipate the dramatic increase in correlations and volatilities and the sharp drop in liquidity that can occur during an extreme crisis. LTCM also succumbed to an internal liquidity crunch brought on by large margin calls on its futures holdings. Ironically, LTCM's strategies were valid in the medium term, and as the crisis ended, the banks that took over LTCM realized substantial profits.