Background of LTCM

This article explains the causes of collapse of a major speculative Hedge Fund (Long Term Capital Management) way back in 1998. This fund was set-up by some very famous people, namely, John Meriwether from Salomon Brothers, Myron Scholes and Robert C Merton among other important names.

The fund was setup as a fixed-income arbitrage, statistical arbitrage and Pairs Trading fund combined with some high leverage and because the master hedge fund Long Term Capital Portfolio L.P. failed in the late 1990s. Salomon Brothers were already an expert in this area.

The company used complex mathematical models to take advantage of fixed income arbitrage deals usually with US, Japanese and European government bonds. The capital base grew due above average returns initially and the company decided to invest the capital and had run out of good bond-arbitrage bets. These trading strategies were non-market directional and were not convergence trades. By 1998 the firm had extremely large positions in merger arbitrage, S&P 500 volatility options and became a big supplier of S&P 500 Vega. Because these differences in value were minute the firm decided to take highly leveraged positions to make a significant profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debit to equity ratio of over 25 to 1.

Causes of Collapse

The causes of the LTCM collapse were is no way linked to the East-Asian financial crises of 1998.

There were some events in 1997 that led to this happening. On Monday, October 27, the DOW dropped 554 points. This 7% market share loss was termed as black Monday and the New York Stock Exchange shut down twice in an attempt to calm the market. Salomon Brothers’ exit from the arbitrage business in July 1998 further aggravated the situation.

The Russian Financial Crisis of August and September 1998 which was caused due to the default of the Russian Government bonds further contributed to these losses. This was called the “Ruble” crisis and it resulted in the Russian Government devaluing the ruble and defaulting on its debt. Declining productivity and an artificially high fixed exchange rate between the ruble and foreign currencies to avoid public turmoil and a chronic fiscal-deficit were events that led to the crisis. The economic cost of the war in Chechnya (estimated at $5.5 billion) also caused this. The firm had investments in Japanese and European bonds and knowing that the Russian Crisis would affect the value of these bonds, the panicked investors sold their holdings and purchased US Government Bonds.

LTCM had to liquidate a number of positions at a highly unfavourable moment and suffer further losses. The company which was proving almost 40 percent returns up to this point experienced a flight to liquidity. The equity value of the firm tumbled from $2.3 billion at the start of the month to just $400 million by September 25, 1998. With liabilities still over $100 billion this translated to a leverage ratio of more than 250 to 1.

The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):

• $1.6 billion in swaps
• $1.3 billion in equity volatility
• $430 million in Russia and other emerging markets
• $371 million in directional trades in developed countries
• $286 million in equity pairs (such as VW, Shell)
• $215 million in yield curve arbitrage
• $203 million in S&P 500 stocks
• $100 million in junk bond arbitrage
• no substantial losses in merger arbitrage

The Subsequent Bailout

Wall Street feared that the downfall of LTCM could have spiralling effects in the global financial markets causing catastrophic losses throughout the financial system. Goldman Sachs, AIG and Berkshire Hathaway on September 23, 1998 offered to buy out the funds partners for $250 million and decided to inject $3.75 billion and to operate LTCM within Goldman’s own trading division. The final bailout was $3.65 billion.

LTCM continued normal operations after that.