The Collapse of LTCM

Long Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether, a former bond trading star at Salomon Brothers, with partners including Myron Scholes and Robert Merton, who shared the 1997 Nobel Prize in economics. Using sophisticated models and enormous leverage, it earned very high returns in its first years. Then, in 1998, after Russia defaulted on its debt, markets moved against its positions all at once. LTCM lost about $4.6 billion in less than four months, and the Federal Reserve Bank of New York organised a rescue by major banks to prevent wider damage.

The strategy#

LTCM specialised in relative value or convergence trades: buying securities that looked cheap and selling similar securities that looked expensive, betting the price gap would narrow. Examples included:

Each trade had a small expected profit, so LTCM used leverage to make returns meaningful. See Arbitrage Strategies.

The leverage#

At the start of 1998, LTCM had roughly $4.7 billion of equity supporting a balance sheet of over $100 billion, leverage of about 25 to 1, plus derivatives positions with a notional value of over $1 trillion. Small price moves against it produced large percentage losses on its capital. See Leverage.

What went wrong in 1998#

The rescue#

By September 1998, LTCM's capital had collapsed. Fearing that a disorderly liquidation would hit its many bank counterparties and destabilise markets, the New York Fed brought together major financial institutions. On 23 September, 14 firms agreed to inject about $3.6 billion in exchange for control of the fund, which was wound down over the following years. No public money was used, but the Fed's role was controversial. The Fed also cut interest rates three times in the autumn of 1998. See Systemic Risk.

Lessons#

1. Being right eventually is not enough: markets can stay irrational longer than a leveraged fund can stay solvent.
2. Correlations rise in crises, so diversification across trades can vanish. See Diversification.
3. Size creates liquidity risk when you are a large share of a market.
4. Models built on calm history underestimate extremes. See Stress Testing and Scenario Analysis.
5. Leverage and counterparty links can turn one fund's failure into a system wide threat. See Market, Credit and Counterparty Risk.

Sources#

• Federal Reserve History, "Near Failure of Long Term Capital Management": https://www.federalreservehistory.org/essays/ltcm-near-failure

Frequently asked questions#

What was LTCM?#

A hedge fund founded in 1994 by John Meriwether with Nobel laureates Myron Scholes and Robert Merton, specialising in leveraged convergence trades.

Why did LTCM fail?#

Its highly leveraged, correlated positions lost heavily when the 1998 Russian default triggered a global flight to liquidity, and it could not exit its large positions.

Was LTCM bailed out by the government?#

The New York Fed organised a rescue in which 14 private financial institutions injected about $3.6 billion; no public funds were used.

Next, learn how one trader destroyed a historic bank in The Fall of Barings Bank.