Long-Term Capital Management

Long-Term Capital Management was a hedge fund company founded by John Meriwether (a former bond trader at Salomon Brothers bank) in 1994 and with Nobel Prize winners Myron Scholes and Robert Merton on the board. Also joining him as principals were Eric Rosenfeld, Greg Hawkins, Larry Hilibrand, Dick Leahy, Victor Haghani and James McEntee. On 24 February, with $1,011,060,243 of investor capital, LTCM began trading.

Contents

1 Strategy 2 1998 downturn 3 A Deeper Understanding of the Risks taken by LTCM 4 References 5 Extrernal links 5.1 Pictures

Strategy

The company had developed complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades) usually with U.S., Japanese, and European sovereign bonds. The basic idea was that over time the value of long-dated bonds issued a short time apart would tend to become identical. However the rate at which these bonds approached this price would be different, and that more heavily traded bonds such as United State Treasury Bonds would approach the long term price more quickly than less heavily traded and more illiquid bonds.

Thus by a series of financial transactions (essentially amounting to buying the cheaper 'off-the-run' bond and short-selling the more expensive, but more liquid, 'on-the-run' bond) it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond came on the run.

Because these differences in value were minute, the fund needed to take highly-leveraged positions in order 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. It had off-balance sheet derivative positions amounting to $1.25 trillion, most of which were in fixed income derivatives such as interest rate swaps. The fund also invested in other derivative security products such as equity options and mortgage securitisations.

1998 downturn

The downfall of the fund started in May and June 1998 when net returns fell to -6.42 and -10.14 % reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998.

The scheme finally unraveled in August and September 1998 when the Russian government defaulted on their sovereign debt (GKOs). Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August the fund had lost $1.85 billion in capital.

The company, which was providing annual returns of almost 40% up to this point, experienced a "flight to liquidity". This prompted a bail-out of $3.625 bn by the banks, organized by the Federal Reserve Bank of New York, ostensibly in order to avoid a wider collapse in the financial markets. The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices which would force other companies to liquidate their own debt creating a vicious cycle.

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

• $1.6 bn in swaps
• $1.3 bn in equity volatility
• $430 mn in Russia and other emerging markets
• $371 mn in directional trades in developed countries
• $215 mn in yield curve arbitrage
• $203 mn in S&P 500 stocks
• $100 mn in junk bond arbitrage
• no substantial losses in merger arbitrage

In the end the basic idea of LTCM was correct, in that the values of sovereign bonds did eventually converge after the company was wiped out. Nonetheless, the incident confirms an insight often (though perhaps apocryphally) attributed to the economist John Maynard Keynes, who is said to have warned investors that although markets do tend toward rational positions in the long run, "the market can stay irrational longer than you can stay solvent."

On a related point, LTCM's downfall confirmed for the financial community the need to keep in mind liquidity risk while making Value-At-Risk calculations - because illiquidity was one of the primary reasons for the downfall.

A Deeper Understanding of the Risks taken by LTCM

Although it is commonly thought that the trading positions taken by LTCM were predominantly convergence trades, this is in fact not true. As LTCM's capital base grew the need for additional returns on that expanded capital led it to undertake other trading strategies. Although these trading strategies were non-market directional, i.e. they were not dependent on overall interest rates or stock prices going up (or down), they were not convergence trades as such. By 1998 LTCM had extremely large positions in areas such as merger arbitrage (profitable when the mergers were consummated, unprofitable if they were not) and S&P500 options (net short long term S&P vol). In fact some market participants believed that LTCM had been the primary supplier of S&P500 gamma which had been in demand by US insurance companies selling equity indexed annuities products for the prior two years.

The profits from these trading strategies were generally not correlated with each other and thus normally LTCM's highly leveraged portfolio benefitted from diversification. However the general flight to quality in the late summer of 1998 led to a marketwide repricing of all risk and these positions then did all move in the same direction. As the correlation of LTCM's positions increased the diversified aspect of LTCM's portfolio vanished and large losses to its equity value occurred. Thus the primary lesson of 1998 and the collapse of LTCM for Value At Risk (VAR) users is not a liquidity one, but more fundamentally that the underlying covariance matrix used in VAR analysis is not static but changes over time.

The fall of LTCM is an important example of the principle that arbitrage is not riskless. This undermines the claim of efficient market theorists that markets must converge instantaneously to efficient prices because of the action of rational investors who will immediately take advantage of pricing anomalies in markets.

References

• See 2000 in literature
• When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein, ISBN 1841155047
• Inventing Money: The story of Long-Term Capital Management and the legends behind it by Nicholas Dunbar, ISBN 0471498114
• How Salesmanship, Brainpower Failed at a Giant Hedge Fund by Michael Siconolfi, Anita Raghavan and Mitchell Pacelle Wall Street Journal, 16 November 1998
• The Failed Wizards of Wall Street by Peter Coy and Suzanne Woolley Business Week, 21 September 1998
• Traders - Risks, Decisions, and Management in Financial Markets by Mark Fenton-O’Creevy, Nigel Nicholson, Emma Soane, and Paul Willman, ISBN 0-19-926948-3

Extrernal links

Pictures

• The Bank of Sweden Prize in Economic Sciences 1997. Robert C. Merton and Myron S. Scholes pictures. Myron S. Scholes with location named as "Long Term Capital Management, Greenwich, CT, USA" when the prize was received. (http://nobelprize.org/economics/laureates/1997/index.html)