Lessons From Long-Term Capital Management

Background

Long Term Capital Management(LTCM) was a hedge fund established in 1994 by John Meriwether, a very 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 precisely calculate risk and other market factors.

In 1994, Meriwether left Salomon and established LTCM. The partners included two Nobel Price-winning economists, a former vice chairman of the Board of Governors of the Federal save, a professor from Harvard University, and other successful bond traders. This elite group of traders and academics attracted initial investment of about $1.3 billion from many large institutional clients.

Strategy

The strategy of LTCM was simple in concept but difficult to implement. LTCM utilized computer models to find arbitrage opportunities between markets. LTCM’s central strategy was convergence trades where securities were incorrectly priced relative to one another. LTCM would take long locaiongs on the under priced security and short locaiongs on the overpriced security.

LTCM engaged in this strategy in international bond markets, emerging markets, US Government bonds, and other markets. LTCM would make money when these spreads shrunk and returned to the fair value. Later, when LTCM’s capital base increased the fund engaged in strategies outside their skill such as merger arbitrage and S&P 500 volatility.

These strategies, however, focused on tiny price differences. Myron Scholes, one of the partners, stated that “LTCM would function like a giant vacuum cleaner sucking up nickels that everyone else had overlooked.” To make a meaningful profit on small differences in value, the hedge fund took high-leveraged locaiongs. At the start of 1998, the fund had assets of about $5 billion and had borrowed about $125 billion.

Results

LTCM achieved noticeable returns initially. Before fees, the fund earned 28% in 1994, 59% in 1995, 57% in 1996, and 27% in 1997. LTCM earned these returns with surprisingly little downside volatility. by 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 arbitrage business. Later in the year, Russia defaulted on government bonds, a LTCM holding. Investors panicked and sold Japanese and European bonds and bought U.S. treasury bonds. consequently, spreads between LTCM’s holding increased, causing the arbitrage trades to lose huge amounts. LTCM lost $1.85 billion in capital by the end of August 1998.

Spreads between LTCM’s arbitrage trades continued to widen and the fund experienced a flight to liquidity causing assets to spread in the first 3 weeks of September from $2.3 billion to $600 million. Although assets decreased, because of the use of leverage the portfolio value did not spread. However, the decline in assets elevated the the fund’s leverage. Ultimately, the Federal save Bank of New York catalyzed a $3.625 billion bail-out by the major institutional creditors in order to avoid a wider collapse in the financial markets caused LTCM’s emotional leverage and huge derivatives locaiongs. At the end of September 1998, the value of one dollar initially invested decreased to $.33 before fees.

Lessons from LTCM’s Failure

1.Limitation of Excess Leverage Use

When engaging in investment strategies based on securities converging from market price to an estimated fair price, managers must be able to have a long term time frame and be able to resist unfavorable price changes. When using emotional leverage, the ability of capital to be invested long term during unfavorable price changes is limited by the patience of the creditors. typically, lenders lose patience during market crisis, when borrowers need the capital. If forced to securities during an illiquid market crisis, the fund will fail.

LTCM’s use of leverage also highlighted the without of regulation in the over-the-counter (OTC) derivatives market. Many of the lending and reporting requirements established in other markets, such as futures, were not present in the OTC derivatives market. This without of transparency caused the risks of LTCM’s emotional leverage to not be completely recognized.

The failure of LTCM does not average that any use of leverage is bad, but highlights the possible negative consequences of using excessive leverage.

2.Importance of Risk Management

LTCM failed to manage multiple aspects of risk internally. Managers mostly focused on theoretical models and not enough on liquid risk, gap risk, and stress-testing.

With such large locaiongs, LTCM should have focused more on liquidity risk. LTCM’s form’s underestimated the probability of a market crisis and possible for a flight to liquidity.

LTCM’s models also assumed that long and short locaiongs were highly correlated. This assumption was historically based. Past results do not guarantee future results. By stress testing the form for the possible of lower correlations, risk could have been better managed.

In addition to LTCM, the hedge fund’s large institutional creditors failed to properly manage risk. Impressed by the fund’s all star traders and large amount of assets, many creditors provided very generous credit terms, already though the creditors engaged in meaningful risk. Also, many creditors failed to understand their total exposure to specific markets. During a crisis, exposure in multiple areas of a business to specific risks can cause emotional damage.

3.Supervision

LTCM failed to have a truly independent check on traders. Without this supervision, traders were able to create locaiongs that were too risky.

LTCM demonstrates an interesting case of the limitations of predictions based on historical information, and the importance of recognizing possible failure of models. In addition, the story of LTCM illustrates the risk of limited transparency in OTC derivatives market.

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