LTCM’s collapse was the credit crunch in miniature:
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Long-Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether (the former vice-chairman and head of bond trading at Salomon Brothers). On its board of directors were Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economics[1]. Initially enormously successful with annualized returns of over 40% in its first years, in 1998 it lost $4.6 billion in less than four months and became a prominent example of the risk potential in the hedge fund industry.[citation needed] The fund folded in early 2000
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 government 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 more heavily traded bonds such as US Treasury bonds would approach the long term price more quickly than less heavily traded and less liquid 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.
As LTCM's capital base grew, they felt pressed to invest that capital somewhere and had run out of good bond-arbitrage bets. This led LTCM to undertake trading strategies outside their expertise. 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 and S&P 500 options (net short long-term S&P volatility). In fact, some market participants believed that LTCM had been the primary supplier of S&P 500 gamma, which had been in demand by US insurance companies selling equity indexed annuities products for the prior two years.
Because these differences in value were minute—especially for the convergence trades—the fund needed 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. It had off-balance sheet derivative positions amounting to $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.
Although success within the financial markets arises from immediate-short term turbulence, and the ability of fund managers to identify informational asymmetries, factors giving rise to the downfall of the fund were established prior to the 1997 East Asian financial crisis. However, in May and June 1998, net returns from the fund in May and June 1998 fell 6.42% and 10.14% respectively, reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. Such losses were accentuated through the Russian Financial Crises in the August and September of 1998, when the Russian Government defaulted on their government bonds. 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. In the first three weeks of September, LTCM's equity tumbled from $2.3 billion to $600 million without shrinking the portfolio, leading to a significant elevation of the already high leverage. Goldman Sachs, AIG and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $4 billion and to operate LTCM within Goldman Sachs's own trading. The offer was rejected and the same day the Federal Reserve Bank of New York organized a bail-out of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets.
The profits from LTCM's trading strategies were generally not correlated with each other and thus normally LTCM's highly leveraged portfolio benefited from diversification. However, the general flight to liquidity in the late summer of 1998 led to a marketwide repricing of all risk leading these positions to 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.
Also, if the fund had been less leveraged, it would have weathered the spike in volatility and credit risk: In the end, the idea of LTCM's directional bets was correct, in that the values of government bonds did eventually converge. Due to the high leverage, however, this only happened after the firm's capital was wiped out. Thus, 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."
Nassim Taleb compared LTCM's strategies to "picking up pennies in front of a steamroller"— a likely small gain balanced against a small chance of a large loss, like the payouts from selling an out-of-the-money option. These strategies would have operated as sort of a reverse St. Petersburg lottery. It should be noted that even in the particular conditions which resulted in the fund's downfall, these large losses would not, if the positions were held to maturity, have come to pass. However, the events of 1998 increased the perceived probability of large losses, to the point where LTCM's portfolio had negative value.
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