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The story
Founded by John Meriwether in 1994.1
Founding
John Meriwether headed Salomon Brothers' bond arbitrage desk until he resigned in 1991 amid a trading scandal. According to Chi-fu Huang, later a Principal at LTCM, the bond arbitrage group was responsible for 80–100% of Salomon's global total earnings from the late 1980s until the early 1990s.
In 1993 Meriwether created Long-Term Capital as a hedge fund and recruited several Salomon bond traders; Larry Hilibrand and Victor Haghani in particular would wield substantial clout and two future winners of the Nobel Memorial Prize, Myron Scholes and Robert C. Merton. Other principals included Eric Rosenfeld, Greg Hawkins, William Krasker, Dick Leahy, James McEntee, Robert Shustak, and David W. Mullins Jr.
The company consisted of Long-Term Capital Management (LTCM), a Delaware-incorporated company based in Greenwich, Connecticut. LTCM managed trades in Long-Term Capital Portfolio LP, a partnership registered in the Cayman Islands. The fund's operation was designed to have extremely low overhead; trades were conducted through a partnership with Bear Stearns and client relations were handled by Merrill Lynch.
Meriwether chose to start a hedge fund to avoid the financial regulation imposed on more traditional investment vehicles, such as mutual funds, as established by the Investment Company Act of 1940 – funds which accepted stakes from 100 or fewer individuals each with more than $1 million in net worth were exempt from most of the regulations that bound other investment companies. The bulk of the money raised, in late 1993, came from companies and individuals connected to the financial industry. With the help of Merrill Lynch, LTCM also secured hundreds of millions of dollars from high-net-worth individuals including business owners and celebrities, as well as private university endowments and later the Italian central bank. By 24 February 1994, the day LTCM began trading, the company had amassed just over $1.01 billion in capital.
1997 Asian financial crisis
Although 1997 had been a very profitable year for LTCM (17%), the lingering effects of the 1997 Asian crisis continued to shape developments in asset markets into 1998. Despite the crisis originating in Asia, its effects were not confined to that region. The rise in risk aversion had raised concerns amongst investors regarding all markets heavily dependent on international capital flows, and this shaped asset pricing in markets outside Asia too.
1998 Russian financial crisis
Although periods of distress have often created tremendous opportunities for relative value strategies, this did not prove to be the case on this occasion, and the seeds of LTCM's demise were sown before the Russian default of 17 August 1998. LTCM had returned $2.7 bn to investors in Q4 of 1997, although it had also raised a total in capital of $1.066 bn from UBS and $133 m from CSFB. Since position sizes had not been reduced, the net effect was to raise the leverage of the fund.
In May and June 1998, returns from the fund were -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. Because the Salomon arbitrage group (where many of LTCM's strategies had first been incubated) had been a significant player in the kinds of strategies also pursued by LTCM, the liquidation of the Salomon portfolio (and its announcement itself) had the effect of depressing the prices of the securities owned by LTCM and bidding up the prices of the securities LTCM was short. According to Michael Lewis in the New York Times article of July 1998, returns that month were circa -10%. One LTCM partner commented that because there was a clear temporary reason to explain the widening of arbitrage spreads, at the time it gave them more conviction that these trades would eventually return to fair value (as they did, but not without widening much further first).
Such losses were accentuated through the 1998 Russian financial crisis in August and September 1998, when the Russian government defaulted on its domestic local currency bonds. This came as a surprise to many investors because according to traditional economic thinking of the time, a sovereign issuer should never need to default given access to the printing press. There was a flight to quality, bidding up the prices of the most liquid and benchmark securities that LTCM was short, and depressing the price of the less liquid securities it owned. This phenomenon occurred not merely in the US Treasury market but across the full spectrum of financial assets. Although LTCM was diversified, the nature of its strategy implied an exposure to a latent factor risk of the price of liquidity across markets. As a consequence, when a much larger flight to liquidity occurred than had been anticipated when constructing its portfolio, its positions designed to profit from convergence to fair value incurred large losses as expensive but liquid securities became more expensive, and cheap but illiquid securities became cheaper. By the end of August, the fund had lost $1.85 billion in capital.
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Because LTCM was not the only fund pursuing such a strategy, and because the proprietary trading desks of the banks also held some similar trades, the divergence from fair value was made worse as these other positions were also liquidated. As rumors of LTCM's difficulties spread, some market participants positioned in anticipation of a forced liquidation. Victor Haghani, a partner at LTCM, said about this time "it was as if there was someone out there with our exact portfolio,... only it was three times as large as ours, and they were liquidating all at once."
Because these losses reduced the capital base of LTCM, and its ability to maintain the magnitude of its existing portfolio, LTCM was forced to liquidate a number of its positions at a highly unfavorable moment and suffer further losses. A vivid illustration of the consequences of these forced liquidations is given by Lowenstein (2000). He reports that LTCM established an arbitrage position in the dual-listed company (DLC) Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8%–10% premium relative to Shell. In total $2.3 billion was invested, half of which was "long" in Shell and the other half was "short" in Royal Dutch. LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge because in their belief the present value of the future cashflows of the two securities should be similar. This might have happened in the long run, but due to its losses on other positions, LTCM had to unwind its position in Royal Dutch Shell. Lowenstein reports that the premium of Royal Dutch had increased to about 22%, which implies that LTCM incurred a large loss on this arbitrage strategy. LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade.
The company, which had historically earned annualized compounded 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 at the start of the month to just $400 million by September 25. With liabilities still over $100 billion, this translated to an effective leverage ratio of more than 250-to-1.
1998 bailout
Long-Term Capital Management did business with nearly every important person on Wall Street. Indeed, much of LTCM's capital was composed of funds from the same financial professionals with whom it traded. As LTCM teetered, Wall Street feared that Long-Term's failure could cause a chain reaction in numerous markets, causing catastrophic losses throughout the financial system.
After LTCM failed to raise more money on its own, it became clear it was running out of options. On September 23, 1998, Goldman Sachs, AIG, and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $3.75 billion and to operate LTCM within Goldman's own trading division. The offer of $250 million was stunningly low to LTCM's partners because at the start of the year their firm had been worth $4.7 billion. Warren Buffett gave Meriwether less than one hour to accept the deal; the time lapsed before a deal could be worked out.
Seeing no options left, the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. The principal negotiator for LTCM was general counsel James G. Rickards. The contributions from the various institutions were as follows:
$300 million: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P.Morgan, Morgan Stanley, Salomon Smith Barney, UBS
$125 million: Société Générale
$100 million: Paribas and Lehman Brothers
Bear Stearns and Crédit Agricole declined to participate.
In return, the participating banks got a 90% share in the fund and a promise that a supervisory board would be established. LTCM's partners received a 10% stake, still worth about $400 million, but this money was completely consumed by their debts. The partners once had $1.9 billion of their own money invested in LTCM, all of which was wiped out.
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 in 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
$286 mn in Dual-listed company pairs (such as VW, Shell)
$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
Long-Term Capital was audited by Price Waterhouse LLP. After the bailout by the other investors, the panic abated, and the positions formerly held by LTCM were eventually liquidated at a small profit to the rescuers. Although termed a bailout, the transaction effectively amounted to an orderly liquidation of the positions held by LTCM with creditor involvement and supervision by the Federal Reserve Bank. No public money was injected or directly at risk, and the companies involved in providing support to LTCM were also those that stood to lose from its failure. The creditors themselves did not lose money from being involved in the transaction.
Some industry officials said that Federal Reserve Bank of New York involvement in the rescue, however benign, would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf in the event of trouble (see Greenspan put). Federal Reserve Bank of New York actions raised concerns among some market observers that it could create moral hazard since even though the Fed had not directly injected capital, its use of moral suasion to encourage creditor involvement emphasized its interest in supporting the financial system.
LTCM's strategies were compared to "picking up nickels in front of a bulldozer" – a likely small gain balanced against a small chance of a large loss, like the payouts from selling an out-of-the-money naked call option. This contrasts with the market efficiency aphorism that there are no $100 bills lying on the street, as someone else has already picked them up.
From Wikipedia’s article on Long-Term Capital Management, shared under CC BY-SA 4.0.4