What Was Long-Term Capital Management (LTCM)?
Long-Term Capital Management (LTCM) was a large hedge fund led by Nobel Prize-winning economists and renowned Wall Street traders. The firm was wildly successful from 1994-1998, attracting more than $1 billion of investor capital with the promise of an arbitrage strategy that could take advantage of temporary changes in market behavior and, theoretically, reduce the risk level to zero.
But the fund nearly collapsed the global financial system in 1998. This was due to LTCM’s highly leveraged trading strategies that failed to pan out. Ultimately, LTCM had to be bailed out by a consortium of Wall Street banks in order to prevent systemic contagion.
- Long-Term Capital Management (LTCM) was a large hedge fund led by Nobel Prize-winning economists and renowned Wall Street traders.
- The firm was profitable in its heyday in the 1990s, drawing over $1 billion of investor capital by promising that its arbitrage strategy would yield huge returns for investors.
- But LTCM’s highly leveraged trading strategies failed to pan out and with losses mounting, the U.S. government feared the company's implosion could be catastrophic for the global financial system.
- Ultimately, a loan fund was created to bail out LTCM in September 1998, enabling it to liquidate in an orderly manner, and a bigger crisis was averted.
Understanding Long-Term Capital Management
LTCM started with just over $1 billion in initial assets and focused on bond trading. The trading strategy of the fund was to make convergence trades, which involve taking advantage of arbitrage between securities. These securities are incorrectly priced, relative to one another, at the time of the trade.
An example of an arbitrage trade would be a change in interest rates not yet adequately reflected in securities prices. This could open opportunities to trade such securities at values, different from what they will soon become, once the new rates have been priced in. LTCM also dealt in interest rate swaps, which involve the exchange of one series of future interest payments for another, based on a specified principal, among two counterparties. Often interest rate swaps consist of changing a fixed rate for a floating rate or vice versa, in order to minimize exposure to general interest rate fluctuations.
Due to the small spread in arbitrage opportunities, LTCM had to leverage itself highly to make money. At the fund’s height in 1998, LTCM had approximately $5 billion in assets, controlled over $100 billion, and had positions, whose total worth was over a $1 trillion. At the time, LTCM also had borrowed greater than $120 billion in assets.
When Russia defaulted on its debt in August 1998, LTCM was holding a significant position in Russian government bonds (known by the acronym GKO). Despite the loss of hundreds of millions of dollars per day, LTCM's computer models recommended that it hold its positions. When the losses approached $4 billion, the federal government of the United States feared that the imminent collapse of LTCM would precipitate a larger financial crisis and orchestrated a bailout to calm the markets. A $3.65-billion loan fund was created, which enabled LTCM to survive the market volatility and liquidate in an orderly manner in early 2000.
LTCM was formed in 1993 and was founded by renowned Salomon Brothers bond trader John Meriwether along with Nobel-prize winning Myron Scholes of the Black-Scholes model.
The Downfall of Long-Term Capital Management
Due to Long Term Capital Management’s highly leveraged nature, coupled with a financial crisis in Russia (i.e., the default of government bonds), LTCM sustained massive losses and was in danger of defaulting on its own loans. This made it difficult for LTCM to cut its losses in its positions. LTCM held huge positions, totaling roughly 5% of the total global fixed-income market, and had borrowed massive amounts of money to finance these leveraged trades.
If LTCM had gone into default, it would have triggered a global financial crisis due to the massive write-offs its creditors would have had to make. In September 1998, the fund, which continued to sustain losses, was bailed out with the help of the Federal Reserve. Then its creditors took over, and a systematic meltdown of the market was prevented.