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 that nearly collapsed the global financial system in 1998. This was due to LTCM’s high-risk arbitrage trading strategies.
The LTCM fund formed in 1993 and was founded by renowned Salomon Brothers bond trader John Meriwether.
BREAKING DOWN Long-Term Capital Management (LTCM)
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.
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.