Long-Term Capital Management

John Meriwether headed Salomon Brothers' bond arbitrage desk until he resigned in 1991 amid a trading scandal.[6] 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.[7]

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[8] and two future winners of the Nobel Memorial Prize, Myron Scholes and Robert C. Merton.[9][10] 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 company incorporated in Delaware but 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.[11]

Myron Scholes (left) and Robert C. Merton were principals at LTCM.

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.[12] In late 1993, Meriwether approached several high-net-worth individuals in an effort to secure start-up capital for Long-Term Capital Management. With the help of Merrill Lynch, LTCM secured hundreds of millions of dollars from business owners, celebrities and even private university endowments and later the Italian central bank. The bulk of the money, however, came from companies and individuals connected to the financial industry.[13] By 24 February 1994, the day LTCM began trading, the company had amassed just over $1.01 billion in capital.[14]

The core investment strategy of the company was then known as involving convergence trading: using quantitative models to exploit deviations from fair value in the relationships between liquid securities across nations, and between asset classes (i.e Fed model-type strategies). In fixed income the company was involved in US Treasuries, Japanese Government Bonds, UK Gilts, Italian BTPs, and Latin American debt, although their activities were not confined to these markets or to government bonds.[15] LTCM was the brightest star on Wall Street at that time.[16]

Despite the fund's prominent leadership and strong growth at LTCM, a 2014 Business Insider article pointed out that there were skeptics from the very beginning:

Investor Seth Klarman believed it was reckless to have the combination of high leverage and not accounting for rare or outlying scenarios. Software designer Mitchell Kapor, who had sold a statistical program with LTCM partner Eric Rosenfeld, saw quantitative finance as a faith, rather than science. Nobel Prize winning economist Paul Samuelson was concerned about extraordinary events affecting the market.[19]

Economist Eugene Fama found in his research that stocks were bound to have extreme outliers. Furthermore, he believed that, because they are subject to discontinuous price changes, real-life markets are inherently more risky than models. He became even more concerned when LTCM began adding stocks to their bond portfolio.[19]

A 2016 CFA article written by Ron Rimkus pointed out the VaR model, one of the major quantitative analysis tool by LTCM, had several flaws in it. VaR model calculated based on historical data. But its data sample was biased such that data caused by unusual events were excluded. VaR also couldn't interpret extreme event such as financial crisis in terms of timing. The model failed to recognize that a financial crisis was a rare event and thus produced biased calculation results.[23]

The value of $1,000 invested in LTCM,[24] the Dow Jones Industrial Average and invested monthly in U.S. Treasuries at constant maturity.

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 $1.066bn from UBS and $133m from CSFB. Since position sizes had not been reduced, the net effect was to raise the leverage of the fund.

Although 1997 had been a very profitable year for LTCM (27%), the lingering effects of the 1997 Asian crisis continued to shape developments in asset markets into 1998. Although this crisis had originated 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.[25]

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.[26] 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.

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 rumours 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).[27] He reports that LTCM established an arbitrage position in the dual-listed company (or "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.[28]

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.[29]

The company, which had historically earned annualised 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.[30]

Historian Niall Ferguson proposed that LTCM's collapse stemmed in part from their use of only five years of financial data to prepare their mathematical models, thus drastically under-estimating the risks of a profound economic crisis.[3] Using ten years of data would have included the 1987 US market crash, while using 80 years of data would have included many minor and major economic downturns including the 1918 Russian sovereign debt default after the First World War and Russian Civil War, highlighting the possibility of a major foreign event causing international repercussions that LTCM seemingly overlooked.

On September 23, 1998, the chiefs of some of the largest investment firms of Wall Street—Bankers Trust, Bear Stearns, Chase Manhattan, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Smith Barney—met on the 10th floor conference room of the Federal Reserve Bank of New York (pictured) to rescue LTCM.

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.[31]

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.[32] The principal negotiator for LTCM was general counsel James G. Rickards.[33] The contributions from the various institutions were as follows:[34][35]

• $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[36][37]
• Bear Stearns and Crédit Agricole[38] 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.[39]

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):[27]

• $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. 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 .[40]

LTCM's strategies were compared (a contrast with the market efficiency aphorism that there are no $100 bills lying on the street, as someone else has already picked them up) to "picking up nickels in front of a bulldozer"[41]—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.

In 1998, the chairman of Union Bank of Switzerland resigned as a result of a $780 million loss incurred from the being short put options on LTCM, which had become significantly in-the-money due to LTCM's collapse.[1]

After the bailout, Long-Term Capital Management continued operations. In the year following the bailout, it earned 10%. By early 2000, the fund had been liquidated, and the consortium of banks that financed the bailout had been paid back, but the collapse was devastating for many involved. Mullins, once considered a possible successor to Alan Greenspan, saw his future with the Fed dashed. The theories of Merton and Scholes took a public beating. In its annual reports, Merrill Lynch observed that mathematical risk models "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited."[42]

After helping unwind LTCM, John Meriwether launched JWM Partners. Haghani, Hilibrand, Leahy, and Rosenfeld signed up as principals of the new firm. By December 1999, they had raised $250 million for a fund that would continue many of LTCM's strategies—this time, using less leverage.[43] With the credit crisis of 2008, JWM Partners LLC was hit with a 44% loss from September 2007 to February 2009 in its Relative Value Opportunity II fund. As such, JWM Hedge Fund was shut down in July 2009.[44] Meriwether then launched a third hedge fund in 2010 called JM Advisors Management. A 2014 Business Insider article stated that his later two funds used "the same investment strategy from his time at LTCM and Salomon."[19]

• Black–Scholes model
• Commodity Futures Modernization Act of 2000
• Game theory
• Greenspan put
• James Rickards
• Kurtosis risk
• Limits to arbitrage
• Martingale (betting system)
• Martingale (probability theory)
• Probability theory
• St. Petersburg paradox
• Value at risk
• When Genius Failed: The Rise and Fall of Long-Term Capital Management
• Black swan problem

• Coy, Peter; Wooley, Suzanne (21 September 1998). "Failed Wizards of Wall Street". Business Week. Retrieved 2006-09-04.
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• Jacque, Laurent L. (2010). Global Derivative Debacles: From Theory to Malpractice. Singapore: World Scientific. ISBN 978-981-283-770-7.. Chapter 15: Long-Term Capital Management, pp. 245–273
• Loomis, Carol J. (1998). "A House Built on Sand; John Meriwether's once-mighty Long-Term Capital has all but crumbled. So why did Warren Buffett offer to buy it?". Fortune. 138 (8).
• Lowenstein, Roger (2000). When Genius Failed: The Rise and Fall of Long-Term Capital Management. Random House. ISBN 978-0-375-50317-7.
• Weiner, Eric J. (2007). What Goes Up, The Uncensored History of Modern Wall Street. New York: Back Bay Books. ISBN 978-0-316-06637-2.

• "Eric Rosenfeld talks about LTCM, ten years later". MIT Tech TV. 2009-02-19.
• Siconolfi, Michael; Pacelle, Mitchell; Raghavan, Anita (1998-11-16). "All Bets Are Off: How the Salesmanship And Brainpower Failed At Long-Term Capital". Wall Street Journal.
• "Trillion Dollar Bet". Nova. PBS. 2000-02-08.
• MacKenzie, Donald (2003). "Long-Term Capital Management and the Sociology of Arbitrage". Economy and Society. 32 (3): 349–380. CiteSeerX 10.1.1.457.9895. doi:10.1080/03085140303130. S2CID 145790602.
• Fenton-O'Creevy, Mark; Nicholson, Nigel; Soane, Emma; Willman, Paul (2004). Traders: Risks, Decisions, and Management in Financial Markets. Oxford University Press. ISBN 9780199226450.
• Gladwell, Malcolm (2002). "Blowing Up". The New Yorker. Archived from the original on 2011-02-24.
• MacKenzie, Donald (2006). An Engine, not a Camera: How Financial Models Shape Markets. The MIT Press. ISBN 978-0-262-13460-6.
• Poundstone, William (2005). Fortune's Formula: The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street. Hill and Wang. ISBN 978-0-8090-4637-9.
• Case Study: Long-Term Capital Management erisk.com
• Meriwether and Strange Weather: Intelligence, Risk Management and Critical Thinking austhink.org
• US District Court of Connecticut judgement on tax status of LTCM losses
• Michael Lewis – NYT – How the Egghead's Cracked-January 1999
• Stein, M. (2003): Unbounded irrationality: Risk and organizational narcissism at Long Term Capital Management, in: Human Relations 56 (5), S. 523–540.