Long-term Capital Management

 

Long-term Capital Management was a large hedge fund management led by Renowned Wall Street Traders and Nobel prize-winning economists. In 1994-1998 the firm was widely successful, attracting more than $1 billion of investor capital with the promise of an arbitrage strategy that could take advantage of small temporary changes in the market behavior and theoretically reduce the risk level to zero.

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Background of LTCM

Long-term Capital Management 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. At the time of the trade, these securities are incorrectly priced relative to one another.

An Example of arbitrage would be a security trading in BSE for Rs 25.50 would be trading at NSE at Rs 25.00. In this situation there is an asset misprice the arbitrager would buy at low and sell at high hence, he will buy the security from NSE at Rs 25 and sell them at BSE at Rs 25.50 and he will earn a riskless profit of Rs. 0.50

LTCM has to leverage itself highly to make money as the spread in arbitrage opportunity is very small.at the fund’s height in 1998, LTCM had approximately $5 billion in assets, controlled over $100 billion, and had a position, whose total worth was over $1 trillion. At the time, LTCM also had borrowed greater than $120 billion in assets.

Cause of Collapse

Due to LTCM’s highly leveraged nature, coupled with financial crises in Russia (i.e., the default of govt bonds), LTCM sustained massive losses and was in danger of defaulting on its loans. This made it difficult for LTCM to cut its losses in its position. 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.

Bailout by Federal Reserve

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 Reserves. Then its creditors took over, and a systematic meltdown of the market was prevented.

Lesson Learned

The lesson from the LTCM episode was the realization that the financial difficulties of a large nonbank financial company could present systemic risk.  Previously, the concept of systemic risk and its corollary concept of too-big-to-fail had been analyzed in terms of banking institutions.  As the chairman of the House Banking Committee noted at the outset of the initial congressional hearing on LTCM, the rescue of LTCM was the first time that the too-big-to-fail doctrine had been applied beyond insured depository institutions. The systemic risk presented by the nonbank financial entities as exemplified by Bear Stearns, Lehman Brothers, and AIG would be at the center of the financial crisis in 2008.

The second lesson related to the risk presented by excessive leverage.  Virtually every analysis of the LTCM case concludes that the excessive leverage of LTCM through its balance sheet and off-balance-sheet exposures was a crucial factor in causing its near failure.  The issue of excessive leverage was not limited to LTCM or other hedge funds.  Other financial institutions in 1998 were as leveraged as, and in some cases, more highly leveraged than LTCM.  A report prepared by the President’s Working Group on Financial Markets on the LTCM episode observed that at the beginning of 1998 (before LTCM began to experience losses)

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Final Thoughts

The other lesson to be learned by other financial institutions is that it is important to aggregate risk exposures across businesses. Many of the large dealer banks exposed to a Russian crisis across many different businesses only became aware of the commonality of these exposures after the LTCM crisis.

 

Author – Hariharan Krishnan

About the Author – Hariharan Krishnan is currently in second year BAF and is also doing FRM part 1. He is passionate about financial markets and loves to play chess and outdoor games.

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