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Long-Term Capital Management (LTCM) was a large hedge fund with $126 billion in assets. Two Nobel Prize-winning economists, along with celebrated Wall Street traders, founded the company. The company amassed over $1 billion in investor capital and achieved near-instant success in its first year (1994).
LTCM managed to get so many investors to buy in due to its powerhouse founders and the promise of an arbitrage strategy that could capitalize on temporary changes in market behavior to, theoretically, decrease the risk of high-reward investments to zero. The company’s trading strategies eventually failed catastrophically and led to a massive bailout in 1998.
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In this article, we will give a primer on Long-Term Capital Management, so you can start investigating and/or voting on whether the hedge fund should have been saved with taxpayer money.
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How Long-Term Capital Management worked
Investors had to put up $10 million to enter the fund and could not withdraw that money for three years. LTCM even refused to answer inquiries about the types of investments it would make. Perhaps due to the all-star team behind LTCM, these restrictions did not discourage the 80 wealthy individuals who ended up investing. As mentioned above, LTCM had just north of $1 billion in initial capital.
LTCM primarily focused on ‘convergence trades’ with bonds. Convergence trades refer to when you invest in securities that are mispriced relative to one another at the time of the trade. For the cheap securities, the company took long positions; for expensive ones, short positions.
The following four trades comprised TCM’s primary investment strategy:
- Convergence among U.S., Japan, and European sovereign bonds;
- Convergence among European sovereign bonds;
- Convergence between On-the-Run and Off-the-Run U.S. government bonds;
- Long positions in emerging markets sovereigns, hedged back to dollars.
LTCM performed exceptionally well, delivering annual returns of 40% in 1995 and 1996. That’s factoring in the 27% management took in fees. Even when the 1997 Asian financial crisis hit, LTCM didn’t just weather the storm. It gave its investors a 17.1% return for the year.
The small spread in arbitrage opportunities meant LTCM had to leverage itself highly to generate capital. At its apex, right before the collapse in 1998, LTCM had approximately amassed $5 billion in assets, controlled over $100 billion, and had positions valued at over $1 trillion. The company had also borrowed more than $120 billion in assets.
The LTCM Crisis
From Extreme Events in Finance
Despite LTCM’s success through the Asian financial crisis, the company could not handle another one. Another crisis began, of course, due to the Asian financial crisis and the decline of demand for oil. This time the crisis hit Russia, right at the end of 1997.
The Russian financial crisis occurred due to fears of a ruble devaluation and a default on domestic debt. Continuous rises in interest rates and capital outflows undermined investors’ confidence in emerging markets. LTCM had invested a great deal of capital in European bonds, particularly Russian government bonds (a.k.a. GKOs).
As you can see in the timeline above, the company’s portfolios started to accrue losses by the middle of 1998. 6% in May. 10% in June. 18% in July. In August alone, LTCM lost $553 million (15% of its total capital). Russia defaulted on its government obligations (GKOs) in August, essentially causing LTCM to collapse.
But why didn’t they just sell the securities before they completely tanked?
Even though LTCM was losing hundreds of millions of dollars on a daily basis, its computer models showed that the company should hold its positions. LTCM could not go against the complex computer models that had brought them so much success in the past.
The Ruble Hedge
To be fair, LTCM did not just sit around, admiring its computer models.
The company believed it could counteract the risk and probable losses of the GKO position by selling off rubles. In the case Russia defaulted on its bonds, the value of its currency would collapse. LTCM hoped that it could offset the losses on the bonds by selling rubles for some profit on the foreign exchange market.
But its gamble, or hedge, failed to pay off.
Although LTCM experienced significant losses due to the shutdown, that alone did not ruin the hedge fund. The moratorium on trading in rubles actually did less damage than the widespread ‘flight to liquidity.’
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The True Damage of the Russian Financial Crisis 1998
The flight to liquidity throughout global fixed-income markets proved the main reason for LTCM’s collapse.
As Russia’s troubles deepened, fixed-income portfolio managers began to shift to more liquid assets. Many panicked investors all around the globe started moving their assets to the most liquid part of the U.S. Treasury market: On-the-Run (most recently issued) Treasuries.
In normal market conditions, the U.S. Treasury market is already quite liquid. But the global flight to liquidity significantly widened the spread between the yield of On-the-Run Treasuries and Off-the-Run Treasuries. Off-the-Run bonds got even cheaper than they already were.
LTCM did not account for one thing: a substantial portion of its balance sheet was exposed to changes in liquidity price. In the case liquidity increased in value (as it did following the crisis), LTCM’s short positions would rise in price relative to its long positions. Essentially the company had colossal, unhedged exposure to one risk factor.
To provide a short summary, global investors shifted to highly liquid Treasury bonds. This caused long-term interest rates to plummet by more than a full point by the end of September 1998. LTCM’s highly leveraged investments crumbled, as a result.
Federal Reserve Intervention
As the losses neared $4 billion, LTCM was on the verge of collapse. An investment group led by Warren Buffett extended a $250 million buyout offer to the shareholders. LTCM shareholders thought the offer too low. Eventually, the Federal government swooped in to prevent LTCM’s collapse, fearing that would trigger a global financial crisis.
Why?
Practically all of the leveraged Treasury bond investors had very similar positions to LTCM’s. Two factors had caused that homogeneity:
- Most of the investors were using the same complex computer models. Meaning, the algorithm recommended they hold onto their GKO positions.
- Many investment banks acquired order flow information through business dealings with LTCM. Thus they probably knew many of LTCM’s actual positions and had taken up similar positions as their clients.
The Federal Reserve created a $3.65 billion loan fund. This allowed LTCM to survive the market volatility and liquidate in early 2000. But did the Federal Reserve really have to bail out LTCM with taxpayer money? Or could global financial markets have fared well enough without the intervention?
The CATO Institute Report
The CATO Institute, a public policy research organization, published a report analyzing the LTCM crisis. The think tank argued that the Fed made a “misguided” and “unnecessary” intervention because (1) LTCM would not have failed and (2) even if it had failed, global financial markets would not have collapsed.
The savings and loan crisis made the Federal Reserve intervene and use $500 billion (in 1990 money) to bail out financial institutions. The bailout cost more money than it took to run the entire U.S. government in 1989, including all federal worker salaries, government programs, military, and intelligence services, social programs and welfare, and interest payments on the national debt.
LTCM would not have failed
There’s little doubt that the company would have failed if they didn’t get any help and/or buyout offers.
As far as the first claim goes, the organization discusses how the LTCM had at least one suitor: the Buffet-backed group.
the offer did not satisfy the LTCM shareholders, but should they really have had a much better option from the Fed waiting for them?
The CATO report states:
“
If the Federal Reserve had washed its hands of LTCM early on the morning of September 23, 1998—and made clear to LTCM that it was doing so—the management of LTCM would have faced a set of alternatives very different from the one they actually faced at the time… [LTCM] would have had to choose between the Buffett offer and almost certain failure. The Buffett offer was not a generous one: it would have cost the management of LTCM their remaining equity, their jobs, and any future management fees they might have obtained from LTCM, but it would at least have left them with a $250 million “exit” payment. The alternative would have been to lose their equity, their jobs, and their management fees and get nothing in return—in short, to lose everything. They would therefore have been crazy to turn Buffett down, and we must suppose they would not have done so.
The Global Financial Market would have been fine
The CATO Institute also argued against the Fed’s claim that LTCM was ‘too big to fail.’ The think tank contended that global financial markets would not have collapsed even if LTCM had.
CATO provided the following evidence:
- Even if many firms would have suffered, the trillions of dollars already in global markets. The losses incurred by LTCM and any other of the leveraged Treasury bond investors would not have come close to equaling the size of the market.
- Firms that have to liquidate positions due to a major crisis often have suitors/buyers. While the stockholders of the collapsing firm will likely take a loss, that can be offset due to competition between buyers.
- History suggests that the failure of massive derivatives companies typically impacts only the markets in which those companies were active, not global financial markets. The failure of LTCM could have had a major negative impact on some of the derivatives markets in which the fund was active, but would not have caused a global liquidity crisis.
- Even in extreme and/or unusual markets where liquidity might be stalled in the aftermath of a major shock, participants can resume trading ASAP. Numerous times in the 1990s, derivatives markets managed to absorb major shocks and quickly bounce back. There was little reason to believe the market response would have differed if LTCM had collapsed.
- Derivatives risk management had experienced major developments prior to LTCM’s failure. These developments included: industry-wide adoption of value-at-risk systems to measure and mitigate overall risk exposure; increasing acceptance of firm-wide risk management guidelines; methodologies for stress testing and scenario analysis; and “credit enhancement” techniques to minimize exposures to counterparties
The Conclusion
The CATO Institute summarizes by saying, “the intervention helped the shareholders and managers of LTCM to get a better deal for themselves than they would otherwise have obtained.”
While the government recouped the bailout money eventually, we must wonder about the capital those LTCM shareholders received and never had to pay back. Even though the Fed. saved the hedge fund, it could have prevented the shareholders from making any money from their failed investments. Isn’t that how it’s supposed to go anyway?
What do YOU Think About the LTCM Crisis?
After seeing the evidence presented in this article, where do you stand on the LTCM crisis? Did LTCM shareholders unfairly receive the wealth that they shouldn’t have? Should the Fed. have intervened?
It’s time for you to voice your opinion. Help your fellow citizens decide whether the LTCM bailout was rigged.
Your vote helps citizens figure out how much is getting ripped off and by whom. That gives us the power, based on strong evidence, to start holding those gaming the system accountable for profiting unethically. All of us must decide democratically, by a vote.
If you are still undecided, your fellow citizens have investigated the issue and presented their own cases for why they believe or don’t believe the corporate tax rate should be viewed as rigged economy theft.
Eradicate the Rigged Layer with the Zero Theft Movement
The rigged layer of the U.S. economy rips all of us off, including YOU. Crony capitalists and officials who have succumbed to regulatory capture have created 50 years of wage stagnation and violations of antitrust laws.
The Zero Theft Movement seeks to end the corporatocracy and rid moneyed interests from politics. Our mission is and will continue to be, on waking up 330 million American citizens to the truth. We can all profit from an ethical, powerful, and safe economy if we stand up against the crony capitalists.
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Standard Disclaimer
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.