Long-Term Capital Management


Long-Term Capital Management

Long-Term Capital Management (LTCM) was a U.S. hedge fund which failed spectacularly in the late 1990s, leading to a massive bailout by other major banks and investment houses. [cite book |title=The Age of Turbulence: Adventures in a New World |last=Greenspan |first=Alan |year=2007 |page=193-195 |id=ISBN 978-1-59420-131-8 |publisher=The Penguin Press]

LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Board of directors members included Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economics. [ [http://nobelprize.org/economics/laureates/1997/index.html The Bank of Sweden Prize in Economic Sciences 1997] . Robert C. Merton and Myron S. Scholes pictures. Myron S. Scholes with location named as "Long Term Capital Management, Greenwich, CT, USA" where the prize was received.] Initially enormously successful with annualized returns of over 40% in its first years, in 1998 it lost $4.6 billion in less than four months and became a prominent example of the risk potential in the hedge fund industry. The fund folded in early 2000.

Founding members

In addition to Meriwether, Scholes and Merton, also joining the company as principals were Eric Rosenfeld, Greg Hawkins, Larry Hilibrand, Robert Shustak, Dick Leahy, Victor Haghani and James McEntee. On 24 February, 1994, LTCM began trading with $1,011,060,243 of investor capital.Lowenstein, R., 2000: "", Random House.]

The fundamental errors

The company had developed complex mathematical models to take advantage of fixed income arbitrage deals (termed "convergence trades") usually with U.S., Japanese, and European government bonds. The basic idea was that over time the value of long-dated bonds issued a short time apart would tend to become identical. However, the rate at which these bonds approached this price would be different, and more heavily traded bonds such as US Treasury bonds would approach the long term price more quickly than less heavily traded and less liquid bonds.

Thus, by a series of financial transactions (essentially amounting to buying the cheaper 'off-the-run' bond and short selling the more expensive, but more liquid, 'on-the-run' bond), it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond came on the run.

As LTCM's capital base grew, they felt pressed to invest that capital somewhere and had run out of good bond-arbitrage bets. This led LTCM to undertake trading strategies outside their expertise. Although these trading strategies were non-market directional, i.e. they were not dependent on overall interest rates or stock prices going up (or down), they were not convergence trades as such. By 1998, LTCM had extremely large positions in areas such as merger arbitrage and S&P 500 options (net short long-term S&P volatility). In fact, some market participants believed that LTCM had been the primary supplier of S&P 500 vega, which had been in demand by US insurance companies selling equity indexed annuities products for the prior two years.Fact|date=February 2007

Because these differences in value were minute—especially for the convergence trades—the fund needed to take highly-leveraged positions to make a significant profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion. It had off-balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.

Downturn

Although success within the financial markets arises from immediate-short term turbulence, and the ability of fund managers to identify informational asymmetries, factors giving rise to the downfall of the fund were established prior to the 1997 East Asian financial crisis. However, 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. Such losses were accentuated through the Russian financial crises in August and September 1998, when the Russian Government defaulted on their government bonds. Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August, the fund had lost $1.85 billion in capital.

As a result of these losses, LTCM had to liquidate a number of its positions at a highly unfavorable moment and suffer further losses. A good illustration of the consequences of these forced liquidations is given by Lowenstein (2000). 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 to 10 percent premium relative to Shell. In total $2.3 billion was invested, half of which long in Shell and the other half short in Royal Dutch (Lowenstein, p. 99). LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge. This may 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 percent, which implies that LTCM incurred a large loss on this arbitrage strategy. According to Lowenstein (p. 234), LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade.

The company, which was providing annual 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 to $600 million without shrinking the portfolio, leading to a significant elevation of the already high leverage.

1998 bailout

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 was rejected and the same day 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. The contributions from the various institutions were as follows: [Wall Street Journal, 25 September 1998] [ [http://www.bloomberg.com/apps/news?pid=20601109&refer=home&sid=a2mbR8rPyzto Bloomberg.com: Exclusive ] ]
* $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: Lehman Brothers, Paribas
* Bear Stearns 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.

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 creating a vicious cycle.

The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):
* $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
* $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.

Unsurprisingly, 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 bailers.

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. [http://www.gao.gov/archive/2000/gg00067r.pdf]

A deeper understanding of the risk-taking

The profits from LTCM's trading strategies were generally not correlated with each other and thus normally LTCM's highly leveraged portfolio benefited from diversification. However, the general flight to liquidity in the late summer of 1998 led to a marketwide repricing of all risk leading these positions to all move in the same direction. As the correlation of LTCM's positions increased, the diversified aspect of LTCM's portfolio vanished and large losses to its equity value occurred. Thus the primary lesson of 1998 and the collapse of LTCM for value at risk (VaR) users is not a liquidity one, but more fundamentally that the underlying covariance matrix used in VaR analysis is not static but changes over time.

Also, if the fund had been less leveraged, it would have weathered the spike in volatility and credit risk: In the end, the idea of LTCM's directional bets was correct, in that the values of government bonds did eventually converge. Due to the high leverage, however, this only happened after the firm's capital was wiped out. Thus, the incident confirms an insight often (though perhaps apocryphally) attributed to the economist John Maynard Keynes, who is said to have warned investors that although markets do tend toward rational positions in the long run, "the market can stay irrational longer than you can stay solvent."

Nassim Taleb compared LTCM's strategies to "picking up pennies in front of a steamroller" ["The Black Swan", Taleb 2007] — a likely small gain balanced against a small chance of a large loss, like the payouts from selling an out-of-the-money option. These strategies would have operated as sort of a reverse St. Petersburg lottery. Even in the particular conditions which resulted in the fund's downfall, these large losses would not, if the positions were held to maturity, have come to pass. However, the events of 1998 increased the perceived probability of large losses, to the point where LTCM's portfolio had negative value.

See also

*Black-Scholes model
*Game Theory
*Greenspan put
*List of business failures
*Martingale (betting system)
*Martingale (probability theory)
*Probability Theory
*St. Petersburg paradox
*""
*JWM Partners LLC

Notes

Further reading

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*es icon cite web |title=LTCM, Long Term Capital Management: La historia |date=2007 Jun 29 |url=http://www.rankia.com/blog/fernan2/2007/06/ltcm-long-term-capital-management-la.html
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* [http://www.erisk.com/Learning/CaseStudies/Long-TermCapitalManagemen.asp Case Study: Long-Term Capital Management]
* [http://www.austhink.org/monk/ltcm.htm Meriwether and Strange Weather: Intelligence, Risk Management and Critical Thinking]


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