Long-Term Capital Management
Long-Term Capital Management L.P. was an American hedge fund which used highly leveraged strategies. In 1998 when LTCM was on the verge of collapse, the fund received a $3.6 billion bailout from a group of 14 banks, in a deal brokered and put together by the Federal Reserve Bank of New York, due to fears the collapse of LTCM would have disastrous effects on the larger financial system.
LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Members of LTCM's board of directors included Myron Scholes and Robert C. Merton, who three years later in 1997 shared the Nobel Prize in Economics for having developed the Black–Scholes model of financial dynamics.
LTCM was initially successful, with annualized returns of around 21% in its first year, 43% in its second year and 41% in its third year. However, in 1998 it lost $4.6 billion in less than four months due to a combination of high leverage and exposure to the 1997 Asian financial crisis and 1998 Russian financial crisis. The master hedge fund, Long-Term Capital Portfolio L.P., collapsed soon thereafter, leading to an agreement on September 23, 1998, among 14 financial institutions for a $3.65 billion recapitalization under the supervision of the Federal Reserve. The fund was liquidated and dissolved in early 2000.
Founding
headed Salomon Brothers' bond arbitrage desk until he resigned in 1991 amid a trading scandal. 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.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 and two future winners of the Nobel Memorial Prize, Myron Scholes and Robert C. Merton. 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, a Delaware-incorporated company 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.
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. The bulk of the money raised, in late 1993, came from companies and individuals connected to the financial industry. With the help of Merrill Lynch, LTCM also secured hundreds of millions of dollars from high-net-worth individuals including business owners and celebrities, as well as private university endowments and later the Italian central bank. By 24 February 1994, the day LTCM began trading, the company had amassed just over $1.01 billion in capital.
Trading strategies
The main strategy was to find pairs of bonds which should have a predictable spread between their prices, and then when this spread widened further to basically place a bet that the two prices would come back towards each other.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. 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. LTCM was the brightest star on Wall Street at that time.
List of Major 1998 Trades
Fixed Income Arbitrage
- Short US swap spread
- Euro Cross-Swap
- Long US mortgages hedged
- Swap curve Japan
- Italian swap spread
- Fixed income volatility
- On-the-run/off-the-run spread
- Junk bond arbitrage
Equity
- Short equity volatility
- Risk arbitrage
- Equity relative value
Emerging Markets
- Long emerging market sovereigns
- Long emerging market currency
- Long emerging market equity hedged to S&P 500
Other
- Yield curve trades
- Short high-tech stocks
- Convertible arbitrage
- Index arbitrage
Fixed income arbitrage
For example, the most recently issued treasury bond in the US – known as the benchmark – will be more liquid than bonds of similar but slightly shorter maturity that were issued previously. Trading is concentrated in the benchmark bond, and transaction costs are lower for buying or selling it. As a consequence, it tends to trade more expensively than less liquid older bonds, but this expensiveness tends to have a limited duration, because after a certain time there will be a new benchmark, and trading will shift to this security newly issued by the Treasury. One core trade in the LTCM strategies was to purchase the old benchmark – now a 29.75-year bond, and which no longer had a significant premium – and to sell short the newly issued benchmark 30-year, which traded at a premium. Over time the valuations of the two bonds would tend to converge as the richness of the benchmark faded once a new benchmark was issued. If the coupons of the two bonds were similar, then this trade would create an exposure to changes in the shape of the typically upward sloping yield curve: a flattening would depress the yields and raise the prices of longer-dated bonds, and raise the yields and depress the prices of shorter-dated bonds. It would therefore tend to create losses by making the 30-year bond that LTCM was short more expensive even if there had been no change in the true relative valuation of the securities. This exposure to the shape of the yield curve could be managed at a portfolio level, and hedged out by entering a smaller steepener in other similar securities.
Leverage and portfolio composition
Because the magnitude of discrepancies in valuations in this kind of trade is small, in order to earn significant returns for investors, LTCM used leverage to create a portfolio that was a significant multiple of investors' equity in the fund. It was also necessary to access the financing market in order to borrow the securities that they had sold short. In order to maintain their portfolio, LTCM was therefore dependent on the willingness of its counterparties in the government bond market to continue to finance their portfolio. If the company were unable to extend its financing agreements, then it would be forced to sell the securities it owned and to buy back the securities it was short at market prices, regardless of whether these were favorable from a valuation perspective.At the beginning of 1998, the firm had equity of $4.7 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt-to-equity ratio of over 25 to 1. 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.
Secret and opaque operations
LTCM was open about its overall strategy, but very secretive about its specific operations, including scattering trades among banks. And in perhaps a disconcerting note, "since Long-Term was flourishing, no one needed to know exactly what they were doing. All they knew was that the profits were coming in as promised," or at least perhaps what should have been a disconcerting note when looked at in hindsight.Opaqueness may have made even more of a difference and investors may have had even a harder time judging the risk involved when LTCM moved from bond arbitrage into arbitrage involving common stocks and corporate mergers.