Long Term Capital Management (LTCM) was a hedge fund created in 1994 by John Meriwether, a successful bond trader at Salomon Brothers. Solomon was one of the first to hire Meriwether Wall Street academics and teachers. Meriwether created a team of academics who applied models based on financial theories to trade. In Solomon, Meriwether’s genius team generated amazing returns and demonstrated a unique ability to accurately calculate risk and other market factors.
In 1994, Meriwether left Solomon and founded LTCM. Members included two Nobel Prize-winning economists, a former vice-chairman of the Federal Reserve Board of Governors, a Harvard University professor, and other successful bond traders. This elite group of merchants and academics attracted an initial investment of about $ 1.3 billion from many large institutional clients.
LTCM’s strategy was simple in concept but difficult to implement. LTCM used computer models to find arbitrage opportunities between markets. The central strategy of the LTCM was convergence trading, where values were misjudged by each other. The LTCM would take long positions in low price security and short positions in excess price.
LTCM has been involved in this strategy in international bond markets, emerging markets, U.S. government bonds, and other markets. The LTCM would make money by reducing these spreads and returning them to fair value. Later, as LTCM’s capital base increased, the fund engaged in strategies outside of their specialization, such as merger arbitrage and the S&P 500 volatility.
These strategies, however, focused on small price differences. Myron Scholes, one of the partners, stated that “the LTCM would function as a giant vacuum cleaner that absorbs the nickel that everyone else has forgotten.” To make a big profit on small value differences, hedge funds took high leverage positions. In early 1998, the fund had assets of about $ 5 billion and borrowed about $ 125 billion.
The LTCM achieved excellent results in the beginning. Prior to the installments, the fund gained 28% in 1994, 59% in 1995, 57% in 1996 and 27% in 1997. The LTCM gained these gains with its surprisingly low volatility. In April 1998, the value of an initially invested dollar rose to $ 4.11.
However, in mid-1998, funds began to fall. These losses were further exacerbated when Salomon Brothers left the arbitration business. Years later, Russia defaulted on government bonds, an LTCM stake. Investors panicked and sold Japanese and European bonds and bought US treasury bonds. As a result, the spread of LTCM’s shareholding increased, and arbitrage businesses lost large numbers. The LTCM lost $ 1.85 trillion at the end of August 1998.
The spread between LTCM’s arbitrage trades continued to widen and the fund ran out of liquidity, with assets falling from $ 2.3 billion in the first 3 weeks of September to $ 600 billion. Although the assets decreased, the value of the portfolio did not decrease as a result of using the lever. However, the fall in assets raised the leverage level of the fund. After all, the Federal Reserve Bank of New York catalyzed a $ 3,625 billion bailout by major institutional creditors to prevent a further collapse in the financial markets, leading to a huge LTCM leverage and high derivative positions. At the end of September 1998, the value of one dollar initially invested fell to $ 0.33 before the quotas.
Lessons from the failure of the LTCM
1. Limiting the use of excessive leverage
When participating in stock-based investment strategies that match the estimated fair market price, managers must have a long-term time frame and be able to withstand adverse price changes. When a lever is used, the ability to invest capital in the long run is limited by improper price changes due to the patience of creditors. Typically, lenders lose patience in a market crisis when loans require capital. If it is forced to stock in a non-market crisis, the fund will fail.
The use of leverage by LTCM also highlighted the lack of regulation in the OTC (OTC) derivatives market. Many of the borrowing and reporting conditions imposed on other markets, such as futures, were not in the OTC derivatives market. This lack of transparency led to a lack of full recognition of the dangers of the LTCM’s formidable lever.
The failure of the LTCM does not mean that the use of the lever is bad, but it does highlight the negative consequences that excessive use of the lever can have.
2. The importance of risk management
The LTCM failed to manage various aspects of the risk internally. Managers were mostly focused on theoretical models and were not sufficient in liquid risk, gap risk, and stress testing.
With these large positions, the LTCM should focus more on liquidity risk. The LTCM model underestimated the likelihood of a market crisis and the possibility of escaping liquidity.
LTCM models also assumed that long and short positions were closely related. This assumption was historically based. Past results do not guarantee future results. Testing the potential model of lower relationships could stress the risk better.
In addition to the LTCM, the large institutional creditors of the hedge fund did not properly manage the risk. Surprised by the fund’s star traders and large amounts of assets, many creditors provided very generous credit terms, although creditors were at high risk. Moreover, many creditors did not understand their full exposure to specific markets. In times of crisis, being exposed to specific risks in many areas of business can cause tremendous damage.
The LTCM failed to have independent verification of traders. Without this oversight, traders were able to create positions that were too dangerous.
The LTCM shows an interesting case of the limitations of predictions based on historical information, and the importance of recognizing the potential failure of models. In addition, the history of LTCM shows the risk of limited transparency in the OTC derivatives market.
To learn more about finance and investing, visit the Sharpe Investing blog.