Long-Term Capital Management
Encyclopedia
Long-Term Capital Management L.P. (LTCM) was a speculative hedge fund
based in Greenwich
, Connecticut
that utilized absolute-return trading strategies (such as fixed-income arbitrage
, statistical arbitrage
, and pairs trading
) combined with high leverage
. The firm's master
hedge fund, Long-Term Capital Portfolio L.P., failed in the late 1990s, leading to a bailout by other financial institutions, under the supervision of the Federal Reserve
.
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 Economic Sciences
. Initially successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis requiring financial intervention by the Federal Reserve Bank
, and the fund closed in early 2000.
John Meriwether
headed Salomon Brothers
' bond trading desk until he resigned in 1991 amidst a trading scandal.
In 1993 he created Long-Term Capital as a hedge fund and recruited several Salomon bond traders and two future Nobel Prize
winners, Myron Scholes
and Robert C. Merton
. Other principals in the firm included Eric Rosenfeld
, Greg Hawkins
, Larry Hilibrand
, William Krasker, Dick Leahy, Victor Haghani
, James McEntee, Robert Shustak, and David W. Mullins Jr.
The company consisted of Long-Term Capital Management (LTCM), a company incorporated in Delaware
but 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 fund
s, as established by the Investment Company Act of 1940
—funds which accepted stakes from one hundred or fewer individuals with more than one million dollars in net worth each were exempt from most of the regulations that bound other investment companies. In late 1993, Meriwether approached several "high net-worth individuals
" in an effort to secure start-up capital for Long Term Capital Management. With the help of Merrill Lynch, LTCM secured hundreds of millions of dollars from business owners, celebrities and even private university endowments. The bulk of the money, however, came from companies and individuals connected to the financial industry. By 24 February 1994, the day LTCM began trading, the company had amassed just over $1.01 billion in capital.
deals (termed convergence trades) usually with U.S., Japanese, and European government bond
s. Government bonds are a "fixed-term debt obligation", meaning that they will pay a fixed amount at a specified time in the future. Differences in the bonds' present value
are minimal, so according to economic theory any difference in price will be eliminated by arbitrage
. Unlike differences in share prices of two companies, which could reflect different underlying fundamentals, price differences between a 30 year treasury bond and a 29 and three quarter year old treasury bond should be minimal—both will see a fixed payment roughly 30 years in the future. However, small discrepancies arose between the two bonds because of a difference in liquidity. By a series of financial transactions, essentially amounting to buying the cheaper 'off-the-run' bond (the 29 and three quarter year old bond) and shorting
the more expensive, but more liquid, 'on-the-run' bond (the 30 year bond just issued by the Treasury
), it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond was issued.
As LTCM's capital base grew, they felt pressed to invest that capital and had run out of good bond-arbitrage bets. This led LTCM to undertake more aggressive trading strategies. 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
(betting whether mergers would be completed or not) and S&P 500
options (net short long-term S&P volatility). LTCM had become a major supplier of S&P 500 vega, which had been in demand by companies seeking to essentially insure equities against future declines.
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, 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 derivative
s such as interest rate swap
s. The fund also invested in other derivative
s such as equity options.
In 1998, the chairman of Union Bank of Switzerland
resigned as a result of a $780 million loss due to problems at Long-Term Capital Management.
to link all the deals together." Equally alarming, Myron Scholes stated that he was not an expert on tax law. A textbook, "Taxes & Business Strategy" (principally written by Myron Scholes), contains chapters on both economic substance and step transaction
s, which are the two concepts under which the tax loss was disallowed by the IRS.
In a memorandum to Long Term's management committee dated November 12, 1996, Myron Scholes wrote: "We must decide in the near future (1) how to allocate these capital losses; (2) how to "trade" them so that they are held in high-valued hands; and (3) how to plan to be able to enjoy the benefits of the use of these losses for the longest period of time. If we are careful, most likely we will never have to pay long-term capital gains on the 'loan' from the Government." He went on, "How should LTCM pay those who brought the Tax Losses to Fruition and allocate the expenses of undertaking the trade?"
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 8-10% premium relative to Shell. In total $2.3 billion was invested, half of which was "long" in Shell and the other half was "short" in Royal Dutch.
LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge. This might 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%, which implies that LTCM incurred a large loss on this arbitrage strategy. 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 at the start of the month to just $400 million by September 25. With liabilities still over $100 billion, this translated to an effective leverage ratio of more than 250-to-1.
Long-Term Capital Management did business with nearly everyone important on Wall Street. Indeed, much of LTCM's capital was composed of funds from the same Financial Professionals it traded with. As LTCM teetered, Wall Street feared that Long-Term's failure could cause a chain reaction in numerous markets, causing catastrophic losses throughout the financial system. After LTCM failed to raise more money on its own, it became clear it was running out of options. On September 23, 1998, 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 stunningly low to LTCM's partners because at the start of the year their firm had been worth $4.7 billion. Warren Buffett
gave Meriwether less than one hour to accept the deal; the time period lapsed before a deal could be worked out.
Seeing no options left 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 principal negotiator for LTCM was general counsel James G. Rickards
. The contributions from the various institutions were as follows:
In return, the participating banks got a 90% share in the fund and a promise that a supervisory board would be established. LTCM's partners received a 10% stake, still worth about $400 million, but this money was completely consumed by their debts. The partners once had $1.9 billion of their own money invested in LTCM, all of which was wiped out.
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):
Long Term Capital was audited by Price Waterhouse LLP. 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 rescuers.
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
.
LTCM's strategies were compared (a contrast with the market efficiency aphorism that there are no $100 bills lying on the street, as someone else has already picked them up) to "picking up nickels in front of a bulldozer" – a likely small gain balanced against a small chance of a large loss, like the payouts from selling an out-of-the-money option.
, who had been closely involved with LTCM, was forced out of the office in a boardroom coup led by Henry Paulson
. Mullins, once considered a possible successor to Alan Greenspan
, saw his future with the Reserve
dashed. The theories of Merton and Scholes took a public beating. In its annual reports, Merrill Lynch observed that mathematical risk models "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited."
After helping unwind LTCM, Meriwether launched JWM Partners
. Haghani, Hilibrand, Leahy, and Rosenfeld all signed up as principals of the new firm. By December 1999, they had raised $250 million for a fund that would continue many of LTCM's strategies—this time, using less leverage. With the Credit Crisis, JWM Partners LLC was hit with 44% loss from September 2007 to February 2009 in its Relative Value Opportunity II fund. As such, JWM Hedge Fund was shut down in July 2009.
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
based in Greenwich
Greenwich, Connecticut
Greenwich is a town in Fairfield County, Connecticut, United States. As of the 2010 census, the town had a total population of 61,171. It is home to many hedge funds and other financial service companies. Greenwich is the southernmost and westernmost municipality in Connecticut and is 38+ minutes ...
, Connecticut
Connecticut
Connecticut is a state in the New England region of the northeastern United States. It is bordered by Rhode Island to the east, Massachusetts to the north, and the state of New York to the west and the south .Connecticut is named for the Connecticut River, the major U.S. river that approximately...
that utilized absolute-return trading strategies (such as fixed-income arbitrage
Fixed income arbitrage
Fixed-income arbitrage is an investment strategy generally associated with hedge funds, which consists of the discovery and exploitation of inefficiencies in the pricing of bonds, i.e...
, statistical arbitrage
Statistical arbitrage
In the world of finance and investments, statistical arbitrage is used in two related but distinct ways:* In academic literature, "statistical arbitrage" is opposed to arbitrage. In deterministic arbitrage, a sure profit can be obtained from being long some securities and short others...
, and pairs trading
Pairs trade
The pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy...
) combined with high leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
. The firm's master
Master-feeder
The master-feeder structure allows asset managers to capture the efficiencies of larger pools of assets although fashioning investment funds to separate market niches....
hedge fund, Long-Term Capital Portfolio L.P., failed in the late 1990s, leading to a bailout by other financial institutions, under the supervision of the Federal Reserve
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
.
LTCM was founded in 1994 by John Meriwether
John Meriwether
John William Meriwether is an American hedge fund executive, seen as a pioneer of fixed income arbitrage.-Education:...
, the former vice-chairman and head of bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
trading at Salomon Brothers
Salomon Brothers
Salomon Brothers was a bulge bracket, Wall Street investment bank. Founded in 1910 by three brothers along with a clerk named Ben Levy, it remained a partnership until the early 1980s, when it was acquired by the commodity trading firm Phibro Corporation and then became Salomon Inc. Eventually...
. Board of directors
Board of directors
A board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization. Other names include board of governors, board of managers, board of regents, board of trustees, and board of visitors...
members included Myron Scholes
Myron Scholes
Myron Samuel Scholes is a Canadian-born American financial economist who is best known as one of the authors of the Black–Scholes equation. In 1997 he was awarded the Nobel Memorial Prize in Economic Sciences for a method to determine the value of derivatives...
and Robert C. Merton
Robert C. Merton
Robert Carhart Merton is an American economist, Nobel laureate in Economics, and professor at the MIT Sloan School of Management.-Biography:...
, who shared the 1997 Nobel Memorial Prize in Economic Sciences
Nobel Memorial Prize in Economic Sciences
The Nobel Memorial Prize in Economic Sciences, commonly referred to as the Nobel Prize in Economics, but officially the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel , is an award for outstanding contributions to the field of economics, generally regarded as one of the...
. Initially successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis requiring financial intervention by the Federal Reserve Bank
Federal Reserve Bank
The twelve Federal Reserve Banks form a major part of the Federal Reserve System, the central banking system of the United States. The twelve federal reserve banks together divide the nation into twelve Federal Reserve Districts, the twelve banking districts created by the Federal Reserve Act of...
, and the fund closed in early 2000.
Founding
| LTCM Partners | |
|---|---|
| John Meriwether John Meriwether John William Meriwether is an American hedge fund executive, seen as a pioneer of fixed income arbitrage.-Education:... |
Former vice chair and head of bond trading at Salomon Brothers Salomon Brothers Salomon Brothers was a bulge bracket, Wall Street investment bank. Founded in 1910 by three brothers along with a clerk named Ben Levy, it remained a partnership until the early 1980s, when it was acquired by the commodity trading firm Phibro Corporation and then became Salomon Inc. Eventually... ; MBA, University of Chicago University of Chicago The University of Chicago is a private research university in Chicago, Illinois, USA. It was founded by the American Baptist Education Society with a donation from oil magnate and philanthropist John D. Rockefeller and incorporated in 1890... |
| Robert C. Merton Robert C. Merton Robert Carhart Merton is an American economist, Nobel laureate in Economics, and professor at the MIT Sloan School of Management.-Biography:... |
Leading scholar in finance; Ph.D., Massachusetts Institute of Technology Massachusetts Institute of Technology The Massachusetts Institute of Technology is a private research university located in Cambridge, Massachusetts. MIT has five schools and one college, containing a total of 32 academic departments, with a strong emphasis on scientific and technological education and research.Founded in 1861 in... ; Professor at Harvard University Harvard University Harvard University is a private Ivy League university located in Cambridge, Massachusetts, United States, established in 1636 by the Massachusetts legislature. Harvard is the oldest institution of higher learning in the United States and the first corporation chartered in the country... |
| Myron Scholes Myron Scholes Myron Samuel Scholes is a Canadian-born American financial economist who is best known as one of the authors of the Black–Scholes equation. In 1997 he was awarded the Nobel Memorial Prize in Economic Sciences for a method to determine the value of derivatives... |
Co-author of Black–Scholes model; Ph.D., University of Chicago University of Chicago The University of Chicago is a private research university in Chicago, Illinois, USA. It was founded by the American Baptist Education Society with a donation from oil magnate and philanthropist John D. Rockefeller and incorporated in 1890... ; Professor at Stanford University Stanford University The Leland Stanford Junior University, commonly referred to as Stanford University or Stanford, is a private research university on an campus located near Palo Alto, California. It is situated in the northwestern Santa Clara Valley on the San Francisco Peninsula, approximately northwest of San... |
| David W. Mullins Jr. David W. Mullins Jr. David Wiley Mullins, Jr. is an American economist and former vice-chairman of the Federal Reserve. He also served as an assistant Secretary of the Treasury for domestic finance in the administration of United States President George H. W. Bush... |
Vice chairman of the Federal Reserve; Ph.D. MIT Massachusetts Institute of Technology The Massachusetts Institute of Technology is a private research university located in Cambridge, Massachusetts. MIT has five schools and one college, containing a total of 32 academic departments, with a strong emphasis on scientific and technological education and research.Founded in 1861 in... ; Professor at Harvard University Harvard University Harvard University is a private Ivy League university located in Cambridge, Massachusetts, United States, established in 1636 by the Massachusetts legislature. Harvard is the oldest institution of higher learning in the United States and the first corporation chartered in the country... ; was seen as potential successor to Alan Greenspan Alan Greenspan Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC... |
| Eric Rosenfeld Eric Rosenfeld Eric Rosenfeld was a trader and principal in the Long-Term Capital Management hedge fund, a landmark Wall Street disaster.Prior to LTCM, Rosenfeld was an instructor at Harvard University, and then a trader at the famed Salomon Brothers... |
Arbitrage group at Salomon; Ph.D. MIT Massachusetts Institute of Technology The Massachusetts Institute of Technology is a private research university located in Cambridge, Massachusetts. MIT has five schools and one college, containing a total of 32 academic departments, with a strong emphasis on scientific and technological education and research.Founded in 1861 in... ; former Harvard Business School professor |
| William Krasker | Arbitrage group at Salomon; Ph.D. MIT Massachusetts Institute of Technology The Massachusetts Institute of Technology is a private research university located in Cambridge, Massachusetts. MIT has five schools and one college, containing a total of 32 academic departments, with a strong emphasis on scientific and technological education and research.Founded in 1861 in... ; former Harvard Business School professor |
| Gregory Hawkins Greg Hawkins Gregory Dale Hawkins was a trader and principal in the hedge fund Long-Term Capital Management that after four spectacularly successful years lost most of its clients' money in 1998 when the Russian government defaulted on its debt payments on August 17, 1998, triggering a devaluation of the... |
Arbitrage group at Salomon; Ph.D. MIT Massachusetts Institute of Technology The Massachusetts Institute of Technology is a private research university located in Cambridge, Massachusetts. MIT has five schools and one college, containing a total of 32 academic departments, with a strong emphasis on scientific and technological education and research.Founded in 1861 in... ; worked on Bill Clinton Bill Clinton William Jefferson "Bill" Clinton is an American politician who served as the 42nd President of the United States from 1993 to 2001. Inaugurated at age 46, he was the third-youngest president. He took office at the end of the Cold War, and was the first president of the baby boomer generation... 's campaign for Arkansas state attorney general |
| Larry Hilibrand Larry Hilibrand Around 1992, arbitrage trader Larry Hilibrand was synonymous with Wall Street hubris when he became the top-paid trader at Salomon Brothers. As one of the most mathematically astute traders, Hilibrand became the youngest managing director in Salomon Brothers history. Subsequently, he was part of a... |
Arbitrage group at Salomon; Ph.D. MIT Massachusetts Institute of Technology The Massachusetts Institute of Technology is a private research university located in Cambridge, Massachusetts. MIT has five schools and one college, containing a total of 32 academic departments, with a strong emphasis on scientific and technological education and research.Founded in 1861 in... |
| James McEntee | Bond-trader |
| Dick Leahy | Executive at Salomon |
| Victor Haghani Victor Haghani Victor Haghani is an Iranian American financier, one of the founding partners of Long Term Capital Management, a hedge fund which collapsed in 1998, to be eventually bailed out by a consortium of leading banks.- Biography :... |
Arbitrage group at Salomon; Masters in Finance, LSE London School of Economics The London School of Economics and Political Science is a public research university specialised in the social sciences located in London, United Kingdom, and a constituent college of the federal University of London... |
John Meriwether
John Meriwether
John William Meriwether is an American hedge fund executive, seen as a pioneer of fixed income arbitrage.-Education:...
headed Salomon Brothers
Salomon Brothers
Salomon Brothers was a bulge bracket, Wall Street investment bank. Founded in 1910 by three brothers along with a clerk named Ben Levy, it remained a partnership until the early 1980s, when it was acquired by the commodity trading firm Phibro Corporation and then became Salomon Inc. Eventually...
' bond trading desk until he resigned in 1991 amidst a trading scandal.
 |
 |
| Myron Scholes Myron Scholes Myron Samuel Scholes is a Canadian-born American financial economist who is best known as one of the authors of the Black–Scholes equation. In 1997 he was awarded the Nobel Memorial Prize in Economic Sciences for a method to determine the value of derivatives... (left) and Robert C. Merton Robert C. Merton Robert Carhart Merton is an American economist, Nobel laureate in Economics, and professor at the MIT Sloan School of Management.-Biography:... were principals at LTCM. |
Nobel Prize
The Nobel Prizes are annual international awards bestowed by Scandinavian committees in recognition of cultural and scientific advances. The will of the Swedish chemist Alfred Nobel, the inventor of dynamite, established the prizes in 1895...
winners, Myron Scholes
Myron Scholes
Myron Samuel Scholes is a Canadian-born American financial economist who is best known as one of the authors of the Black–Scholes equation. In 1997 he was awarded the Nobel Memorial Prize in Economic Sciences for a method to determine the value of derivatives...
and Robert C. Merton
Robert C. Merton
Robert Carhart Merton is an American economist, Nobel laureate in Economics, and professor at the MIT Sloan School of Management.-Biography:...
. Other principals in the firm included Eric Rosenfeld
Eric Rosenfeld
Eric Rosenfeld was a trader and principal in the Long-Term Capital Management hedge fund, a landmark Wall Street disaster.Prior to LTCM, Rosenfeld was an instructor at Harvard University, and then a trader at the famed Salomon Brothers...
, Greg Hawkins
Greg Hawkins
Gregory Dale Hawkins was a trader and principal in the hedge fund Long-Term Capital Management that after four spectacularly successful years lost most of its clients' money in 1998 when the Russian government defaulted on its debt payments on August 17, 1998, triggering a devaluation of the...
, Larry Hilibrand
Larry Hilibrand
Around 1992, arbitrage trader Larry Hilibrand was synonymous with Wall Street hubris when he became the top-paid trader at Salomon Brothers. As one of the most mathematically astute traders, Hilibrand became the youngest managing director in Salomon Brothers history. Subsequently, he was part of a...
, William Krasker, Dick Leahy, Victor Haghani
Victor Haghani
Victor Haghani is an Iranian American financier, one of the founding partners of Long Term Capital Management, a hedge fund which collapsed in 1998, to be eventually bailed out by a consortium of leading banks.- Biography :...
, James McEntee, Robert Shustak, and David W. Mullins Jr.
David W. Mullins Jr.
David Wiley Mullins, Jr. is an American economist and former vice-chairman of the Federal Reserve. He also served as an assistant Secretary of the Treasury for domestic finance in the administration of United States President George H. W. Bush...
The company consisted of Long-Term Capital Management (LTCM), a company incorporated in Delaware
Delaware
Delaware is a U.S. state located on the Atlantic Coast in the Mid-Atlantic region of the United States. It is bordered to the south and west by Maryland, and to the north by Pennsylvania...
but based in Greenwich, Connecticut
Greenwich, Connecticut
Greenwich is a town in Fairfield County, Connecticut, United States. As of the 2010 census, the town had a total population of 61,171. It is home to many hedge funds and other financial service companies. Greenwich is the southernmost and westernmost municipality in Connecticut and is 38+ minutes ...
. LTCM managed trades in Long-Term Capital Portfolio LP, a partnership registered in the Cayman Islands
Cayman Islands
The Cayman Islands is a British Overseas Territory and overseas territory of the European Union located in the western Caribbean Sea. The territory comprises the three islands of Grand Cayman, Cayman Brac, and Little Cayman, located south of Cuba and northwest of Jamaica...
. The fund's operation was designed to have extremely low overhead; trades were conducted through a partnership with Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
and client relations were handled by Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
.
Meriwether chose to start a hedge fund to avoid the financial regulation imposed on more traditional investment vehicles, such as mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
s, as established by the Investment Company Act of 1940
Investment Company Act of 1940
The Investment Company Act of 1940 is an act of Congress. It was passed as a United States Public Law on August 22, 1940, and is codified at through . Along with the Securities Exchange Act of 1934 and Investment Advisers Act of 1940, and extensive rules issued by the Securities and Exchange...
—funds which accepted stakes from one hundred or fewer individuals with more than one million dollars in net worth each were exempt from most of the regulations that bound other investment companies. In late 1993, Meriwether approached several "high net-worth individuals
High net worth individual
A high-net-worth individual is a person with a high net worth. In the private banking business, these individuals typically are defined as having investable assets in excess of US$1 million. As explained below, the U.S...
" in an effort to secure start-up capital for Long Term Capital Management. With the help of Merrill Lynch, LTCM secured hundreds of millions of dollars from business owners, celebrities and even private university endowments. The bulk of the money, however, came from companies and individuals connected to the financial industry. By 24 February 1994, the day LTCM began trading, the company had amassed just over $1.01 billion in capital.
Trading strategies
The company used complex mathematical models to take advantage of fixed income arbitrageFixed income arbitrage
Fixed-income arbitrage is an investment strategy generally associated with hedge funds, which consists of the discovery and exploitation of inefficiencies in the pricing of bonds, i.e...
deals (termed convergence trades) usually with U.S., Japanese, and European government bond
Government bond
A government bond is a bond issued by a national government denominated in the country's own currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country...
s. Government bonds are a "fixed-term debt obligation", meaning that they will pay a fixed amount at a specified time in the future. Differences in the bonds' present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
are minimal, so according to economic theory any difference in price will be eliminated by arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
. Unlike differences in share prices of two companies, which could reflect different underlying fundamentals, price differences between a 30 year treasury bond and a 29 and three quarter year old treasury bond should be minimal—both will see a fixed payment roughly 30 years in the future. However, small discrepancies arose between the two bonds because of a difference in liquidity. By a series of financial transactions, essentially amounting to buying the cheaper 'off-the-run' bond (the 29 and three quarter year old bond) and shorting
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
the more expensive, but more liquid, 'on-the-run' bond (the 30 year bond just issued by the Treasury
Bureau of the Public Debt
The Bureau of the Public Debt is an agency within the Fiscal Service of the United States Treasury Department. Under authority derived from Article I, section 8 of the Constitution, Public Debt is responsible for borrowing the money needed to operate the federal government, and is where donations...
), it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond was issued.
As LTCM's capital base grew, they felt pressed to invest that capital and had run out of good bond-arbitrage bets. This led LTCM to undertake more aggressive trading strategies. 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
Risk arbitrage
Risk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.Two principal types of merger are possible: a cash merger, and a stock merger. In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash...
(betting whether mergers would be completed or not) and S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
options (net short long-term S&P volatility). LTCM had become a major supplier of S&P 500 vega, which had been in demand by companies seeking to essentially insure equities against future declines.
Because these differences in value were minute—especially for the convergence trades—the fund needed to take highly-leveraged
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
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, for a debt to equity ratio
Debt to equity ratio
The debt-to-equity ratio is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as Risk, Gearing or Leverage...
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 derivative
Interest rate derivative
An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate...
s such as interest rate swap
Interest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
s. The fund also invested in other derivative
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
s such as equity options.
In 1998, the chairman of Union Bank of Switzerland
Union Bank of Switzerland
Union Bank of Switzerland was a large integrated financial services company located in Switzerland. The bank, which at the time was the second largest bank in Switzerland, merged with Swiss Bank Corporation in 1998, to become UBS to form what was then the largest bank in Europe and the second...
resigned as a result of a $780 million loss due to problems at Long-Term Capital Management.
Tax avoidance
Long Term Capital Management was found to have entered into certain tax avoidance transactions. Approximately $100 million of losses claimed by LTCM were disallowed by United States District Court of Connecticut. An e-mail dated March 10, 1995, to Jan Blaustein Scholes, Myron's girlfriend at the time and general counsel responsible for setting up leasing transactions associated with the disallowed losses, stated : "For our CHIPS III entity let's use a name unrelated to CBB. It makes it just a bit harder for the IRSInternal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
to link all the deals together." Equally alarming, Myron Scholes stated that he was not an expert on tax law. A textbook, "Taxes & Business Strategy" (principally written by Myron Scholes), contains chapters on both economic substance and step transaction
Step transaction doctrine
The step transaction doctrine is a judicial doctrine in the United States that combines a series of formally separate steps, resulting in tax treatment as a single integrated event. The doctrine is often used in combination with other doctrines, such as substance over form. The doctrine is applied...
s, which are the two concepts under which the tax loss was disallowed by the IRS.
In a memorandum to Long Term's management committee dated November 12, 1996, Myron Scholes wrote: "We must decide in the near future (1) how to allocate these capital losses; (2) how to "trade" them so that they are held in high-valued hands; and (3) how to plan to be able to enjoy the benefits of the use of these losses for the longest period of time. If we are careful, most likely we will never have to pay long-term capital gains on the 'loan' from the Government." He went on, "How should LTCM pay those who brought the Tax Losses to Fruition and allocate the expenses of undertaking the trade?"
Downturn
Although much 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. 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 arbitrageArbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
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
Dual-listed company
A dual-listed company or DLC is a corporate structure in which two corporations function as a single operating business through a legal equalization agreement, but retain separate legal identities and stock exchange listings...
(or "DLC") Royal Dutch Shell
Royal Dutch Shell
Royal Dutch Shell plc , commonly known as Shell, is a global oil and gas company headquartered in The Hague, Netherlands and with its registered office in London, United Kingdom. It is the fifth-largest company in the world according to a composite measure by Forbes magazine and one of the six...
in the summer of 1997, when Royal Dutch traded at an 8-10% premium relative to Shell. In total $2.3 billion was invested, half of which was "long" in Shell and the other half was "short" in Royal Dutch.
LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge. This might 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%, which implies that LTCM incurred a large loss on this arbitrage strategy. LTCM lost $286 million in equity pairs trading
Pairs trade
The pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy...
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
Flight-to-Liquidity
A flight-to-liquidity is a financial market phenomenon occurring when investors sell what they perceive to be less liquid or higher risk investments, and purchase more liquid investments instead, such as US Treasuries...
. In the first three weeks of September, LTCM's equity tumbled from $2.3 billion at the start of the month to just $400 million by September 25. With liabilities still over $100 billion, this translated to an effective leverage ratio of more than 250-to-1.
1998 bailout
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
, AIG
American International Group
American International Group, Inc. or AIG is an American multinational insurance corporation. Its corporate headquarters is located in the American International Building in New York City. The British headquarters office is on Fenchurch Street in London, continental Europe operations are based in...
, and Berkshire Hathaway
Berkshire Hathaway
Berkshire Hathaway Inc. is an American multinational conglomerate holding company headquartered in Omaha, Nebraska, United States, that oversees and manages a number of subsidiary companies. The company averaged an annual growth in book value of 20.3% to its shareholders for the last 44 years,...
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 stunningly low to LTCM's partners because at the start of the year their firm had been worth $4.7 billion. Warren Buffett
Warren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
gave Meriwether less than one hour to accept the deal; the time period lapsed before a deal could be worked out.
Seeing no options left the Federal Reserve Bank of New York
Federal Reserve Bank of New York
The Federal Reserve Bank of New York is one of the 12 Federal Reserve Banks of the United States. It is located at 33 Liberty Street, New York, NY. It is responsible for the Second District of the Federal Reserve System, which encompasses New York state, the 12 northern counties of New Jersey,...
organized a bailout of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. The principal negotiator for LTCM was general counsel James G. Rickards
James G. Rickards
James G. Rickards is an American lawyer, economist and investment banker with 35 years of experience on Wall Street, working in capital markets. He is a writer and is a regular commentator on finance and the emerging field of threat finance. Rickards advised clients of an impending financial...
. The contributions from the various institutions were as follows:
- $300 million: Bankers TrustBankers TrustBankers Trust was an historic American banking organization. The bank merged with Alex. Brown & Sons before being acquired by Deutsche Bank in 1998.-History:A consortium of banks created Bankers Trust to perform trust company services for their clients....
, Barclays, ChaseChase Manhattan BankJPMorgan Chase Bank, N.A., doing business as Chase, is a national bank that constitutes the consumer and commercial banking subsidiary of financial services firm JPMorgan Chase. The bank was known as Chase Manhattan Bank until it merged with J.P. Morgan & Co. in 2000...
, Credit Suisse First BostonCredit Suisse First BostonCredit Suisse First Boston was the former name of the banking firm Credit Suisse.-History:In 1978, Credit Suisse and First Boston Corporation formed a London-based 50-50 investment banking joint venture called the Financière Crédit Suisse-First Boston...
, Deutsche BankDeutsche BankDeutsche Bank AG is a global financial service company with its headquarters in Frankfurt, Germany. It employs more than 100,000 people in over 70 countries, and has a large presence in Europe, the Americas, Asia Pacific and the emerging markets...
, Goldman SachsGoldman SachsThe Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
, Merrill LynchMerrill LynchMerrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
, J.P.Morgan, Morgan StanleyMorgan StanleyMorgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000....
, Salomon Smith Barney, UBSUBS AGUBS AG is a Swiss global financial services company headquartered in Basel and Zürich, Switzerland, which provides investment banking, asset management, and wealth management services for private, corporate, and institutional clients worldwide, as well as retail clients in Switzerland... - $125 million: Société GénéraleSociété GénéraleSociété Générale S.A. is a large European Bank and a major Financial Services company that has a substantial global presence. Its registered office is on Boulevard Haussmann in the 9th arrondissement of Paris, while its head office is in the Tours Société Générale in the business district of La...
- $100 million: Lehman BrothersLehman BrothersLehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
, Paribas - Bear StearnsBear StearnsThe Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
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. LTCM's partners received a 10% stake, still worth about $400 million, but this money was completely consumed by their debts. The partners once had $1.9 billion of their own money invested in LTCM, all of which was wiped out.
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
Virtuous circle and vicious circle
A virtuous circle and a vicious circle are economic terms. They refer to a complex of events that reinforces itself through a feedback loop. A virtuous circle has favorable results, while a vicious circle has detrimental results...
.
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 swapsSwap (finance)In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
- $1.3 bn in equity volatilityVolatility (finance)In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
- $430 mn in Russia and other emerging marketsEmerging marketsEmerging markets are nations with social or business activity in the process of rapid growth and industrialization. Based on data from 2006, there are around 28 emerging markets in the world . The economies of China and India are considered to be the largest...
- $371 mn in directional trades in developed countries
- $286 mn in equity pairs (such as VW, Shell)
- $215 mn in yield curveYield curveIn finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
arbitrageArbitrageIn economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices... - $203 mn in S&P 500S&P 500The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
stocks - $100 mn in junk bond arbitrage
- no substantial losses in merger arbitrage
Long Term Capital was audited by Price Waterhouse LLP. 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 rescuers.
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
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
.
LTCM's strategies were compared (a contrast with the market efficiency aphorism that there are no $100 bills lying on the street, as someone else has already picked them up) to "picking up nickels in front of a bulldozer" – a likely small gain balanced against a small chance of a large loss, like the payouts from selling an out-of-the-money option.
Aftermath
After the bailout, Long-Term Capital Management continued operations. In the year following the bailout, it earned 10%. By early 2000, the fund had been liquidated, and the consortium of banks that financed the bailout had been paid back; but the collapse was devastating for many involved. Goldman Sachs CEO Jon CorzineJon Corzine
Jon Stevens Corzine is the former CEO of Goldman Sachs and of MF Global, and a one time American politician, who served as the 54th Governor of New Jersey from 2006 to 2010. A Democrat, Corzine served five years of a six-year U.S. Senate term representing New Jersey before being elected Governor...
, who had been closely involved with LTCM, was forced out of the office in a boardroom coup led by Henry Paulson
Henry Paulson
Henry Merritt "Hank" Paulson, Jr. is an American banker who served as the 74th United States Secretary of the Treasury. He previously served as the Chairman and Chief Executive Officer of Goldman Sachs.-Early life and family:...
. Mullins, once considered a possible successor to Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
, saw his future with the Reserve
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
dashed. The theories of Merton and Scholes took a public beating. In its annual reports, Merrill Lynch observed that mathematical risk models "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited."
After helping unwind LTCM, Meriwether launched JWM Partners
JWM Partners
JWM Partners LLC was a hedge fund started by John Meriwether after the collapse of Long Term Capital Management in 1998. LTCM was one of the most spectacular failures of Wall Street, leading to a bailout of around $4 billion that was provided by a consortium of Wall Street banks...
. Haghani, Hilibrand, Leahy, and Rosenfeld all signed up as principals of the new firm. By December 1999, they had raised $250 million for a fund that would continue many of LTCM's strategies—this time, using less leverage. With the Credit Crisis, JWM Partners LLC was hit with 44% loss from September 2007 to February 2009 in its Relative Value Opportunity II fund. As such, JWM Hedge Fund was shut down in July 2009.
See also
- Black–Scholes model
- Commodity Futures Modernization Act of 2000Commodity Futures Modernization Act of 2000The Commodity Futures Modernization Act of 2000 is United States federal legislation that officially ensured the deregulation of financial products known as over-the-counter derivatives. It was signed into law on December 21, 2000 by President Bill Clinton...
- Game TheoryGame theoryGame theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...
- Greenspan putGreenspan putThe "Greenspan Put" refers to the monetary policy approach that Alan Greenspan, the former Chairman of the United States Federal Reserve Board, and other Fed members exercised from the late 1987 to 2000....
- Kurtosis riskKurtosis riskKurtosis risk in statistics and decision theory denotes the fact that observations are spread in a wider fashion than the normal distribution entails...
- List of business failures
- Martingale (betting system)Martingale (betting system)Originally, martingale referred to a class of betting strategies popular in 18th century France. The simplest of these strategies was designed for a game in which the gambler wins his stake if a coin comes up heads and loses it if the coin comes up tails...
- Martingale (probability theory)Martingale (probability theory)In probability theory, a martingale is a model of a fair game where no knowledge of past events can help to predict future winnings. In particular, a martingale is a sequence of random variables for which, at a particular time in the realized sequence, the expectation of the next value in the...
- Probability TheoryProbability theoryProbability theory is the branch of mathematics concerned with analysis of random phenomena. The central objects of probability theory are random variables, stochastic processes, and events: mathematical abstractions of non-deterministic events or measured quantities that may either be single...
- St. Petersburg paradoxSt. Petersburg paradoxIn economics, the St. Petersburg paradox is a paradox related to probability theory and decision theory. It is based on a particular lottery game that leads to a random variable with infinite expected value, i.e., infinite expected payoff, but would nevertheless be considered to be worth only a...
- Value at riskValue at riskIn financial mathematics and financial risk management, Value at Risk is a widely used risk measure of the risk of loss on a specific portfolio of financial assets...
- When Genius Failed: The Rise and Fall of Long-Term Capital ManagementWhen Genius Failed: The Rise and Fall of Long-Term Capital ManagementWhen Genius Failed: The Rise and Fall of Long-Term Capital Management is a book by Roger Lowenstein published by Random House in 2000. As of 2008, there have been six editions....