Long-Term Capital Management

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Long-Term Capital Management
Industry Investment services
Founded 1994
Founders John W. Meriwether
Defunct 1998
Headquarters Greenwich, Connecticut
Key people Myron S. Scholes
Robert C. Merton
Products Financial Services
Investment management

Long-Term Capital Management L.P. (LTCM) was a hedge fund management firm[1] based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high financial leverage. The firm's master hedge fund, Long-Term Capital Portfolio L.P., collapsed in the late 1990s, leading to an agreement on September 23, 1998 among 16 financial institutions, which included Bankers Trust, Barclays, Bear Stearns, Chase Manhattan Bank, Credit Agricole, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Paribas, Salomon Smith Barney, Societe Generale, and UBS, for a $3.6 billion recapitalization (bailout) under the supervision of the Federal Reserve.[2]

LTCM was founded in 1994 by John W. Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Members of LTCM's board of directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives".[3] Initially successful with annualized return of over 21% (after fees) in its first year, 43% in the second year and 41% in the third year, in 1998 it lost $4.6 billion in less than four months following the 1997 Asian financial crisis and 1998 Russian financial crisis requiring financial intervention by the Federal Reserve, with the fund liquidating and dissolving in early 2000.

Founding[edit]

LTCM Partners
John W. Meriwether Former vice chair and head of bond trading at Salomon Brothers; MBA, University of Chicago
Robert C. Merton Leading scholar in finance; Ph.D., Massachusetts Institute of Technology; Professor at Harvard University
Myron S. Scholes Co-author of Black–Scholes model; Ph.D., University of Chicago; Professor at Stanford University
David W. Mullins Jr. Vice chairman of the Federal Reserve; Ph.D. MIT; Professor at Harvard University; was seen as potential successor to Alan Greenspan
Eric Rosenfeld Arbitrage group at Salomon; Ph.D. MIT; former Harvard Business School professor
William Krasker Arbitrage group at Salomon; Ph.D. MIT; former Harvard Business School professor
Gregory Hawkins Arbitrage group at Salomon; Ph.D. MIT; worked on Bill Clinton's campaign for Arkansas state attorney general
Larry Hilibrand Arbitrage group at Salomon; Ph.D. MIT
James McEntee Bond-trader
Dick Leahy Executive at Salomon
Victor Haghani Arbitrage group at Salomon; Masters in Finance, LSE

John W. Meriwether headed Salomon Brothers' bond trading desk until he resigned in 1991 amid a trading scandal.[4]

Myron Scholes 2008 in Lindau.png Robert C. Merton.jpg
Myron S. Scholes (left) and Robert C. Merton were principals at LTCM.

In 1993 he created Long-Term Capital as a hedge fund and recruited several Salomon bond traders and two future winners of the Nobel Memorial Prize, Myron S. Scholes and Robert C. Merton.[5][6] 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.[7]

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 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.[8] 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.[9] By 24 February 1994, the day LTCM began trading, the company had amassed just over $1.01 billion in capital.[10]

Trading strategies[edit]

The company used complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades) usually with U.S., Japanese, and European government bonds. Government bonds are a "fixed-term debt obligation", meaning that they will pay a fixed amount at a specified time in the future.[11] 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.[12] 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. LTCM also attempted creating a splinter fund in 1996 called LTCM-X that would invest in even higher risk trades and also focus on Latin American markets. LTCM turned to UBS bank to invest in and write the warrant for this new spin-off company.[13]

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 market neutral, 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.[14]

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.[15] 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[edit]

The value of $1,000 invested in LTCM,[16] the Dow Jones Industrial Average and invested monthly in U.S. Treasuries at constant maturity.

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 arbitrage business in July 1998. Such losses were accentuated through the 1998 Russian financial crisis in August and September 1998, when the Russian Government defaulted on their government bonds.[17] 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).[18] 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.[19] 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.[20]

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.[21]

1998 bailout[edit]

On September 23, 1998, the chiefs of some of the largest investment firms of Wall Street—Bankers Trust, Bear Stearns, Chase Manhattan, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Smith Barney—met on the 10th floor conference room of the Federal Reserve Bank of New York (pictured) to rescue LTCM.

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 with whom it traded. 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.[22]

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.[23] The principal negotiator for LTCM was general counsel James G. Rickards.[24] The contributions from the various institutions were as follows:[25][26]

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.[27]

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):[18]

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.[28]

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"[29] – a likely small gain balanced against a small chance of a large loss, like the payouts from selling an out-of-the-money naked call option.

Aftermath[edit]

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. 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."[30]

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.[31] 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.[32]

In 1998, the chairman of Union Bank of Switzerland resigned as a result of a $780 million loss due to the collapse of Long-Term Capital Management.[1]

See also[edit]

Notes[edit]

  1. ^ a b A financial History of the United States Volume II: 1970 -2001, Jerry W. Markham, Chapter 5: Bank Consolidation, M.E.Sharpe, Inc., 2002
  2. ^ Greenspan, Alan (2007). The Age of Turbulence: Adventures in a New World. The Penguin Press. pp. 193–195. ISBN 978-1-59420-131-8. 
  3. ^ 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.
  4. ^ Dunbar 2000, pp. 110–pgs 111–112
  5. ^ Dunbar 2000, pp. 114–116
  6. ^ Loomis 1998
  7. ^ Dunbar 2000, pp. 125, 130
  8. ^ Dunbar 2000, p. 120
  9. ^ Dunbar 2000, p. 130
  10. ^ Dunbar 2000, p. 142
  11. ^ Dunbar 2000, p. 80
  12. ^ Dunbar 2000, p. 98
  13. ^ Lowenstein, Roger (2000). When Genius Failed: the Rise and Fall of Long-Term Capital Management. Random House Trade Paperbacks. pp. 95–97. ISBN 978-0-375-75825-6. 
  14. ^ Lowenstein 2000, pp. 124–25
  15. ^ Lowenstein 2000, p. 191
  16. ^ Lowenstein 2000, p. xv
  17. ^ Bookstaber, Richard (2007). A Demon Of Our Own Design. USA: John Wiley & Sons. pp. 97–124. ISBN 978-0-470-39375-8. 
  18. ^ a b Lowenstein 2000
  19. ^ Lowenstein 2000, p. 99
  20. ^ Lowenstein 2000, p. 234
  21. ^ Lowenstein 2000, p. 211
  22. ^ Lowenstein 2000, pp. 203–04
  23. ^ Partnoy, Frank (2003). Infectious Greed: How Deceit and Risk Corrupted the Financial Markets. Macmillan. p. 261. ISBN 0-8050-7510-0. 
  24. ^ Kathryn M. Welling, "Threat Finance: Capital Markets Risk Complex and Supercritical, Says Jim Rickards" welling@weeden (February 25, 2010). Retrieved May 13, 2011
  25. ^ Wall Street Journal, 25 September 1998
  26. ^ Bloomberg.com: Exclusive
  27. ^ Lowenstein 2000, pp. 207–08
  28. ^ GAO/GGD-00-67R Questions Concerning LTCM and Our Responses General Accouting Office, February 23, 2000
  29. ^ Lowenstein 2000, p. 102
  30. ^ Lowenstein 2000, p. 235
  31. ^ Lowenstein 2000, p. 236
  32. ^ Katherine Burton and Saijel Kishan (July 8, 2009). "Meriwether Said to Shut JWM Hedge Fund After Losses". Bloomberg.  Retrieved on July 27, 2009.

Bibliography[edit]

Further reading[edit]