Long-Term Capital Management
|Founder||John W. Meriwether|
|Myron S. Scholes
Robert C. Merton
Long-Term Capital Management L.P. (LTCM) was a hedge fund management firm based in Greenwich, Connecticut that used 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.
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". 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.
|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|
|Dick Leahy||Executive at Salomon|
|Victor Haghani||Arbitrage group at Salomon; Masters in Finance, LSE|
|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—Larry Hilibrand and Victor Haghani in particular would wield substantial clout—and two future winners of the Nobel Memorial Prize, Myron S. 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 (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 funds, as established by the Investment Company Act of 1940—funds which accepted stakes from 100 or fewer individuals with more than $1 million 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.
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. 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 differing 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.
LTCM also attempted creating a splinter fund in 1996 called LTCM-X that would invest in even higher risk trades and focus on Latin American markets. LTCM turned to UBS bank to invest in and write the warrant for this new spin-off company.
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.
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 derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.
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 before 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 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 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 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:
- $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: Paribas, Credit Agricole
- Bear Stearns and Lehman Brothers 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.
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
- $286 mn in Dual-listed company pairs (such as VW, Shell)
- $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. 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 naked call option.
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."
After helping unwind LTCM, Meriwether launched JWM Partners. Haghani, Hilibrand, Leahy, and Rosenfeld 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.
- Black–Scholes model
- Commodity Futures Modernization Act of 2000
- Game theory
- Greenspan put
- Kurtosis risk
- Martingale (betting system)
- Martingale (probability theory)
- Probability theory
- St. Petersburg paradox
- Value at risk
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While J.M. presided over the firm and Rosenfeld ran it from day to day, Haghani and the slightly senior Hilibrand had the most influence on trading.
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