What is long-term capital management (LTCM)?
Long Term Capital Management (LTCM) was a large hedge fund led by Nobel Prize winning economists and renowned Wall Street traders. The business was a resounding success from 1994 to 1998, attracting over $ 1 billion in investor capital with the promise of an arbitrage strategy that could take advantage of temporary changes in market behavior and, in theory, reduce the risk level to zero.
But the fund nearly collapsed the global financial system in 1998. This was due to LTCM’s highly leveraged trading strategies which were unsuccessful. In the end, LTCM had to be bailed out by a consortium of Wall Street banks in order to prevent systemic contagion.
LTCM was created in 1993 and was founded by renowned Salomon Brothers bond trader John Meriwether and Nobel Prize winner Myron Scholes of the Black-Scholes model.
Key points to remember
- Long Term Capital Management (LTCM) was a large hedge fund led by Nobel Prize winning economists and renowned Wall Street traders.
- The business was a resounding success from 1994 to 1998, attracting over $ 1 billion in investor capital with the promise of an arbitrage strategy that could take advantage of temporary changes in market behavior and, in theory, reduce the risk level to zero.
- The fund nearly collapsed the global financial system in 1998 due to LTCM’s heavily indebted trading strategies, which were unsuccessful. In the end, LTCM had to be bailed out by a consortium of Wall Street banks in order to prevent systemic contagion.
Understanding long-term capital management
LTCM started with just over $ 1 billion in initial assets and focused on bond trading. The fund’s trading strategy was to do convergence transactions, which involved taking advantage of securities arbitrage. These securities have an incorrect price, relative to each other, at the time of the transaction.
An example of an arbitrage transaction would be a change in interest rates that is not yet adequately reflected in the prices of the securities. This could open up opportunities to trade these securities at different values from what they will become soon, once the new rates are incorporated. LTCM has also dealt with interest rate swaps, which involve the exchange of one series of future interest payments for another, on the basis of a specified principal, between two counterparties. Often, interest rate swaps involve changing a fixed rate to a variable rate or vice versa, to minimize exposure to general interest rate fluctuations.
Due to the low dispersion of arbitrage opportunities, LTCM had to mobilize strongly to earn money. At the height of the fund in 1998, LTCM had approximately $ 5 billion in assets, controlled more than $ 100 billion and had positions totaling more than $ 1 trillion. At the time, LTCM had also borrowed more than $ 120 billion in assets.
When Russia defaulted on debt in August 1998, LTCM held an important position in Russian government bonds (known by the acronym GKO). Despite losing hundreds of millions of dollars a day, LTCM’s computer models recommended that it keep its positions. When losses approached $ 4 billion, the U.S. federal government feared that the impending collapse of LTCM would precipitate a larger financial crisis and orchestrated a bailout to calm the markets. A $ 3.65 billion loan fund was created, which allowed LTCM to survive market volatility and liquidate in an orderly fashion in early 2000.
The fall in long-term capital management
Due to the highly indebted nature of Long Term Capital Management, coupled with a financial crisis in Russia (i.e. the default on government bonds), LTCM suffered massive losses and risked defaulting on its own loans. It was therefore difficult for LTCM to reduce its losses in its positions. LTCM held huge positions, totaling around 5% of the total global fixed income market, and had borrowed huge sums of money to finance these leveraged transactions.
If LTCM had defaulted, it would have triggered a global financial crisis due to the massive write-offs that its creditors should have made. In September 1998, the fund, which continued to suffer losses, was replenished with the help of the Federal Reserve. Then its creditors took over and a systematic market collapse was avoided.