Lessons from long-term capital management
Long Term Capital Management (LTCM) was a hedge fund established in 1994 by John Meriwether, a highly successful bond trader at Salomon Brothers. At Salomon, Meriwether was one of the first on Wall Street to hire the best academics and professors. Meriwether established a team of academics who applied models based on financial theories to trade. At Salomon, Meriwether’s group of geniuses generated staggering returns and demonstrated an unmatched ability to accurately calculate risk and other market factors.
In 1994, Meriwether left Salomon and established LTCM. The partners included two Nobel Prize-winning economists, a former vice chairman of the Federal Reserve Board of Governors, a Harvard University professor, and other successful bond traders. This elite group of merchants and academics attracted an initial investment of around $ 1.3 billion from many large institutional clients.
LTCM’s strategy was simple in concept but difficult to implement. LTCM used computer modeling to find arbitrage opportunities between markets. LTCM’s core strategy was convergence trading where securities were priced incorrectly against each other. LTCM would take long positions on undervalued stocks and short positions on overvalued stocks.
LTCM participated in this strategy in the international bond markets, emerging markets, US government bonds, and other markets. LTCM would make money when these spreads were reduced and returned to fair value. Later, when LTCM’s capital base increased, the fund engaged in strategies unrelated to its expertise, such as merger arbitrage and the volatility of the S&P 500.
However, these strategies focused on small price differences. Myron Scholes, one of the partners, stated that “LTCM would function like a giant vacuum cleaner sucking up nickels that everyone else had overlooked.” To make a significant profit with small differences in value, the hedge fund took high-leverage positions. As of early 1998, the fund had assets of about $ 5 billion and had borrowed about $ 125 billion.
LTCM initially achieved exceptional returns. Before fees, the fund gained 28% in 1994, 59% in 1995, 57% in 1996, and 27% in 1997. LTCM earned these returns with surprisingly little downside volatility. Until April 1998, the value of a dollar initially invested increased to $ 4.11.
However, in mid-1998, the fund began to experience losses. These losses were further compounded when Salomon Brothers exited the arbitration business. Later in the year, Russia defaulted on government bonds, a holding of LTCM. Investors panicked and sold Japanese and European bonds and bought US Treasuries. Therefore, the spreads between LTCM holdings increased, causing arbitrage trades to lose large amounts. LTCM lost $ 1.85 billion in equity at the end of August 1998.
Spreads between LTCM’s arbitrage trades continued to widen and the fund experienced a leak into liquidity, causing assets to shrink in the first 3 weeks of September from $ 2.3 billion to $ 600 million. Although assets decreased, due to the use of leverage, the value of the portfolio did not decrease. However, the decline in assets raised the fund’s leverage. Ultimately, the Federal Reserve Bank of New York catalyzed a $ 3.625 billion bailout by major institutional creditors to prevent a broader collapse in financial markets that caused LTCM’s dramatic leverage and huge positions in derivatives. At the end of September 1998, the value of a dollar invested initially decreased to $ .33 before commissions.
Lessons from the failure of LTCM
1.Limitation of excessive use of leverage
When engaging in equity-based investment strategies that converge from the market price to an estimated fair price, managers must be able to have a long-term time frame and be able to withstand unfavorable price changes. When using dramatic leverage, the ability to invest long-term capital during unfavorable price changes is limited by the patience of creditors. Lenders typically lose their patience during a market crisis, when borrowers need capital. If you are forced to take securities during an illiquid market crisis, the fund will fail.
The use of LTCM’s leverage also highlighted the lack of regulation in the over-the-counter (OTC) derivatives market. Many of the borrowing and reporting requirements established in other markets, such as futures, were not present in the OTC derivatives market. This lack of transparency meant that the risks of LTCM’s dramatic leverage were not fully recognized.
The failure of LTCM does not mean that any use of leverage is bad, but it does highlight the potential negative consequences of using excessive leverage.
2. Importance of risk management
LTCM was unable to manage multiple aspects of risk internally. Managers focused mostly on theoretical models and not enough on liquid risk, gap risk, and stress tests.
With such large positions, LTCM should have focused more on liquidity risk. The LTCM model underestimated the likelihood of a market crisis and the potential for a flight to liquidity.
The LTCM models also assumed that long and short positions were highly correlated. This assumption was historically based. Past results do not guarantee future results. By stress testing the model to detect the potential for lower correlations, the risk could have been better managed.
In addition to LTCM, the large institutional creditors of the hedge fund did not adequately manage risk. Impressed by the fund’s star traders and large assets, many creditors provided very generous credit terms, even though creditors took significant risk. Additionally, many creditors failed to understand their full exposure to specific markets. During a crisis, exposure in multiple areas of a company to specific risks can cause dramatic damage.
LTCM was unable to have truly independent control over the merchants. Without this supervision, traders were able to create positions that were too risky.
LTCM demonstrates an interesting case of the limitations of predictions based on historical information and the importance of recognizing possible model flaws. Additionally, LTCM’s story illustrates the risk of limited transparency in the OTC derivatives market.
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