What Was 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, that blew up in 1998, forcing the U.S. government to intervene to prevent financial markets from collapsing.
Key Takeaways
- Long-Term Capital Management (LTCM) was a large hedge fund led by Nobel Prize-winning economists and renowned Wall Street traders.
- LTCM was profitable in its heyday and by the spring of 1998, drew in about $3.5 billion of investor capital by promising that its arbitrage strategy would yield huge returns for investors.
- LTCM’s highly leveraged trading strategies failed to pan out and, with losses mounting due to Russia's debt default, the U.S. government had to step in and arrange a bailout to stave off global financial contagion.
- Ultimately, a loan fund, comprised of a consortium of Wall Street banks, was created to bail out LTCM in September 1998, enabling it to liquidate in an orderly manner.
Understanding Long-Term Capital Management (LTCM)
From its start in 1994, LTCM was wildly successful, attracting about $3.5 billion of investor capital by the spring of 1998, with the promise of anarbitragestrategy that could take advantage of temporary changes in market behavior and, theoretically, reduce the risk level to zero.
However, LTCM's highly leveraged trading strategies failed to pan out and it suffered monumental losses. The reverberations were felt across the financial landscape and nearly collapsed the global financial system in 1998. Ultimately, the U.S. government had to step in and arrange a bailout of LTCM by a consortium of Wall Street banks in order to prevent systemic contagion.
LTCM started with just over $1 billion in initial assets and focused on bond trading. The trading strategy of the fund was to make convergence trades, which involve taking advantage of arbitrage opportunities between securities. To be successful, these securities must be incorrectly priced, relative to one another, at the time of the trade.
An example of an arbitrage trade would be a change in interest rates not yet adequately reflected in securities prices. This could open opportunities to trade such securities at values different from what they will soon become—once the new rates have been priced in.
LTCM was formed in 1994 and was founded by renowned Salomon Brothers bond trader John Meriwether, along with Nobel-prize winning Myron Scholes of the Black-Scholes model.
LTCM also dealt in interest rate swaps, which involve the exchange of one series of future interest payments for another, based on a specified principal among two counterparties. Often interest rate swaps consist of changing a fixed rate for a floating rate or vice versa, in order to minimize exposure to general interest rate fluctuations.
Due to the small spread in arbitrage opportunities, LTCM had to leverage itself highly to make money. At the fund’s height in 1998, LTCM had approximately $5 billion in assets, controlled over $100 billion, and had derivative positions whose total worth was over $1 trillion. At the time,LTCM also had borrowed more than $155 billion in assets.
Long-Term Capital Management (LTCM) Demise
When Russia defaulted on its debt in August 1998, LTCM was holding a significant position in Russiangovernment bonds, known by the acronym GKO. Despite the loss of hundreds of millions of dollars per day, LTCM's computer models recommended that it hold its positions.
LTCM's highly leveraged nature, coupled with a financial crisis in Russia, led the hedge fund to sustain massive losses and be in danger of defaulting on its own loans. This made it difficult for LTCM to cut its losses in its positions. LTCM held huge positions, totaling roughly 5% of the total global fixed-income market, and had borrowed massive amounts of money to finance these leveraged trades.
IfLTCMhad gone into default, it would have triggered a global financial crisis due tothe massive write-offs its creditors would have had to make.
When the losses approached $4 billion, the federal government of the United States feared that the imminent collapse of LTCM would precipitate a largerfinancial crisisand orchestrated abailoutto calm the markets. A $3.625-billion loan fund was created, which enabled LTCM to survive themarket volatilityandliquidatein an orderly manner in early 2000.
FAQs
Long-Term Capital Management (LTCM) was a large hedge fund, led by Nobel Prize-winning economists and renowned Wall Street traders, that blew up in 1998, forcing the U.S. government to intervene to prevent financial markets from collapsing.
What is the history of LTCM? ›
LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Members of LTCM's board of directors included Myron Scholes and Robert C.
What was the key factor to the collapse of the LTCM? ›
Rather, the ultimate cause of its demise was the ensuing flight to liquidity described in the following section. The ultimate cause of the LTCM debacle was the "flight to liquidity" across the global fixed income markets.
What was the total loss of LTCM? ›
LTCM was being forced to liquidate to meet margin calls. On September 2, 1998 Meriwether sent a letter to his investors saying that the fund had lost $2.5 billion or 52% of its value that year, $2.1 billion in August alone. Its capital base had shrunk to $2.3 billion.
What is LTCM strategy? ›
The business model of LTCM was based on convergence trading. This strategy involved buying undervalued securities and selling overvalued ones, expecting that prices would eventually converge to fair values. To implement this strategy, LTCM used sophisticated mathematical models and substantial leverage.
What happened at LTCM? ›
But, in 1998, a series of unforeseen events resulted in huge losses for the fund. LTCM's positions were highly leveraged — in other words, it had borrowed money to place bets. Those bets turned sour when Russia defaulted on its debt, causing market turmoil.
What is the LTCM capital management? ›
Long-Term Capital Management (LTCM) was a large hedge fund led by Nobel Prize-winning economists and renowned Wall Street traders. LTCM was profitable in its heyday and by the spring of 1998, drew in about $3.5 billion of investor capital by promising that its arbitrage strategy would yield huge returns for investors.
Was the collapse of LTCM a risk management failure? ›
LTCM was so big that the Federal Reserve Bank of New York had to facilitate a bailout to the fund, fearing that the liquidation might wreck the global financial markets. The primary factor contributing to LTCM's failure has been widely pointed out as its poor risk management.
What happened in the financial collapse? ›
The 2008 financial crisis began with cheap credit and lax lending standards that fueled a housing bubble. When the bubble burst, the banks were left holding trillions of dollars of worthless investments in subprime mortgages. The Great Recession that followed cost many their jobs, their savings, and their homes.
What was the biggest financial collapse in the world? ›
The Great Depression of 1929–39
Encyclopædia Britannica, Inc. This was the worst financial and economic disaster of the 20th century. Many believe that the Great Depression was triggered by the Wall Street crash of 1929 and later exacerbated by the poor policy decisions of the U.S. government.
Bubbles Grow, Bailouts Ensue: The Tale of the Fed and Long-Term Capital Management. In September of 1998, the Federal Reserve went to unprecedented lengths to rescue the hedge fund Long-Term Capital Management and avert a global financial meltdown. For Wall Street, it was a turning point for risk-taking.
What major investment bank collapsed? ›
Lehman Brothers world headquarters is shown in New York on Sept. 15, 2008, the day the 158-year-old investment bank, choked by the credit crisis and falling real estate values, filed for bankruptcy. Fifteen years ago, the world witnessed the largest commercial collapse in history.
What is long-term capital? ›
A long-term capital gain is the profit earned from the sale of shares or other assets when they are held for more than 12 months at the time of sale. It is calculated as the difference between the sale price and purchase prices of assets held for more than a year.
What was one of the key factors that contributed to the collapse of LTCM? ›
Under pressure, John Meriwether decided to permit potential investors to invest in the fund “on special terms” and forbade existing investors to withdraw more than 12% of their investment. The main cause of the LTCM crisis was what we could call “the flight to liquidity” across the global fixed income markets.
What is the convergence strategy of LTCM? ›
LTCM's trading strategy was based on a concept known as convergence trading. The core idea was to take advantage of tiny discrepancies in the prices of related securities. While the discrepancies were small, LTCM believed that, over time, the prices would "converge" to their theoretical correct values.
What happened to American Capital strategies? ›
American Capital was sold to Ares Management in 2017 at a sale price that totaled $4.1 billion.
What is the history of Annaly capital Management? ›
(“Annaly”) was founded in 1996 out of the collaboration of a handful of forward-thinking entrepreneurs, including Michael A. J. Farrell and Wellington J. Denahan. The Company was created with the goal of delivering competitive and dependable returns in a variety of interest rate and economic conditions.
When was Pershing Square Capital Management founded? ›
Company history
In 2004, Ackman started Pershing Square Capital Management with $54 million in funding from his personal funds and a seed investment from Leucadia National.
