Long-Term Capital Management

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Long-Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether, a famed Salomon Brothers bond trader. Meriwether's team of star traders and academics attempted to create a fund that would profit from the combination of the academics' quantitative models and the traders' market judgment and execution capabilities. Also part of the project were the Nobel-prize winning economists Myron Scholes and Robert Merton, and David Mullins, a former vice-chairman of the Federal Reserve Board who quit his job to become a partner at LTCM. Eighty founding investors put up $10 million apiece, including Bear Stearns and Merrill Lynch.[1]

LTCM roiled the financial industry in the late '90s when some of its highly leveraged investments started to crumble and domino-effect-losses resulted in banks and pension funds that had invested in LTCM. LTCM attracted sophisticated investors, including many large investment banks, who invested $1.3 billion at its inception. At the end of September 1998, the fund was near default and the Federal Reserve Bank of the United States, believing that a systemic crisis could result from the fund’s failure, coordinated a $3.5 billion rescue package from 14 U.S. investment and commercial banks, which received 90 percent of LTCM's equity.[2]

LTCM's main strategy involved relative value strategies or convergence trades. These trades involved finding securities that were mispriced relative to one another, and going long in the cheap ones and selling short the expensive ones. For example, a typical trade involved buying Italian government bonds and selling German Bund futures; buying the less liquid contract and selling the more liquid treasuries.[3]

Background

LTCM’s investment strategies were based on trading the volatility of foreign currencies and bonds. However, the Asia currency crisis in 1998 and Russia’s devaluation of the ruble and a subsequent bond default, caused volatility spikes and massive losses for LTCM. The U.S. stock market dropped 20 percent in response; European markets fell 35 percent.[4]

A resulting flight to quality pushed U.S. interest rates to drop by more than a full point. As a result, LTCM’s highly leveraged investments started to crumble. By the end of August 1998, it had lost 50 percent of the value of its capital investments. Since so many banks and pension funds were invested in LTCM, its problems threatened to push most of them to near bankruptcy.

To save the U.S. banking system, then Federal Reserve Chairman Alan Greenspan worked out a deal with 14 banks to recapitalize the hedge fund.

The Fed also began lowering interest rates to reassure investors that it would do whatever was necessary to support the U.S. economy.

Recent News

In August of 2010, Hedge Fund Research released reports that relative value strategies were gaining popularity again. The average relative value fund had returns of 5.33 percent and had taken in $10 billion from investors. Experts believed this was due to the massive issuance of bonds by the UK government, fiscal stimulus packages and unusual central bank monetary policies that have caused price inefficiencies.[5]

References

  1. Case Study: Long-Term Capital Management. erisk.com.
  2. Case Study LTCM-Long-Term Capital Management. SunGard AMBIT ERISK.
  3. Lessons Learned from Long Term Capital Management. Risk Institute.
  4. What Was the LTCM Hedge Fund Crisis?. About.com.
  5. Price Anomalies Spur Return Of Controversial Hedge Fund Strategy. FT.