Lessons from long-term capital management

Background

Long Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether, a very successful bond trader at Salomon Brothers. In Salomon, Meriwether was one of the first on Wall Street to employ top academics and professors. Meriwether founded a team of academics who applied models based on financial theories in trading. In Solomon, Meriwether’s group of geniuses achieved an incredible return and demonstrated an incomparable ability to accurately calculate risk and other market factors.

In 1994, Meriwether left Salomon and founded LTCM. Among the partners were two Nobel Prize-winning economists, a former vice chairman of the Federal Reserve Board of Governors, a professor at Harvard University and other successful bond traders. This elite group of traders and academics has attracted initial investments of about $ 1.3 billion from many large institutional clients.

Strategy

The LTCM strategy was simple in concept but difficult to implement. LTCM used computer models to find opportunities for arbitrage between markets. The central strategy of LTCM was convergent trading where the securities had wrong prices relative to each other. LTCM would occupy long positions on undervalued securities and short positions on overpriced securities.

LTCM has addressed this strategy in international bond markets, emerging markets, U.S. government bonds, and other markets. LTCM would make money if these ranges were reduced and returned to fair value. Later, when the capital base of LTCM increased a fund that dealt with strategies beyond their expertise, such as merger arbitrage and S&P 500 volatility.

These strategies, however, focused on small price differences. Myron Scholes, one of the partners, said “LTCM will function like a giant vacuum cleaner that sucks nickel that everyone else overlooked.” To make a significant profit on small value differences, the hedge fund took positions with high leverage. In early 1998, the fund had assets of about $ 5 billion and borrowed about $ 125 billion.

Results

LTCM initially achieved outstanding returns. Prior to benefits, the fund earned 28% in 1994, 59% in 1995, 57% in 1996, and 27% in 1997. LTCM earned these yields with surprisingly little instability. By April 1998, the value of one dollar invested had risen to $ 4.11.

However, in mid-1998, the fund began to suffer losses. Those losses were further exacerbated when the Salomon Brothers withdrew from the arbitration deal. Later in the year, Russia failed to hold government bonds, holding LTCM. Investors panicked to sell Japanese and European bonds and buy U.S. government bonds. Thus, the gaps between the LTCM holdings increased, due to which the arbitrage trades lost huge amounts. LTCM lost $ 1.85 billion in capital by the end of August 1998.

The range between LTCM’s arbitration business continued to expand and the fund experienced a flight to liquidity, which is why the assets decreased in the first 3 weeks of September from 2.3 billion to 600 million dollars. Although assets decreased, the value of the portfolio did not decrease due to the use of leverage. However, the reduction in assets increased the leverage of the fund. Finally, the Federal Reserve Bank of New York catalyzed $ 3.625 billion in aid from major institutional lenders to avoid a wider collapse in financial markets that caused LTCM’s dramatic leverage and huge derivative positions. In late September 1998, the value of one dollar invested initially decreased to $ 0.33 before fees.

Lessons from LTCM failure

1. Limit excessive lever use

When engaging in securities-based investment strategies that converge from market to estimated fair value, managers must have a long-term time frame and be able to withstand adverse price changes. When dramatic leverage is used, the ability of capital to invest in the long run during adverse price changes is limited by the patience of creditors. Lenders usually lose patience during a market crisis when borrowers need capital. If forced into securities during an illiquid market crisis, the fund will fail.

LTCM’s use of leverage has also highlighted the lack of regulation in the OTC derivatives market. Many lending and reporting requirements established in other markets, such as futures, were not present in the OTC derivatives market. This lack of transparency has caused the risks of the dramatic impact of LTCM not to be fully recognized.

The failure of the LTCM does not mean that any use of leverage is bad, but rather highlights the potential negative consequences of using excessive leverage.

2. The importance of risk management

LTCM has failed to manage multiple aspects of risk internally. Managers focused mainly on theoretical models, and insufficiently on liquidity risk, gap risk and stress testing.

With such large positions, LTCM should focus more on liquidity risk. The LTCM model underestimated the likelihood of a market crisis and the potential to escape liquidity.

LTCM models also assumed that long and short positions were highly correlated. This assumption was historically based. Previous results do not guarantee future results. By testing stress on a model for the potential for lower correlations, risk could be better managed.

In addition to LTCM, large institutional hedge fund lenders have failed to properly manage risk. Impressed by all of the fund’s major traders and the large amount of assets, many lenders provided very generous credit terms, even though the lenders were exposed to significant risk. Also, many lenders did not understand their overall exposure to certain markets. During a crisis, exposure to certain risks in multiple areas of business can cause dramatic damage.

3. Supervision

LTCM failed to conduct a truly independent vendor check. Without this oversight, traders could have created too many risky positions.

LTCM shows an interesting case of predictive constraints based on historical information and the importance of recognizing potential model failures. In addition, the LTCM story illustrates the risk of limited transparency in the OTC derivatives market.

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