Long-Term Capital Management

Long-Term Capital Management (LTCM), a hedge fund founded in early 1994, generated stellar
returns in its first few years of operation: 43% in 1995 and 41% in 1996. The partners worked
together at Salomon Brothers (now Citigroup) and, given their success, decided to start their own
fund and proceeded to seek capital from investors. Funding was provided to LTCM despite the
secretive nature of its positions. In addition, investors were locked into investments for long
periods of time in order to prevent liquidation issues since the fund was focused on long-term
investment strategies. In the later years of operations, the partners at LTCM invested a large
portion of their net worth in the fund since they believed so strongly in the success of their
trading strategies.
With positions in equity, fixed income, and derivatives markets all around the globe, LTCM grew
enormously. At the beginning of 1998, it had $125 billion of assets on $4.7 billion of equity
capital, yielding leverage of 28 to 1. Although this balance sheet leverage was in line with other
large investment banks, it underestimated the true leverage by overlooking the economic leverage
in LTCM’s positions. For example, LTCM’s positions represented notional principal in excess of $
1 trillion. The astronomical use of leverage was possible because financial institutions often
waived initial margin requirements based on the reputation of the principals, freeing up capital to
take on more leverage.
Most of LTCM’s investment strategies could be classified as relative value, credit spreads, and
equity volatility. Their relative value strategies involved arbitraging price differences among
similar securities and profiting when the prices converged. One benefit of this convergence
strategy is that being long and short similar securities hedges risk exposure and reduces volatility.
LTCM believed that, although yield differences between risky and riskless fixed-income
instruments varied over time, the risk premium (or credit spread) tended to revert to average
historical levels. Noticing that credit spreads were historically high, they entered into mortgage
spreads and international high-yield bond spreads intending to profit when the spreads shrank to
more typical historical levels. Similarly, their equity volatility strategy assumed that volatility on
equity options tended to revert to long-term average levels. When volatility implied by equity
options was abnormally high, LTCM “sold volatility” until it regressed to normal levels.
In August of 1998, Russia unexpectedly defaulted on its debt, sending Russian interest rates
soaring to 200% and crushing the value of the ruble. This economic shock triggered investor
concern about already faltering economies in the Pacific rim, causing the yields on developing
nations’ debt to increase and a flight to the quality of government bonds in industrialized
countries. Yields on corporate debt—both high and low quality—also increased sharply. In other
words, the flight to quality increased, rather than decreased,credit spreads, causing huge losses for
LTCM. Shortly thereafter, Brazil also devalued its currency, thereby further increasing interest
rates and risk premiums. The general increase in volatility also generated losses in LTCM’s equity
volatility strategies.
Although prices in relative value arbitrage strategies sometimes diverge and create temporary
losses before they ultimately converge, the large increase in yield spread caused huge losses and
severe cash flow problems caused by realizing marked to market losses and meeting margin calls.
The effect of the losses and the cash flow crisis were compounded by the firm’s hyper leverage.
LTCM lost 44% of its capital in just one month. The firm’s lack of equity capital created a cash
flow crisis and made it necessary to liquidate positions to meet margin calls.
If LTCM had sufficient equity to withstand the cash flow crisis created by the sharp divergence of
asset prices, it might have ultimately been able to realize the benefits of convergence. Instead,
LTCM risked the possibility of insolvency before convergence could occur. Notice the similarity
to the funding liquidity risk in the Metallgesellschaft case.
One of the fundamental risks faced by LTCM was model risk, the risk that valuation or trading
models are flawed. Their models assumed that historical relationships were useful predictors of
future relationships, which is often true in the absence of economic shocks. However, external
shocks often cause correlations that are historically low to increase sharply. When Russia
defaulted on its debt, credit spreads, risk premiums, liquidity premiums, and volatility around the
world increased. LTCM partly adjusted for this possibility by using correlations that were greater
than historical correlations in their stress tests. However, these adjustments inadequately captured
the spike in correlations caused by the cascading effect of economic shocks.
The models also assumed that low-frequency/high-severity events were uncorrelated over time.
Rather than occurring highly infrequently and independently over time, one economic shock
triggered another so that extremely low probability events were occurring several times per week.
As a result, traditional VaR models underestimated risk in the tails of the distribution.
LTCM was diversified across the globe, across different asset classes, and across different trading
strategies. Fundamentally, however, all of its trading strategies were based on the notion that risk
premiums and market volatility would ultimately decline. Since the success of all its trading
strategies hinged on a single economic prediction, LTCM was far less diversified than a cursory
examination would suggest and was, therefore, subject to market risk.
LTCM’s extreme leverage enabled it to assume extremely large, high-profile positions that
attracted the attention of imitators who initiated similar or identical trades, thereby adding to the
size of LTCM’s positions in some sense. When it became necessary to liquidate positions, the firm
found itself in the position of being a market maker, rather than a price taker as traditional
valuation models assume. In addition to suffering the price impact of liquidating its own
enormous positions, LTCM found itself competing with imitators who were also liquidating their
positions. Market prices largely depended on expectations about LTCM’s actions.
Falling prices resulting from LTCM’s forced liquidation created more marked to market losses and
margin calls, which forced more liquidations that resulted in a self-reinforcing cycle. LTCM
considered the possibility of market impact to some extent in its short risk measures but
underestimated the magnitude of its influence on market prices, particularly in the event of
forced liquidation. Trading liquidity risk was also present in the Metallgesellschaft case.
As a hedge fund, LTCM s reporting obligation to regulators was limited. Although the size of its
positions required financial statement reporting and daily position reporting, these reports were
incomplete and lacked disclosure of derivative positions and trading strategies.
Ultimately, the Federal Reserve Bank of New York orchestrated a bailout in which 14 leading
banks and investment houses invested $3.65 billion for a 90% stake in LTCM. The LTCM case
demonstrated the need for several suggested improvements when implementing risky investment
strategies and seeking investor funds. One suggestion is to ensure that an initial margin is
provided. LTCM had to mark their positions to market, but in many cases, the initial margin was
waved. Another suggestion is to incorporate potential liquidation costs into prices in the event of
adverse market conditions. A third suggestion is the need for greater position disclosure. A final
suggestion is better utilization of stress testing when evaluating financial risk; namely credit risk.
LTCM planned for the possibility of increasing disruptions in short-term market movements.
However, it failed to supplement VaR measures with stress scenarios that incorporated the
possibility that competitors were holding similar positions that might be liquidated at the same
time in the event of extreme market movements.