Why Long-Term Capital Management (LTCM) Failed
Long-Term Capital Management (LTCM) was a highly successful hedge fund in the mid-1990s that was founded by John Meriwether, a former vice-chairman and head of bond trading at Salomon Brothers.
LTCM’s team included several Nobel laureates and the group had a track record of exceptional returns through complex, high-risk strategies.
Key Takeaways – LTCM Failure
- LTCM was at its peak a successful hedge fund with Nobel laureates on staff, but it used high-risk strategies (that it wasn’t aware was high risk).
- Its strategies were relative value and capital structure arbitrage involving mispriced securities.
- LTCM posed a systemic risk to the entire financial system because of the losses its counterparties were exposed to.
- Its collapse from its leverage and market volatility led to a bailout.
How LTCM Failed
The original core strategy of the fund relied on trades predicting the convergence of the spread between “off-the-run” and “on-the-run” bonds in fixed-income futures markets.
The LTCM debacle was linked to two main strategies:
Relative Value Arbitrage
LTCM implemented relative value strategies that involved buying and selling similar securities that were mispriced relative to each other.
For example, if a bond was underpriced relative to a similar bond, LTCM would buy the undervalued bond and short the overvalued bond, expecting the prices to converge.
Such strategies, though normally considered low risk, relied heavily on the premise that markets would behave rationally and efficiently.
Capital Structure Arbitrage (CSA)
CSA involved exploiting pricing discrepancies between different securities issued by the same firm.
For instance, a company’s equity and its debt are often priced independently, and in certain situations, mispricing can occur.
LTCM would take positions in these securities, expecting the mispricing to correct over time.
Because the spread involved in most relative value and arbitrage trades is so small (particularly in the case of true arbitrage trades), the fund leveraged up many times to generate the high annualized returns (over 40 percent) in its first few years.
Because LTCM was successful at exploiting these relative value and arbitrage opportunities, and the intellectual capital of their team was so high, more and more investors wanted to invest with them.
This caused their assets under management to grow at the same time these opportunities were being arbitraged out of the market, both by themselves and other competitors who were looking to copy them.
After all, they were considered to be on the forefront of investing at the time and any valuable opportunities with reasonable margins to them attract competition regardless of the business.
Going Outside Their Expertise
To obtain their desired results, they increased their leverage and were forced to allocate capital to second- and third-tier ideas – in other words, markets and trades that were beyond the initial scope of their expertise.
They went into strategies such as merger and acquisition (M&A) arbitrage, and standard long and short directional bets. They also applied strategies to less liquid emerging markets after previously focusing mostly in more liquid developed markets.
Going into 1998, even though the firm’s assets under management were $5 billion (high, but not uncommon), its notional exposure to the markets was well over $100 billion.
In the summer of 1998, markets were volatile due to the fallout from currency crises in developing Asian markets from the year before, and Russia was nearing a point where it would have to devalue its currency and eventually default on its debt.
On top of that, Salomon Brothers, one of LTCM’s counterparties, decided to exit the arbitrage business entirely. This caused a widening in the spreads of LTCM’s trades with less liquidity in those markets.
Russia’s problems led to a reduction in “risk on” trades and a flight into global safe haven assets (e.g., US Treasury bonds, gold, yen). This caused a further widening of the spreads on LTCM’s relative value and arbitrage trades.
Moreover, the run-up in tech shares would soon become the story of the late 1990s.
The NASDAQ dot-com bubble was starting to begin, where long-term fundamental valuations of tech companies were misunderstood or virtually ignored as part of the “you can’t lose” euphoria.
While these arbitrage strategies were generally sound assuming markets behave rationally, the problem, as mentioned, was that LTCM used enormous amounts of leverage to increase their potential returns.
LTCM had borrowed around $30 for every $1 of its own capital.
One popularly reported figure put LTCM as having $129 billion in notional exposure against $4.72 in equity capital.
Moreover, these arbitrage opportunities often had very thin margins.
So, even a small move in the wrong direction could lead to substantial losses.
That’s precisely what happened during the 1997 Asian financial crisis and the 1998 Russian financial crisis.
The carry trade went out of favor.
This led to a significant divergence in prices, rather than the convergence LTCM’s strategies depended on.
Risk Management Errors
Despite the accomplishments of their team, LTCM had a major risk management oversight in that the correlations of their positions became increasingly linked for no other reason than the fact that they owned them.
This wasn’t taken into account in their models, as much of their staff came from academic backgrounds who generally lack the experience to account for such factors.
If you become a material portion of your market(s), that can become a problem because of the liquidity premium associated with that.
Similar to the concept of cornering a market in anything, when anyone becomes a material part of one’s markets, the possibility of getting squeezed gets higher.
People will trade against you to squeeze you out of it.
In reality, the notion of a truly risk-free arbitrage bet is non-existent.
On a very small scale with premium execution, it might not be an issue.
This put the fund at risk to its counterparties’ financing fees and their willingness to provide financing.
When market liquidity decreased and the spreads widened, their mark-to-market losses widened.
Combining modest losses with the leverage they took on, it didn’t take much to render the firm insolvent.
Because of the size of LTCM’s positions, compounded by its imprudent use of leverage, liquidating them was not feasible.
The fund’s counterparties also began to understand the scope of LTCM’s problems – which meant their own problems.
This, in turn, led to the hedging of counterparty risk specific to themselves. Now there were counterparties to the counterparties of LTCM, and so on.
This dispersed LTCM’s issues to more and more entities in the financial system and led to even worse problems for LTCM itself.
To avoid default, and potential systemic issues for the economy at large, the Federal Reserve Bank of New York stepped in to negotiate a bailout package with LTCM’s creditors.
In response, the Federal Reserve organized a bailout by several major banks to prevent a broader market meltdown.
The LTCM episode is often used to illustrate the dangers of leverage, lack of diversification, and the potential for systemic risk in the financial sector.
A well-known book was written on LTCM’s failure – When Genius Failed by Roger Lowenstein.
WHEN GENIUS FAILED (BY ROGER LOWENSTEIN)
Key Takeaways for Traders from the LTCM Failure
Leverage Can Greatly Magnify Losses
High amounts of leverage can significantly increase the potential for profits, but they also exponentially magnify potential losses.
LTCM had a leverage ratio of around 30:1 at its peak (for the firm overall, and was more leveraged within specific trades), meaning a small adverse movement in their position could wipe out their capital.
Traders need to manage leverage carefully and understand the risks associated with it.
Market Inefficiencies Don’t Always Correct Quickly
LTCM’s strategies were based on the belief that market inefficiencies would correct quickly, allowing them to profit from arbitrage opportunities.
However, these corrections can sometimes take longer than expected or may not happen at all due to unpredictable market events.
Traders should not blindly rely on the market to always behave rationally or efficiently.
Diversification is Critical
LTCM focused primarily on fixed-income arbitrage strategies, leaving them highly exposed when market conditions shifted during the Asian and Russian financial crises.
These crises led to significant losses for LTCM, proving the importance of diversification across different asset classes and strategies.
It’s important for traders to diversify their investment portfolio to reduce risk and ensure resilience during adverse market conditions.