Long-Term Capital Management

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Long-Term Capital Management (LTCM) was a U.S. hedge fund which used trading strategies such as fixed income arbitrage, statistical arbitrage, and pairs trading, combined with high leverage. It failed spectacularly in the late 1990s, leading to a massive bailout by other major banks and investment houses,^[1] which was supervised by the Federal Reserve.

LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Board of directors members included Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences.^[2] Initially enormously successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis and became a prominent example of the risk potential in the hedge fund industry. The fund folded in early 2000.

[edit] Founding

John Meriwether headed Salomon Brothers' bond trading desk until he was forced to resign in 1991 when his top bond trader, Paul Mozer, admitted to falsifying bids on U.S. Treasury auctions. Because Salomon was the largest bidder on treasury bonds at auction, the Treasury department feared that Salomon would be able to take a strategic position on the bonds in order to influence the price.^[3] As such, Salomon (or any single bidder) was restricted from purchasing more than 35% of the bonds sold at any auction. Mozer circumvented this limitation by making fraudulent bids on behalf of Salomon clients and then transferring the bonds to Salomon's accounts following the transaction. The revelation of this scandal depressed the company's share price and drove investor Warren Buffett to sack its chief executive officer, John Gutfreund. Though Meriwether was not directly implicated, calls for his ousting rose within the company and he resigned before he was to be let go.^[4]

In 1993 he announced that he would launch a hedge fund called Long-Term Capital.^[5] Meriwether used his well-established reputation to recruit several Salomon bond traders and some brilliant mathematicians. He also recruited two future Nobel Prize winners, Myron Scholes and Robert C. Merton, both of whom worked in Salomon Brothers' fixed income trading department.^[6] Other principals in the firm included Eric Rosenfeld, Greg Hawkins, Larry Hilibrand, William Krasker, Dick Leahy, Victor Haghani, James McEntee, Robert Shustak, and David W. Mullins Jr..

Long-Term Capital consisted of Long-Term Capital Management (LTCM), a company incorporated in Delaware but based in Greenwich, Connecticut. LTCM managed trades in Long-Term Capital Portfolio LP, a partnership registered in the Cayman Islands. The fund's operation was designed to have extremely low overhead; trades were conducted through a partnership with Bear Stearns and client relations were handled by Merrill Lynch.^[7]

Meriwether chose to start a hedge fund to avoid the financial regulation imposed on more traditional investment vehicles, such as mutual funds, as established by the Investment Company Act of 1940—funds which accepted stakes from one hundred or fewer individuals with more than one million dollars in net worth each were exempt from most of the regulations that bound other investment companies.^[8] In late 1993, Meriwether approached several "high net-worth individuals" in an effort to secure start-up capital for Long Term Capital Management. With the help of Merrill Lynch, LTCM secured hundreds of millions of dollars from business owners, celebrities and even private university endowments. The bulk of the money, however, came from companies and individuals connected to the financial industry.^[9] By 24 February 1994, the day LTCM began trading, the company had amassed just over $1.01 billion in capital.^[10]

[edit] Trading strategies

The company used complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades) usually with U.S., Japanese, and European government bonds. Government bonds are a "fixed-term debt obligation", meaning that they will pay a fixed amount at a specified time in the future.^[11] Differences in the bonds' present value are minimal, so according to economic theory any difference in price will be eliminated by arbitrage. Unlike differences in share prices of two companies, which could reflect different underlying fundamentals, price differences between a 30 year treasury bond and a 29 and three quarter year old treasury bond should be minimal—both will see a fixed payment roughly 30 years in the future. However, small discrepancies arose between the two bonds because of a difference in liquidity^[12]. By a series of financial transactions, essentially amounting to buying the cheaper 'off-the-run' bond (the 29 and three quarter year old bond) and shorting the more expensive, but more liquid, 'on-the-run' bond (the 30 year bond just issued by the Treasury), it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond was issued.

As LTCM's capital base grew, they felt pressed to invest that capital and had run out of good bond-arbitrage bets. This led LTCM to undertake more aggressive trading strategies. Although these trading strategies were non-market directional, i.e. they were not dependent on overall interest rates or stock prices going up (or down), they were not convergence trades as such. By 1998, LTCM had extremely large positions in areas such as merger arbitrage and S&P 500 options (net short long-term S&P volatility). LTCM had become a major supplier of S&P 500 vega, which had been in demand by companies seeking to essentially insure equities against future declines.^[13]

Because these differences in value were minute—especially for the convergence trades—the fund needed to take highly-leveraged positions to make a significant profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt to equity ratio of about 25 to 1. It had off-balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.

Long Term Capital Management was found to have entered into certain tax avoidance transactions. Approximately $100 million of losses claimed by LTCM were disallowed by United States District Court of Connecticut. An e-mail dated March 10, 1995, to Jan Blaustein Scholes, Myron's girlfriend at the time and general counsel responsible for setting up leasing transactions associated with the disallowed losses, stated : "For our CHIPS III entity let’s use a name unrelated to CBB. It makes it just a bit harder for the IRS to link all the deals together." Equally alarming, Myron Scholes stated that he was not an expert on tax law. A textbook, "Taxes & Business Strategy" (principally written by Myron Scholes), contains chapters on both economic substance and step transactions, which are the two concepts under which the tax loss was disallowed by the IRS.

In a memorandum to Long Term’s management committee dated November 12, 1996, Myron Scholes wrote: "We must decide in the near future (1) how to allocate these capital losses; (2) how to "trade" them so that they are held in high-valued hands; and (3) how to plan to be able to enjoy the benefits of the use of these losses for the longest period of time. If we are careful, most likely we will never have to pay long-term capital gains on the 'loan' from the Government." He went on, "How should LTCM pay those who brought the Tax Losses to Fruition and allocate the expenses of undertaking the trade?"^[14]

[edit] Downturn

Although much success within the financial markets arises from immediate-short term turbulence, and the ability of fund managers to identify informational asymmetries, factors giving rise to the downfall of the fund were established prior to the 1997 East Asian financial crisis. In May and June 1998 returns from the fund were -6.42% and -10.14% respectively, reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. Such losses were accentuated through the Russian financial crises in August and September 1998, when the Russian Government defaulted on their government bonds. Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August, the fund had lost $1.85 billion in capital.

As a result of these losses, LTCM had to liquidate a number of its positions at a highly unfavorable moment and suffer further losses. A good illustration of the consequences of these forced liquidations is given by Lowenstein (2000).^[15] He reports that LTCM established an arbitrage position in the dual-listed company (or "DLC") Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8 to 10 percent premium relative to Shell. In total $2.3 billion was invested, half of which long in Shell and the other half short in Royal Dutch.^[16] LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge. This may have happened in the long run, but due to its losses on other positions, LTCM had to unwind its position in Royal Dutch Shell. Lowenstein reports that the premium of Royal Dutch had increased to about 22 percent, which implies that LTCM incurred a large loss on this arbitrage strategy. LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade.^[17]

The company, which was providing annual returns of almost 40% up to this point, experienced a flight-to-liquidity. In the first three weeks of September, LTCM's equity tumbled from $2.3 billion to $600 million without shrinking the portfolio, leading to a significant elevation of the already high leverage.

[edit] 1998 bailout

LTCM's financial problems sent shock waves throughout financial markets, as illustrated by the September 21, 1998 cover of Business Week^[18]

Goldman Sachs, AIG and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $3.75 billion and to operate LTCM within Goldman's own trading division. The offer was rejected and the same day the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. The contributions from the various institutions were as follows: ^{[19] [20]}

• $300 million: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P.Morgan, Morgan Stanley, Salomon Smith Barney, UBS
• $125 million: Société Générale
• $100 million: Lehman Brothers, Paribas
• Bear Stearns declined to participate.

In return, the participating banks got a 90% share in the fund and a promise that a supervisory board would be established.

The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices, which would force other companies to liquidate their own debt creating a vicious cycle.

The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):^[21]

• $1.6 bn in swaps
• $1.3 bn in equity volatility
• $430 mn in Russia and other emerging markets
• $371 mn in directional trades in developed countries
• $286 mn in equity pairs (such as VW, Shell)
• $215 mn in yield curve arbitrage
• $203 mn in S&P 500 stocks
• $100 mn in junk bond arbitrage
• no substantial losses in merger arbitrage

Long Term Capital was audited by Price Waterhouse LLP.

Unsurprisingly, after the bailout by the other investors, the panic abated, and the positions formerly held by LTCM were eventually liquidated at a small profit to the bailers.

Some industry officials said that Federal Reserve Bank of New York involvement in the rescue, however benign, would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf in the event of trouble. Federal Reserve Bank of New York actions raised concerns among some market observers that it could create moral hazard.^[22]

LTCM's strategies were compared (a contrast with the market efficiency aphorism that there are no $100 bills lying on the street, as someone else has already picked them up) to "picking up nickels in front of a bulldozer"^[23]— a likely small gain balanced against a small chance of a large loss, like the payouts from selling an out-of-the-money option.

[edit] Aftermath

After the bailout, Long-Term Capital Management continued operations. In the year following the bailout, it earned 10 percent. By early 2000, the fund had been liquidated, and the consortium of banks that financed the bailout had been paid back; but the collapse was devastating for many involved. Goldman Sachs CEO Jon Corzine, who had been closely involved with LTCM, was forced out of the office in a boardroom coup led by Henry Paulson. Mullins, once considered a possible successor to Alan Greenspan, saw his future with the Reserve dashed. The theories of Merton and Scholes took a public beating. In its annual reports, Merrill Lynch observed that mathematical risk models "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited."^[24]

After helping unwind LTCM, Meriwether launched JWM Partners. Haghani, Hilibrand, Leahy, and Rosenfeld all signed up as principals of the new firm. By December 1999, they had raised $250 million for a fund that would continue many of LTCM's strategies—this time, using less leverage.^[25]

[edit] See also

• Arbitrage
• Black-Scholes model
• Game Theory
• Greenspan put
• JWM Partners LLC
• List of business failures
• Martingale (betting system)
• Martingale (probability theory)
• Probability Theory
• St. Petersburg paradox
• When Genius Failed: The Rise and Fall of Long-Term Capital Management
• Value at risk

[edit] Notes

[edit] Bibliography

• Coy, Peter; Wooley, Suzanne (21 September 1998), "Failed Wizards of Wall Street", Business Week, http://www.businessweek.com/1998/38/covstory.htm, retrieved on 2006-09-04 
• Crouhy, Michel; Galai, Dan; Mark, Robert (2006), The Essentials of Risk Management, New York: McGraw-Hill Professional, ISBN 0-071-42966-2, http://books.google.com/books?id=sD0PNeDmHmgC&printsec=frontcover&source=gbs_summary_r&cad=0 
• Dunbar, Nicholas (2000), Inventing Money: The story of Long-Term Capital Management and the legends behind it, New York: Wiley, ISBN 0-471-89999-2 
• Loomis, Carol J. (1998), "A House Built on Sand; John Meriwether's once-mighty Long-Term Capital has all but crumbled. So why did Warren Buffett offer to buy it?", Fortune 138 (8) 
• Lowenstein, Roger (2000), When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House, ISBN 0-375-50317-X 
• Weiner, Eric J. (2007). What Goes Up, The Uncensored History of Modern Wall Street. New York: Back Bay Books. ISBN 0-316-06637-0. 

[edit] Further reading

• Siconolfi, Michael; Pacelle, Mitchell; Raghavan, Anita (1998-11-16). "All Bets Are Off: How the Salesmanship And Brainpower Failed At Long-Term Capital". Wall Street Journal. 
• "Trillion Dollar Bet". PBS Nova. 2000-02-08. http://www.pbs.org/wgbh/nova/stockmarket. 
• MacKenzie, Donald (2003). "Long-Term Capital Management and the Sociology of Arbitrage". Economy and Society 32 (3): 349–380. doi:10.1080/03085140303130. http://www.journalsonline.tandf.co.uk/openurl.asp?genre=article&doi=10.1080/03085140303130. 
• Fenton-O'Creevy, Mark; Nicholson, Nigel; Soane, Emma; Willman, Paul (2004). Traders — Risks, Decisions, and Management in Financial Markets. Oxford University Press. ISBN 0-19-926948-3. 
• Gladwell, Malcolm (2002). "Blowing Up". New Yorker, the. http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm. 
• MacKenzie, Donald (2006). An Engine, not a Camera: How Financial Models Shape Markets. The MIT Press. ISBN 0-262-13460-8. 
• Case Study: Long-Term Capital Management
• Meriwether and Strange Weather: Intelligence, Risk Management and Critical Thinking
• [http://www.usdoj.gov/tax/082704JBALongTermUS.pdf

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