A hedge fund with two Nobel laureates on its board needed a $3.6 billion rescue.
Long-Term Capital Management had star traders and two future Nobel prize-winning economists on its board. For three years it earned returns of 21 to 43 per cent. Then, in 1998, it lost $4.6 billion in under four months, and the Federal Reserve Bank of New York had to organise a rescue.
LTCM was founded in 1994 by John Meriwether, former head of bond trading at Salomon Brothers. Among its partners were Myron Scholes and Robert Merton, who shared the 1997 Nobel prize in economics for their work on pricing options. Its core strategy was convergence trading: find pairs of closely related bonds whose prices had drifted apart, bet that they would come back together, and profit as they did.
Those price gaps were tiny, so LTCM borrowed heavily to make them pay. At the start of 1998 it had 4.7 billion dollars of its own capital and over 124 billion borrowed, a ratio above 25 to 1, plus derivative positions with a face value of about 1.25 trillion. Some investors were wary from the start. Warren Buffett and Charlie Munger declined to invest, judging the leverage too risky, and the economist Eugene Fama warned that real markets have more extreme events than models assume.
In August 1998 Russia defaulted on its domestic bonds. Investors fled to the safest, most easily traded securities, which were exactly the ones LTCM had bet against, while the less liquid ones it owned fell. Other firms holding similar trades sold too, widening the gaps further. One partner said it was as if someone with their exact portfolio, three times larger, was liquidating all at once. By 25 September the fund's capital had shrunk from 2.3 billion at the start of the month to 400 million.
Fearing a chain reaction through Wall Street, the New York Fed brokered a deal in which 14 financial institutions put in about 3.6 billion dollars in exchange for 90 per cent of the fund. The partners' own 1.9 billion was wiped out. The fund was wound up in early 2000. Its lesson is that a trade that is right in the long run can still ruin you if you cannot survive the short run.
Source: Wikipedia — Long-Term Capital Management · Text summarised from Wikipedia (CC BY-SA 4.0)
