MASA JUMA | HARRIS MEMON | HARRY NG | HUGH WANG | TOM WELLS
 

  Long-Term Capital Management  

 

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   Contents
 

  03 Introduction

  04 The Rise of LTCM

04 Fund Management: Assembling the Team

 
04 Bond Market Crash of ‘94
 
06 Asian Financial Crisis
 
07 The Fall of LTCM
 
07 Saloman Brother’s Arbitrage Closure
  07 The Russian Crisis
  09 Financial Instruments Used

  09 I. Bonds

  11 II. Swaps

12 III. Options
 
13 IV. Equities & Others
 
14 Key Lessons Learnt
 
14 Lessons #1 - #7
 
16 Post-Progress after LTCM
  17 References

LTCM
 

 
The financial technology company …
  

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
   

LTCM
 
 
 
 
 
 
… in the changing
  financial environment
 
 

Introduction  

  events that led to the rise and fall of Long-Term

This essay first seeks to describe in detail the key
Capital Management (hereafter LTCM), a supersized hedge fund that towards the end of its life
 
nearly threatened to collapse the entre financial sector it traded in. This is followed by a critical
discussion and theory of the various financial   instruments used by the fund, and finally a
evaluation of what could be learnt from the actions of LTCM.
 

   

  03 | LTCM.

 
THE RISE OF LTCM
Fund Management: Assembling the Team

The fund was set up on February 1994 by John Meriwether, a former bond trader with
Salomon Brothers who had left his position as vice-chairman that oversaw the fixed
income securities of the firm due to controversies arising from the confession of a bond
trader under Meriwether whom attempted to corner the treasury bond auction market.
Subsequently, Meriwether began the process of assembling a group of partners that
included some of his former bond traders, the former vice-chairman of the Federal
Reserve and two leading academics in the field of financial economics. The academic
scholars within the team were responsible for the creation and faming the Black-
Scholes formula used for pricing options with their practices and application of it in
LTCM.

The team assembled by Meriwether brought together a high level of synergy through
the combination of the best traders Meriwether knew, which was backed by a strong
academic background. LTCM soon afterwards embarked on raising $2.5 billion to start
the fund with. However, the firm only was able to raise $1.3 billion from a group of
approximately 80 high net-worth investors which nevertheless, was a record amount
unheard of for a newly start-up hedge fund. Each investor had to meet a $10 million
initial deposit investment with a fixed lock-in period.

Bond Market Crash of ’94: Ingredients for LTCM’s success

The fund began trading in early 1994 and with only two months of trading, LTCM had
ran into a series of events that enabled the firm to deliver consistently strong returns
that would allow it to outperform the markets for the next few years of the fund’s life.
Collectively, these events pieced together to what is now described as the ‘bond
market crash of 1994’. Arguably, the crash began when Alan Greenspan, the head of
the Federal Reserve, raised short-term interest rates in the U.S. by a quarter of a
percent. The U.S. economy at the time was strengthening and price increases in the
commodity markets placed upward pressure for Federal Reserve to raise short term
interest rates help bring down spot prices of commodities (Schnabel, 2010).

The resultant effect to raise rates had a detrimental effect on 30 year U.S. treasury
bonds due to bond prices tend to share an inverse relationship with interest rates.
However, Lowenstein notes that the bond prices changed “more than they should have”
(p.41), as many bondholders were desperate to sell. One can argue that these bond
holders, including in particular - hedge funds, were at the time highly leveraged and
moved to sell to liquidate their positions. (Ehrbar, 1994).

04 | LTCM.
Several other factors exacerbated tumbling bond prices when news of Banks Trust
were suffering huge trading losses, that investors speculated to hit approximately $1
billion (Wessel et al., 1994).  

Furthermore, Wessel et al. attribute part of the mass selling to the trade-impasse that
existed between the U.S. and Japan early 1994 which caused a surge in the Japanese
Yen against the declining U.S. greenback. As a result, this caused a number of large
hedge funds realizing heavy losses, including Soros Fund Management, which lost
$650 million in only two days following speculation on exchange rates.

The selling of long-term securities in the U.S. in favour of higher liquidity had spread
east to Europe also. Borio and McCauley (1996) argues that international capital flows
played a key role in the turbulence in the bond markets. Many investors and hedge
funds that had acquired European bonds began selling at an alarming rate, leaving
some investors to take large unprecedented losses in an attempt to sell off their
positions.

Lastly, the accentuation of tumbling U.S. Treasury bond prices was triggered in Mexico,
March of 1994. Presidential candidate Luis Donaldo Colosio’s assassination brought
Mexico bond prices to fall, spilling over to neighbouring emerging markets such as
Argentina and Brazil to follow suit. Borio and McCauley (1996) explains that although a
market spill over is more prominent in the equity markets, they were culpable for part of
the bond market crash as well. Large investing institutions and hedge funds, through
the use of derivatives had amplified their risk and continued to sell whatever they could,
pushing U.S. treasury bond prices to fall even further.

Compounding these individual events together, created what is known today as the
bond market crash of 1994, which had resulted in bond yields to rise from 6.2% to
7.6%. What heightened the mass selloff was the level of leverage each investor faced.
Lowenstein points out that with investors leveraging themselves, they are implicitly
linking themselves with other investors. Thus, what was supposedly a negative isolated
event in Mexico had negative implications for an institution that may have no active and
direct financial interest in Mexican bonds. Simply by supplying the debt or by engaging
in trades with investors that do have such interests, the shock was able to transmit
through this channel alone. In a fight to achieve liquidity and minimize losses, the selling
undertaken by investors led to a spread that had widen sufficiently enough for LTCM to
take arbitrage on by using trades and financial tools that will be further analysed in
section two of this essay. Therefore, one could argue that had bond markets avoided a
crash, LTCM may not have achieved the level of success it experienced in the early
years of the fund.

05 | LTCM.
Despite the success of LTCM following the events that took place around the fund’s
inception discussed earlier, there were a number of major events that brought down
LTCM as spectacularly as the fund’s rise. The dynamics of the fall-out of these events
followed a remarkably similar pattern to the fund’s impressive rise.

! !
The Asian Financial Crisis: An Omen by Meriwether

The Asian Financial Crisis in 1997 that took the world markets by a storm originally had
limited effects on LTCM’s fund performance directly. Indeed Lowenstein (2001) had
described the immediate fallout of the event as “an opportunity” for LTCM (p.118), the
aftershocks of the crisis later on had sever implications for a number of positions that
the fund took on during the final years of its existence.

The crisis which affected predominantly the ‘Asian Tigers’, most notably Indonesia,

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Thailand, Korea and the Philippines, was a result of a failure in their pegged exchange
rate system. These countries’ currencies had become grossly overvalued as a result of
a high influx of foreign capital prior to the crisis. Following the equally fast pace of
withdrawals in foreign capital, the Baht and other closely tied currencies quickly fell.
The government of Thailand’s announcement of adopting a floating exchange rate
system instead of the pegged U.S. exchange rate regime led the Thai Baht to devalue
by 20% on the same day (Lowenstein, 2001). Following the drop, surrounding countries
such as the Asian Tigers fell in a similar fashion, much akin to the aftermath of the
Mexican assassination and its spill over effects to neighbouring countries.

Despite the argument that the Asian crisis represented an opportunity for LTCM to
continue to make exceptional returns on their investments, later in 1997 it had proven
difficult to attain the returns LTCM had once garnered the envy of other hedge funds.

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Meriwether announced that the majority of investors would have their original
investments returned citing difficulties in finding the opportunities to deliver “the
outsized returns that [LTCM] have been blessed with”, the partners however, along with
a number of other ‘strategic investors’ such as the Bank of Taiwan and Jimmy Cayne,
CEO of Bear Stearns, kept their money in the fund. The move reduced the capital within
the firm by $2.7 billion (Jacque, 2010) therefore increasing the funds leverage ratio from
18 to 1 to 28 to 1 (Lowenstein, 2001). The reduction in the firm’s capital had no
immediate detrimental effect on the fund and was not the main trigger for its decline,
however, it was instrumental during the period that exacerbated the problems LTCM
had to face later on. Mainly, two major problems helped shape the decline of the fund:
Meriwether’s arbitrage desk closure and the Russian Crisis of 1998.

06 | LTCM.
THE FALL OF LTCM
Salomon Brother’s Arbitrage Desk Closure: End of an Era

Salomon Brother’s forced decision to close its bond arbitrage desk, where Meriwether
and many of his partners began, marked the beginning of the LTCM’s demise as the
Salomon Brothers had mimicked many of LTCM’s convergence trades. Salomon
Brother’s merger with Citicorp, under its parent company Travelers led Sandi Weill, co-
head of Citicorp, to dismantle Salmon’s business model as he believed its trading
strategies yielded unsatisfactory results and was a form of ‘pseudo-scientific gambling’.
LTCM’s long-dated positions on many convergence trades were further widened when
the Salomon Brothers liquidated their positions to exit the market. Producing one of the
worse month returns for LTCM, at an astonishingly hurtful -14%. The situation
worsened when the news of the closure of Salomon’s arbitrage desk became public,
resulting in investors to quickly unload arbitrage trades fearing that the opportunity to
make arbitrage profits was diminishing, further pushing its convergence trades apart.
Recovery was near impossible when the Russian Crisis hit, delivering the final blow to
LTCM’s once remarkably performing fund.

The Russian Crisis of 1998: LTCM’s Demise

The Russian crisis of 1998 was not an overnight occurrence, but rather, one that has its
roots in the economic and political processes of the country. The crisis itself however,
was triggered by similar circumstances that had affected Asia during the 1997 crisis
mentioned earlier, one that was reflective of speculative attacks on the Russian Ruble in
much the same ways as had happened the year previously (Chiodo and Owyang, 2002).
In an effort to defend the currency, the central bank of Russia depleted $6 billion of its
foreign exchange reserves in doing so (Lowenstein, 2001). To aggravate the situation
further, Russia’s primary commodity, oil, had dropped in price to $11 per barrel; less
than half their level a year earlier (Chiodo and Owyang, 2002). This resulted in more
speculation regarding the devaluation of its currency, forcing the central bank to
increase the lending rate by banks to 150 percent (Chiodo and Owyang, 2002). Added
to this was the fact that there were a number of loans to Russian corporations and
banks totalling around $4 billion that was due in September, as well as billions of dollars
in ruble futures maturing in Autumn (Chiodo and Owywang, 2002). Eventually, the
market collapsed which led to long-term Russian GKOs falling in face value to half of
what they were two months earlier (Lowenstein, 2001). Soon after the devaluation of its
currency, it defaulted on its debt.

The devaluation of the ruble and debt defaults defined the Russian crisis and was the
catalyst that prompted knee-jerk reaction of mass selling from investors. The markets,
much like they did with the Asian financial crisis and Mexico’s bond crisis four years

07 | LTCM.
 earlier, show seemingly similar interrelatedness. The European and U.S. markets
experienced huge volatility, with the Dow Jones Industrial Average falling 280 points by
noon before recovering (Lowenstein, 2001). Emerging markets fell in unison as investors
sought less risky investments and as a result, Brazilian bonds in which LTCM had a
large stake in, began to fall. Coupled with the losses LTCM had incurred with the
Russian GKOs, LTCM began to lose money rapidly. LTCM lost as much as $550 million
on the Friday that followed Russia’s announcement alone (Lowenstein, 2001). Such
volatility had a huge detrimental effect on LTCM’s sustainability due to the risky
strategies it had pursued.

Ironically, the way in which events compounded and unfolded that led to the emphatic
rise of LTCM were mirrored by those that happened only a few years later on, leading to
the fall of the fund. Following the above events, many investors engaged in a ‘flight to
liquidity’, a phrase coined by Meriwether (Lowenstein, 2001), as they had done four
years earlier as a result of the huge amount of leverage investors had placed
themselves under. The continued selling by investors left LTCM crippled thus resulting
in their ultimate demise.

  LTCM’s Timeline Overview: A Recap  

 
Late  1997:  Fund  has  £7  billion  in  its  control  
  but  after  achieving  returns  of  only  27%,  $2.7  
1994:   LTCM   is   created   billion  is  returned  to  investors  
with   equity   capitalisation    
of  £1.3  billion   17th  August  1998:  Russia  devalues  
its  currency  and  defaults  on  its  debt  
Mid   1997:   Asian   tiger   countries    
suffer   financial   crisis   with   massive  
devaluation  of  currencies  
 
22nd  September  1998:  
  Equity  drops  to  $600  million  
1st  September  1998:  Equity  drops  to  $2.3  
  billion  and  the  fund  offer  investor  chance  
 

to  invest  on  special  terms  

 

  23rd  September  1998:   The   Federal   Reserve  

organise   a   rescue   package   fearing   a  
  systematic  meltdown.  

  4th  Quarter  
1999:  LTCM  is  
  liquidated    

08 | LTCM.
FINANCIAL INSTRUMENTS USED
LTCM’s trading strategy mainly centered around market-neutral arbitrage with a focus
on convergence and relative value trades in fixed income securities. Convergence

LTCM
trades involved a variety of short and long positions in very similar securities that were
differently priced when in theory they should have had the same price. LTCM’s
convergence trades were based on the expectation that this gap in pricing would
narrow, thus providing the fund with an arbitrage opportunity through its different
positions. The nature of these trades were non-directional, meaning that they were not
dependent on interest rates moving in a certain direction, but more on the convergence
between yields (Stonham 1999).

In simple terms, LTCM screened U.S., European and Japanese treasuries, including
mortgage- backed securities for any mispricing between the same or very similar
securities (Jacque 2010). LTCM would then take advantage of these abnormal price
opportunities by buying, i.e. taking long positions in the cheaper securities while
simultaneously short selling the more expensive securities (Mackenzie 2003).

I. BONDS

Yield Curve Arbitrage

At the heart of LTCM’s convergence trades was the quasi arbitrage of “on the run” for
“off the run” long-term US treasuries, which was built on the idea that over time the
value of long-term bonds issued a short time apart would become identical, which was
in line with the fund’s convergence theme. “On-the-run” long-term US treasuries are
newly issued bonds that the US government lists every six months. Due to their liquid
nature, investors were willing to pay liquidity premiums on these treasuries resulting in
prices, which were perceived to be overvalued by LTCM. “Off-the-run” long-term US
treasuries are similar to “on-the-run” bonds, however, they were issued more than six
months ago, i.e. not as recent as the “on-the-run” treasuries, and were are as liquid.
LTCM believed that “Off-the-run” long-term US treasuries were slightly underpriced.

LTCM
Whenever LTCM would observe a large spread between similar treasuries it would buy
the cheaper off-the-run US treasuries and in the meantime short sell the more
expensive on the run treasuries, wait for the spread to start converging in order to lock
in a profit on the short sale or long position.

One limitation of this strategy was that it resulted in narrow profits. This necessitated
the use of a substantial amount of leverage by LTCM in order to capture significant
returns (Jorion 2000). In this context, LTCM was able to widen its leverage base by
lending the bonds it purchased to a bank. The bank would then pledge these bonds as

09 | LTCM.
collateral to LTCM, thus enabling LTCM to deposit these bonds with the owner of the
bond it borrowed the bonds for the short sale from (Jacque 2010).

An illustration of the abovementioned strategy is a convergence trade carried out by

LTCM in 1994. LTCM noticed that the spread between of-the- run 30-year treasuries
issued in February 1993 with a 7.36% yield and on-the-run 30 year treasuries issued 6
months later in August 1993 offering a 7.24% yield, was large. Consequently, it
purchased off-the-run treasuries worth USD 1 billion and at the same time wrote-off the
same amount of the on-the-run treasuries, making a profit of USD5 million(Jacque
2010). The fact that LTCM needed to invest USD1 billion in order to realize a relatively
low USD 5 million profit highlights the extent of leverage LTCM needed to raise in
order to reap tangible profits

To safeguard itself against both upward and downward movements in interest rates
LTCM used to both own, that is long, and short-sell long-term US treasuries, thus
maintaining a hedged position since its long bond position equaled its short bond
position (Jacque 2010). The fund’s convergence plays proved to be highly successful
in the beginning where, despite the fact that LTCM first started trading in a bearish
bond market in 1994, the fund was able, through its bets on convergence between
spreads, to return 42.8% to its investors in 1995, 40.8% in 1996 and 17% in 1997
(Stonham 1999). However, trouble began brewing for LTCM with the start of the Asian
financial crisis, which resulted in a shift towards safer investments provided by
European and American treasuries. This unexpected demand had a direct impact on
several of LTCM’s signature convergence trades as, instead of converging, spreads
began to diverge (Jorion 200). By the end of the crisis LTCM had losses of USD215
million from yield-curve arbitrage, as LTCM’s fund managers seemed to have failed to
take into account the possibility of an unforeseen and adverse event taking place that
would leave spreads not acting in line with their historical levels.

High Yield (Junk Bond) Arbitrage

LTCM sought to exploit pricing inefficiencies apparent in riskier securities such as

mortgage backed bonds in several European countries. Despite the increased risk
these trades were still in the boundaries of LTCM’s yield convergence trades. For
example in 1998, LTCM was the biggest investor in Danish mortgage bonds with a USD
8 billion long position in the higher yield and higher risk 30-year Danish mortgage
bonds, while short selling an equivalent amount of lower yield 10-year Danish
government bonds, based on the assumption that the spread between them would
narrow , creating a margin of profit for LTCM ( Stonham 1999). LTCM also felt the
stirrings of the Asian crisis in this area. When in May/ June 1998, a setback in the
mortgaged back securities market led to a 16% reduction in LTCM’s capital, further

10 | LTCM.
increasing the fund’s leverage (Jorion 2000). In total losses from high yield (junk bond)
arbitrage amounted to USD100 million.

II. SWAPS

Interest Rate Swap Spreads

LTCM also heavily dealt in the arbitrage of interest rate swap spreads under the
umbrella of its convergence strategies (Jacque 2010). A swap is an agreement
between two parties to exchange cash flows in the future at predetermined dates. A
simple forward contract and a swap have the same underlying concepts. The most
common type of a swap is a “plain vanilla” interest rate swap, where “one party agrees
to pay cash flows equal to interest at a predetermined fixed rate on a principal for a
number of years. In return, the party receives interest at a floating rate on the same
principal for the same period” (Hull 2009). The floating rate in most interest rate swaps
is the London Interbank Offered Rate (LIBOR), while the fixed rate is the swap rate,
which the party receives in exchange for paying the LIBOR rate. The ‘swap spread’ is
the difference between the fixed interest rate and the yield of a government bond with a
similar maturity (Hull 2009). At the time of the 1998 crisis, LTCM had approximately
10,000 swaps with a total notional value of USD1.25 trillion (Mackenzie 2003).

Swap spreads indicate arbitrage opportunities and LTCM would conduct a

convergence trade whenever the spread would reach the top or bottom of the average
range on the assumption that the spread will eventually narrow to its mean value
(Jacque 2010). As was the case with its treasury convergence trades, LTCM’s swap-
spread trades were also heavily leveraged. If LTCM observed a low swap spread, it
would take out a repurchase agreement in order to purchase treasuries. It would then
enter into a symmetrical interest rate swap under the terms of which LTCM pays a fixed
rate to receive a floating rate, i.e. the 6 month floating LIBOR. In this case the negative
swap spread is compensated by the positive differential between the LIBOR LTCM
receives from the swap and the Repo rate it has to pay. LTCM would also expect the
trade to become slightly more profitable when the swap spread reverts to its historical
mean value. Similarly, convergence trades were also conducted when high swap
spreads were observed. In both cases, profits were in the meager range of 3-5 basis
points, however, they were amplified through the power of leverage. (Jacque 2010).

LTCM suffered a setback with the merger between Travelers, which gained Salomon
Brothers as part of the deal, and Citicorp. Consequently, the new owners decided to
liquidate Salomon’s arbitrage positions, which had an adverse impact on LTCM’s fixed
income and interest rate swap convergence trades, as Salomon Brothers were
mirroring many of LTCM’s convergence trades at the time (Mackenzie 2003). In this

11 | LTCM.
case, LTCM had failed to factor in the risk that other funds that were mimicking their
trades they had on them.

LTCM also took advantage of foreign bond markets, which were not as liquid and

!
efficient as U.S markets, thus providing LTCM with arbitrage opportunities in the UK,
Germany, Italy and Japan. For example, LTCM become heavily involved in the Italian
capital markets, where it took advantage of unusually high treasury yields which
contributed to a widening of the swap spread. This was attributed to a strong market
sentiment the Italian government bonds were riskier than AAA rated Italian corporate
bonds. Nonetheless, LTCM believed that the spread would narrow on improved
confidence in that Italian government with the launch of the single currency (Euro) in
1999 (Mackenzie 2003). Consequently, LTCM purchased Italian treasuries through a
repurchase agreement, thus taking advantage of the high differential between yields
and fixed rates. It then entered into a swap agreement where it was paying fixed rates
that were lower than the yields it was receiving while at the same time being on the
receiving end of Italian LIBOR that was higher than the repo rate it was paying, leaving
room for a positive spread that would result in a capital gain when the swap spreads
reverted to normal levels (Jacque 2010).

III. OPTIONS

Equity Volatility with Straddles and Strangles

LTCM used the combination of writing or shorting put and call options to create a
variety of strangle and straddle option strategies that bet against a highly volatile
market. LTCM began writing long-term call and put options on the U.S. S&P500,
collecting what they thought to be over-priced premiums in a market where the implied
volatility of the options far exceeded their historical volatility.

Writing a strangle or a straddle option strategy works through receiving premiums for
the options first and remains profitable as long as the options are not exercised before
expiration. In LTCM’s case, they had bet that the index volatility was going to subside
and the chances of people exercising the options it was writing were unlikely. Straddle
works by writing out-the-money calls and puts with identical strike prices while
strangles have different strike prices. Strangles would allow LTCM to construct less
speculative and larger payoff ranges strategy than straddles but at the cost of receiving
smaller premiums in doing so.

The Asian and Russian crisis in 1997 that reverberated throughout the world market
indices had caused LTCM’s short position on long-dated equity volatility strategy to fail
as margin calls came in on its deep out-the-money options. What LTCM had failed to
consider, believing that shorting volatility at 22% to its historical volatility at 15%, was

12 | LTCM.
that implied volatility is only an estimate and not the true realized volatility in the future.
They are completely different variables, much like apples and oranges; they themselves
cannot be assumed to be the same. LTCM seemed to have overlooked this
fundamental and basic fact, and instead began to think that they were betting that real
volatility was going to revert to its 15% historical normal over time. However, this was
not the case and equality volatility did rise to 40% thus leaving LTCM to suffer huge

(!")
losses since this strategy LTCM had pursued left them naked with unlimited downsides.

−!
LTCM’s emphasis on V@R and favoritism on historical volatility trends over forward
forecasting ultimately led them to put too much confidence in its risky investing
decisions.

IV. EQUITIES & OTHERS

Paired Stocks

LTCM’s convergence play on the equity markets through the use of paired stocks was
another risky trade by betting that divergence found between two securities would
revert to normal. A paired stock is a financial instrument used to profit from deviation by
simultaneously taking a long position on one stock and a short on another similar
security. Often, they involve shares of companies within the same industry or shares of
the same company that are listed simultaneously on two or more exchanges. Choosing
a correct pair is the key focus and is considered a market neutral strategy.

In LTCM’s paired trades on Royal Dutch Shell Group, factors such as differences in
liquidity, taxes, expectations and regulations had put a 7 – 12% premium on Royal
Dutch listed on the Amsterdam Exchange over the Shell stock listed on the LSE. LTCM
acted swiftly to arbitrage these two asset prices when it had thought that a change in
tax regulations would make it more preferably for investors to hold Shell stocks over
Royal Dutch and that past spreads will reassert themselves. This had proved to be
disastrous when the supposed convergence never happened, instead further
divergence occurred when the premium for Royal Dutch shares jumped 22%. However,
the strategy could have played out in the long term, but due to LTCM’s other
investments suffering huge losses and margin calls - the firm had to realize its positions
on its equity paired trades at an unfavorable time, taking deep losses accounting for
$286 million.

The problem here was that LTCM had again diverged away from arbitraging mispricing
approach and instead had followed into playing the convergence game with riskier tools
such as paired stock trades. LTCM did not anticipate the firm’s liquidity as a factor
before entering into this strategy, the firm had never intended to pull out early and its
paired trades were suppose to be held long-term. Black swans again played into the
downfall of this strategy, forcing LTCM realize untimely losses to cover margin calls on
other derivative bets.

13 | LTCM.
Russian GKOs: Sovereign Default

Amongst other investments in other emerging market government bonds, LTCM had a
sizable portion in Russian GKOs. To hedge its GKO positions, LTCM believed that by
selling rubles with forward contracts, this would offset the losses on the bonds. In
theory, the application of shorting forward contracts on its Russian rubles would have
worked, should the government default on its bonds, the devaluation of the ruble would
mean gains on the short forward contracts of rubles.

However, what LTCM failed to consider was when the Russian ruble collapsed, LTCM
did not expect that the forward contracts that they had entered into could have
defaulted. When the Russian banks defaulted on their forward contracts with LTCM,
this essentially removed the theoretical hedge on LTCM’s strategy. With no hedge,
LTCM had absorbed all losses on the GKO defaults, exacerbating the losses that were
unaccounted for in its strategy when longing GKOs, LTCM had fallen victim again to
over relying on historical trends to predict future outcomes and did not account for
‘black swans’ in their equations. In this case, several of them led to a $430 million
realized loss.

KEY LESSONS LEARNT

This part shall briefly explain the shortcomings of LTCM and what lessons can be
learned from them. Whether they are applied to a hedge fund or any company that
seeks to temper its success with sustainability, the missteps of Long-Term Capital
Management offer plenty of insight into how-whether a company knows it or not-its
downfall is often its own doing.

1. Stress Testing of Liquidity Risk.

Despite the $900 million Standby Letter of Credit, and over a $1 billion in working
capital, LTCM still required a rescue. No matter how extreme they may appear, worst‐
case scenarios do, and will, happen. This phenomenon is common enough in capital
markets crises that it should be built into risk models, either by introducing a new risk
factor — liquidity — or by including a flight to liquidity in the stress testing. This could
be accomplished crudely by classifying securities as either liquid or illiquid. Liquid
securities are assigned a positive exposure to the liquidity factor; illiquid securities are
assigned a negative exposure to the liquidity factor. The size of the factor movement
(measured in terms of the movement of the spread between liquid and illiquid securities)
can be estimated either statistically or heuristically (perhaps using the LTCM crisis as a
"worst case" scenario). Jorion (2000).

14 | LTCM.
But also bear in mind that there will always be events, or compound or correlated
events, which will not be anticipated. And no stress testing model (economic,
proprietary, accounting or regulatory) is a complete descriptor of the complex reality.
There will always be missing elements from any prior analysis, and thus as part of risk
management design one must have procedures in place to deal with managing crises
(defined as events not anticipated in any fashion beforehand), which cannot be known
in advance. LTCM did to an extent, as it had a team of senior management who had
dealt with crises of the past (1987 Crash; S&L crisis), nevertheless it was not able to
prevent the events.

2. Market Risk.

When markets become illiquid, for whatever reason, bid / offer spreads will diverge
dramatically, and self‐interest and self‐preservation will drive market prices. As in
liquidity risk, worst‐case scenarios do, and will, happen. Jorion (2000)

3. Operational Risk

Always guard against the event of any private, internal documents and memorandum
becoming public. In the domain of the uninitiated, they can be taken out of context and
cause material, reputational, and financial damage. For example, on September 2, one
of the investors leaked a confidential letter to Bloomberg which explicated the decline
of net asset value of LTCM’s portfolio.

4. Reputational Risk.

The market’s perception, including that all your customers and counterparties, of your
risk appetite and profile, must be persistently managed. Processes must be in place
(and stress tested) and capital allocated, to protect shareholder, stakeholder, and
investor capital in the event of adverse publicity. Dowd (1999)

5. Breakdown of Patterns

Usually, traders can hedge their bets by investing in many different geographical
regions. But in recent years, the patterns have become synchronized, so that a decline
in one region would no longer be offset by a rise in another, which means different
markets function individually and or not entirely dependent on another market..

6. Credit Risk

The credit analysis was badly done, such as allowing a non‐bank counterparty to write
swaps and pledge collateral for no initial margin as if it were part of a peer group of
top‐tier banks with the highest credit rating. Practically all the non-bank counterparties
had a blind spot when it came to LTCM. They forgot the useful discipline of charging
non‐bank counterparties initial margin on swap and repo transactions. Collectively they

15 | LTCM.
were responsible for allowing LTCM to build up layer upon layer of swap and repo
positions. They believed that the first‐class collateral they held was sufficient to
mitigate their loss if LTCM disappeared. It may have been over time, but their margin
calls to top up deteriorating positions simply pushed LTCM further towards the brink.
Their credit assessment of LTCM didn't include a global view of its leverage and its
relationship with other counterparties. Jorion (2000).

7. Political Risk

The models failed to assess realistically the risk that Russia would backslide so abruptly
on the road to capitalism, Haubrich (2007). Many of the large dealer banks exposed to
a Russian crisis across many different businesses only became aware of the
commonality of these exposures after the LTCM crisis. For example, these banks
owned Russian GKOs on their arbitrage desks, made commercial loans to Russian
corporates in their lending businesses, and had indirect exposure to a Russian crisis
through their prime brokerage lending to LTCM. A systematic risk management process
should have discovered these common linkages ex ante and reported or reduced the
risk concentration.

Post-Progress after the fall of LTCM (Stonham 1999)

The President’s Working Group on Financial Markets in the US revealed, in December

!
1998, it was planning to recommend new reporting standards on risk taking by hedge
funds and other financial firms which use high leverage ratios in their proprietary trading.
The Group discussed plans for ‘more direct regulation’ of leverage activity through
capital requirements and margin calls in derivatives markets. The US Commodities and
Futures Trading Commission, the main US futures regulator, was particularly critical of
the extensive loans made to LTCM by banks in the over-the-counter derivatives market,
when the banks had little knowledge of the kind of risks LTCM was being exposed to in
its derivatives trading. All the US regulatory authorities involved in the LTCM affair
agreed that hedge funds should both provide more information to creditors and
investors (greater ‘transparency’) and be subject to greater supervision.

16 | LTCM.
REFERENCES

Borio, C.E.V., McCauley, R.N. (1995) “The Anatomy of the Bond Market Turbulence of 1994”.
Bank of Chiodo, A J. and Owyang, M T. “A Case Study of a Currency Crisis: The Russian
Default of 1998.” Federal Reserve Bank of St. Louis Review, November/December 2002, 84(6),
pp. 7-17

Dowd, K. (1999) “Too Big to Fail? Long-Term Capital Management and the Federal Reserve”

Ehrbar, A. (1994). THE GREAT BOND MARKET MASSACRE.

Available: http://money.cnn.com/magazines/fortune/fortune_archive/1994/10/17/79850/index.ht
m. Last accessed: 15/03/2011

Haubrich, J.G. (2007) “Some Lessons on the Rescue of Long-Term Capital Management”

Hull, J.C., (2008), Options, Futures and Other Derivatives, 7th edn., Prentice Hall
International Settlements Working Paper 32.

Jacque, LL, (2010) “Global Derivative Debacles From Theory to Malpractice. 1st ed. Singapore:
World Scientific”.

Jorion, P. (2000) “Risk Management Lessons from Long-term Capital Management”.

Lowenstein, R, 2001. When Genius Failed. 1st ed. London: Fourth Estate.

Mackenzie, D. (2003) ‘Long-Term Capital Management and the sociology of arbitrage’,

Economy and Society, pp. 349–380

Schnabel, J A., (2010) "Interest rates, commodity prices, and the cost-of-carry model", The
Journal of Risk Finance, 11:2, pp.221 – 223

Stonham, P. (1999). “Too Close to the Hedge: The Case of Long-Term Capital Management LP
Part One: Hedge Fund Analytics”. European Management Journal, Vol. 17, pp. 282-289.

Wessel, D., Jereski, L. and Smith, R. (1994) “Stormy Spring : Three-Month Tumult In Bonds
Lays Bare New Financial Forces”. Available: http://salsa.babson.edu/Pages/Articles/94-
05%20StormySpring.htm. Last accessed: 15/03/2011

17 | LTCM.
  

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