Caso Long-Term Capital Management

Among the PRMIA Case Studies, LTCM has some unique characteristics:

No US taxpayer money was involved in the rescue

No retail depositor’s money was involved or threatened

No politicians were involved

No laws were broken and no‐one went to prison

No‐one was fined or censured

No LTCM employee was indicted for fraud

No internal or regulatory authority audit report ever highlighted any risk, or operational,

concerns

Any losses suffered by LTCM professional investors were minor relative to their wealth

There was no proven, shareholder, or legal suites for any form of negligence or malfeasance

And no bankruptcies were declared

Not quite so unique about LTCM, was the hype and sensationalism created in the media by distorted

coverage about what was, essentially, an overreaction by many commentators to the usual and

known risks involved by anyone investing in high‐risk, potentially high‐reward strategies in the

wholesale markets. But when extremely large numbers are involved, and large potential losses,

linked with personalities of international repute, and in a climate of the unknown, it becomes

susceptible to easy, and headline‐grabbing, reporting.

So why is LTCM included as a PRMIA Case Study?

Because It offers an insight into the professional derivative markets of the 1990s, some of the

personalities and institutions involved, those who trade in those markets, some deep insight into the

trading strategies and dynamics of those markets, the motives and performance of the US

regulators, the rational and irrational behaviour of all concerned; but more importantly – the lessons

(which should have been) learned from the entire episode.

So what happened

The investment partnership Long‐Term Capital Management was set up in 1993 by John

Meriwether, previously a successful bond trader and then senior manager at the US investment

bank, Salomon Brothers. Meriwether recruited to LTCM, from Salomon and elsewhere, an

impressive team of experienced traders and specialists in mathematical finance. Much of its trading

was with leading banks, and it largely avoided risky 'emerging markets', preferring well‐established

ones such as those in government bonds of the leading industrial nations. The fund avoided

speculation based on hunches. It built carefully researched mathematical models of the markets in

which it traded, and invested in a way designed to achieve insulation from market movements,

seeking small pricing anomalies from which it could profit. Although it had to borrow large amounts

and commit money on a large scale to make an adequate return from these anomalies, LTCM

scrupulously measured and controlled the risks it was taking.

The investor’s who were attracted to LTCM’s business strategy reads like a “Who’s Who” of

professional and sophisticated investors who knew the risks involved, had committed both equity

and loan capital (locked in for perhaps 3 years with various contractual mechanisms to ensure no

quick flight of their capital), and, presumably had the approval of the investment committees of

their respective institutions. They included: LTCM partners (who invested $100 million); and other

whose investment totalled $1 billion; Liechtenstein Global Trust; Bank of Italy; Credit Suisse; UBS;

Merrill Lynch (employees' deferred payment plan); Donald Marron, chairman, PaineWebber; Sandy

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Weill, co‐CEO, Citigroup; McKinsey executives; Bear Stearns executives; Dresdner Bank; Sumitomo

Bank; Prudential Life Corp; Bank Julius Baer (for clients); Republic National Bank; St John’s University

endowment fund; and University of Pittsburgh.

In total $1.1 billion was raised, and the transparency of their investment was provided by Monthly

Net Asset Valuations, Quarterly Balance Sheets, annual financial statements including full disclosure

of off balance sheet contractual positions, and periodic presentations to lenders concerning financial

condition and portfolio policy.

LTCM were strikingly successful from the start of trading in 1994 when it earned 28% after fees in 10

months. In LTCM's first two full years of operation it produced 43% and 41% return on equity and

had amassed an investment capital of $7.5 billion. The fund was closed to new investors in 1995. In

the last quarter of 1997 LTCM returned $2.7 billion to investors. Such numbers are quite startling,

but not especially so, considering the amount of capital involved, its corresponding leverage, and the

probably very high nominal principal amount of each trade chasing perhaps no more than a few

basis points per trade.

But it all started to go sour in the summer of 1998 because of unusually adverse market conditions.

There were, perhaps, five contributory factors, some of which were extreme events, which lead to

the Federal Reserve Bank of New York orchestrating an orderly rescue of LTCM:

1. Russia's devaluation of the rouble and partial default on its rouble‐denominated debt. The

Russian default was just such an extreme event, though one that no one had anticipated:

the surprise was not that Russia was in economic trouble, but that it defaulted on debts

denominated in roubles, rather than simply printing more money, and also that it

temporarily blocked some foreign exchange transactions by Russian banks. LTCM itself had

only a minor direct exposure to events in Russia, but the precise form of Russia's actions

caused significant losses to Western banks. An investment fund called High Risk

Opportunities failed, and (quite unfounded) rumors began to circulate that Lehman

Brothers, an established investment bank, was also about to do so. Suddenly, market unease

turned into self‐feeding fear. A 'flight to quality' took place, as a host of institutions sought

to liquidate investments that were seen as difficult to sell, and potentially higher risk,

replacing them with lower risk, more liquid alternatives. Because LTCM's 'convergence

arbitrage' generally involved holding the former, and short selling the latter, the result was a

substantial market movement against the fund.

2. Another, perhaps anecdotal, factor was the simple fact that it took place in August, when

many European and US traders, and managers, were on holiday and markets tended to be

thinner and less liquid than usual.

3. LTCM was by no means the only market participant involved in convergence arbitrage: many

of the world's leading banks, notably Wall Street investment banks who were also LTCM

investors, had broadly similar large positions.

4. The majority of these banks employed value‐at‐risk models not just as LTCM did (to gauge

the overall risks faced by the fund), but also as a management tool. By allocating value‐atrisk

limits to individual traders and trading desks, big institutions prevent the accumulation

of over‐risky positions while giving traders flexibility within those limits. However, if adverse

market movements take positions up to or beyond the limits, the traders involved have no

alternative but to try to cut their losses and sell, even if it is an extremely disadvantageous

time to do so. In August 1998, widespread efforts to liquidate broadly similar positions in

roughly the same set of markets seem to have intensified the adverse movements that were

the initial problem. Crucially, they also led to greatly enhanced correlations between what

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historically had been only loosely related markets, across which risk had seemed to be

reduced by diversification.

5. LTCM’s position, however, was constructed so robustly that, though they caused major

losses, these problems were not fatal. In September 1998, though, a social process of a

different kind got underway ‐ in effect a run on a bank. LTCM's difficulties became public. On

2 September Meriwether sent a private fax to the company's investors, describing its

financial situation and seeking to raise further capital to exploit what he described (quite

reasonably) as attractive arbitrage opportunities. The fax was posted almost immediately on

the Internet and was read as evidence of desperation. The nervousness of the markets

crystallized as fear of LTCM's failure. Almost no one could be persuaded to buy, at any

reasonable price, an asset that LTCM was known or believed to hold, because of the concern

that the markets were about to be saturated by a fire sale of the fund's positions. In its

attempt to raise additional capital, LTCM had shown its positions to outsiders, which may

have caused leaks on what was held. In addition, LTCM's counterparties ‐ the banks and

other institutions that had taken the other side of its trades ‐ tried to protect themselves as

much as possible against LTCM's failure by a mechanism that seems to have sealed the

fund's fate. As good business practice, LTCM had constructed its trades so that solid

collateral,

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