Understanding LTCM's collapse

Discussion in 'Wall St. News' started by Mosholu, Oct 9, 2007.

  1. Mosholu


    Can someone explain me in plain English LTCM's trading methodology and the reasons that collapse to its collapse?

  2. Simply put: huge leverage, massive investments in illiquid bonds, and investing in unstable countries (Russia), promoted the decline.

    Not being humble enough to take moderate losses early, caused the cathastrophe.

    Long-Term Capital Management
    The most famous hedge fund collapse involved Long-Term Capital Management (LTCM). The fund was founded in 1994 by John Meriwether (of Salomon Brothers fame) and its principal players included two Nobel Prize-winning economists and a bevy of renowned financial services wizards. LTCM began trading with over $1 billion of investor capital, attracting investors with the promise of an arbitrage strategy that could take advantage of temporary changes in market behavior and, theoretically, reduce the risk level to zero.

    The strategy was quite successful from 1994 to 1998, but when the Russian financial markets entered a period of turmoil, LTCM made a big bet that the situation would quickly revert back to normal. LTCM was so sure this would happen that it used derivatives to take large, unhedged positions in the market, betting with money that it didn't actually have available if the markets moved against it.

    When Russia defaulted on its debt in Aug 1998, LTCM was holding a significant position in Russian government bonds (known by the acronym GKO). Despite the loss of hundreds of millions of dollars per day, LTCM's computer models recommended that it hold its positions. When the losses approached $4 billion, the federal government of the United States feared that the imminent collapse of LTCM would precipitate a larger financial crisis and orchestrated a bailout to calm the markets. A $3.65-billion loan fund was created, which enabled LTCM to survive the market volatility and liquidate in an orderly manner in early 2000.

    LTCM started with just over $1 billion in initial assets and focused on bond trading. The trading strategy of the fund was to make convergence trades, which involve taking advantage of arbitrage between securities that are incorrectly priced relative to each other. Due to the small spread in arbitrage opportunities, the fund had to leverage itself highly to make money. At its height in 1998, the fund had $5 billion in assets, controlled over $100 billion and had positions whose total worth was over a $1 trillion.

    Due to its highly leveraged nature and a financial crisis in Russia (i.e. the default of government bonds) which led to a flight to quality, the fund sustained massive losses and was in danger of defaulting on its loans. This made it difficult for the fund to cut its losses in its positions. The fund held huge positions in the market, totaling roughly 5% of the total global fixed-income market. LTCM had borrowed massive amounts of money to finance its leveraged trades. Had LTCM gone into default, it would have triggered a global financial crisis, caused by the massive write-offs its creditors would have had to make. In September 1998, the fund, which continued to sustain losses, was bailed out with the help of the Federal Reserve and its creditors and taken over. A systematic meltdown of the market was thus prevented.