Story of LTCM: The Nobel Prize-Winning “Geniuses” Who Lost $4 Billion and Almost Caused a Global Financial Meltdown

Sun, Jan 31, 2021 7:05 AM on Stock Market, Exclusive, Recommended,

- Ishan Pandey

At the start of 1998, Long Term Capital Management (LTCM) was the largest hedge fund in the world. Its assets were worth over 125 billion dollars and the notional value of its derivatives stood at over a trillion dollars.

Their team had people like two Nobel prize-winning economists, a few Harvard professors, and a former Vice Chairman of the Federal Reserve. They successfully combined the knowledge of Academicians with the experience of traders, eradicating virtually every risk from the market.

Or at least that's what everyone thought.

Everyone wanted a piece of the pie. Banks would lend them at ridiculously low-interest rates and brokers would offer them very low trading fees. However, just a few months later the fund lost almost 40% and was on the verge of bankruptcy. On September 23rd, 1998, the Federal Reserve had to step in and broker a deal to rescue it. This is the story of LTCM and why academic models can fail in our world of randomness.

The Story of LTCM

LTCM was established by John Meriwether in February 1994. He was a bond trader at Solomon Brothers. His team had earned a reputation for being extremely profitable but he had to resign due to some controversies. Thanks to this reputation, he started the fund and attracted very high profile individuals. He secured almost 1.3 billion dollars in initial funding. His trading strategy is popularly known as convergence trading.

The idea was to exploit historically correlated assets that were similar but trading at different prices. For example, 30 years US treasury bond issued a few months ago and the same bond issued today is virtually the same asset, right? However, the older bond was yielding 7.3% while the same new bond was yielding 7.2%. LTCM would buy the old bonds and short the new ones. If you're unfamiliar with shorting, when you short an asset, you make money if its price goes down and lose money if its price goes up. These two were virtually the same asset and LTCM models determined that eventually, the new bond would come down in prices while the old bond would go up making LTCM a tiny 0.1% return.

This strategy was theoretically risk-free but there was a problem. The returns from these trades were extremely low as seen above. So to amplify these returns, LTCM started using a lot of leverage. We are talking about 20: 1 or 30: 1 leverage. At its peak, this number was as high as 250: 1. LTCM posted great returns for the first 4 years. The initial 1.3 billion dollars had turned into 5 billion at the end of 1997.

How Things Got Messy and Out of Hand For LTCM

LTCM's models included an assumption called "The Efficient Market Hypothesis". It's a theory that says the stock market is rational and investors invest based on facts rather than emotions. In the long run, this idea holds significant merit and some studies have proven it right. In the short run, however, this is mostly not true. A lot of emotion is ruling the market and if some extreme events happen, the market can remain irrational for very long.

One such extreme event happened in 1997. On June 2nd, 1997, Thailand de-pegged its currency to the US dollar due to low reserves. This started a chain of events that led to the Asian Crisis of 1997. Out of nowhere, these booming economies started going down. Investors started dumping assets in these countries and started buying safer assets like the US Government Bonds. LTCM’s models had determined that these emerging bonds were extremely cheap and the US bonds were expensive. So, they started aggressively buying emerging market bonds and shorting the US Government bonds. LTCM was confident that this was a temporary market overreaction and the market would converge back to normal after some time making them huge returns.

Since LTCM was using so much leverage, a tiny drop in its portfolio (3-4%) could wipe out its capital. LTCM's models predicted that a drop this big was virtually impossible. However, on August 17th, 1998, something impossible happened. Russia defaulted on its loan and devalued its currency. This sent massive shockwaves throughout the financial world. As if this wasn’t bad enough, no one came to its rescue (Not even the IMF).

Investors started panic selling everything except the highest quality assets. Remember all those emerging market bonds LTCM bought? Their prices started going further down since investors didn’t consider them the highest quality assets. The US Government Bond was considered the highest quality asset and everyone started buying it causing a massive price rise. So LTCM was losing a lot of money on both their emerging bonds and the US bonds. Banks started seeing these losses and wanted to raise interest rates on LTCM. However, since LTCM was using so much debt, it simply could not afford a higher interest rate.

To give you an idea, despite getting such low-interest rates, LTCM was paying as much as 200 million dollars every month in interest. It had assets totaling 125 billion dollars out of which only 4 billion dollars were of its investors. So even at this rate, they would run out of money in just one and a half years. Investors started seeing this and didn't want to invest further and banks did not want to lend more. By September 1998, LTCM had lost almost 40% of its value and was on the brink of bankruptcy. LTCM was so intertwined with all the big banks that if it went bankrupt, many big banks would go with it and others would have to write off huge losses causing their lending to slow in the coming years, starting a recession.

Too Big To Fail (TBTF); or are they?

Seeing this, Alan Greenspan, the then Chairman of the Federal Reserve, brokered a deal with 14 US banks to bail LTCM out for 3.5 billion dollars.

Many experts see this event as the starting point of the Fed's morally hazardous decisions to bail big institutions out with taxpayers' money. This creates a situation where big institutions become too greedy and take huge risks to make money. They know they are “Too Big To Fail (TBTF)” and the Fed will come to their rescue if anything goes wrong. This was evident during the 2008 Financial crisis where big banks issued reckless loans and the Fed had to bail them out with around 500 billion dollars of taxpayers' money. This is also evident in the 2020 Covid-19 pandemic where the Fed has promised to buy distressed bonds of private companies as long as necessary.

Be an intelligent investor; Learn from this story

So what are the takeaways from this story? The first one would be “The market can remain irrational longer than you can remain solvent”. This quote from John M Keynes explains everything that was wrong with LTCM. Were the strategies bad? No. If LTCM could just afford interest payment for a few more years, the markets would have most probably converged and made them a lot of money. But the banks and their investors weren’t sure about it and LTCM eventually ran out of money before the market converged. Thus, in the stock market, being right early and being wrong can mean the same thing.

Another takeaway would be that Academic models do not work all the time. Models are only as good as the assumptions they are based on and in this case, the Efficient Market assumption didn't hold true causing the entire model to fail. Models are based on averages and the probability of those averages happening. However, extremes are rarely considered and our world is filled with so much randomness that extreme events happen all the time. Just a few months before losing 40%, LTCM's models had predicted that the probability of losing 20% in a single year was 1 in a septillion (1/10^24).

Another would be about the dangers of leveraging. Leveraging doesn’t only amplify gains, it amplifies losses too. If you use 10:1 leverage, you will make a 100% return when your assets increase by just 10%. However, this also means you will lose all your money if your assets drop by only 10%.

Article by Ishan Pandey

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