Long-Term Capital Management refers to an enormous hedge fund that had been created and led by several famed Wall Street investor traders and economists who were Nobel Prize winners. Because of its huge size and connectedness to many other systemically important financial institutions and markets, its demise nearly brought down the worldwide financial system back in 1998. It was the firm’s risky arbitrage-styled trading strategies that broke the company and endangered the U.S. financial system. Legendary Salomon Brothers John Meriwether the bond trader founded the company in 1993.
What made Long-Term Capital Management such a systemic risk was that the fund boasted $126 billion worth of assets. Because it traded with significantly leveraged positions, it actually controlled a substantially greater number of positions than the massive $126 billion in assets it held. The near collapse of this hedge fund giant back in the end of 1998 almost started a financial crisis and did cause financial panic throughout the globe.
The success of Long-Term Capital Management lay in its incomparable and unsullied reputations of the founders and owners. Principal stakeholders in the fund included the Nobel Prize winners for Economics— Robert Merton and Myron Scholes. These three individuals (with John Meriwether) who really were the heart and soul of LTCM all proved to be legendary experts in derivatives investing. They knew how to deploy these highly risky assets in order to beat the market and earn significantly higher than average annual returns.
Admission to this speculative fund cost investors a flat $10 million investment. They had to commit the money for a full three years and not inquire about what kinds of investments the Long-Term Capital Management invested in and traded. These were steep and unheard of restrictions and limitations for a hedge fund at the time, yet investors begged to be let in the fund. Their enthusiasm seemed warranted, as in its first two years, LTCM did provide fantastic returns of 42.8 percent for 1995 and 40.8 percent for 1996. These stellar returns were even after the management received a steep 27 percent cut in fees. These were the golden age years of the fund.
Even in 1997, the Long-Term Capital Management firm managed to successfully hedge the majority of the Asian currency crisis risk to return a still impressive 17.1 percent that year. Yet returns were fast declining from their peak, and the writing was already on the wall. By September of the following year in 1998, the LTCM firm’s highly risky trades began to catch up with it. The firm neared bankruptcy. The regulators quickly ascertained that it was simply too big too fail thanks to its enormous size and importance. Because of this realization, the Federal Reserve stepped in to bail out the massive hedge fund.
What led to the downfall of Long-Term Capital Management lay in its core strategies. As with many hedge funds, these relied upon making hedges for a number of volatile events (which were supposed to be predictable) in both bonds and foreign currencies markets. This went awry for the fund giant in 1998 when Russia decided to devalue its currency and to default on the Russian government sovereign bonds.
This catastrophic economic event proved to be outside of the typical range of volatility for which the LTCM had prepared and hedged. European stock markets plunged 35 percent in response. The American stock exchanges declined 20 percent in sympathy. Investors then fled to their usual safe haven suspects, the U.S. Treasury bonds. This enormous increase in buy side volume pushed up the prices which inversely pushed down the longer term interest rates by over a full percentage point.
It all combined to cause the extremely leveraged investment positions of LTCM to begin to crack and fail. By the conclusion of August in 1998, the capital investments of Long-Term Capital Management had drastically declined by fully 50 percent of their original value. Numerous pension funds and banks had invested heavily in the fund. The collapse in their investments also threatened to force many of them to almost bankruptcy condition.
It was bond trading giant Bear Stearns that finished off LTCM. As manager of their derivatives and bond settlements, Stearns demanded a $500 million payment all at once. LTCM had been outside of its agreements with the investment bank for three months at this point, and they could not meet the margin cash call.
The banking system now stood on the verge of collapse in the U.S. This is when the FRBNY (Federal Reserve Bank of New York) President William McDonough leaned on 15 banks to jointly bail out the fund with a $3.5 billion investment that gave them 90 percent ownership of LTCM. The Fed also aggressively began cutting their benchmark Fed funds interest rate. They pledged to U.S. investors that they would take any action necessary to support the markets and economy.