LTCM and the 1998 Crisis

Why this matters

Long-Term Capital Management was a hedge fund led by a team of market experts including two Nobel laureates, well known for using sophisticated mathematical models to make impressive profits.¹ In September 1998 it was weeks from collapse, and the Federal Reserve judged that its failure could disrupt markets well beyond the fund itself. It's a case study in how leverage turns a reasonable strategy into a dangerous one, and in what happens when many investors try to sell the same things at once.

The fund and its strategy

LTCM was founded in February 1994 by John Meriwether, a former vice chairman of Salomon Brothers. It looked for temporary price differences between similar securities, buying the cheaper one and selling the dearer one, and profiting as the gap closed. It returned 20% in 1994, 43% in 1995, 41% in 1996, and 17% in 1997.¹

By the nature of the strategy, each dollar invested earned a low return, so the fund borrowed heavily to make its returns worthwhile.¹ At the end of 1997 it returned about $2.7 billion to its investors, cutting its capital by about 36% to $4.8 billion.² It didn't cut its positions, so its leverage went up.¹ By August 31, 1998, its balance sheet held over $125 billion in assets, more than 25 times its capital at the start of the year and nearly four times the assets of the next largest hedge fund. The notional amount of its over-the-counter derivatives was $1.3 trillion at the end of 1997.²

	Gap narrows 0.2 point	Gap widens 1 point	Gap widens 4 points
Gain or loss on $25 billion of paired positions	+$50 million	−$250 million	−$1 billion
Return on $1 billion of capital	+5%	−25%	−100%

A fund with $1 billion of its own money and leverage of 25 to 1 buys a slightly cheaper bond and sells short a nearly identical one, betting the price gap between them will narrow. A tiny move in its favor earns a solid return on capital. A modest move against it wipes out a quarter of the fund, and lenders start asking for more collateral just when the fund has least to give.

The shock

The financial crisis that began in Southeast Asia in 1997 intensified in 1998.¹ On August 17, Russia devalued the ruble and declared a moratorium on its debt payments. That sparked a "flight to quality," in which investors avoided risk and sought out liquidity.² LTCM had largely bet that the gaps in its portfolio would narrow. In almost every case, they widened.¹

Daily data.³⁴ Investors bid up the safest bonds and demanded more to hold riskier ones, the opposite of the convergence LTCM had bet on.

In August alone the fund lost $1.8 billion, taking its losses for the year past 50% and its capital down to $2.3 billion. It told investors it was seeking new capital.² It suffered further losses and found it hard to reduce its positions because they were so large.² The models behind it had been built on calmer times. Losses in individual markets greatly exceeded what conventional risk models suggested were probable, and shocks hitting many markets at once showed that global portfolios like LTCM's were less diversified than assumed.²

The rest of this lesson is for members

Still to come in this lesson: The rescue, What it showed, the key takeaways, and 2 quiz questions with explanations.

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