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Long-Term Capital Management

 

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Long-Term Capital Management was a hedge fund company founded by John Meriwether (a former bond trader at Salomon Brothers bank) in 1994 and with Nobel Prize winners Myron Scholes and Robert Merton on the board.

The company had developed complex mathematical models to take advantage of arbitrage deals (termed convergence trades) usually with U.S., Japanese, and European sovereign bonds. The basic idea was that over time the value of long-dated bonds issued a short time apart would tend to become identical, and by a series of financial transactions (essentially amounting to buying the cheaper 'off-the-run' bond and short-selling the more expensive, but more liquid, 'on-the-run' bond) it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond came on the run.

Because these differences in value were minute, the fund needed to take highly-leveraged positions in order to make a significant profit. At the beginning of 1998, the firm had equity of $5 billion and had borrowed over $125 billion.

The fund also invested in other derivative security products such as equity options and mortgage securitisations.

The scheme unraveled in August and September 1998 when the Russians defaulted on their sovereign debt (GKOs). Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged.

The company was providing returns of almost 40% up to this point, and a "flight to liquidity" the company lost a possible $100 bn and needed an Federal Reserve Bank of New York organised bail-out of $3.5bn, apparently in order to avoid a wider collapse in the financial markets. The fear was that there would be a chain reaction, as one company liquidiated its securities to over its debt leading to a drop in prices which would force other companies to liquidate its debt creating a vicious cycle.

Ironically, in the end the basic idea of LTCM was correct, and the values of sovereign bonds did eventually converge after the company was wiped out.

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