What Was Long-Term Capital Management (LTCM) and What Happened?

What Was Long-Term Capital Management (LTCM)?

Long-Term Capital Management (LTCM) was a large hedge fund, led by Nobel Prize-winning economists and renowned Wall Street traders, that blew up in 1998, forcing the U.S. government to intervene to prevent financial markets from collapsing.

Understanding Long-Term Capital Management (LTCM)

From its start in 1994, LTCM was wildly successful, attracting about $3.5 billion of investor capital by the spring of 1998, 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.

However, LTCM's highly leveraged trading strategies failed to pan out and it suffered monumental losses. The reverberations were felt across the financial landscape and nearly collapsed the global financial system in 1998. Ultimately, the U.S. government had to step in and arrange a bailout of LTCM by a consortium of Wall Street banks in order to prevent systemic contagion.

LTCM's Business Model

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 opportunities between securities. To be successful, these securities must be incorrectly priced, relative to one another, at the time of the trade.

An example of an arbitrage trade would be a change in interest rates not yet adequately reflected in securities prices. This could open opportunities to trade such securities at values different from what they will soon become—once the new rates have been priced in.

LTCM also dealt in interest rate swaps, which involve the exchange of one series of future interest payments for another, based on a specified principal among two counterparties. Often interest rate swaps consist of changing a fixed rate for a floating rate or vice versa, in order to minimize exposure to general interest rate fluctuations.

Due to the small spread in arbitrage opportunities, LTCM had to leverage itself highly to make money. At the fund’s height in 1998, LTCM had approximately $5 billion in assets, controlled over $100 billion, and had derivative positions whose total worth was over $1 trillion. At the time, LTCM also had borrowed more than $155 billion in assets.

Long-Term Capital Management (LTCM) Demise

When Russia defaulted on its debt in August 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.

LTCM's highly leveraged nature, coupled with a financial crisis in Russia, led the hedge fund to sustain massive losses and be in danger of defaulting on its own loans. This made it difficult for LTCM to cut its losses in its positions. LTCM held huge positions, totaling roughly 5% of the total global fixed-income market, and had borrowed massive amounts of money to finance these leveraged trades.

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 $3.625-billion loan fund was created, which enabled LTCM to survive the market volatility and liquidate in an orderly manner in early 2000.