Long-Term Captial Management (LTCM) - Swaps, VIX, emerging markets

The ironically-named Long Term Capital Management (LTCM) was started in 1994 by Salomon Brothers bond trader John Meriwether in concert with academians Myron Scholes and Robert C. Merton. It in fact lasted four years. Scholes and Merton had developed quantitative hedging models for fixed income arbitrage, and the trio sought to implement them proftably as a hedge fund. This all worked beautifully, producing returns of about 40% per year, until late 1998. At this point, amidst the Asian Financial Crisis, Russia defaulted on its sovereign debt, and a cascade of events was set off that destroyed the fund. LTCM was vulnerable because, to profit based on its arbitrage strategy, extremely high leverage needed to be employed (100:1 or more). The fund had a equity of about $4.72 billion at peak, and positions in excess of $1.25 trillion. Thus a small mistake leading to a few percentage drop in the net position's worth could completely wipe out the capital base. This is indeed what happened, and we defer to Wikipedia for the details of the downfall as well as the subsequent bank/Fed bailout:

The company, which was providing annual returns of almost 40% up to this point, experienced a Flight-to-Liquidity. In the first 3 weeks of September LTCM's equity tumbled from $2.3 billion to $600 million without shrinking the portfolio, leading to a significant elevation of the already high leverage. Goldman Sachs, AIG and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $4 billion and to operate LTCM within Goldman Sachs's own trading. The offer was rejected and the same day the Federal Reserve Bank of New York organized a bail-out of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. The contributions from the various institutions were as follows:

• $300 million: Bankers Trust, Barclays, Chase, Deutsche Bank, UBS, Salomon Brothers, Smith Barney, J.P.Morgan, Goldman Sachs, Merrill Lynch, Credit Suisse First Boston, Morgan Stanley
• $125 million: Societe Generale
• $100 million: Credit Agricole, Paribas
• Lehman Brothers and Bear Stearns declined to participate.

In return the participating banks got a 90% share in the fund and a promise that a supervisory board would be established.

The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices which would force other companies to liquidate their own debt creating a vicious cycle.

The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):

• $1.6 bn in swaps
• $1.3 bn in equity volatility
• $430 mn in Russian and other emerging markets
• $371 mn in directional trades in developed countries
• $215 mn in yield curve arbitrage
• $203 mn in S&P 500 stocks
• $100 mn in junk bond arbitrage
• no substantial losses in merger arbitrage

Over the years we have observed many rumors (and some open discussion) regarding a gold connection at LTCM. The fund allegedly had about 400 tonnes of gold held on a lease from the Fed or some other major bank, worth about $4 billion at the time. Apparently a payment of approximately this amount was made to the Fed by the LTCM bailout consortium: was this cash in lieu of LTCM's gold loss? Or was the gold supplied from somewhere else, e.g., the Bank of Italy? If so, the bailout cannot be categorized as "free of public funding", as the public (some public) would still be out the corresponding amount of gold. This article has another interesting observation regarding LTCM and gold:

There is no mention of gold in any form in this book. In response to repeated assertions by Bill Murphy on Le Métropole Café, LTCM's counsel took the extraordinary step in June 1999 of sending an affidavit from LTCM partner Eric Rosenfeld (who seems to have been charged with being fund spokesman - he also answered written questions for Lowenstein) asserting LTCM had never had any dealings in gold "in any ... form whatsoever." Why it was necessary to respond in such a way to a obscure dissident website then only 9 months old, when no litigation was in process, is an interesting question.

Since those early days, Le Métropole Café has greatly extended its network of "Deep Throats" supplying information from all over the world. One of these has reported a conversation between Myron Scholes and a boyhood friend in Hamilton, Ontario to the effect that LTCM was indeed massively short gold, that the position was relieved by the authorities who swore the partners to secrecy for which they were indemnified.

We would love to hear more details if anyone knows anything.

We also note with much dismay that Meriwether was awarded a Lifetime Achievement Award in 2006 by Alternative Investment News. We do agree, however, that producing a total collapse in value, engendering a bailout, and nearly precipitating a broader collapse in global financial markets is an "alternative" outcome.

For further information on LTCM's collapse, see the following:

• Wikipedia: When Genius Failed: The Rise and Fall of Long-Term Capital Management (Book)
• Thayer Watkins case study on LTCM
• Kevin Dowd (CATO): Too Big to Fail?: Long-Term Capital Management and the Federal Reserve
• Ibrahim Warde: LTCM, a hedge fund above suspicion
• Please send in any other great articles on the LTCM implosion!