Hedge Funds – The Story of Long Term Capital Management
October 26, 2012 10:15 am in Hedging and Hedge Funds
This chapter is all about how a seemingly ‘can’t-do-wrong’ hedge fund went bust, and whose sheer size sent tremors down Wall Street and the financial markets, so much so that the government had to step in and take matters in hand to avoid a financial meltdown.
Long Term Capital Management, a hedge fund manager, was started in 1994 by John W Meriwether, who was at one time the head of bond trading at Salomon Brothers.
Meriwether included top bond traders from Salomon Brothers in the management of LTCM as well as cutting edge economists such as Myron S Scholes and Robert C Merton, who later went on to win the Nobel Prize. The investable funds were held in a Cayman Island registered partnership called Long-Term Capital Portfolio LP. With the help of Merrill Lynch the firm was able to raise capital of about $1 billion by February 1994.
Starting out with fixed income arbitration deals, LTCM gradually branched out to other trades such as merger arbitrage, interest rate swaps and options, because the firm soon exhausted available opportunities in fixed income. Meanwhile funds continued to pour in and the pressure to turn out market beating profits grew. Ultimately the firm had to take recourse to deals in which the spread was small but which required substantial funds for implementation. LTCM soon had a huge amount of debt on its books and by 1998 this figure had grown to $124.5 billion. Apart from this, LTCM also had over $1 trillion worth of open positions in interest rate derivatives and swaps. But so far, the fund had managed to keep a good record with investors getting returns of about 40% per annum.
In September 1998, the Russian government defaulted on their bonds causing international turmoil in the bond markets. Investors bailed out of bonds such as those issued by Japan and Europe, and piled into safe haven bonds issued by the United States. This turmoil caused huge variances in the prices of bonds and inflicted massive losses on LTCM – which lost about $1.85 billion of its capital.
In a domino effect, the fund had to bail out of other positions, many at a substantial loss because it was no longer possible to hold those trades for the time required to make a profit. Panicked investors headed for the exits, and this resulted in LTCM’s equity crashing from $2.3 billion to about $400 million in that same month.
It was a sobering example of how market realities could crush number-crunching and “just-can’t-fail” trades supported by the best financial brains and executed by star traders.
Unfortunately, the ramifications of the LTCM debacle stretched far beyond the firm itself and its investors. The huge debts, as well as the portfolio losses, could now unhinge Wall Street itself because of their sheer size and the chain reaction that could be set up in the form of end to end defaults.
After a rescue attempt organized by Goldman Sachs, Warren Buffett and AIG fizzled out, the Federal Reserve Bank of New York had to step in and organize a bailout of LTCM through various banks. Sounds familiar?
The bailout enabled the fund to continue its operations until 2000 by which time the money invested by the rescuers was repaid and the fund liquidated.
Why did we tell you this story? It’s because we want to tell it as it really is – in the financial markets, as also hedge funds, risk lurks around the corner, and you should be well aware of it.
We will continue with the good, bad and ugly of the hedge fund industry. Coming up next is the story of Bridgewater Associates, one of the most successful hedge funds in history.
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