8

Long-Term G 111
Mismanaged! T;;y
"JM and the Arb Boys"

introduction
Long-Term Capital Management (LTCM) began operations
in 1994 with more than $1 billion in capital and what
looked like an unbridled potential to succeed. Among its
principals was a virtual who's who of world-class academics
and seasoned Wail Street practitioners. A string of k
outstanding successes1 built LTCM's equity position in three
short years to $7.1 billion. In 1996 alone, the company-
cleared more than $2 billion. LTCM's principals, who had
invested $146 million in 1994, watched as their share of the
pie grew to $1.9 billion. They were all multimillionaires, and
so was everyone lucky enough to have a piece of the action.
In fact, one LTCM principal was already half way to
becoming a billionaire.
Who would have guessed that, by 1998, LTCM would be
bankrupt, its principals heavily in debt, and the world's
financial system would have barely escaped a financial
meltdown? The story of LTCM's precipitous decline is told
with a smile, a tear, and a smirk. After all, it's not every day

1 Profits for the firs! iO months of operation in !994 were 20%, and for the three years ihereafter,
they were 43%, 41 %. and 17%.
232 CHAPTER 8: Long-Term Capital M/smanagement: "JM, and the Arb Boys"

that the best, the brightest, and the most arrogant fail so
and institutional investors), who do not
astoundingly and so visibly. the regulatory protections from risk-tal
many of us find helpful. Hedge fum
This chapter is divided into seven major parts. It begins by
employ aggressive, short-term tradira
describing LTCM—the company, its business, and who ran it. gies and have high leverage ratios corr
The second part of the chapter explains LTCM's investment other financial intermediaries. They e
strategy. It clarifies how a hedge fund, 2 like LTCM, can enues from fees that are based part!
amount of assets under managem
structure an investment portfolio that earns profits regardless
partly on performance. To remain uni
of whether the market moves up or down (i.e., a market- in the United States, they limit the n
neutral portfolio). Spreads, convergence and relative value beneficial owners, abstain from raisi
via public offerings, and refrain from a<
trades, volatility plays, and leverage enter heavily into this
or soliciting widely, Hedge funds
explanation. The discussion then turns to LTCM's rise to directly with the trading desks of bar
stardom from 1994 to 1997, followed by an explanation of the rity firms, insurance companies, muti
considerable value this company added, for three years, to the and other managed funds.
When LTCM failed in 1998, th
global financial markets. The next part focuses on why LTCM between 2,500 and 3,500 hedge fui
failed and how it managed to lose $4.5 billion in less than United States combined with capital
two months without the complicity of rogue traders, $20O billion and $350 billion and as
ing from $800 biiiion to $1 trillion. Co
deception, or market manipulation. Part six describes how
other broad types of financial inter
LTCM was rescued, and the final section suggests some hedge funds were relatively small, rar
conclusions and lessons to be learned from this very 20% to 4O% the size of mutual func
unfortunate financial debacle. funds, commercial banks, insurance c
and retirement funds, 4
There is no "typical" hedge fund,
enormously and take a variety of
ranging from outright purchases an
assets to arbitrage transactions, spn
Risk Notepad 8.1 . and derivative positions (e.g., optioi
forwards, and swaps). In short, th-
What Is a Hedge Fund? ai most anything their investors, credi
terparties, and management allow t
The term hedge fund is an oxymoron because of assets that may or may not |
To the typical investor, these funds \e
these funds often take positions—large posi- opportunities associated with specifte
tions—that are anything but hedged, in fact, the They are usually privately organs:
economies of scale in purchasing, <
name has littie or nothing to do with the func- partnerships or limited liability compa?
sionai investment expertise.
tions these funds perform. Hedge funds are professionally manage investment funds
St is a misconception to think ths
mostly unregulated, 3 highly diversified portfolios qualified purchasers (e.g., wealthy individ
funds are highly volatile, specuiath

2See Risk Noiepad S.I: What Is a Hedge Fund?

3 Inthe United States, hedge funds are not regulated by ihe Securities and Exchange Commission, but ''President's Working Group
they do come under the supervisory powers of the Commodity Futures Trading Commission and Capita! Management: Report c
Department ol Treasury, 28 i
National Futures Association.
 Introduction 233

and institutional investors), who do not need ail but it is equally misguided to think that they are
the regulatory protections from risk-taking that safe, just because the word "hedge" is in the
many of us find helpful. Hedge funds often name. The rule of thumb is buyer beware;
employ aggressive, short-term trading strate- remember that you must not underestimate the
gies and have high leverage ratios compared to danger of a rattlesnake just because the word
other financial intermediaries. They earn rev- "rattle" is in its name. Investments in hedge
enues from fees that are based partly on the funds may or may not be hedged. Hedge funds
amount of assets under management and can pursue a wide range of investment strate-
partly on performance. To remain unregulated gies, including highly leveraged speculative
in the United States, they limit the number of positions. Depending on your age, as wei! as
beneficial owners, abstain from raising funds family and financial status, you can choose
via public offerings, and refrain from advertising among hedge funds with larger or smaller risks.
or soliciting widely. Hedge funds compete Normally, hedge fund portfolios are revalued
directly with the trading desks of banks, secu- (i.e., rnarked-to-market) daily. They differentiate
rity firms, insurance companies, mutual funds, themselves by the strategies they use to select
and other managed funds. investments and by how much risk they take
When LTCM failed in 1998, there were with clients' funds. Many use proprietary strate-
between 2,500 and 3,500 hedge funds in the gies, analytical methods, and trading models.
United States combined with capital between They achieve economies of scale by making
$200 billion and $350 billion and assets rang- large transactions, and then distribute the bene-
ing from $800 billion to $1 trillion. Compared to fits to their clients.
other broad types of financial intermediaries, Just as animals can be classified into major
hedge funds were relatively small, ranging from species, hedge funds can also be classified
20% to 4O% the size of mutual funds, pension into a few broad categories. The major cate-
funds, commercial banks, insurance companies, gories of hedge funds are aggressive growth,
and retirement funds.4 convergence, distressed-security, emerging-
There is no "typical" hedge fund. They vary market, equity, income-generating, macro,
enormously and take a variety of positions, market-neutral, pooled, relative-value, and
ranging from outright purchases and sales of risk-management
assets to arbitrage transactions, spread trades, Over the years, some hedge fund managers
and derivative positions (e.g., options, futures, have gained almost celebrity status and theif
forwards, and swaps). In short, they can do generous salaries have made them among the
almost anything their investors, creditors, coun- richest people in the world. People like George
terparties, and management allow them to do. Soros (Soros Fund), Stanley Druckenmiiler
To the typical investor, these funds bring value (Soros Fund), Henry Kravis (Kohiberg Kravis
because they provide wide diversification, Roberts), Thomas Lee (Thomas H. Lee Co.), and
economies of scale in purchasing, and profes- Julian Robertson (Tiger Management) have
sional investment expertise. become familiar names both for their brilliant
It is a misconception to think that ail hedge performance and sometimes self-aggrandizing
funds are highly volatile, speculative ventures, behavior.

''President's Working Group on Financial Markets. Hedge Funds. Leverage, and the Lessons of Long-Term
Capita! Management: Report of the President's Working Group on Financial Markets. Washington, DC:
Depart mem of Treasury, 28 April 1999.
234 CHAPTER 8: Long-Term Capisai Mismanagement: "JM and the Arb Boys"

LTCM: The Company on Wall Street (know

but four of them des*
LTCM opened its doors for business at the end of February 1994. Its John Merh
capita! was about h a l f the $2,5 b i l l i o n thai John Meriwether, its founder, was clearly th
had set as a goal for beginning equity when he left Salomon Brothers, but nice guy, who
then, not many hedge f u n d s start operations so well endowed. Long- Brothers. In 1
Term Capital Portfolio L.P. (LTCP) was the actual "Fund," and t h i s profitable bon
Cayman Islands l i m i t e d p a r t n e r s h i p was managed by Long-Term Capital become vice
Management L.P., which was a Delaware-chartered limited partnership trading, arbit
that was operated from Greenwich, Connecticut and owned by John His trading opera
Meriwether and the 11 other principals. s 1986, the company
Investors did not invest directly in LTCP. Rather, the Fund had a hub- 1991, one of his tra
and-spoke-type structure, with a network of global conduits collecting funds government securit
and investing in LTCP. Each conduit tailored its investment terms to the reg- leant and reported
ulatory, tax, and accounting idiosyncrasies of a particular nation or region. John Gutfreund. Al
By 1997, all of LTCM's investors were multimillionaires, but that was not a should have been
high hurdle to clear because they were all millionaires in 1994, when LTCM Treasury; Mozer sr
began. The m i n i m u m investment needed to claim a piecv of LTCM's action Astonishingly, V
was $10 million; so, it was an exclusive club, with only the rich and a host of head of Salomon :
domestic and foreign financial intermediaries as members. delayed too long b<
U.S. Treasury. The
THE LTCM BUSINESS of both Gutfreunc
Warren Buffett. a
The company's i n i t i a l trades were primarily arbitraging the global bond
Company, and ma
markets; though, by 1995, it had already diversified its portfolio by entering
porary CEO, savin
into domestic and foreign equity arbitrage trades. And why not? LTCM's
Meriwether's re
strategy, after all, did not require an in-depth knowledge of any particular
at Salomon Brott
underlier (e.g., Microsoft stock), b u t rather it required a keen understand-
administrative pr<
ing of the spreads between [he yields or prices ofunderliers—and that was largely
suffered a three
the domain of statistical modeling and security market wisdom that came
founded LTCM in
from years of experience—or at least they thought.
eight members o
Salomon's tradins
THE PRINCIPALS
Robert C. Mes
One of the exceptional features of LTCM was the cast of characters who Scholes for their
founded and ran the company. It was a distinguished and impressive group, ant mathematics
among whom were two Nobel laureates, a vice chairman of the Federal at Columbia Un:
Reserve System, and some of the brightest, most successful bond arbitragers
6 Meriwether neither i
I ''LTCM'.s limited parmers presented themselves as prinapab and noi as partners because they fell H might
; be viewed as deceptive to have titles t h a t implied u n l i m i t e d liability. The LTCM principals also did not 100 hard. In Decembi
| want a hierarchy of corporate lilies: so they chose the t i t l e "principal" for all limited-partner-type Salomon Brothers. N
j people at LTCM. Unless otherwise noted, the management company (LTCM) and Fund (LTCP) are Muehring, "John M<
i treated as one in ihis chapter «md genetically called Long-Tern) Capital Management (LTCM), 68-81.
 LTCM: The Company 235

on Wall Street (known as the "arb boys"). Initially, LTCM had 12 principals,
but four of them deserve special mention.
John Meriwether ("JM," as he was called), the founder of LTCM,
was clearly the company's guiding light. He was a tough, respected,
nice guy, who started LTCM after leaving his former job at Salomon
Brothers. In the late 1970s and 1980s, Meriwether built a highly
profitable bond arbitrage group at Salomon Brothers and went on to
John Men we! her
become vice chairman in charge of Salomon's global fixed-income
trading, arbitrage, and foreign exchange businesses.
His trading operation at Salomon Brothers was so successful that, by
1986, the company was devoting half its equity to JM and his team, but in
1991, one of his traders, Paul Mozer, confessed to making false bids at U.S.
government security auctions. Meriwether knew the violations were signif-
icant and reported them to his bosses, Thomas (Tommy) Strauss and CEO
John Gutfreund. Ail three men understood the infraaions were serious and
should have been reported immediately to the Federal Reserve and U.S.
Treasury; Mozer should have been dealt with deiiberately—perhaps fired.
Astonishingly, Mozer was not reprimanded; in fact, he was kept as the
head of Salomon Brothers' government bond trading desk, and Salomon
delayed too long before disclosing the infractions to the Federal Reserve and
U.S. Treasury. The scandal blossomed and resulted in. the 1991 resignations
of both Gutfreund and Strauss. Leaderless, Salomon Brothers convinced
Warren Buffett. a premier investor, head of Berkshire Hathaway Holding
Company, and major shareholder in Salomon Brothers, to become its tem-
porary CEO, saving Salomon from a potentially worse situation.
Meriwether's resignation came just a few days after Buffett took the helm
at Salomon Brothers. As part of a Securities and Exchange Commission
administrative proceeding, Meriwether agreed to pay a $50,000 fine and
suffered a three-month suspension.6 After a brief hiatus, Meriwether
founded LTCM in 1994, and, by 1995, he plucked from Salomon Brothers
eight members of his old team, who were responsible for almost 90% of
Salomon's trading profits.
Robert C. Merlon shared the 1997 Nobel Prize in Economics with Myron
Scholes for their trailblazing work on option pricing- Merton was a brilli-
ant mathematician, who earned an undergraduate degree in engineering
at Columbia University, a Ph.D. in applied mathematics at the California

i 6 Meriwether n e i t h e r admitted nor denied culpability. As for the fine, ii did not hit his bank account
i too hard. In December 1992, Meriweiher and Thomas Strauss self led a suit for back pay against
! Salomon Brothers. Meriwether's share of the compensation settlement was $18 million. Kevin
I Muehring, "John Meriwerher by the Numbers," Institutional Investor 30 ( 1 1 ) (November 1996),
i 68-81.
236 CHAPTER 8: Long-Term Capital Mwmanagemeni: "JM and the Arb Boys"

Institute of Technology, and a Ph.D. in economics from the Massachusetts IDENTIFYING SMALL M
Institute of Technology (MIT). While teaching at MIT's Sloan School of Man- LTCM earned its profits
agement and later at the Harvard Business School, Merton made significant out of equilibrium (i.e
contributions to finance in the area of option pricing models. His research company was not trying
Linked continuous-time stochastic processes with continuous-decision-making ing to find a haystack
by agents, and this led him into pricing contingent contracts, like options. research time and effo
Myron S. Scholes, a native Canadian, was one of the most creative IBM. Rather, it searche
dreamers in the LTCM group. He graduated from McMaster University in earning relatively mini
Canada with a degree in economics and went on to receive a Ph.D. from the investment funds, LTCi\y
University of Chicago. Afterwards, Scholes taught at prestigious academic
institutions, such as MIT's Sloan School of Management, the University of assets' prices, but rath
Chicago's Graduate School of Business, and Stanford University's Business prices and the spread b
School and Law School. From the start, Scholes was interested in factors neutral portfolio that gc
determining the demand for traded securities and the characteristics thai To execute its stratej
differentiated one security's risk/return profile from another. Schoies met
needed abundant sou:
Robert Merton while they were both teaching at MIT and began collaborat- reverse positions quick
ing on the work that won them the Nobel Prize. Later, they renewed con- credit rating was esser
tact when they were hired by Salomon Brothers as consultants. and trade counterpart!*
David W. Mullins, Jr., became a professor at Harvard University's LTCM used its high-]
Graduate School of Business Administration after completing his under- security markets to si
graduate work at Yale University, receiving his M.S. degree in finance from investment assets, assc
MIT's Sloan School of Management, and earning a Ph.D. in finance and derivative counterpart;
economics at MIT. In March 1989, M u l l i n s was selected by President George two assets' relative vah
H. W. Bush to be Assistant Secretary lor Domestic Finance, and in Decem-
could be given for wh
ber of the same year, he became one of the seven members of the Federal
traders exploited the o
Reserve System's Board of Governors. Highly regarded and well connected, couid muster, purchas
especially in international circles, some thought that M u l l i n s might one day ously selling the relath
replace Alan Greenspan as Chairman of the Federal Reserve.
These four principals joined a h a n d f u l of others from academia and prac-
USING A MINIMUM O!
tice to form LTCM. Together they helped to develop trading strategies,
which they were confident would bring them all unheard-of profits. The second facet of L"
using as little equity <
necessities, like marg
LTCM'S Strategy derivative) positions ai
company also earmarl
The principles guiding LTCM's strategy were focused and clear: identify small caused cash outflows <
imperfections in the market; exploit these imperfections mercilessly, using as
little equity capital as possible by t a k i n g leveraged positions that elevate risks
to relatively high, but controlled, levels; secure long-term f u n d i n g to be able 7 Thisleverage ratio put LTCN
double the ratio of the lop fi
to ride out aberrations in price movements; and charge hefty fees for the
Funds. Leverage, and the U'sson
world-class talent employed to develop and implement trading strategies. an Financial Markets. Washing!
 LTCM'S Strategy 237

IDENTIFYING SMALL MARKET IMPERFECTIONS

LTCM earned its profits during the transition periods when markets were
out of equilibrium (i.e., moving from one equilibrium to another). The
company was not trying to find a needle in the haystack; rather, it was try-
ing to find a haystack of needles. In other words, LTCM did not devote
research time and effort trying to discover rising stars, like Microsoft or
IBM. Rather, it searched for a multitude of low-risk arbitrage deais, each
earning relatively miniscule returns, but, using its billions of dollars of
investment funds, LTCM was able to accumulate substantial earnings. Rela-
tively few of LTCM's trades were outright bets on the direction of individual
assets' prices, but rather they were wagers on the spread between asset
prices and the spread between yields. The goal was to construct a market-
neutral portfolio that gained value in rising and falling markets.
To execute its strategies and attain the desired risk-return goals, LTCM
needed abundant sources of credit and substantial market liquidity to
reverse positions quickly and at firm prices. Therefore, maintaining a high
credit rating was essential because, without it, LTCM's sources of finance
and trade counterparties would surely disappear.
LTCM used its high-powered research team and expert understanding of
security markets to study relationships between the prices of different
investment assets, assorted maturities of the same asset, assets and their
derivative counterparts, as well as various types of derivatives. Whenever
two assets' relative values looked out of whack and a rational explanation
could be given for why they should converge to the historic norm, LTCM
traders exploited the opportunity with as much financial firepower as they
could muster, purchasing the relatively underpriced asset and simultane-
ously selling the relatively overpriced asset.

USING A MINIMUM OF EQUITY CAPITAL

The second facet of LTCM's strategy was to exploit market imperfections,
using as little equity capital as possible. Equity was conserved to pay for
necessities, like margin requirements on LTCM's leveraged (equity and
derivative) positions and haircuts on its reverse repurchase agreements.7 The
company also earmarked risk capital in case unfavorable price movements
caused cash outflows on contracts that were marked to market. Exhibit 8.1

'This leverage ratio pur LTCM nearly on par with the top five investment banks and approximately
double rhe ratio of she top five banks. See President's Working Group on Financial Markets. Hedge
Funds, Leverage, and the Lessons of Lmg-Term Capita! Management: Report of the President's Working Group
on Financial Markets. Washington, DC: Department of Treasury, 28 April 1999, 29.
238 CHAPTER 8: Long-Term Capiial M/.cmanagcmenl: "JM and (he Arb Boys"

An example might he
Exhibit 8. 1 LTCM's Asset-to-Equity Ratio: March 1994 to July 1998 into a total return swaj
mark-to-market provisio
a $100 million notional i
interbank offered rate (
return earned on the S£
equaled 2%, and the S8rl
receive 12% of the noti(
LIBOR were 5%, then LT
$5.5 million) from its svt
if dividends equaled l°/<
then LTCM would pay i
&MK£: Andre F, Perold, "Long-Term Capua! Management, L,P, (A)," Harvard
Business School, Case 9-200-007, 22

The Effects of Levera;

LTCM's leveraged positi
shows LTCM's assel-to-equity ratio from March 1994 to July 1998. At times age created an enormoi
during this period, LTCM's leverage exceeded 30-to-l. assets and its return on
In the absence of equity, LTCM financed most of its security purchases difference, let's round
with reverse repurchase agreements (reverse repos) having six-month to difference leverage has
12-month maturities. 8 Under a reverse repo agreement, LTCM bought a If LTCM started with !
bond, and then used it as collateral for a loan, the proceeds from which it borrowed nothing) in
LTCM used to pay for a new bond. So long as LTCM's interest costs were less $250 million, which w<
than the return on its securities, profits could be earned. 9 (see Exhibit 8.2). By coi
With limited e q u i t y at its disposal, LTCM also leveraged its positions by by borrowing $120 billi
entering into over-the-counter total return swaps. In exchange for paying a year's end, the $5 bitli<
fixed or floating rate of interest, these financial instruments gave LTCM the million (just as before)
financial benefits of owning the underliers (e.g., equity indices, bundles of earned $6 billion. The I
loans, or portfolios of bonds} but at a fraction of the cost in terms of equity + 6 billion]/f$5 billion
expended. For example, with a total return swap on a share index, LTCM be 125% (i.e., [$250 n
could acquire the risk-return profile of a diversified stock portfolio, finance 8.2. In other words, th
it with fixed-rate or floating-rate borrowings, and use a relatively small por- borrowed funds increa
tion of its own capital to meet any collateral requirements and/or mark- For highly leverage
to-market obligations. 1 0 The U.S. margin requirement on stocks is 50%; so, debt-financed assets c
the savings, in terms of capital conservation, can be considerable. same time, losses cou

l! The $100 million principal

s Under a mwx<' repurchase agreeiHiMi. an individual sells securities at a specified price to a securities
of the swap, Neither counte
dealer with n simultaneous commitment to repurchase ihe same or similar seenrilies at a fixed priu-
pal is used only to figure out
on a specific daie in (he f u t u r e . Usually, reverse repos have very short-ierm maturities (e.g.
!2 LTCM would earn 2% in d
overnight), hut term repo.s are also available. The yields on repo loans are among the lowest, because
1.5% (i.e.. 6.5%), which yie
they are colaierali/.ed with securities.
n LTCM would earn 1% in
9I..TCM had about 75 counierpanies for its repurchase and reverse repurchase agreements.
LiBOR plus 1.5% (i.e., 7.5%
t9Coliatcrai requirements are neguiiaied based on a hedge fund's overall level of perceived risk.
 LTCM'S Strategy 239

An example might help to clarify these swaps. Suppose LTCM entered

into a total return swap on the S&P Stock Index with no collateral or
mark-to-market provisions. The swap had a maturity of two years and
a $100 million notional principal. 11 LTCM was required to pay the London
interbank offered rate (LIBOR) plus 1.5%, and LTCM received the total
return earned on the S&P Stock Index. At the end of Year 1, if dividends
equaled 2%, and the S&P Stock Index appreciated by 10%, then LTCM would
receive 12% of the notional principal and have to pay LIBOR plus 1.5%. If
LIBOR were 5%, then LTCM would receive a net payment equal to 5,5% (i.e.,
$5.5 miiiion) from its swap counterparty. 12 By contrast at the end of Year 2,
if dividends equaled 1%. the S&P Index fell by 8%, and LIBOR were 6%,
then LTCM would pay its swap counterparty 14.5% (i.e., $14.5 million). 1 3

The Effects of Leverage on Risk and Return

LTCM's leveraged positions elevated both risk and potential return. Lever-
age created an enormous difference between the company's return on total
assets and its return on equity. To understand why there was such a large
difference, let's round off LTCM's 1997 equity at $5 billion and see what
difference leverage has on the company's return on equity.
If LTCM started with $5 billion of equity and invested only these funds (i.e.,
it borrowed nothing) in assets earning 5%, at year's end, it would have earned
$250 million, which would be a 5% return on both its assets and its equity
(see Exhibit 8.2). By contrast, assume that LTCM leveraged its $5 billion equity
by borrowing $120 billion and earning a net return on these assets of 5%. At
year's end, the $5 billion of equity-financed assets would have earned $250
million (just as before) and its $120 billion of debt-financed assets would have
earned $6 billion. The total return on assets would be 5% (i.e., [$250 million
+ 6 bilJion]/[$5 billion + $120 billion] = 5%), but the return on equity would
be 125% (i.e., ($250 million + $6 billion]/[$5 billion] = 125%); see Exhibit
8.2. In other words, the return on assets was exactly the same as before, but
borrowed funds increased, the return on equity 25 times.
For highly leveraged firms like LTCM, any profits on the mountain of
debt-financed assets causes the return on equity to skyrocket, but at the
same time, losses could quickly wipe out the skimpy equity backing these

1 'The $100 miiiion principal is notional because is is in ihe background from the beginning to the end
of the swap. Neither counterparty is required to pay or expects to receive it. The $100 million princi-
pal is used only to figure out the counterparties' net payment/receipt each period.
12 LTCM would earn 2% in dividends, pius 10% in capita! gains, and be required 10 pay LiBOR plus
1.5% (i.e., 6.5%), which yields a net return of 5.5% (i.e.. 10% 4 2% - 6.5% = 5.5%).
nLTCM would earn 1% in dividends, lose 8% on the S&P Slock Index, and be required to pay a
LiBOR plus 1.5% (i.e., 7.5%). which yields a net loss of 14.5% (i.e., 1% - 8% - 7.5% « -14.5%).
240 CHAPTER 8: Long-Term Capita! Mismanagement: "JM and the Arb Boys"

Exhibit 8.2 Is Return on 1Equity Meaningful will lose no more thar

for Highly Leveraged Companies?
Equity Assets next 100 days, we sho
Dollar Return on Return on 1
(Millions $) (Millions $) Relitrnn on Equity Assets 1 VaR analyses are bas
Assets I cal standard deviation
(Millions $) 1
for this volatility. The i
Case 1 5,000 5,000 250 250/5,000 •» 5% 250/5,000 * 5% j- econometric and conrf
Case 2 5,000 125,000 250 6,250/5,000-125% 6,250/125,000 = 5% i very sophisticated and
4-6,000
results of these analy:
6,250 significantly different 1
The operational goa
net asset value (NAV
yearly range of fluctu
found this goal was a
assets. At the beginning of 1998, LTCM had assets equal to approximately maintained, LTCM co
$125 billion and equity equal to $4.7 billion, so a mere 3.8% decline in height. One reason LI
asset value would have eliminated all of the firm's equity. was engaged mainly i
outright positions.
Elevate Risks to Relatively High, but Controlled, Levels Another reason for
LTCM increased the risk of its portfolio because the company understood can be traced to the f
full well that greater risk brought the potential for greater returns. To con- tunity presented itsel:
trol these risks, LTCM diversified its portfolio and used a statistical tool in doing so, LTCM we
called Value at Risk. LTCM also employed an extensive and detailed work- would change and er
ing capital model t h a t gave incentives to traders to finance their positions to make large trades
using term agreements, rather than use overnight financing to manage
date its positions, th
liquidity risks.
assets in its portfolio
Diversification LTCM's managers tried to acquire a portfolio that was pany's gains. As a res
diversified by geographic region, security market, and currency. By owning because it was not si
positions with uncorreiated returns, unexpected negative shocks were Finally, LTCM had
expected to offset (fully or partially) unexpected positive shocks, thereby breeds imitators. Try a
smoothing the portfolio's average return. For example, if LTCM was long actions secret, the fin;
European swaps but short U.K. swaps, the unanticipated gains (or losses) pany's success. Imitati
on the U.K. swaps mighi offset (fully or partially) the unanticipated losses the financial landscaj
(or gains) on the European swaps. Similarly by making diversified currency markets more compel
bets, LTCM's returns could be stabilized because the depreciation of one on mispriced assets.
currency might be offset by the appreciation of another.
Value at Risk (VaR) To determine the appropriate level of risk, LTCM !4 VaR estimates could be mat
relied heavily on Value at Risk (VaR) analysis to q u a n t i f y the vulnerability as sufficient information was
15See Appendix 8.2: What A
of its portfolio to changes in market prices and returns. VaR is a statistical
.prenhail.com/marthinsen.
measure, which is used mainly by institutions that want to determine the H"'Net asset value" is the dol

downside vulnerability of r h e i r actively traded portfolios. With VaR, a shares outstanding. Net asset
I7 5ee Andre F. Perold, "Long
company can make statements like: "We are 99% certain that our portfolio number: 9-200-007 (5 Mover
 LTCM'S Strategy 241

will lose no more than $105 million during any one day" or "For 99 of the
next 100 days, we should lose no more than $105 million." 14
VaR analyses are based on estimates of volatility, and typically the histori-
cal standard deviation of the asset returns in a portfolio is used as a proxy
for this volatility. The academic superstars at LTCM were skilled in advanced
econometric and computer techniques; so, they could interpret past data in
very sophisticated and meaningful ways. But for all their sophistication, the
results of these analyses were meaningless if the future turned out to be
significantly different from the past. 15
The operational goal at LTCM was to lift the risk of its portfolio to 20% of
net asset value (NAV) 16 per year (i.e., it wanted its portfolio to have a
yearly range of fluctuation equal to 20% of its value), 1 7 but the company
found this goal was almost impossible to achieve. Despite the leverage it
maintained, LTCM could not raise its portfolio's risk levei to the desired
height. One reason LTCM found this task to be so difficult was because it
was engaged mainly in spread trades, which are inherently less risky than
outright positions.
Another reason for LTCM's inability to increase its level of portfolio risk
can be traced to the fund's size. LTCM was so large that, when an oppor-
tunity presented itself, the fund would quickly try to build a position, but
in doing so, LTCM would buy and sell in such volumes that market prices
would change and erode the potential profits. As a result, LTCM's ability
to make large trades was curtailed. Similarly, when LTCM tried to liqui-
date its positions, the size of its transactions and the illiquidity of the
assets in its portfolio caused prices to move adversely and erode the com-
pany's gains. As a result, LTCM had to take smaller positions than desired
because it was not sure that they could be liquidated at profitable rates.
Finally, LTCM had difficulty increasing its level of risk because success
breeds imitators. Try as LTCM did to keep its strategies, positions, and trans-
actions secret, the financial world was not blind to the sources of this com-
pany's success. Imitators with similar strategies and portfolios began to dot
the financial landscape like dandelions in spring. Competition made the
markets more competitive, which reduced the opportunity to earn returns
on mispriced assets.

I ' 4 VaR estimates couid be made for ^iny desired time period (e.g., day, week, month, 01 year), as iong
\s sufficient information was available.
| l5 See Appendix 8.2: What Are the Problems With Value at Risk, which can he found at http://www
.prenhalS.com/marthinsen.
"'"Net asset value" is the dollar value of a fund's assets minus its liabilities divided by the number of
shares outstanding. Net asset values are closely watched statistics and usually updated every day.
l7 See Andre F. Perold, "Long-Term Capita! Management. LP. (A)," Harvard Business School, Product
number: 9-200-007 (5 November 1999), 1 1-12.
242 CHAPTER 8: Long-Term Capital Mismanagement: "JM and the Arb Boys"

SECURING LONG-TERM FUNDING To ensure that LTCM

In developing its strategy, LTCM knew that some of its positions could take as ing were crucial, but eq
long as six months to two years before they earned profits, and, therefore the and Bear Stearns, LTC1V
company needed well-developed and extensive financial backing (liquidity) trades. At times, LTCM
from banks and other financial institutions to be able to wait it out. LTCM total notional value of
arranged credit, lines ($900 million), 1 8 a three-year, unsecured loan ($230 mil- marked to market, wh
lion), and financed most of its security purchases in the six-month to one-year daily to settle its losing
(reverse) repo market, which gave the company a buffer that would not have were received on its w
been present if it had used the short-term reverse repo market. LTCM also stabi- LTCM's numerous posi
lized its equity financing by writing a covenant into the investment contract task even harder was
that limited investors' ability to withdraw capital from the fund. At first, this complicated deals usi
covenant stipulated that equity remain invested for at least three years, but in transactions. As a resu
1996 this restriction was eased, allowing investors to cash out one third of
CHARGING HEFTY FE
their capital at the end of each year after the first one. Therefore, someone
who invested $12 million at the end of 1996 could withdraw nothing in 1997, LTCM's fees were hea
but thereafter could withdraw $4 million at the end of 1998, 1999, and 2000. would say excessive),
It is f a i r to say t h a t w i t h o u t these immense and, at limes, unquestioned Most other hedge fun
funding sources, LTCM could never have pyramided its positions to the ing to 25% of the inc
towering levels it achieved. B r i m m i n g with f u n d s during the boom years of funds charged 20%,
the 1990s and eager to do business with the best and the brightest, many until the fund's all-tin
banks and dealers ignored time-tested banking principles, like demanding How could LTCM c
collateral for loans, ensuring t h a i charges were s u f f i c i e n t for the risks taken, dards? What would
properly accounting for (off-balance-sheet) derivative positions that brought to the table?
increased their exposures to LTCM, and demanding business relationships as having "...in effec
that were transparent instead of obfuscated with crafty legerdemain. 12 founding principa
LTCM's secretive practices created a shield behind which the f u n d could or MIT, either as gra
conceal the e x t e n t to which it was indebted. As a result, each counterparty principals were able
saw only its piece of the business and not the total structure of risks and for a while, it seemec
returns that LTCM had built.
Long-term funding was crucial to LTCM's strategy because it allowed the
company to take positions and then hold them, if necessary, for extended LTCM'S impressive I
periods. LTCM was a risk taker and often took positions that few others
would touch, Of course, LTCM took these positions because is; felt the In the early years,
expected rewards were adequate for the risks being assumed. As the com- LTCM's total assets ii
pany's portfolio grew and became more diversified, additional risk became (Exhibit 83).
easier to take on because most of the nonsystematic risks associated with One of the main
the new positions dissolved in the vast melting pot of LTCM's other assets. because of the com

!SThis credii facility was syndicated by Chase Manhattan Bank wiili about 24 oilier financial instiiu- I I9 Commem by Douglas Br
lions. In general, credit lines are reiasively expensive sources of financing for hedge funds. Therefore, i elates. See Kevin Muehr
they usually increase iheir leverage with reverse repurchase agreements and derivatives. \r 19%), 68-81.
 LTCM'S Impressive Performance: 1994-1997 243

To ensure that LTCM had sufficient liquidity, long-term sources of financ-

ing were crucial, but equally important were the roles of LTCM's back office
and Bear Stearns, LTCM's agent for clearing, settling, and keeping track of
trades. At times, LTCM had thousands of open derivative positions with a
total notional value of about $1.25 trillion. Many of LTCM's contracts were
marked to market, which meant that the company had to pay out funds
daily to settle its losing trades and, of course, it had to make sure payments
were received on its winning trades. Tracking the cash flows connected to
LTCM's numerous positions was a sophisticated operation. What made this
task even harder was LTCM's custom of hiding its positions by transacting
complicated deals using multiple counterparties for different legs of the
transactions. As a result, netting margin payments was often impossible.

CHARGING HEFTY FEES

LTCM's fees were head-and-shoulders above the industry average (some

would say excessive), charging an annual 2% base fee on the fund's NAV.
Most other hedge funds charged 1%. In addition, an incentive fee amount-
ing to 25% of the increase in the company's NAV was charged. Most other
funds charged 20%, but if LTCM's NAV fell, the 25% charge did not kick in
until the fund's all-time high was surpassed.
How could LTCM charge fees that were so much above the industry stan-
dards? What would you pay to have the intellectual power this company
brought to the table? An article in Institutional Investor characterized LTCM
as having "...in effect the best finance faculty in the world."19 Seven of its
12 founding principals were connected, in some way, to Harvard University
or MIT, either as graduates, faculty members, or both. Clearly, the LTCM
principals were able to convince investors that their strategy would work;
for a while, it seemed they were right.

LTCM'S Impressive Performance: 1994-1997

In the early years, LTCM's record spoke for itself. From 1994 to 1997,
LTCM's total assets increased from approximately $20 billion to $130 billion
( Exhibit. 8.3).
One of the main reasons for the rapid increase in LTCM's assets was
because of the company's outstanding earnings record. Exhibit 8.4 shows

"Comment by Dougias Breeden, professor at Duke University and principal at Smith Breeden Asso-
ciates. See Kevin Muehring, "John Merivveiher by the Numbers," institutional Investor 30 ( I I )
(November 1996), 68-81,
244 CHAPTER 8: Long-Term Capital Mb-managemem: "JM and the Arb Boys"

the gravity-defying i
Exhibit 8.3 The Meteoric Rise in LTCM's Assets: June 1994 to November 1997 November 1997, as LT
LTCM fees) increased
only were these retu
monthly declines, wh
From 1994 to the
pals and hundred-fif
formance. The princi
November 1997, LTC
lion (Exhibit 8,5). P
equity grow in three
"Phenomenal" and
formance, During the
exceeded 40%. But
assets and equity and
Most of LTCM's retur
the company leverag
1997, estimates in
Source: Andrt1 F. Perold. "Long-Term Capital Manajxmcm, L..P. (A)," Harvard was mediocre, betwe
Business School, Case 9-200-007, 22.

Exhibit 8,5 LJCM's Equi

Exhibit 8.4 index of LTCM's Gross and Net Returns: February 1994 to November
1997 (February 1994 - 1.0)
4. o ?"' ••'•'"""''• • • •"• -..-.-..,—.-.v*,™™.

Saurce. Andre F. Peraid, "ions-Term Captfai-Management. L.P. (A)." Harvard Business Saurct: Andre F.'Perold, "
School Case 9-200-007. 19. School, Case 9-200-007
 LTCM'S Impressive Performance: 1994-1997 245

the gravity-defying increase in LTCM's earnings from February 1994 to

November 1997, as LTCM's gross returns and net returns (i.e., returns net of
LTCM fees) increased by approximately 290% and 180%, respectively. Not
only were these returns high, they were also stable, with only occasional
monthly declines, which were quickly offset the following months by gains.
From 1994 to the end of 1997, LTCM's investors, along with its princi-
pals and hundred-fifty or so employees, were elated with the fund's per-
formance. The principals were especially happy. Between March 1994 and
November 1997, LTCM built its equity base from $1.25 billion to $7.1 bil-
lion (Exhibit 8.5). Principals, who invested $146 million, had their LTCM
equity grow in three short years to $1.9 billion.
"Phenomenal" and "sensational" were adjectives attached to LTCM's per-
formance. During the first three years of its life, the annual return on equity
exceeded 40%. But can success be judged only by looking at the growth of
assets and equity and the return on equity? Shouldn't risk also be considered?
Most of LTCM's return on equity was due to the stratospheric levels to which
the company leveraged itself. Despite LTCM's exceptional returns from 1994 to
1997, estimates indicate that the company's gross return on assets
was mediocre, between 0.67% and 2.45%, and when its off-balance-sheet

Exhibit .8.5 ITCM's Equity: March 1994 to Member 1997

8.0

7.0

Source: Andre E Pevoid, "Long-Term Capiiai Management, L.P, (C),* Harvard Business
School Case 9-200-007, 8.
246 CHAPTER 8: Long-Term Capita! /W/smanagemenc "JM and ihe Arb Boys"

positions were considered, the return was 1% or lower.20 But even at a paltry on a geological fault Sine
1%, when leveraged by a 30-to-l ratio, translated into a 30% return on equity. strutted on faulty assurn
Evaluating LTCM based on its risk-adjusted rate of return is an even- its portfolio. The risks
handed way of assessing the company's performance relative to other hedge leverage ratios were su]
funds and investments. At the same time, any overall evaluation of LTCM and state-of-the-art risk
should recognize the company's positive impact on the development and to earn stable returns r
functioning of the global financial system. falling. What happened'
LTCM's failure was tb
catalysts. The first was «
LTCM'S Contributions to Efficient Markets like economic lightenin
Once shaken, the hedg<
LTCM's contributions go beyond the return on equity it gave to its principals inflicted wounds. These
and investors during the three-year period of extraordinary growth. For a many of LTCM's basic ri
brief while, LTCM contributed significantly to the functioning and efficiency tion the company's risl<
of the national and international capita! markets. LTCM provided liquidity chain reaction of eveni
to markets that needed buyers and sellers. Many of its positions were illiq- creditworthiness and, tl
uid because no one else dared to accept the risks at quoted market prices. clearing arrangements,
LTCM was willing to do so only because its expertise (and there was enor- and collateral call, the
mous expertise in the company) in finding mispriced opportunities led it to 1998) that it would not
accept such risks. LTCM was ihe w i l l i n g counterparty to which numerous
market participants could transfer risks, and its profits came from valuing
EXOGENOUS MACROE
the risks more accurately than other market participants.
U.S. AND GLOBAL SPF
LTCM's return on assets was small, but it made extraordinary profits by
borrowing a mountain of funds and using them to sweep up money that was LTCM and its many in
left sitting on the table due to capital market inefficiencies. As a result of its worldwide markets. Bu
buying and selling (and LTCM was willing to take either side of a misaligned spreads widened in aln
market), the markets came closer into alignment, which ensured that thou- domestically, internatk
sands of other participants got fairer prices for their transactions. rhage cash.
Despite its contributions to market efficiency and its initial successes, in
the end, LTCM failed — and in spectacular fashion. Understanding the causes U.S. Yield Spreads W
of this collapse provides insight into why no strategy is bulletproof and no During 1998, U.S. sp
bet is a sure thing when global financial markets are involved. Treasury bonds, the sp
to 120 basis points; tt
basis points; j u n k bon
Why and How LTCM Failed rose from 35 to nearly
relative to triple-A-rai
LTCM was an extraordinary company that failed because of extraordinary ing country debt rose
circumstances. Just as a w e l l - b u i l t house can collapse if it is constructed ury bond rate. The
Remember, LTCM's s
Ji> Stfc
Roger Lowenstdn. when Genius Failed: The Rise and Fail ef Long-Term Capital Management. New
York: Random House. 2000, 78, and Carol Loomis, "A House Bui): on Sand," Fortune 138 (8)
normal range. As sp
(26 October i998». 1 10-1 18. deep losses.
 Why and How LTCM Failed 247

on a geological fault line, a well-built hedge fund can crumble if it is con-

structed on faulty assumptions about the market and the inherent risks in
its portfolio. The risks associated with LTCM's enormous size and high
leverage ratios were supposed to be controlled by a diversified portfolio
and state-of-the-art risk management tools. The company was supposed
to earn stable returns regardless of whether the markets were rising or
falling. What happened?
LTCM's failure was the result of a chain reaction involving three major
catalysts. The first was a series of exogenous macroeconomic shocks that acted
like economic lightening bolts to shake the entire hedge fund industry.
Once shaken, the hedge fund industry attacked itself, causing many self-
inflicted wounds. These endogenous, hedge-fund-related reactions undermined
many of LTCM's basic risk-management assumptions and called into ques-
tion the company's risk-management measures. The final catalyst in this
chain reaction of events involved feedback effects that jeopardized LTCM's
creditworthiness and, therefore, threatened its sources of financing and its
clearing arrangements. Even though LTCM was able to meet every margin
and collateral call, there was considerable fear (especially in September
1998} that it would not be able to do so.

EXOGENOUS MACROECONOMIC SHOCKS:

U.S. AND GLOBAL SPREADS WIDEN
LTCM and its many imitators placed major bets on spreads narrowing in
worldwide markets. But because of a series of major economic catastrophes,
spreads widened in almost every market, and everywhere you looked (i.e.,
domestically, internationally, and cross-border) these bets began to hemor-
rhage cash.

U.S. Yield Spreads Widen

During 1998, U.S. spreads skyrocketed. For example, relative to U.S.
Treasury bonds, the spread on mortgage rates surged from 95 basis points
to 120 basis points; the spread on corporate bonds rose from 99 to 105
basis points; j u n k bond spreads rose from 224 to 276 basis points; swaps
rose from 35 to nearly 100 basis points, and the spread on B-rated bonds
relative to triple-A-rated bonds rose i'rom 200 to 570 basis points. Emerg-
ing country debt rose from 300 to 1,700 basis points above the U.S. Treas-
ury bond rate. The same pattern appeared throughout the world.
Remember, LTCM's strategy was to bet that spreads would return to a
normal range. As spreads continued to widen, LTCM began to record
deep losses.
248 CHAPTER 8: Long-Term Capita! Mismanagement: "JM and ihe Arb Boys"

Yield Spreads Widen Globally level. What doesn't

Numerous events converged on LTCM (and the world at large) in 1997 LTCM as 1998 beg
and 1998 to widen the spreads on virtually all financial assets. A statisti- Russian Default
cian, trying to estimate the probability of all these events happening at press than the fina
once, would probably have calculated the odds at about the same level as cies, capital flight
someone being struck multiple times by lightning or being killed by falling ruble; to complica
space debris, falling. Russia tri
Asian Tiger Crisis of 1997 One of the first significant events to hit rubles, but these
LTCM was the Asian Tiger crisis, which started in Thailand during the businesses to borr
summer of 1997, spread to other East Asian countries (the Philippines, activities (e.g., wo
Malaysia, South Korea, Indonesia, and Hong Kong), and went on to can afford to borr
affect countries as far away as Argentina, Brazil, and (yes) the United Bankruptcies s
States. The source of the 1997 problem was the Asian countries had long grew, many bank
pegged their currencies to the U.S. dollar, but their exchange rates had international rese
become unsustainably overvalued. Speculators, sensing devaluations systems staggering
were imminent, pounded ihe markets tenaciously by selling baht, rupi- bailout in July 1
ahs, ringitts, and pesos. The central banks of these Asian nations sup- off the crisis. The
ported their fixed exchange rates until they ran out of international the ruble and a
reserves. When they did, their currencies were cut loose to float unteth- currency debt.22
ered to the moorings of the U.S. dollar. LTCM lost on
When currency crises like these happen, investors typically respond by were limited rela
investing heavily in safe assets and sound currencies. As a result, they bought important about
dollar-denominated U.S. government bonds and invested deeply in stable which spread to
assets denominated in European currencies, such as German marks and Swiss Venezuela), to m
francs, This flight to quality pushed down the yields on financial assets in the other hedge fund
developed nations and pushed up the return on assets in the emerging mar-
kets, causing spreads to widen. LTCM had bet continuously that the spreads Volatile Politic
would narrow, so when they widened, the company lost on both sides of its Bad economic an
spread positions. But in the stormy clouds of this international crisis, LTCM hit LTCM like re
saw a glimmer of light because wider spreads meant new opportunities to company in whi
increase its positions and to benefit later when the spreads converged to their vote for its acqui
historically normal ranges. The problem was finding ways to finance these and LTCM incu
new opportunities in a stressed economic environment. requirements. In
Because its Asian investments were concentrated mainly in Japan, LTCM profits were fu
weathered the Asian storm and managed to end 1997 with a respectable, (IMF)-led bailou
albeit diminished, return. Even after refunding $2.7 billion 21 to investors at dent Mohamed S
the end of 1997, LTCM's equity capita! was still at a healthy $4.7 billion threatened to de
had hurt China'
2 1 At
(he end of 1997, LTCM forced investors to lake back $2.7 billion of their investment funds, but
ihc company tiki not reduce its investment posiiions. This Sorceil refund is discussed laier in this ! 22 Russia had made a $
chapter ami also in the Epilogue: Whai Happened to ihe Partners. Creditors, Investors, and Consor- \d speculation tha
tium? ai ihe end of the chapter. \e Risk Notepad 8.2:
 Why and How LTCM Failed 249

level. What doesn't kill you, makes you stronger might have been the credo at
LTCM as 1998 began.
Russian Default No sooner had the Asian crisis left the front pages of the
press than the financial crisis in Russia began. Like the Asian Tigers' curren-
cies, capital flight put enormous pressure on the international value of the
ruble; to complicate matters, the price of oil (a major Russian export) was
falling. Russia tripled its interest rates to encourage investors to stay in
rubles, but these efforts only served to undermine the ability of domestic
businesses to borrow at reasonable rates in order to finance normal business
activities (e.g., working capital capital expenditures, and expansion). Who
can afford to borrow when interest rates are more than 200%?
Bankruptcies soared, unemployment rose, government budget deficits
grew, many banks were threatened with insolvency, and the central bank's
international reserves were depleted. With Russia's economic and financial
systems staggering on the brink of collapse, the IMF arranged a $22.6 billion
bailout in July 1998; unfortunately, the bailout was not enough to stave
off the crisis. The ruble continued to fall. On 17 August, Russia devalued
the ruble and announced a debt moratorium on $13.5 biliion of local
currency debt. 22
LTCM lost on its Russian bond positions, but the company's exposures
were limited relative to other hedge funds and securities firms. What was
important about the Russian ruble crisis was that it triggered contagion, 23
which spread to other parts of the world (e.g., Brazil, Turkey, and
Venezuela), to many other investment markets and, thereby, affected many
other hedge funds in a similar way.

Volatile Political and Economic Climate

Bad economic and political news continued during late 1997 and 1998 and
hit LTCM like relentless sledgehammers. In August 1997, Tellabs, Inc., a
company in which LTCM held positions, announced that the shareholder
vote for its acquisition of Ciena Corp. would be canceled. Spreads widened
and LTCM incurred heavy cash outflows to meet compulsory margin
requirements. In the end, losses amounted to about $150 million. LTCM's
profits were further eroded when an International Monetary Fund
(IMF)-led bailout of Indonesia ran into problems, and rioting forced Presi-
dent Mohamed Suharto to resign after 32 years of authoritarian rule; China
threatened to devalue the yuan because the Japanese yen's depreciation
had hurt China's export trade; Iraq was stirring Middle East tensions as it

! 22 Russia had made a $3.5 billion Eurobond issue less than a month before the default, causing wide-
I spread speculation that Russia would default, as weii, on ihese dollar-denominaied securities.
I 23See Risk Notepad 8,2: What Is Contagion?
250 CHAPTER 8: Long-Term Capital M/Vmanagemern: "JM and the Arb Boys"

that were bets on wide

were bets on narrowe
Risk Notepad 8.2 thought that talented 1
What Is Contagion? then taking positions \

Contagion occurs when events in one nation or which had similar economic charact
liquidate its proprietary
region spill over to other nations or regions. The unsustainable fiscal and current act
more closely linked the economies, the more likely ances) as Mexico. Similarly, the A
resulted in a flood of
changes in one will influence the other, and the 1997 and 1998 had a significant I pre-crisis withdrawals
more simiiar are countries' circumstances (e.g., in nearby countries as the core of the crisis sp LTCM later.
terms of current account and budget deficits, and from Thailand to the Philippines, Malaysia, Set LTCM built what it th
rates of inflation, reai GDP growth, and unem- Korea, Indonesia, and Hong Kong, but it <&•.. tions. What it missed s
ployment), the more likely currency speculators spread as far as Latin America, where count by similar investment
will select those countries as potential targets. like Argentina and Brazil were impacted. price volatility of these
Contagion has been responsible for transmit- Contagion is herd behavior at its woist.s
funding needs, and liqi
ting considerable economic hardship to many its coid. cruel touch can disrupt trade flows, cap-
related, the positions ii
countries. For instance, when the Mexican peso ital markets, investment decisions, government
(Tequila] crisis occurred in December 1994, and central bank policies, bank lending, inflation
with the portfolios of
investors panicked and tried to puil their funds out rates, and the size of government budget to underestimate its ti
of countries like Argentina, Brazil, and Venezuela, deficits. abandon in the wron.
distribution would h
returns converged to i
afforded by diversifies
thwarted U.N, weapon inspeciion teams. All of these events converged and
drove a larger wedge between developing nations' yields and the yields of just as likely to be ma!
The situation was
developed nations. As yield spreads widened, LTCM's losses mounted.
shops selling position
ENDOGENOUS SHOCKS: SPREADS GO HELTER SKELTER
many cases, these trac
have accurate inform;
AND VAR GETS TWISTED
By 1998, many hedge f u n d s were b u i l t to imitate the past successes of Value at Risk Anal)
LTCM. As a result, the diversified portfolio that LTCM spent so much time How could LTCM ha
constructing was duplicated m a n y times over. Wider margins put these sim- used VaR analysis as
ilarly structured hedge funds under pressure to cover their losses, as well as short-term changes \%
meet the collateral obligations, haircuts, and margin requirements on both
new trades and existing positions. Investors fled to safer investments, and 1994. At the 99% lex
hedge f u n d managers tried, simultaneously, to reduce their exposures. 24
The mass exodus of hedge f u n d s from existing positions caused market 25 Thisresul! was anticipatec
irades that will eventually b
spreads to change in predictable but bizarre ways, Relative value trades
merits. Therefore, arbitrage
Shleifer and Robcn w. Visl
24Thr importance of these endogenous reactions is highlighted in Donald Mackenzie, "Long-Term Cap- 35-55.
ital Management and the Sociology of Arbitrage," Economy and Society 1-2(3) (August 2003) 349-380. A •^Based on five-year histori
relatively re-coni empirical Miicly casts sonic doubt on ilie importance of ihe endogenous effects. See approximately 0.1 (or iowe
Tobias Adrian. "Measuring Risk in the Hedge Fund Sector." Federal Resent Bank of New York Current Issues but even that was not enou
in Economic* and Finamv 1 3 ( 3 ) (March/April 2007), 1-7. This study is also available a:: htip://www was seven times the histori<
.nc-wyorkfed.org/research/curreni.Jssues. Accessed 28 December 2007 Sociology of Arbitrage," Eco
 Why and How LTCM Failed 251

that were bets on wider spreads narrowed, and relative value trades that
were bets on narrower spreads widened. It was as if all the care and
thought that talented hedge fund managers had put into analyzing and
then taking positions were suddenly thrown out the window. 25 In June
and July of 1998, the situation got worse as Salomon Brothers began to
liquidate its proprietary bond arbitrage business. Salomon's decision to exit
resulted in a flood of security sales that coincided with LTCM's largest
pre-crisis withdrawals and helped set the stage for even greater losses for
LTCM later.
LTCM built what it thought was a portfolio of economically unrelated posi-
tions. What it missed seeing was that many of these positions were linked
by similar investment fund owners with similar strategies. As a result, the
price volatility of these positions was connected by parallel risk tolerances,
funding needs, and liquidity requirements. Rather than being highly uncor-
related, the positions in LTCM's portfolio turned out to be highly correlated
with the portfolios of other hedge funds. This misperception caused LTCM
to underestimate its true level of risk, causing the company to move with
abandon in the wrong direction. Under normal conditions, LTCM's asset
distribution would have been fine, but when the correlations among
returns converged to one (i.e., perfect correlation), the normal protections
afforded by diversification were eliminated. Losses on one position were
just as likely to be matched, rather than offset, by other positions. 26
The situation was made even worse by hedge funds and proprietary
shops selling positions in anticipation of LTCM liquidating its portfolio. In
many cases, these trades were highly speculative because the sellers did not
have accurate information about the composition of LTCM's portfolio.

Vaiue at Risk Analysis Gone Awry

How could LTCM have suffered such heavy losses when it systematically
used VaR analysis as a navigation tool for estimating its vulnerability to
short-term changes in market prices? The fund had never lost more than
2% of its value (i.e., $100 million) in any month since operations began in
1994. At the 99% level of confidence, LTCM's econometricians assured the

i - 5 This result was anticipated in a research anicle published in 1997. The a u t h o r s showed thai even
I irades that wii! eventually be profitable may have 10 be abandoned early due to adverse price move-
| merits. Therefore, arbitrage may not be able to completely eliminate price anomalies. See Andrei
| Shleifer and Roben W. Vishney. "The Limits of Arbitrage," Journal of Finance L f l ( I ) (March 1997),
I 35-55.
} 56Based on five-year historical data, the correlation among the asset returns in LTCM's portfolio was
i approximately 0.1 (or lower). LTCM used a more conservative correlation of 0.3 in its VaR analyses,
I but even that was not enough. Richard Leahy, a LTCM principal, felt that she true correlation in 1998
i was seven times the historic level. See Donald MacKenzie, "Long-Term Capital Management and the
' Sociology of Arbitrage," Economy and Society 32(3) (August 2003), 358, 364.
252 CHAPTER 8: Long-Term Capital Mismanagement: "JM and the Arb Boys"

principals and investors that the company should lose no more than $105
Exhibit 8.6 Trades That Cause
million per day. 27 With LTCM's sizeable equity, there seemed to be more
than enough cushion to endure any major hit. Activity
Stock market volatiiity
Mode! Risk Swaps
On two important levels, LTCM suffered from high model risk. First, the
Emerging markets: Russia
company adopted the risk-management system of Salomon Brothers,
where JM and many of his traders had worked previously. But investment Directional trades

hanks are different from hedge funds, and their risk-management systems Equity pairs (e.g., Volkswagen and Sh
should also be different. Investment banks usually have a larger number of Yield curve
independent income sources and better access to liquidity than hedge S&P stocks
funds. These differences are significant because they influence these finan-
Junk bond arbitrage
cial institutions' exposures 10 risk and their ability to sustain losses u n t i l
positions become profitable. Risk arbitrage
A second source of model risk came from LTCM's use of VaR as its princi- Total
pal measure of portfolio risk. VaR assumes that the f u t u r e will be like the Source: Roger Lowensiein, When Genius Faiiec
past, and the world can be summarized by assuming all possible future House, 2000, 234.

events fit neatly into a normally distributed, bell-shaped distribution func-

tion. 28 Both of these assumptions may be true most of the time, but they
are not true a l l the time. days from Thursday, 10
Exhibit 8.6 summarizes the losses sustained by LTCM in 1998, which $145 million, $120 m
amounted to approximately $4.5 billion. Based on VaR, with 99% probabil-
respectively—accumul;
ity, this company's yearly r e t u r n s should have varied by no more than about
tember, LTCM again 1<
$714 million, which was only SO.5% of LTCM's $6.8 billion equity. 2 9 Other-
losses of $152 million,-
wise stated, a yearly reduction in returns by an amount greater than
happen perhaps once e
$714 million should have occurred roughly once every hundred years. Never-
month. 33
theless, just for the month of August, LTCM's performance was down 44%,
and it was down 52% from the previous year. 30 On one day (Friday, 21
FEEDBACK SHOCKS
August) alone, LTCM lost $553 million, and four trading days later (Thurs-
As LTCM's position w<
day, 27 August), it lost an additional $277 million. During the five trading
to protect themselves
27 This$1 05 million figure is an overestimate. Assuming a highly diversified pocifolio, the daily stan- problematic. LTCM w<
dard deviation of LTCM's portfolio in September 1997 was $45 million/day; which means that a 99% sures, but many of th
level of confidence would he 2.33 standard deviations (2/33 x $45 million/day 5~ S I 0 5 million/day)
from the average return. See Andre F. Perold, "Long-Term Capital Management. L.P. ( A ) . " Harvard the beginning that its
Business School, Product number: 9-200-007 (5 November 1999). t 1-12.
-•sSee Appendix 8.2: What Arc the Problems With Value at Risk, which explains in more detail some
of ihe deficiencies of VaR analysis. Available at hup://www.prenhall.com/rnanhinsen. ''Roger Lowenstein, When G,
*9This $714 million figure was derived as follows: (Standard deviation per year) •-••• (Standard devia- Random House, 2000, 180.
tion per day) x (Square root of 252 trading days per year). Therefore, $45 million/day x (252 working "Ibid., pp. 191 and 197,
days/year}0-5 ~ $714.4 million/year. "Almost half of LTCM's cas
*°John Menu-ether, "Letter to Investors of LTCM" (2 September 1998). See Andre F. Perold, "Long- option positions. Swaps alsc
Term Capita! Management. L.P. ( D ) . " Harvard Business School. Product number: 9-200-010 (28 "Long-Term Capita! Manage
October 1999), 2003). 349-380.
 Why and How LTCM Failed 253

Exhibit 8.6 Trades That Caused LTCM's Lo|p'.in 1993

Activity Losses
Stock market volatiiity $1,300 million

Swaps $1,600 million

Emerging markets: Russia $430 million

Directional trades $371 million

Equity pairs (e.g., Volkswagen and Shell) $286 million

Yield curve $215 million

S8-P stocks $203 million

Junk bond arbitrage $100 million

Risk arbitrage Broke even

Total $4,505 million

Source: Roger Lowenstein, When Genius Failed- The Rise and Fall of Long-Term Capital Management. New York: Random
House, 2000, 234.

days from Thursday, 10 September to Wednesday, 16 September, LTCM lost

$145 million, $120 million, $55 million, $87 million, and $122 million,
respectively—-accumulated losses of $529 million!33 On Monday, 21 Sep-
tember, LTCM again lost $553 million, and the following day racked up
losses of $152 million.32 According to VaR, losses of such magnitude should
happen perhaps once every few millennia, but not during the course of one
month. 33

FEEDBACK SHOCKS

As LTCM's position worsened, liquidity dried up, its counterparties sought

to protect themselves, and the services of LTCM's clearing agent became
problematic. LTCM was desperate for funds and wanted to reduce its expo-
sures, but many of these positions were illiquid. The company knew from
the beginning that its positions might be hard to liquidate; so the company

"Roger Lowenstein, When Genius Failed: The Rhe and Fall of Long-Term Capital Management. New York:
Random House. 2000, ISO.
"Ibid., pp. 193 and 197.
^Almost half of LTCM's cash outflows in September 3 998 (about $1 billion) were from its index
option positions. Swaps also accounted for a large portion of the losses. See Donald MacKenzie.
"Long-Term Capita! Management and the Sociology of Arbitrage," Economy and Society 32(3) {August
2003), 349-380.
254 CHAPTER 8: Long-Term Capita! M/smanagemem: "JM and the Arb Boys"

Clearing Services and Le

positioned itself to have enough f u n d i n g if things went wrong. Now, LTCM LTCM was also in danger o
found itself with a portfolio of assets t h a t few individuals wanted, and clearing, settling, and reco:
potential buyers, like Salomon Dean Whitter, Societe Generate, Bankers would stop performing tt
Trust, and Morgan Stanley Smith Barney, were driving hard bargains below $500 million, and L"
because they knew how distressed LTCM had become, old level. As conditions we
Another problem was tr
Aggressive Marking to Market culate with reports that, th
LTCM always negotiated two-way (i.e., LTCM and its counterparty) collat- the Cayman Islands. Cre<
eral and mark-to-market covenants in order to conserve and stabilize its rights under Cayman law
supply of working capital. The company also negotiated term agreements tions, close-out (i.e., term
for posting collateral; therefore, when LTCM ran into trouble, dealers could further reduced the willir
not change the haircuts or other financing terms on LTCM's existing posi-
tions. Without such recourse, dealers tried to collect as much as they could A Ray of Sunshine: LT
by aggressively marking to market LTCM's positions in favor of themselves. Fortunately for LTCM, o
This aggressive mark-to-market pricing caused a systematic decline in million revolving credit 1
LTCM's net asset value for virlually every position in its portfolio. this credit line was neg'
The problem was that, d u r i n g the 1990s, competition for hedge fund material adverse change (iV
business caused many banks and security firms to relax or discard parts of syndicate to cut or can*
their internal risk-management policies. R a t h e r than impose collateral that, if these funds were
requirements t h a t accounted for a hedge fund's potential exposures, these in effect. The credit-line
financial institutions were satisfied if they covered just current exposures. by 50% or more at the
Instead of analyzing the joint effects of credit, liquidity, and market risks, canceled.35 But LTCM's
they analyzed each risk as if it were independent. Now, the tide had turned, point, it had more than
and these counterparties were scurrying to protect themselves from these
highly interdependent risks. The Beginning of th<
LTCM's penchant for secrecy and opaqueness exacerbated the problem. In May and June 1998
In an effort to conceal its profitable positions and trading strategies from the respectively, then, dui
market, LTCM often used different counterparties for each leg of a complex almost broke even. 1\
deal. For example, it might take a long position in Royal Dutch Shell (RDS)
and a short position in Shell Transport (ST), which as a pair has very little trades and 18% from
risk, but then use RDS as collateral for a margin loan from JP Morgan and 1998 reduced LTCM's
borrow ST from Union Bank of Switzerland. Counterparties knew, at best,
their own (bilateral) exposures to LTCM, but they had no idea of LTCM's u Bear Sterns was also resr
overall level of risk. When LTCM came under financial pressure, these transaciions, providing marg
lions. Bear Sterns evemualh
counterparties assumed the worst and panicked. En masse, they considered cdlateralize potential seulem
just their own unhedged legs of LTCM's deals and, therefore, overestimated "Covenants on the $900
accounting period 10 (he ne
the company's true level of risk. U they had access to LTCM's records, they [ion. See Andre F. Perold, "I
would have seen that it had a closely related short position for almost every uci number: 9-200-009 {5 ?
long instrument and a closely related Song position for almost every short \5John Meriwether. "Leuer i
1 Capita! Management. L.P. (D
instrument. Therefore, the net risk on LTCM's deals was much smaller than ! See Appendix 8.1: LTCM's <V
the sum of their parts.
 Whv and How LTCM Failed 255

Clearing Services and Legal Uncertainties

LTCM was also in danger of losing the services of Bear Stearns, its agent for
clearing, settling, and recording trades.34 Bear Stearns was adamant that it
would stop performing these functions the minute LTCM's deposits fell
below $500 million, and LTCM was rapidly approaching this critical thresh-
old level. As conditions worsened, the noose got tighter.
Another problem was that rumors of LTCM's possible demise began to cir-
culate with reports that the company might file for bankruptcy protection in
the Cayman Islands. Creditors and counterparties were uncertain of their
rights under Cayman law—especially, concerning their ability to net posi-
tions, close-out (i.e., terminate) contracts, and sell collateral. This added risk
further reduced the willingness of market participants to deal with LTCM.

A Ray of Sunshine: LTCM's Credit Line

Fortunately for LTCM, one source of liquidity not threatened was its $900
million revolving credit line with a syndicate of banks Jed by Chase. When
this credit line was negotiated in 1996, LTCM paid dearly to exclude the
material adverse change (MAC) provision, which would have allowed the bank
syndicate to cut or cancel LTCM's line of credit. LTCM figured (correctly)
that, if these funds were ever needed, the MAC provision would probably be
in effect. The credit-line agreement stipulated that only if LTCM's equity fell
by 50% or more at the end of any accounting period could the facility be
canceled.35 But LTCM's accounting period ended 31 July 1998, and at that
point, it had more than enough equity to meet this capital threshold.

The Beginning of the End

In May and June 1998, LTCM posted losses of approximately 7% and 10%,
respectively, then, during July (the lull before the storm), the company
almost broke even. The floodgates opened in August 1998, when LTCM's
performance was down 44% with 82% of the losses coming from relative
trades and 18% from directional trades.36 Losses of $1.8 billion in August
1998 reduced LTCM's capital base to $2.3 billion, which was about 50%

34Bcar Sierns was also responsible for financing LTCM's intraday foreign exchange and security
transactions, providing margin to purchase securities, and borrowing securities for LTCM's short posi-
uons. Bear Sterns eveniuaily stopped providing LTCM with iniraday ciean'ng credit and required it to
coNaieraiize potential seukrmeru exposures.
55Covenants on the $900 million term credit prohibited LTCM from drawing down, from one
accounting period 10 the next, more than 50% of the amount by which its equity exceeded $1 bil-
lion. See Andre F. Perold. "Long-Term Capila! Management. L.P (C)." Harvard Business School, Prod-
uct number: 9-200-009 (5 November 1999). 4.
36John Meriwether. "Leitt-r 10 Investors of LTCM" (2 September i998). See Perold, Andre F. "Long Term
Capila! Management. L.P. (Dj." Harvard Business School, Product number: 9-200-010 (28 October 1999),
See Appendix 8.1: LTCM's Major Trades, which can be found ai hiipV/www.prenhali.ajrn/rnarrhinsen.
256 CHAPTER 8: Long-Term Capital M/smanagement: "JM and the Arb Boys"

U.S. and worldwide c

Exhibit 8.7 LTCM's Accumulated (Normalized! Earnings: February 1994 solvency of all their
to July 1998
quickly. Globally, Ger
losses of $144 million;
$678.5 million and $
United States also fac
At first, it looked
enough among banks
large bank failure or s
other financial institu
cards for the Fed to
LTCM's $80 billion in
led to horrific reducti
problems, such as the
Until 1998, LTCM
1998, the word was o
Ssurce: Andre F. Peroid, "Long-Term Capita! Management. L.P. (C),' Harvard Business would buy a portfoli
School, Case 9-200-009, 8. had long-term poten
problem was that ma
below its year-earlier level. Of these losses, 16% were from LTCM's positions in if they were allowed
emerging markets. Despite the illiquidity of its portfolio and its size, LTCM still relayed LTCM's posit
felt that its funding sources were more than adequate to ride out any storm, In September 199
but it soon became apparent that the company's funding sources would be York Federal Reserv
exhausted long before the profits on healthy trades could be realized. see if a rescue coul
Exhibit 8.7 shows the rise and fail of LTCM's earnings from 1994 to 1998. uncharted waters be
Between 1994 and the end of 1997, LTCM turned each dollar of invested funds LTCM, but time was
into more than $4 of accumulated capital, but in 1998, investors watched in McDonough conven
shock as their accumulated earnings fell from $4 to about 33 cents. 37 stood at $1.5 billio
about $600 million.
On Wednesday (T
The Fed, warren Buffett, and the Rescue of LTCM Warren Buffett, hea
tional Group Inc. (A
Banks and securities firms that had been f u n d i n g LTCM and providing
the assets, liabilitie
necessary services during the company's meteoric rise wanted nothing to do
Capital Portfolio L.P
with it once losses started accumulating. No one at the Fed felt any particular
was managed by LT
responsibility to save LTCM's wealthy principals or its sophisticated investors.
in place, buy off any
Nevertheless, there was fear that LTCM had grown so large and its tentacles
had penetrated so deeply into such a wide cross section of the global finan- J8LTCM was so secretive t
cial markets that its bankruptcy could result in a financial meltdown of the 59The negotiations among
the context of a classic pri$
''investors who were not principals or in the core investor group did not lose t h a i much when LTCM vate and public incentive
failed because ihc company farced them in 1997 to t a k e back $2.7 billion of their invested capital. games. See Beth Seely, "L
Because LTCM had been so successful up until t h a t point, investors resisted taking back these funds, Dilemma," Working Paper
but in the end, the forced refund saved them billions in losses. Commission (Washington
 The Fed, Warren Buffett, and the Rescue of LTCM 257

U.S. and worldwide capital markets. If the markets began to question the
solvency of all their counterparties, liquidity in the market could dry up
quickly. Globally, Germany's Dresdner Bank AG was facing LTCM-related
losses of $144 million; Switzerland's UBS and Credit Suisse reported losses of
$678.5 million and $55 million, respectively. Financial institutions in the
United States also faced substantial write-offs.
At first, it looked as though LTCM's positions were distributed broadly
enough among banks so that, for the most part, losses would not result in any
large bank failure or systemic damage (i.e., a domino effect among banks and
other financial institutions). Nevertheless, there were still too many hidden
cards for the Fed to know how much to wager on this assumption. With
LTCM's $80 billion in assets on the line, massive collateral sales could have
led to horrific reductions in asset prices and resulted in complicated financial
problems, such as the deterioration in bank assets and the withering of credit.
Until 1998, LTCM's records were closely guarded secrets,38 but by mid-
1998, the word was out that it was actively seeking a white knight. No suitors
would buy a portfolio sight unseen; so, to convince them that its positions
had long-term potential, LTCM had to open its books to Wall Street. The
problem was that many of these suitors were LTCM's major competitors, and
if they were allowed more than a peek at these records, they could have
relayed LTCM's positions to their trading desks and fleeced LTCM like a lamb.
In September 1998, William (Bill) J. McDonough, President of the New
York Federal Reserve Bank, called together a consortium of major banks to
see if a rescue could be negotiated. Technically, the Fed was sailing in
uncharted waters because it did not have jurisdiction over hedge funds like
LTCM, but time was running out. On Friday, 18 September, when William
McDonough convened the prestigious financial institutions, LTCM's equity
stood at $1.5 billion. By the following Wednesday, it was already down to
about $600 million. Something needed to be done quickly.39
On Wednesday (23 September), just a few days before a deal was struck,
Warren Buffett, head of Berkshire Hathaway, along with American Interna-
tional Group Inc. (AIG), and Goldman, Sachs & Co. (GS) made an offer for
the assets, liabilities (financing), and contractual positions of Long-Term
Capital Portfolio L.P.(LTCP), which was the Cayman Islands-based fund that
was managed by LTCM. Buffett wanted to purchase LTCP, keep the financing
in place, buy off any net asset value of third-party investors, boot out LTCM's

}8LTCM was so secretive that it kept its trades confidential even after the positions were closed.
39The negotiations among LTCM, consortium members, and the Federal Reserve can be analyzed in
ihe context of a classic prisoner's dilemma game. This framework illuminates the tradeoffs between pri-
vate and public incentives as well as the differences between one-time static games and repeated
games. See Beth Seely, "Long-Term Capita! Management: An Analysis of Intervention as a Prisoners'
Dilemma," Working Paper No. 99-01. Division of Economic Analysis: Commodity Futures Trading
Commission (Washington D.C., 24 February 1999), 1-20.
258 CHAPTER 8: Long-Term Capital Mismanagement: "JM and the Arb Boys"
T

madcap traders, and take control of the board of directors. The $250 million The recapitaliza
offer would have gone to LTCM's shareholders wiih the promise of an addi- when 14 banks an
tional $3.75 billion, it' needed, lo stem future losses. Most of the funds ($3 cue effort 4 3 Cont
billion) were to come from Berkshire Haihaway. 40 Buffett made his offer at tern did not advan
about 11:00 A.M. and gave LTCM an hour to respond. Given the strict lime and a forum prov
limit, JM was unable to secure the needed approvals. 41 As a result, Buffett's reluctant). Togeth
offer went unanswered arid lapsed after one hour. infusion looked to
consortium was e
For most of the
because they wer
Risk Notepad 8.3 statements, bala
Another Look at Warren Buffett's Offer for LTCM the slumping m
pummeled in th
LTCM might have accepted Warren Buffett's offer, The short time fuse was also a preca postpone its IPO
but there was a major technical problem. JM and having the bid shopped around. Still,
institutions were
his management team had only one hour to fett was one of the premier investors
and overbearing
respond. Many financial agreements (e.g., swaps) tieth century and must have known for
require counterparty approval before they can be advised) that LTCM needed counte
added to the co
assigned. Geary, most of LTCM's counterparties approval before positions could be trans went smoothly,
would have been delighted to transfer their posi- Therefore, it is unclear why Buffett, the Sage fe end, none oi the
tions to BH-AIG-GS, but LTCM had more than Omaha, structured this offer the way he did. losses during th
24O major counterparties and thousands of Ultimately, the consortium's $3.65 bilfif r|' mark-to-market
complicated deals to consider42 Under normal was accepted. It did not require courier alized. Even in
conditions, it would have taken more than an approval because the offer was an investment in
millions of dolla
hour to get the necessary approvals. Accomplish- LTCM's equity, rather than the transfer of posi-
ing this feat under the threat of bankruptcy and
margin account
tions. The economic difference was subtle, but the
while making sure to avoid claims of fraud or legal difference was crucial. The consortium deal Under the rec
deception proved to be an impossible task in the was head and shoulders better than the BH-AIG- of the fund (i.
space of 60 minutes. As a result, Buffett's offer GS offer, and this is important. The LTCM princi- original owners
was not rejected by JM. It simply lapsed without pals had a fiduciary responsibility to aict with pany was writte
an answer. undivided loyalty and transparency, to avoid con- with LTCM for
To this day, the one-hour time limit imposed on flicts of interest and fraud, and to negotiate the By accepting 1
JM is confusing. It makes sense from the perspec- best deal possible for its owners. The difference
tive that LTCM's asset prices were changing dra- between the BH-AIG-GS offer and the consortium
\The banks were: 1.
matically, and any bid faced considerable risk. offer was unquestionably material. i ($300 million), 4. D
; Travelers/Salomon
1 ($300 million), 9.
40 Goldman Sachs agreed to invest $300 million and manage LTCM's portfolio. Berkshire Haihaway \n Stanley Dean \0 mi
Inc.. agreed to contribute S3 billion, and AIG was willing to contribute $700 million. Sec Mitchell
Pacclle. Leslie Seism, and Steven l.ipin, "How KuUeu, AIG and Goldman Sought Long-Term Capital, \. "Baiiout B
but Were Rejected," Watt Street Jounm! 00 September 1908), Cl. \s and Lend*
41 See Risk Notepad 8.V. Another Look at Warren BuH'est's Offer for LTCM. \' Eyes," Wain
42Aboiu 90% of LTCM's trades were with 15 counterparties, but in some cases, die counterparties wore I 44 Credit rating agen
affiliates {e.g., JP Morgan, JP Morgan Tokyo, cine! .IP Morgan London). Negotiating wish 40 counterparties \t banks, such as L
each having six affiliates meant involving 240 counterparties. The President's Working Group on Financial 45Goidman Sachs w
Markets reported that LTCM had more th.in 60,000 trades on its books, See President's Working Group on •^President's Worki
Financial Markets. Hedge Fmuk, Leverage, and r/w /.,?$&?«.< of ion^-'Kfrni Capifa! Management: Rgp&rt i>fihe Presi- \ Management: I
dent's Working Group on Finaneial MaF&e®. Washington, DC; Department of Treasury, 28 April 1999, I ! I Department of Trea
b Boys"
The Fed, Warren Buffett, and the Rescue of LTCM 259

iors. The $250 million The recapitalization agreement for LTCM was finalized on 28 September,
>e promise of an addi- when 14 banks and brokerage houses contributed $3.65 billion to the res-
Viost of the funds ($3 cue effort. 43 Contrary to some published reports, the Federal Reserve Sys-
ffett made his offer at tem did not. advance a penny of the funds; its role was purely as a facilitator
Given the strict lime and a forum provider (and perhaps, as an arm-twisting persuader for the
1 A s a result, Buffelt's
reluctant). Together with LTCM's $400 million in remaining equity, the cash
infusion looked to be enough to get LTCM through this financial crisis. The
consortium was expected to last for three years while LTCM was liquidated.
For most of the participants, rescuing LTCM was a bitter pill to swallow
because they were being asked for help at a. time when their own income
statements, balance sheets, and credit ratings were being decimated by
CM
the slumping markets. 44 Shares of these financial institutions had been
pummeled in the market; Goldman Sachs, a private company, had to
around. Still postpone its IPO due to poor market conditions. 45 Now, these financial
ier investors institutions were being asked to save a group whose arrogance, secrecy,
have known for bii|S and overbearing style of trading were of epic dimensions, which just
needed counterplr|| added to the consortium members' chagrin. Nevertheless, the liquidation
is could be transferri|jj went smoothly, and by early 2000, LTCM's portfolio had been sold. In the
iy Buffett, the Sage feiij end, none of the top six security firms incurred any realized or unrealized
'ier the way he did.
losses during the third quarter of 1998 as a result of the failure. LTCM's
ium's $3.65
mark-to-market exposures in August and September were fully coilater-
at require courier
er was an investment in alized. Even in September 1998, when margin calls ran into tens of
in the transfer of posi- millions of dollars, LTCM had more than 300% of the needed funds in its
ence was subtle, but the margin account. 46
al. The consortium deal Under the recapitalization plan, the consortium gained 90% ownership
better than the BH-A1G- of the fund (i.e., LTCP) and operational control as general partner. The
>rtant. The LTCM princi- original owners' (i.e., LTCM's principals' and investors') claim on the com-
iponsibiiity to act with
pany was written down to 10%, with the provision that the principals stay
isparency, to avoid con-
with LTCM. for one year and help liquidate its trades in an orderly manner.
i, and to negotiate the
owners. The difference
By accepting 10% of a company that now had at least $3.65 billion in
ffer and the consortium
material. 4i The banks were: i . Bankers Trust ($300 million), 2. Barclays ($300 million), 3. Chase Manhattan
($300 million), 4. Deutsche Bank {$100 million), 5. Union Bank of Switzerland {$300 million), 6.
Travelers/Salomon Smith Barney ($300 million), 7. J.P. Morgan ($300 million), 8. Goldman Sachs
($300 million), 9. Merrill Lynch ($300 million), !0. Credit Suisse-First Boston (S300 million), 11.
olio. Berkshire Hathaway Morgan Stanley Dean Whiuer ($300 million), 12. Societe Generale ($125 million), 13. Bank Paribas
700 million. Sec Miichcl! ($100 million), and 14. Lehman Brothers ($!00 million). Steven Lipin, Matt Murray, and Jacob M.
Long-Term Capital, Schiesinger, "Bailout Blues: How a Big Hedge Fund Marketed Its Expertise and Shrouded its Risks—
Regulators and Lenders Knew Little About the Gambles at Long-Term Capital—'Stardust' in
Investors' Eyes," Wall Street'Journal (25 September 1998), Al.
s, the counterparties were 4Jl Credi! rating agencies, like Standard and Poor's, were threatening to downgrade the debt of invest-
ing with 40 counterparties ment banks, such as Lehman Brothers. Goldman Sachs, and Merrill Lynch.
orkinji Group on Financial 45 Goldman Sachs waited until May 1999 to go public.
.ideal's Working Group on ^President's Working Group on Financial Markets. Hedge Funds, Leverage, and the Lessons of Long-Term
lagemait; Report ?f>hc Pmi- Capital Management: Report of the President's Working Croup on Financial Markets. Washington, DC;
ry, 28 April 1999, I I Department of Treasury. 28 April 1999, 8-7 and C-12.
260 CHAPTER 8: Long-Term Capital Mismanagement: "JM and the Arb Boys"

consortium-supplemented equity, the LTCM's shareholders had increased injuries. Despite th

their take by $150 million more than the Buffett et. al proposal but it was learned from this e
still only one-tenth of their positions one year earlier. The deal also came
with an implied call option because, if LTCM recovered, the principals' BE CAREFUL WHA
interests would rise and, conceivably, they could repurchase LTCM from LTCM tried to prof
the consortium. iund industry wide
Reaction to the Fed-sponsored rescue was mixed. Those who favored it ically based risk m
lauded the Fed and the consortium for saving the global financial system bulence gave rise
from immeasurable damage. Al the same time, critics protested that the res- flight to quality, flig
cue was just another example of capitalist hypocrisy.47 Why was the Fed sources of credit a
willing to intervene on the behalf of rich investors, about 1 50 employees, engage in new tra
and a handful of principals? Why should the LTCM principals be allowed to
keep anything after inflicting such losses? Wasn't this the fund that was BEWARE OF MOD
incorporated in the Cayman Islands to avoid paying U.S. taxes? Why was
LTCM placed large
the Fed not giving such limousine service to countries like Russia, Brazil
cated statistical an
and Argentina? Frustrations and anger ran deep.
ment model that
One of the central issues involved moral hazard, a major cause of market
it used risk manag
failure. 48 For the Fed, the moral hazard issue boiled down to a simple ques-
investment bank
tion: If it bailed out LTCM, might the Fed be signaling to other hedge funds
occasions when m
and financial institutions that there would always be a safety net for those
historical precede
companies deemed "too big to (ail/'resulting in an even greater number of
LTCM made an
failures in the future? in other words, would the Fed be granting LTCM a
wrong. First, it as
free put option on its own portfolio, thereby providing an incentive for other
large discrete pr
companies to take greater financial risks in the future? 49 Although the Fed
assumed that, pr
did not contribute a penny to the recapitalization, its presence might have
Again, it was w
raised the value of the implied protection {the put option) given to LTCM.
mally distributed
and control its ris
Conclusions and Lessons to Be Learned fat tails, which
occurring than
LTCM was a creature of turmoil structured to thrive in turbulence, regard- good things hap
less of whether the markets went up or down. The greater the volatility investors' decisio
(and it made no difference whether this instability was company, industry, someone decide
domestically, or globally based), the greater the opportunities. How ironic, what someone
then, that in the end, turbulence was a major cause of the company's undo- was wrong. Mom
ing. The LTCM failure was like a huge plane crash in which all the passen- against LTCM, in
gers, crew, and crash site residents walked away with relatively minor
ALL FOR ONE M
'"Michae! Schroedcr and Jacob M. Schlcsinger. "Fed May Face Recriminalion over Handling of Fund
Bailout," Wall Street Journal (25 September 1998). A8. LTCM was not t
48Moral hazard occurs when individuals with insurance take greater risks {because they are protected) cash flow proble
than they would have taken wiihnm insurance.
49See, Anonymous (editorial), "Decade of Mora) Ha/ard." Wall Street Journal (25 September 1998), A14,
try-wide losses w
oys"
Conclusions and Lessons to Be Learned 261

ders had increased injuries. Despite the lack of extensive damage, there are many lessons to be
>roposal, but it was learned from this episode.
rhe deal also came
ed, the principals' BE CAREFUL WHAT YOU WISH FOR
rchase LTCM from LTCM tried to profit from mispriced spreads. When spreads facing the hedge
fund industry widened and then went topsy-turvy, they undermined histor-
3se who favored it ically based risk management measures. Greater economic and financial tur-
ai financial system bulence gave rise to an abundance of new opportunities, but the market's
tested thai the res- flight to quality, flight to liquidity, and flight from arbitrage threatened LTCM's
Why was the Fed sources of credit as well as the willingness and ability of its counterparties to
LU 150 employees, engage in new trades and to hold open positions.
ipals be allowed to
:he fund that was
BEWARE OF MODEL RISK
. taxes? Why was
ike Russia, Brazil, LTCM placed large bets using considerable practical experience and sophisti-
cated statistical analyses, but its conclusions were based on a risk manage-
>r cause of market ment model that ultimately proved to be faulty for two major reasons. First,
i to a simple ques- it used risk management parameters that may have been better suited to an
3ther hedge funds investment bank than a hedge fund; second, it did not account for those
ifety net for those occasions when markets react and move in ways that are inconsistent with
greater number of historical precedent.
granting LTCM a LTCM made and deeply believed in four major assumptions that proved
ncentive for other wrong. First, it assumed that prices would move continuously, which means
Although the Fed large discrete price changes would not occur. It was wrong, Secondly, it
sence might have assumed that price volatility would return quickly to its historic average.
given to LTCM. Again, it was wrong. Thirdly, LTCM assumed that asset returns were nor-
mally distributed, so that, with 99% accuracy, the company could calculate
and control its risk levels. Again, it was wrong—the real world seems to have
fat tails, which means extreme events have much larger probabilities of
occurring than the normal distribution indicates (i.e., very bad and very
rbulence, regard- good things happen more often than expected). Finally, LTCM assumed that
iter the volatility investors' decisions were independent of one another in the sense that what
rnpany, industry, someone decides today will not influence what he decides tomorrow, and
ities. How ironic, what someone decides today will not influence anyone else. Again, LTCM
company's undo- was wrong. Momentum in the global, financial markets kept spreads moving
:h all the passen- against LTCM, indicating that decisions are not independent.
relatively minor
wer Handling or Fund ALL FOR ONE AND "1" FOR ALL
LTCM was not the only financial intermediary to experience profitability and
.isc ihey are projected)
cash flow problems. Losses were endemic to the industry. In part, the indus-
September 1998), A14. try-wide losses were due to hedge funds that emulated LTCM's successes and
262 CHAPTER 8: Long-Term Capita! Mismanagement: "JM and ihe Arb Boys"

adopted similar strategies, When these imitator funds tried to liquidate their IN THE LONG RUN,
positions ail at once, market prices turned sharply against them. Correlations BEING EFFICIENT
among the prices of otherwise unrelated assets suddenly converged to one, In competitive mar
their highest level. Portfolios t h a t were once very diversified looked increas- success invites imita
ingly like a common, industry-wide portfolio. The new correlations made original profits were
LTCM's VaR estimates virtually useless indicators of the true risks facing the time, profiting from
company. sweeping money of
follow. LTCM soon
LEVERAGE IS A FAIR-WEATHER FRIEND techniques lost their
In its final report in 1999, the President's Working Group on Financial increasingly, to its o
Markets concluded that the principal policy issue emerging from the LTCM
collapse was excessive leverage, 50 As times, LTCM's leverage ratio rose YOU CANT FLOAT
above 30:1, which meant if investment returns increased assets by a little If the first rule of m
less than 3.5%, the company earned 100% on its equity, and if they fell by hold of something else
the same amount, the company was insolvent.'' 1 Leverage adds to risk and, can't sell. When the
therefore, gives companies more opportunities to succeed and also more have a ready marke
opportunities to fail. It is for this reason that the credit risk of leveraged ond (or third) look
hedge funds, even those with market-neutral strategies and stellar past per- to such extreme lev
formances, must be objectively assessed and constantly monitored. when economic co
skelter, LTCM had
FINANCIAL TRANSPARENCY iS THE FIRST STEP to meet its ever-inc
IN MEANINGFUL REFORM The problem wa
The lack of financial transparency was a major source of this debacle. LTCM portfolios and risk
hid its positions by dividing trades among half dozen or more counterpar- market to focus on
ties, each having only a partial understanding of LTCM's overall position. marked-to-market
Only part of these chain-linked trades surfaced to the balance sheets of the same way. The
these financial intermediaries because they were derivative positions, many the solvency of the
of them highly leveraged. Ln the end, these positions increased substantially
the systemic risks from LTCM's failure, and the contagion from LTCM's fail- SOME THINGS AR
ure threatened to spill over into the global financial markets. Because hedge By mere size alon
funds are here to stay, financial regulators (e.g., the Federal Reserve Sys- was rescued in 199
tem, Securities and Exchange Commission, Japanese Ministry of Finance, large hedge fund r
and European Central Bank) are seeking efficient ways to balance regula- mission (CFTC). I
tion with open competition. Central banks worldwide are also searching for than the next lar
more effective methods to supervise the network of regulated banks that funds had an avera
deal on a regular basis with hedge funds. LTCM's failure
have brought sign
parties, many of
^President's Working Group on Financial Markets. /-te%? Funds. L^verag?, and the tessons af Long-Term
Capita! Management: Report of thf President's Working Gn'up MI Financial Murkeu. Washington, DC: I "Sec President's Workin
Department of Treasury, 28 April 1999. ; Term Capital Managemen
'''Near (he end, in the summer of 1998, ITCM's leverage rose above 100:! because of the rapid \t of Treasury,
decline in its equity and ihe more sluggish relative decline in its assets.
 Conclusions and Lessons to Be Learned 263

IN THE LONG RUN, BET ON GLOBAL FINANCIAL MARKETS

BEING EFFICIENT
In competitive markets, excess profits are difficult to achieve because
success invites imitation, and imitation reduces the margins on which the
original profits were made. Some markets may be slow to react, but over
time, profiting from inefficient markets is like picking low-hanging fruit or
sweeping money off a table. If it is that easy, then others will be sure to
follow. LTCM soon had many imitators, and as a result, its proprietary
techniques lost their distinctive edge, which meant the company fell victim,
increasingly, to its own success.

YOU CANT FLOAT WITHOUT LIQUIDITY

If the first rule of mountain climbing is Don't let go of one thing until you have a
hold of something else, then the first rule of hedge funds is Don't buy what you
can't sell. When the going gets rough, liquidity is crucial and if you do not
have a ready market, into which you can sell your assets, then maybe a sec-
ond (or third) look at your assets is needed. Had LTCM not leveraged itself
to such extreme levels, iliiquidity would not have been such a problem, but
when economic conditions in 1997 and 1998 unexpectedly went helter
skelter, LTCM had to liquidate portions of its portfolio at fire sale prices just
to meet its ever-increasing margin calls and collateral requirements.
The problem was that many financial intermediaries had very similar
portfolios and risk management systems. As well they were forced by the
market to focus on short-term financial results because their portfolios were
marked-to-market daily. In a liquidity crunch, these institutions acted in
the same way. Their flight to liquidity depressed asset prices and threatened
the solvency of these highly leveraged companies.

SOME THINGS ARE WORTH DOING FOR THE GREATER GOOD

By mere size alone, LTCM dominated the hedge fund landscape. When it
was rescued in 1998, LTCM was the biggest and the most highly leveraged
large hedge fund reporting to the U.S. Commodity Futures Trading Com-
mission (CFTC). Its $125 billion of assets were nearly four times greater
than the next largest fund. 5 2 By comparison, the 10 largest U.S. hedge
funds had an average size of only about $36 billion.
LTCM's failure could have caused widespread contagion, which would
have brought significant financial pressures on its large, direct counter-
parties, m a n y of whom were losing considerable amounts because of

52See President's Working Group on Financial Markets. Hedge Funds, Leverage, and (he Lessons of Long-
Term Capua! Management: Report of the President's Working Group on Financial Markets, Washington, DC:
Department of Treasury. 28 April 1999, 14 and C- S3.
264 CHAPTER 8: Long-Term Capital M/smanagement: "JM and the Arb Boys"
T

their comparable portfolio positions. 53 The financial crisis could have also Fund, a hedge fund ba
caused pressure on international exchanges where LTCM represented 5% held a full-time profess
to 10% of the open interest and an even greater percent of the daily his heavy schedule of
turnover. But over and above this, if LTCM's counterparties were hedged Mullins, Jr., left LTCM t
beforehand, the failure of this f u n d could have caused a mass scramble to Since the fund's ince
shore up the newly exposed positions. As a result, market prices could of the arbitrage lords
have moved even more unfavorably, causing wider and deeper conse- the company. Those in
quences. Credit risks would have been reevaluated, which could have led October 1998, many of
to a credit squeeze, and the greater uncertainty could have increased the Meriwether and the ot
risk premium embedded in nominal yields. trading decisions, and
When the greater good is larger than the sum of benefits accruing to the sliced, and diced. Neve
individual vested interests (i.e., in this case, the counterparties to LTCM's keep their homes57 an
trades and its creditors), there needs to be a way to communicate fully and stayed with the compa
clearly what is at stake. If private parties have no incentive to limit their set backs, but that sho
bilateral risks to reduce contagion effects, then perhaps, it is up to central deserved some downsi<
banks, securities regulators, and private associations to open the eyes of key leave before year's end
players about the externalities. The trick is doing this without rewarding after the collapse, Joh
irresponsibility or encouraging bad behavior in the future. LTCM, had already sta

CREDITORS AND 1NVE

Epilogue Because of the rescue,
What Happened to the Principals, Creditors, Investors, and Consortium? ironic twist of fate, inv
group made out mud
LTCM's management company, Long-Term Capital Management L.P., was unsuccessfully to amf
transferred to the consortium. The recapitalization saved most of the parties LTCM principals decid
involved in this debacle from serious collateral damage. Because the pany did not need sue
destruction seemed so small, after the dust settled, Myron Scholes called in December 1997 o
LTCM's failure the "non-fault bankruptcy of his hedge fund," but he was equity capital, but the
probably not considering the damaged reputations and lost jobs at hedge a result, LTCM began
funds and financial institutions around the world. 54 rather than over $7 b
Investors were ups
THE PRINCIPALS AND EMPLOYEES was clear. During the
Myron S. Scholes retired four months after LTCM collapsed, planning to LTCM had quadruple
return to California, where he would lecture and write at Stanford Univer- mind would force its ir
sity. 55 In August 2000, Scholes began working for Oak Hill Platinum Partners principals had grown
in 1994 had grown t
I S *LTCM estimated that us top 17 counterparties would have tost between $3 billion to S5 billion if i!
I defaulted. Ibid. p. 17.
56 Robert Goldwyn Blument
I 54This quote comes from a speech by Myron Scholes ai an Economist magazine-sponsored symposium
) on the first anniversary of LTCM's failure. Giecl in Anonymous, "Finance and Economics: Economics 80(32) (7 August 2000), 10.
57 John Meriwether's house
i Focus: When ihe Sea Dries Up," The Economist 352 (8134) (25 September 1999), 93.
| "Anita Raghavan and Mitchell Pacdle, "Key Figures Set to Leave Hedge Fund—Long-Term Capital east of New York City.
58 Eric Rosenield, Larry Hili
1 Losing Two Fanners," Wall Street .Journal ( 3 February 3 999), C t .
 Epilogue 265

Fund, a hedge fund backed by Robert M. Bass.56 Robert C. Merton. who

held a full-time professorship at Harvard University since 1988, continued
his heavy schedule of lecturing, researching, and consulting. David W,
Mullins, Jr., left LTCM to become chairman of vSimplify, a portai company.
Since the fund's inception, LTCM's staff members had been the servants
of the arbitrage lords and routinely invested all their bonuses back into
the company. Those invested bonuses were now gone, and by the end of
October 1998, many of these employees (about 20%) were laid off. John
Meriwether and the other principals lost most of their autonomy to make
trading decisions, and their exorbitant management fees were slashed,
sliced, and diced. Nevertheless, as part of the deal, LTCM's principals got to
keep their homes 57 and received bonuses of $250,000 for the year they
stayed with the company. Many of the principals still faced bitter financial
set backs, but that should be expected because they caused the fiasco and
deserved some downside consequences. Some of them were permitted to
leave before year's end for lucrative jobs on Wall Street. Just over a year
after the collapse, John Meriwether, along with five of his colleagues58 at
LTCM, had already started a. new hedge fund.

CREDITORS AND INVESTORS

Because of the rescue, virtually all of LTCM creditors were paid in full; in an
ironic twist of fate, investors who were not principals or part of LTCM's core
group made out much better than you might at first expect. After trying
unsuccessfully to amplify its risk to the desired 20% per year level, the
LTCM principals decided that, for the level of risk it was taking, the com-
pany did not need such a large capital base. As a result, it took the bold step
in December 1997 of forcing investors to take back $2.7 billion of their
equity capital, but the company did not reduce its investment positions. As
a result, LTCM began 1998 with approximately $4.7 billion in equity capital
rather than over $7 billion, which it would have had.
Investors were upset and felt betrayed by the forced refund. The reason
was clear. During the three years from February 1994 to December 1997,
LTCM had quadrupled their portfolios. Investors asked: What fund in its right
mind would force its investors to take their money and go home? But the LTCM
principals had grown rich. The $146 million of equity capital they invested
in 1994 had grown to $1.9 billion, and these funds along with the equity

56 Robert Goldwyn Biurnenrhai. "Life After Long-Term Captia! May Be Very Sweet, Indeed," Barren's
80(32) (7 August 2000), 10.
57 John Merivvether's house was a 67-acre estate in Westchesler County, NY, a wealihy suburb north-
east of New York City,
5 8 EricRosenfe!d, Larry Hiiibrand, Vinor Haghani, Richard Leahy, and Arjun Krishnamachar.
266 CHAPTER 8: Long-Term Capital M/smanagemeni: "JM and the Arb Boys"

and financial support of a core group of strategic investors and key banks Why did LTCM
were all it needed. 5. Why was long
All together, during their four-year roller-coaster ride (i.e., from fortune to 6, What: were LTC
despair), John Meriweiher and his band of arbitragers netted outside (non- sources?
principal) investors average annual returns of slightly less than 20%, which is jy Given its strate
not a bad return. But these investors made out as well as they did because credit rating?
they were forced to take a refund. Therefore, when the collapse occurred, ^1
8./ Explain how L
they had nothing (or relatively less) invested in LTCM. In the end, it was Explain the en
John Meriwether and the other principals who were most harmed by the caused LTCM'
LTCM failure. diversification
10. How did LTCM
THE CONSORTIUM 11. Explain the th
The consortium had mixed results. Spreads did not converge rapidly and /L2?)What is Value
economic conditions remained tenuous. As a result, some, but not all, of failure?
LTCM's positions were closed with profits, but overall the results were satisfy- 13. Explain the m
ing because the full $3.65 billion invested by the consortium was paid back. 59 14. Explain the ca
LTCM.
15. Explain the R
Review Questions 16. What role did
was the Fed i
Given the economic and political turmoil t h a t took place in 1998,
what bet would have earned John Meriwether and his team of Further Reading
arbitrageurs the highest profits?
Suppose the yield on a two-year Treasury note was 4%, and the Please visit
yield on a five-year Treasury note was 6%. If you expected this following embellishr
yield spread to widen, explain the spread trade you would execute.
a. After a year, suppose the yield on a iwo-year Treasury * Appendix 8,1:
note fell to 3.5%, and t h e yield on a five-year Treasury * Appendix 8.2:
note rose to 6.5%. Would you profit or lose on your trade? * Appendix 8.3:
Explain.
b. After a year, suppose the yield on a two-year Treasury
Bibliography
note rose to 6% and the yield on a five-year Treasury note
fell to 5.5%. Would you profit or lose on your trade? Adrian, Tobias. "Meas
Explain. New York Current tow
Using the informal ion from Exhibit 8.2, calculate the return on Anonymous (Editoria
assets and the return on equity if LTCM had earned only a 1% net 199S), A14.
Anonymous. "Finance
return (instead of a 5% net return) on the investment assets
Economic 352 (8134)
purchased with borrowed funds. Anonymous. Hedge Fu
www. magnum, com/i
(M Blumenthal, Robert Gc
Barren's SO (32) (7 Ai
 Bibliography 267

<D Why did LTCM have difficulty raising its level of risk?
5. Why was long-term funding crucial to LTCM's strategy?
6, What were LTCM's major assets? What were its major financing
sources?
Given its strategy, why was it vital for LTCM to have a high
credit rating?
Explain how LTCM minimized its use of equity.
Explain the endogenous (i.e., hedge-fund-related) factors that
caused LTCM's portfolio to lose the normal protections afforded by
diversification.
How did LTCM secure Song-term funding?
Explain the three major catalysts that caused LTCM to fail.
What is Value at Risk (VaR), and what role did it play in the LTCM
failure?
Explain the major benefits of a total return swap.
Explain the causes of the Asian Tiger crisis and how it affected
LTCM.
15. Explain the Russian ruble crisis and how it affected LTCM.
16. What role did the Federal Reserve play in the LTCM rescue? Why
was the Fed involved?

Further Reading
Please visit http://www.prenhall.com/marthinsen, where you can find the
following embellishments on and extensions of this chapter.
« Appendix 8.1: LTCM's Major Trades
* Appendix 8.2: What Are the Problems With Value at Risk?
• Appendix 8.3: UBS and the LTCM Warrant Fiasco

Bibliography
Adrian, Tobias. "Measuring Risk in the Hedge Fund Sector." Federal Reserve Bank of
New York Current Issues in Economics and Finance 13(3) (March/April 2007), 1-7.
Anonymous (Editorial) "Decade of Mora! Hazard." Wall Street Journal (25 September
1998), A14.
Anonymous. "Finance and Economics: Economics Focus: When the Sea Dries Up," The
Kconofnisr 352 (8134) (25 September 1999), 93.
Anonymous. Hedge Fund Association. "About Hedge Funds" (23 February 2003). http://
www.magnurn.com/hedgefunds/abouthedgefunds.asp. Accessed 28 December 2007.
Blumenthal. Robert Goldwyn, "Life After Long-Term Capital May Be Very Sweet, Indeed/'
Barren's 80 (32) {7 August 2000).