page_title: Long-Term Capital Management
section_title: Downturn
hierarchical_section_title: Long-Term Capital Management / Downturn
caption_attribution_description: English: The value of $1000 invested in the hedge fund Long-Term Capital Management, of $1,000 invested in the Dow Jones Industrial Average, and of $1,000 invested monthly in U.S. Treasuries at constant maturity.
context_page_description: Long-Term Capital Management L.P. was a hedge fund based in Greenwich, Connecticut that used absolute return trading strategies combined with high financial leverage. LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Members of LTCM's board of directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives".
  Initially successful with annualized return of over 21% in its first year, 43% in the second year and 41% in the third year, in 1998 it lost $4.6 billion in less than four months due to a combination of high leverage and exposure to the 1997 Asian financial crisis and 1998 Russian financial crisis.
context_section_description: Although periods of distress have often created tremendous opportunities for relative value strategies, this did not prove to be the case on this occasion, and the seeds of LTCM's demise were down before the Russian default of 17 August 1998. LTCM had returned $2.7 bn to investors in Q4 of 1997, although it had also raised a total in capital of $1.066bn from UBS and $133m from CSFB. Since position sizes had not been reduced, the net effect was to raise the leverage of the fund.
  Although 1997 had been a very profitable year for LTCM (27%), the lingering effects of the 1997 Asian crisis continued to shape developments in asset markets into 1998. Although this crisis had originated in Asia, its effects were not confined to that region. The rise in risk aversion had raised concerns amongst investors regarding all markets heavily dependent on international capital flows, and this shaped asset pricing in markets outside Asia too.
  In May and June 1998 returns from the fund were -6.42% and -10.14% respectively, reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. Because the Salomon arbitrage group (where many of LTCM's strategies had first been incubated) had been a significant player in the kinds of strategies also pursued by LTCM, the liquidation of the Salomon portfolio (and its announcement itself) had the effect of depressing the prices of the securities owned by LTCM and bidding up the prices of the securities LTCM was short. According to Michael Lewis in the New York Times article of July 1998, returns that month were circa -10%. One LTCM partner commented that because there was a clear temporary reason to explain the widening of arbitrage spreads, at the time it gave them more conviction that these trades would eventually return to fair value (as they did, but not without widening much further first).
  Such losses were accentuated through the 1998 Russian financial crisis in August and September 1998, when the Russian government defaulted on its domestic local currency bonds. This came as a surprise to many investors because according to traditional economic thinking of the time, a sovereign issuer should never need to default given access to the printing press. There was a flight to quality, bidding up the prices of the most liquid and benchmark securities that LTCM was short, and depressing the price of the less liquid securities it owned. This phenomenon occurred not merely in the US Treasury market but across the full spectrum of financial assets. Although LTCM was diversified, the nature of its strategy implied an exposure to a latent factor risk of the price of liquidity across markets. As a consequence, when a much larger flight to liquidity occurred than had been anticipated when constructing its portfolio, its positions designed to profit from convergence to fair value incurred large losses as expensive but liquid securities became more expensive, and cheap but illiquid securities became cheaper. By the end of August, the fund had lost $1.85 billion in capital.
  Because LTCM was not the only fund pursuing such a strategy, and because the proprietary trading desks of the banks also held some similar trades, the divergence from fair value was made worse as these other positions were also liquidated. As rumours of LTCM's difficulties spread, some market participants positioned in anticipation of a forced liquidation. Victor Haghani, a partner at LTCM, said about this time "it was as if there was someone out there with our exact portfolio,... only it was three times as large as ours, and they were liquidating all at once."
  Because these losses reduced the capital base of LTCM, and its ability to maintain the magnitude of its existing portfolio, LTCM was forced to liquidate a number of its positions at a highly unfavorable moment and suffer further losses. A vivid illustration of the consequences of these forced liquidations is given by Lowenstein (2000). He reports that LTCM established an arbitrage position in the dual-listed c
caption: The value of $1,000 invested in LTCM,[22] the Dow Jones Industrial Average and invested monthly in U.S. Treasuries at constant maturity.
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