From the archiveCase study · Sep 19986 min read
LTCM: the hedge fund that needed a $3.6bn rescue
After Russia defaulted in August 1998, Long-Term Capital Management’s convergence trades all went wrong at once: it lost more than 90% of its capital, and on 23 September 14 banks and brokers agreed to put in $3.6bn to head off a fire sale.
Russia’s default on 17 August 1998 set off a rush to safety. LTCM lost 44% in August alone, and on 23 September 14 banks and brokers agreed to put in $3.6bn for 90% of the fund.
With about $28 of assets per $1 of capital, in trades others copied, LTCM was hit as everyone cut the same positions at once: spreads widened instead of converging and liquidity vanished.
A trade that looks cheap can get cheaper when its holders are forced to sell. Size for a liquidity crisis, not for a model’s normal day: leverage decides who can wait.
The trader’s angle
How leverage, crowded positions and a shock in a distant market can turn small, safe-looking bets into a threat to the whole financial system.
Leverage, end-1997
28 to 1
$129bn of assets, $4.7bn capitalBalance-sheet assets against capital, per the US Treasury. On top sat derivatives with a notional value of more than $1 trillion.
Loss in August 1998
-44%
downin one monthAfter Russia’s default, almost all of LTCM’s spreads widened at once instead of converging.
Capital by mid-September
under $1bn
downfrom $4.7bn in JanuaryMore than 90% of the fund’s capital was gone in under nine months.
10-year US swap spread
close to 100bp
upSep 1998Measured against the newest 10-year Treasury, by one textbook’s account: four to five times its level of the previous six years. Measures against older bonds rose less.
A convergence trade buys one asset and sells a near-identical one that is more expensive, betting that the price gap will close. A classic example: buy an older US bond and sell the newest one of similar maturity, which usually trades at a small premium because it is the easiest to buy and sell.
The gaps are tiny, so the trade only pays with heavy . And it carries a hidden risk. In a panic, investors pay up for the safest and most liquid assets, so the gap can widen sharply before it closes. If you are forced to sell before then, the loss becomes real.
What happened
Long-Term Capital Management was founded in 1994 by John Meriwether, a former Salomon Brothers executive, and became famous for its mathematical models. It returned more than 40% in both 1995 and 1996, and 17% in 1997.
At the end of 1997 it handed capital back to investors without shrinking its positions. That left about $129bn of assets on $4.7bn of capital. Its was about 28 to 1: almost everything it held was bought with borrowed money. On top sat derivatives with a notional value of more than $1 trillion, mostly .
On 17 August 1998 Russia devalued the rouble and defaulted on its debt, and investors fled from risk of every kind. LTCM lost 44% of its value in August alone, and by mid-September its capital was below $1bn. On 23 September, after creditors met at the Federal Reserve Bank of New York, 14 banks and brokers agreed to rescue it. They put in about $3.6bn in return for 90% of the fund, and no public money was used.
Why it happened
LTCM’s positions were mostly bets that price gaps between similar assets would narrow: older against newer Treasuries, swap rates against government bond yields, and similar trades in other major bond markets. Each looked low-risk on its own, because the gaps were small and had been stable. But they shared one hidden exposure: they all lost money when investors suddenly paid up for safety and liquidity.
An default supplied exactly that. and other risk premia jumped worldwide, and the gaps LTCM had bet would converge widened instead, in almost every case.
Worse, its trades were : other hedge funds and banks’ own trading desks held similar positions, and as losses mounted they cut them at the same time. Dealers, worried about their own exposure, pulled back from making markets. The more everyone tried to sell, the wider the spreads went: a spiral that models built on calm years had not allowed for.
How it ripples through markets
How a Russian default broke a New York hedge fund
- 1
Russia devalues and defaults
downRouble17 August 1998: the rouble is devalued and debt payments are suspended.
- 2
A rush to safety and liquidity
upSwap spreadsInvestors pay up for the safest, most easily traded bonds, such as newly issued Treasuries, pushing their down against and less liquid bonds, so widen.
- 3
Convergence trades diverge
downLTCM capitalEach trade bets that the premium on the safer, more liquid asset will shrink, so the rush to safety widens the gaps instead. With heavy leverage, LTCM loses 44% in August.
- 4
Everyone cuts the same trades
Funds and bank desks with similar positions sell at once, and dealers stop making markets.
- 5
Fire-sale fears
With capital below $1bn, a default would force counterparties to dump collateral into barely functioning markets.
- 6
Rescue and rate cuts
downFed funds rate14 firms agree to put in $3.6bn on 23 September; the Fed cuts rates three times by 17 November.
Why it mattered for traders
LTCM’s trades did not have to be wrong in the long run to ruin it. It only had to be unable to survive the short run. At 28 to 1, every widening ate into a thin layer of capital and meant posting more to lenders and counterparties. As the market guessed what LTCM held, no one wanted to buy positions that a forced seller might soon dump.
The danger for the system was a fire sale. LTCM’s counterparties included many of the biggest banks on Wall Street and in Europe. A default would have sent them rushing to close out contracts and sell collateral into markets that were already barely functioning. The Fed feared markets could seize up, hurting firms and economies far beyond LTCM.
So the firms that stood to lose most paid to recapitalise it instead. It was a lesson in : a default in Moscow hit Treasuries and swaps in New York through one leveraged fund.
What happened next
The strain didn’t end with the rescue. The Fed cut its by a quarter point on 29 September, again between scheduled meetings on 15 October, and again on 17 November, taking the federal funds rate to 4.75%.
In April 1999 the President’s Working Group on Financial Markets concluded that the central problem was excessive leverage, which lenders had failed to restrain, and noted that banks and brokers were often bigger and more leveraged than hedge funds. At the end of 1998 the five largest US investment banks had average leverage of about 27 to 1. One of the 14 firms that rescued LTCM was Lehman Brothers; ten years later it failed, with no rescue at all.
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Sources
- Federal Reserve History — Near Failure of Long-Term Capital Management
- Federal Reserve Board — Testimony of Chairman Alan Greenspan on the private-sector refinancing of Long-Term Capital Management
- President’s Working Group on Financial Markets (CFTC copy) — Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management
- US Treasury — Treasury release on the Working Group’s LTCM findings
- Commodity Futures Trading Commission — Testimony of Brooksley Born on Long-Term Capital Management, 1 October 1998
- BIS Committee on the Global Financial System — A Review of Financial Market Events in Autumn 1998
- Federal Reserve Board (via FRASER) — Reduction in the discount rate, 15 October 1998
- McGraw-Hill Education — Long-Term Capital Management (case study)
An original summary written from the sources above. Figures are rounded; follow the links for the full record.
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