ce

x perien
d in g e
Bo n d t ra

Black LOANS
.6B
= $3
U T
I LO

RE
B A

SU
ES
PR
%
p t o 40
Scholes U
rns
retu
r
ri wethe
Me INVESTMENTS
Merton Up to $1 trillion in derivatives

Mullins

LTCM
$1.25 billion up to $7B PRES
down to $555M SU RE

LOANS
 Agenda
• Introduction
• Strategies
• LTCM’s Success
• When Genius failed
• Counterparties
• Bailout-Fed’s Intervention
• Lessons Learnt
• Conclusion
Background
 Key Members
• John Meriwether who founded Long Term
Capital Management 1993.
• Fixed Income Trader at Salomon Brothers.
• Two Nobel Laureates: Robert Merton and
Myron Scholes.
• Former Regulator David Mullins.
• Had huge respect in Wall Street more than
Average Dealer or Broker.
 Strategies
• Spread Trades
Relative-value trades
paired trades
Convergence trades
• Fixed Income Arbitrage-Yield Curve Trades
• Pooled mortgage market Investments
• Buying and selling volatility
• Merger Arbitrage/Risk Arbitrage
Cash Merger
Stock Merger
 It was a Game
• It was unregulated.
• Free to operate in any market.
• No capital charges.
• Only few reporting to US Securities &
Exchange Commission (SEC).
• Interest rate swaps on market rate with no
initial margin.
 Borrow From a bank

Buy Securities with that Cash

Borrow From another bank keeping

securities as collateral

This theory could leverage to

infinity
Background
LTCM’s Success
 Background

• The hedge fund incorporated a Delaware limited

partnership LTCM L P,but the Fund, LTC Portfolio L
P, was a Cayman Islands entity.
• By 1997, the equity had risen to $7 billion, but by the
beginning of 1998 this had fallen to $4.8 billion ($2.7
billion or 36 percent of its capital having been
returned to investors in 1997.
 Borrowings
• LTCM borrowed a further $124.5 billion, giving a
leverage ratio of 25:1,and the asset base was four
times that of the next largest hedge fund.

• At that time, most hedge funds did not borrow more

than their equity, and it was rare for the leverage
ratio to exceed 10:1
 Returns
For a few years LTCM offered investors spectacular returns after
hefty fees of 2 percent for administration plus an incentive fee of
25 percent.
 The SEC for June 30 1998 showed that LTCM had
equity stakes in 77 companies, worth $541 million. It
also got into emerging markets , including Russia.

Russia was "8% of its book" which would come to $10

billion. Meriwether applied a formula which brought in
new investment During 1997, under this formula.
• UBS put in $800 mn in the form of a loan and $266
mn in straight equity.
• Credit Suisse Financial Products put in a $100 mn
loan and $33 mn in equity.
• Other loans may have been secured in this way,
but they haven’t been made public.
• Investors in LTCM were pledged to keep in their
money for at least two years.
• LTCM entered 1998 with its capital reduced to $4.8
bn.
When Genius Failed
• In 1997 the fund’s assets had grown to about $120 billion
and its capital to about $7.3 billion despite that high
leverage—an assets-to-equity ratio of over 16 to 1

• The management concluded that the capital base was too

high to earn the rate of return on capital for which they
were aiming.

• They returned $2.7 billion of capital to shareholders,

reducing the capital to $4.8 billion and increasing its
leverage ratio to around 25 to 1.
 FACTORS AGAINST LTCM

• The time-frame within which rates would converge again

• Counterparties had lost confidence in themselves and LTCM.
• Many counterparties had put on the same convergence trades,
some of them as disciples of LTCM.
• Some counterparties saw an opportunity to trade against LTCM’s
known or imagined positions ( taking the opposite position).
• Most of LTCM’s bets had been variations on the same theme,
convergence between liquid treasuries and more complex
instruments that commanded a credit or liquidity premium.
Unfortunately convergence turned into dramatic divergence and
lost $550 million in one day.
• Hence LTCM was being forced to liquidate to meet margin
calls.
 THE BIG TROUBLE

•Big trouble for LTCM started on:-

•July 17 1998 when Salomon Smith Barney announced
it was liquidating its dollar interest arbitrage positions.
That month, the fund dropped about 10%
because Salomon Brothers was selling all the
things that Long-Term owned.
 RUSSIA DEFAULTS

•ON Aug 17, 1998 the Russian government devalued the

ruble and declared a moratorium on future debt
repayments of $13.5billion.
•This lead to the large increases in the spreads between the
prices of Western government and emerging market bonds
and the fund had bet massively on those spreads’ narrowing.
•This resulted the decline of LTCM’s capital down to $2.3
billion at the end of August 1997 and the fund had lost over
half of the equity capital it had had at the start of the year.
The Assets got reduced to $107 billion from $ 120 billion
so its leverage ratio had climbed to over 45 : 1 which is a
very high ratio that to in a volatile environment.
•As its losses mounted, meeting margin calls became difficult
for the fund and needed more collateral to ensure that it could
meet its obligations to counterparties.
•The fund was running short of high-quality assets for
collateral to maintain its positions, and it also had great
difficulty liquidating its positions: many of its positions were
relatively illiquid even in normal times and hence still more
difficult to sell in the declining markets.
•By September 19 the fund’s capital was down to only
$600 million.
•The fund had an asset base of $80 billion, and its leverage
ratio was approaching stratospheric.
 SWAPS
• LTCM had done swap upon swap with 36 different
counterparties.
• In many cases it had put on a new swap to reverse a
position rather than unwind the first swap, which would have
required a mark-to-market cash payment in one direction or
the other.
• LTCM’s on balance sheet assets totalled around $125
billion, on a capital base of $4 billion, a leverage of about 30
times.
• But that leverage was increased tenfold by LTCM’s off
balance sheet business whose notional principal ran to
around $1 trillion.
 Fall down Graph
Russia 80% loss over 5 weeks
defaults

$4.50
4.00

3.00

2.00

1.00

0.00
3/1994 1/1995 1/1996 1/1997 1/1998

Gross value of $1 invested March 1994 - October 1998 in LTCM

When Genius Failed pp. xiv
• US Fed hearing LTCM problem from
Wall Street banks.
• Bear stearns (clear house) wanted
$500 mn collateral to continue trade.
 Counterparties
• 20 Counterparties
• Probable Loss of $3 bn.
• Looking for single buyer of the portfolio.
• AIG was looking to buy.
• LTCM’s capital base dwelled $600 mn.
• UBS $800 mn credit and $266 mn sent team to
study portfolio.
• Vice president Peter Fischer, JP Morgan,
Merrill Lynch, Goldman sachs and UBS.
Was LTCM a bailout?
 Counterparties & Bail-out
• LTCM borrowed $470 mn from Chase
Manhattan Bank.
• Fed planned to chip $250 mn from 16 banks to
total LTCM’s capital $4 bn.
• Warren Buffet offered to Buy portfolio $250 mn
& Recapitalize it from:
 $3 bn from Berkshire Hathaway group
 $700 mn from AIG
 $300 mn from Goldman Sachs
Condition: John Meriwether and team will have no Management.
 Bail-out
• Fed cannot bail-out as LTCM was in
Caynes Island.
• JP Morgan did not reply.
• Bear Stearns denied as it already had
lost from it.
• Lehman Brothers also denied.
• 13 banks left to bail-out at last.
• Meriwether left with 10% stake.
Bail-out Funds
Bank Amount
Contributed
Bankers Trust $300M
Barclays 300M
Chase 300M
CSFB 300M
Deutsche Bank 300M
Goldman Sachs 300M
Merrill Lynch 300M
JP Morgan 300M
Morgan Stanley 300M
Salomon 300M
UBS 300M
Société Générale 125M
Lehman Bros 100M
Paribas 100M
Bear Stearns $0. (Karma)
Total: $3.625B
 The Losers
• LTCM partners: $1.1 bn
• Liechtenstein Global Trust: $30 mn
• Bank of Italy: $100 mn
• Credit Suisse: $55 mn
• UBS: $690 mn (Biggest Loser)
• Merrill Lynch (deferred employees payment): $22 mn
• Donald Marron, chairman, Paine Webber: $10 mn
• Sandy Well, co-ceo, Citigroup: $10 mn
• McKinsey executives: $10 mn
• Bear Stearns executives: $10 mn
• Dresdner Bank: $145 mn
• Sumitomo Bank: $100 mn
• Prudential Life Corp: $5.43 mn
Was LTCM successful
(as a bailout)?
 After Story
• Mid 1998, LTCM making again profit of $400
mn.
• June 1999, 14% up of net fees of members.
• Meriwether looking for $4.7 bn fund redeem.
• July 1999, LTCM paid $300 mn to original
investors who had 9% stake.
• $1 bn to 14 consortium members.
 Relevance to Current Crisis

• Investment strategies

• Market dynamics

• Moral hazards
 Lessons
The account of collapse of LTCM made
us analyze and think of things which were
essential to be considered to make sure
such type of mistakes doesn’t happen the
next time.
They are
Risk Factor
Risk is basically anything affecting the efficient performance.

Transparency
It is basically to deal with relationship management and openness.

Trading Credit
Taking leverage to multiply the profits. Good ? To a certain level.

Frequent Market Analysis

A hedge fund should make frequent analysis about market conditions so as to
anticipate the worst case scenario since there are lots of risk factor involved in
it.

Regulations
There must be proper regulations to hedge funds as well . Though it is not
confined to retail investors it is still public money and something should have a
strict enforcement in using the same.
 Risk types

•Liquidity Risk
Operational efficiency to meet the margin requirements,
budgeted planning etc.
•Market Risk
Market perceptions, factors driving the market, psychological
aspects on making a instrument liquid and illiquid etc.
•Credit Risk
Efficient formulation of credit policies and ensuring lesser
deviations, in such formed policies.
•Governance Risk
Corporate governance, responsibility and regulatory measures.
•Operational Risk
Maintaining secrecy of operational information, trying to avoid
small mistakes as it could lead to bigger problems.
•Reputational Risk
Maintaining the so earned reputation with good transparency
with clients, employees,shareholders, investors etc.
 Reference List
• Shirreff, D (n.d.) “Lessons from the Collapse of
Hedge Fund, Long-term Capital Management”.
• Butler et al (2007) “Long Term Capital Management
case study” Cornell University, New York.
• Halstead, J,M et al (2005) “Hedge Fund Crisis and
Financial Contagion: Evidence from Long Term
Capital Management” pp.65-67.
• The Trillion Dollar Bet (2000) [Accessed from
www.youtube.com on 6’ November’ 2015].
 ce
x perien
d in g e
Bo n d t ra

Black LOANS
.6B
= $3
U T
I LO

RE
B A

SU
ES
PR
%
p t o 40
Scholes U
rns
retu
r
ri wethe
Me INVESTMENTS
Merton Up to $1 trillion in derivatives

Mullins

LTCM
$1.25 billion up to $7B PRES
down to $555M SU RE

LOANS