The Collapse of a Biggest Hedge Fund

How a Hedge Fund Nearly Collapse The Global Financial Market

By Arsalan HaroonPublished 2 years ago • 9 min read

Edited by the author

In the 1990s, a Hedge fund was founded by the smartest guys on wall street, Every institutional investor believe them, and large banks were willing to give them special conditions to borrow money to invest.

But in a few years, this hedge fund would come close to collapsing the global financial system.

With sophisticated financial modeling, Long term capital management with just over 4 billion dollars in equity had control assets of 120 billion dollars thanks to enormous amounts of leverage provided by banks.

Its off-balance sheet operations through all types of financial engineering and complex derivatives ( swaps, options, futures).

According to the report jointly prepared by SEC, Fed, US treasury department, and future commission, The value of the assets behind the derivatives contracts traded by this hedge fund amounted to 500 billion dollars in foreign exchange swaps, 750 billion dollars in swaps, and 150 billion dollars in options and other derivatives.

An enormous amount of leverage had made this fund the largest hedge fund at the time, and everybody believed these hedge fund managers were some of the brightest gentlemen on wall street.

But on 23 September 1998, federal reserves urgently launched large rescue operations to prevent this hedge fund from bankruptcy, Which nearly crashed the global financial system because of its enormous leverage and size.

What is a hedge fund?

According to Investopedia, a hedge fund is a limited partnership of private investors whose money is managed by a professional fund manager who uses a wide range of strategies, including leveraging or non-traditional assets to earn an above-average return.

A regular person cannot directly invest in a hedge fund.

Hedge funds are exclusively available to wealthy investors, pension funds, insurance companies, and endowments.

So how does LTCM, with the genius guys in the financial world, come close to collapsing the global financial market?

In The Beginning

In the mid-1990s, Long term capital management was the largest hedge fund in the US and four times bigger than its competition.

Long-term capital management was founded in 1994 by John Meriwether, a former head of domestics fixed income arbitrage group and vice chairman at Salomon brothers.

He was a superstar bond trader for the Salomon brothers.

But in 1991, the Salomon brothers were caught in a treasury secretary trading scandal involving Meriweather subordinate Paul Mozer.

He was forced to resign and was charged 50k USD in penalties.

After resigning from the Salomon brothers, He wanted to bring together some of the brightest minds from the financial world and academics to create a hedge fund that uses complex mathematical formulas to find anomalies in the bond market.

Many respected finance professors and famous bond traders were part of his hedge fund, including former vice president of the Fed David Mullins, Eric Rosenfield, a former Harvard professor, Robert Merton, and Myron Scholes.

Robert and Myron Scholes won the Nobel prize for their famous black Scholes model, which is used to value options.

Black Scholes option pricing models are taught in finance and economic courses globally.

Robert Merton and Myron Scholes were actively designing and implementing complex mathematical models and evaluating the value of complex derivatives to decide what trading they should do.

Long-term capital management has united the brightest minds in academics and traders in the financial world.

So many reputable people were running this fund that nobody could ever think they could go bust in just four years after starting the fund.

LTCM started with 1 billion dollars in capital from institutional investors.

Most investors don’t even consider knowing in detail about the strategy used by the fund to make above average return.

They trusted LTCM because the people running the fund were geniuses in the finance industry, and nobody would doubt their ability.

LTCM mainly focused on bond trading, and the fund strategy was to make convergence trade, meaning taking advantage of arbitrage opportunities between securities historically related in a certain way.

For example, a 29-year-old bond issued a year ago would get unattractive to investors when a newly issued 30-year bond comes into the market.

Typically investors will jump to newly issued bonds because they will be more liquid than the old bond. It makes the new bond overvalued, thereby reducing the yield.

On the other hand, the bond issued a year ago would go down because investors will rush to buy newly issued bonds and sell the old ones. So it will get undervalued, and thereby the yield would increase.

The LTCM would go long on a bond undervalued by the market and go short on the newly issued bond, which was overvalued by the market because they believe both securities would go to their real value in a few months.

So LTCM would use their mathematical model and complicated formulas to find these historically related bond anomalies, which they could take advantage of.

One of LTCM’s trades was to buy 30-year German bonds while at the same time shorting 10-year German bonds because they determined with their mathematical models that the spread between the two bonds was big.

The spread between two securities will only be 12 or 10 basis points which is way low. Considering 100 basis points equals 1%.

The spread of 12 or 10 basis points was not big enough to give a higher return.

For example, LTCM would earn 10 cents from their 100 dollars with ten basis points. So to increase their return with tiny basis points, they must take a lot of leverage.

So that’s what they did, and banks were happy to give them billions of dollars in loans because they thought the LTCM strategy was not very risky and wouldn’t lose a lot of money.

The problem with leverage is that it does increase the return on investment. But it also increases the risk of losing large amounts of capital if their trades go a bit wrong.

But LTCM determines with their mathematical models that the market will not go down much and their portfolio will be safe.

No matter how complicated your formulas are, you can’t eliminate the risk of an unexpected event that takes the market down.

So what was the performance of Long term capital management in the beginning?

Well, their strategy was working significantly great, and the investors were happy to invest in their fund.

While S&P 500 returns were 1.32%, Their fund return after fees were 21% in its first year. 43% in 1995, 41% in 1996 and 17% in 1997.

LTCM’s return outperformed the market every year. It quickly rose to become the largest hedge fund on Wall street.

The Collapse Of The Largest Hedge Fund

LTCM models have one big flaw, which would play a large part in their downfall. Its model assumes that the market is rational and past events could accurately predict the future.

But from time to time, an unpredictable event could shock the market, and no mathematical model can put them accurately in their formulas because they are, by nature, unpredictable.

1997 Asian financial Crises sent the market into chaos as Asian economies collapsed. But IMF Bailed Out Asian economies so investors won’t pull their money away from emerging countries.

But when Russia was affected by an economic crisis and defaulted on its sovereign debt in august 1998. It sent the market into turmoil, and capital went away from emerging market bonds into safer US treasury bonds.

It made the bond prices of emerging economies fall significantly, and yields reach higher levels as investors were getting out from them. It also made the US government bond prices rise and yield fall as investors looked for safety. In this unexpected scenario, LTCM’s portfolio took a huge hit.

During the Asian financial crisis, LTCM Models statistically determined that the yield spread between the emerging bond and US Bonds was high.

US Bonds were overvalued by the market, and Emerging market bonds were undervalued due to the Asian financial crisis.

LTCM models tell them that it would converge to their real value. So they shorted the US government bond and went long on emerging market bonds.

But then, in august 1998, when Russia defaulted, It caused a further decline in emerging bonds and an increase in US bond prices as most investors were looking for safety. So the difference between them got wider.

Typically, US treasury Bonds never move more than 2 or 3 points in 2 or 3 days, But they suddenly jumped 21 points in august 1998.

The LTCM model never expected that decline. Historically, it doesn’t happen. So they couldn’t occur according to the model.

But as Keynes said, markets can remain irrational longer than you can remain solvent.

LTCM’s European bonds portfolio was also declining. LTCM trades were going in the opposite direction.

In August 1998, the hedge fund calculated that its daily “Value at risk” — meaning it could lose only $35 million in a day. But later that month, it dropped by $550 million in a day!

This type of “risk management” is a big part of modern finance. The risk was defined as a potential market movement based on historical data. But history is a terrible guide for the future.

Before 1929, a historically based model would have calculated very few odds of a great depression. But after it happened, it would greatly increase the odds of that event.

By mid-Sep, The fund had lost 40% of its value. The situation was getting worse. As a result, LTCM leverages further sour as their securities value declined, and they were desperately looking for capital from investors to survive.

LTCM’s portfolio was leveraged to 25 to 1, meaning for a billion dollars they put in, LTCM borrowed the rest of 24 billion dollars.

LTCM’s portfolio Leverage was sour to 250 to 1 as their assets declined. LTCM knew that its portfolio was so vast that if it started liquidating its position, It could cause the global financial market to crash.

LTCM was losing billions of dollars per day. They have to raise new capital, or they could collapse.

LTCM partners run to their banks and wealthy investors like Soros for help to put more capital into their funds. But institutional investors or banks put them down or say them to convince other investors to get new funds from them.

As banks and institutional investors realized that LTCM was in big trouble, they started to bet against them, Which further declined the value of LTCM assets.

No one was giving them new capital in their bad times. as their positions declined, their leverage also soured as much as 250 to 1,

LTCM Partners asked the Fed for help because their position was so big that if they sold in the market, it could crash the global financial system.

To avoid such a financial disaster. The Federal Reserve outlined a rescue plan carried out by leading banks such as Goldman Sachs, Credit Suisse, JP Morgan, and Deutsche Bank, which provided more than 4 billion to bail out this giant hedge fund.

Conclusion

LTCM collapse taught us that no matter how mathematically complex your models are. Any unexpected events can crush your portfolio. Specially, When you are highly leveraged, it can worsen the situation. Remember, leverage is a double edge sword!