FREE ESSAY ON LTCM'S IMPACT ON THE INTERNATIONAL FINANCIAL SYSTEM

LTCM'S IMPACT ON THE INTERNATIONAL FINANCIAL SYSTEM

LONG TERM CAPITAL MANAGEMENT L.P. - A CASE STUDY
Rarely if ever has a single firm had as tremendous an impact on international economics
as Long Term Capital Management L. P. (LTCM). This report describes the company itself
and its investment strategies, with particular attention paid to its international
influence and importance. LTCM's activities in the financial world ultimately caused a
near-collapse in the entire international financial system. In fact, had the Federal
Reserve Bank of New York (FRBNY) not intervened to coordinate a major buyout of LTCM
after it sunk into insolvency, the entire financial system could have been seriously
jeopardized. 
Company Profile
Set up as a particularly large hedge fund, and comprised of Ph.D. economists and
established Wall Street bond traders, LTCM is a very interesting case, as well as an
extremely volatile and important fund.
-  Key Members and Their Backgrounds
Founded in part by Nobel laureates Robert Merton and Myron Scholes, LTCM based its
investment strategies on the mathematical models developed by Scholes, Merton, and
Fischer Black. The model itself, commonly known as the "Black-Scholes Options Pricing
Model", is famous for two major insights into economic thought. First, the model
determines how to eliminate risk as a variable in the option-pricing equation. This was
accomplished as a result of the second major insight, which was the idea of using
continuous time for option pricing as opposed to second-by-second timing, a most crucial
element that Robert Merton borrowed from a Japanese rocket scientist named Ito.
Discovering how risk can be eliminated from large-scale investing is obviously an
enormous break-through that puts greed in peoples' eyes and gets major investment players
fighting for the chance to invest where the model will first be used in practice.
Integrating the notion of continuous time into the pricing model eliminated the problem
of an appropriate option price being out-of-date by the time it was calculated. As
champions of these powerful tools, Merton and Scholes decided to play the very financial
markets that had already been transformed by their insights. The Black-Scholes model is:
Value of a call option = P0N(d1) - X [N(d2)]
eKRFt 
Where Po = the current price of a stock
X = the exercise (strike) price on the option
t = time remaining until expiration of the option
KRF = continually compounded risk-free interest rate
e = the natural antilog of 1.00 or 2.71828
N(d) = the probability that a standardized, normally distributed random variable will
have a value less than or equal to d, essentially the hedge ratios.1
The Black-Scholes pricing model can adjust the value of options to reflect continuously
changing stock prices. Black, Scholes and Merton appeared to have made the break-through
that could finally bring perfect efficiency to the world's markets. 
John Meriwether, a wealthy and famous Wall Street bond trader from Soloman Brothers Inc.,
also played an integral role in the history of the firm. Meriwether left Soloman after
having his name too closely associated with a bond-auction fraud scandal orchestrated by
one of his colleagues. Meriwether, an old friend of Scholes, brought his expertise in
bond markets and bond futures to the firm as its top executive. Also a co-founder,
Meriwether brought with him from Soloman several of his former colleagues, who had also
left Soloman after the bond fraud scandal in 1992.
-  Hedge Funds and the Uniqueness of LTCM
A hedge fund is organized much like a mutual fund (both are private, pooled investment
accounts), but with some significant differences. Legally, a hedge fund is
distinguishable by the fact that it limits the number of investors to 500 per fund. Also,
to qualify to invest in American hedge funds requires a minimum capital amount of US$5
million for individuals, and US$25 million for institutional investors. In the case of
LTCM, only those individuals and institutions that the fund's partners sought out were
able to invest in the firm. 
Other things that distinguish hedge from mutual funds are:
 Hedge fund managers have almost complete autonomy in determining what assets to
hold, and are not at all limited in what types of assets they can hold.
 Hedge funds are allowed to engage in short selling.
 Hedge funds may use leverage to increase levels of funding and of risk and
return.
 Hedge funds can limit the amount cash injected into and withdrawn from the fund
by its investors.2
LTCM was therefore able to engage in virtually any investment strategies its managers
chose. The fund's founders were not subject to any rules regarding the types of assets
they could hold in the fund, including derivative securities, margins, bond futures and
currencies. The fund's managers could also short-sell assets at will. Many believe the
excessive use of leverage became a serious problem at LTCM. Holders of this theory even
believe that excessive leverage caused the fund's near collapse. 
The term hedge fund is essentially a misnomer, as it sounds like "hedging" but is almost
the opposite idea. Hedging refers to investment strategies that reduce the risk
associated with owning financial assets, usually by use of derivatives. A hedge fund is a
large, privatized pool of investment money that is normally invested in relatively
high-risk securities. 
LTCM was not the average hedge fund. It primarily used techniques and strategies of
arbitraging between bonds and bond futures derived from the mathematical insights
provided by the Black-Scholes model that allowed them to continually monitor the "true"
value of derivative securities. The sheer size of their investments distinguished them as
well. Starting with about US$4 billion of initial capital, the fund rapidly grew to
obtain a peak position of US$1.2 trillion. The institution's risk-management practices
consisted of attempting to eliminate risk by continually adjusting their holdings to
react to continually changing market prices. When LTCM nearly collapsed, the partners
themselves personally lost US$1.9 billion, of the total US$4.4 billion that the fund lost
(see Exhibit A - Pie Chart of Losses). 
-  Investment Strategies
Using arbitrage techniques that appeared infallible, LTCM used excessive leverage to
magnify its earnings. Contrary to the myth, hedge funds are not all highly leveraged.
LTCM was often leveraged at about thirty times its capital and the institution was
primarily borrowing from the same companies that had invested in it. Many companies
invested in LTCM under the assumption that LTCM's strategies were infallible.3 
LTCM essentially engaged in the types of trades that no one else would think of, and for
this reason, they quickly became the "firm-to-watch" and emulate for many fund managers.
In fact, some believe that this mirroring of investment strategies contributed to its
downfall. 
LTCM was chiefly involved with making trades in bond markets where price-determination is
still somewhat inefficient.4 The institution placed bets on interest rate spreads between
corporate bonds and government bonds, and on the volatility of markets. LTCM used the
Black-Scholes pricing model and other state-of-the-art price-determination techniques to
see which bonds were undervalued and which were overvalued according to those
mathematical models, and then placed their bets accordingly. The firm watched differences
between government bonds and corporate bonds, and when the difference was believed to be
at its peak, it would buy into the relatively cheap corporate bonds and short sell the
relatively expensive government bonds. When the gap between the two tightened, the fund
would profit, but if the gap spread further, the fund would sustain a loss. However, in
LTCM's case, the sheer size of the investments the company was making could often drive
the rates in LTCM's desired direction.5
One particular trade that persisted in LTCM and exemplified their overall trading
strategies was a bet on the convergence of yield spreads between French bonds (OATs) and
German bonds (bunds). According to parties associated with LTCM, the fund "engaged in
dozens of cash and futures trades, interest rate swaps, currency forwards and options . .
. to build a US$10 billion position."6 When the spread between the OATs and the bunds
went to 60 basis points in the forward market, LTCM decided to double its position.
Another competing arbitrageur says that this deal was actually "only one leg of an even
more complex convergence bet, which included hedged positions in Spanish peseta and
Italian lira bonds."7
LTCM reportedly derived approximately one third of its profits from an Italian tax-driven
arbitrage deal of which many other arbitrageurs were also taking advantage.8 LTCM was
distinguished in its trading strategies primarily by two things; the thoroughness of its
preparations for the trades it made, and the fund's propensity to invest abnormally large
amounts of cash in profitable deals.
With all of these factors working in the company's favor, it is difficult to see how LTCM
could fail so miserably and suddenly.
What Went Wrong
In September 1998, LTCM found itself in a crisis situation. It appears that the
institution had underestimated the consequences that short-term liquidity problems could
pose.9 Shortly after falling into insolvency, the Federal Reserve Bank of New York
rescued the company from bankruptcy.
-  LTCM's Collapse and Possible Causes
It is impossible to determine for certain what specific factors caused LTCM's collapse
and near-demise. Many say that the excessive amount of leverage the fund was using (about
30 times their capital) magnified their losses inordinately when they began losing
cash.10 Also, LTCM relied on an academic pricing model that ultimately proved to be a
model only applicable during "normal" market conditions, and not in extreme conditions.
Magnified risk and theoretical economics certainly played a role in LTCM's near demise. 
Another contributor was the global financial crisis in September 1998. There were two
likely "smoking guns" of that particular global financial anomaly. The first was the
currency reform in Thailand and the ensuing devaluation of the nation's currency. The
second was the Russian government defaulting on their debts, which dried up the liquidity
associated with the ruble and Russian financial assets. 
In mid-1998, Thailand switched from a fixed exchange rate system to a floating rate
system. When the demand they had expected for their assets did not materialize, their
currency value plummeted. This led to the collapse of a few large Asian banks that had
significant stake in Thailand, which led to a general, rapid economic downturn in the
Asian countries in which LTCM had outstanding interest rate options.
Around the same time period, Russia, another country with which LTCM had outstanding
currency bets, was in the midst of an economic collapse of their own. Social revolt
against the communist government put a stranglehold on Russia's fiscal policy discretion
and control. When the Russian Government defaulted on their debts, the market's reaction
was expectedly catastrophic, and LTCM among others lost all their interests in Russia.
The million-to-one chance that these types of events would happen simultaneously actually
materialized. LTCM had left itself particularly susceptible to losses in this type of
situation. When a hedge fund arbitrages between the currency bonds of several major
economic nations and futures on those bonds, a major collapse in one of those nations can
begin a domino effect with the potential of destroying all the players involved,
essentially by drying up the liquidity in those assets. For example, if LTCM is betting
on interest rates in Japan to increase, and they do, LTCM will assume they are "in the
money" on that deal. They will use the cash they have not yet received to secure similar
interest rate bets with, say, Germany. Then, if Japan defaults on the money they owe
LTCM, the German options they have secured will also dry up. The German institution with
which LTCM was trading will then also be out of the money it expected to receive from
LTCM. It is then clear that supply and demand for liquidity of financial assets is at the
root of LTCM's investment strategies.
LTCM relied on the global diversity of its positions, assuming that global
diversification cancels out all risk.11 But correlation between global markets tend to
magnify upward in times of trouble, reflecting economic linkages between markets and
social factors. Representatives of LTCM believe the near collapse of the company was a
result of two stages of external panic.12 First, Wall Street firms began to doubt LTCM.
Social panic followed Wall Street firms' market panic. Rumors spread that LTCM had
weakened. LTCM believe that other companies used their weakness as an opportunity to
strengthen. Wall Street firms began to duplicate LTCM's investment strategies, which
weakened LTCM's market position. The institution was weak and owned a huge portion of the
market. Of course, other companies would want to destroy LTCM to strengthen their own
positions. 
Another suggested contributor to the near collapse of LTCM is as follows. A large number
of positions in the LTCM portfolio depended on a narrowing of the spread between two
related securities (i.e. hedging two securities). This means that investors take a long
position (i.e. buy) the higher yielding security, and take a short position (i.e. sell)
the lower yielding security and hope the spread will narrow. When substantial leverage is
used, the spread can be extremely profitable if the spread relationship remains constant
or narrows. In fact, betting on volatility in markets this way leads to a "catch-22"
situation. A firm is betting on markets to be volatile, and will profit when they are,
but buying derivative securities such as volatility swaps and straddles is a zero-sum
game. When the firm profits, its counterparty loses, which makes the firm less likely to
collect their money because the loss could put the counterparty into bankruptcy. This is
called "counterparty risk", and LTCM was certainly affected by it when the liquidity in
Russian and Asian markets dried up.
If the liquidity had been available, LTCM might have been able to survive. Therefore, the
problem was not necessarily the leverage LTCM employed; the lack of market liquidity
might have been a more direct cause of the fund's failure. Other companies with similar
trades were trying to narrow these spreads at the same time. This caused spreads to
widen, resulting in big losses by banks and highly leveraged hedge funds such as LTCM.13

LTCM lost money at unprecedented rates. After returning over 40% for three consecutive
years, the fund lost US$500 million, on two consecutive days.14 Very few firms, if any,
have the liquidity not to be overwhelmed by a US$1 billion loss in a period of 48 hours.
LTCM became insolvent very suddenly, and the portfolio's value continued to plummet due
to psychological market reactions (i.e. loss of confidence, changed credit ratings). Over
a six-week period in August/September 1998, LTCM lost approximately US$4.4 billion, and
would have declared bankruptcy had it not been for the FRBNY's intervention. 
-  How The Fed Saved LTCM and Why They Did So
The FRBNY saved LTCM from bankruptcy by consolidating fourteen American investment banks
and securities firms to collectively bail out LTCM for $3.625 billion in September 1998.
The company still exists, and John Meriwether is now involved in slowly reimbursing many
of the funds' initial investors for what Myron Scholes calls a "non-fault bankruptcy."15

Why did the Fed go to such trouble to rescue this particular company? What did it stand
to gain by doing so? What was it trying to accomplish or avoid? The answer is that after
conducting an audit of LTCM's books, the FRBNY recognized the strategic importance of
this firm's international financial position. The FRBNY was concerned that LTCM's default
could pose great danger to the entire international financial system due to the size,
nature and complexity of the wealth they had spread around the globe. The international
significance of LTCM's investments is discussed in the following section.
LTCM's International Significance
LTCM had spread its investment position into 75 different nations, in order to avoid
concentrating risk in any one given area.16 This ultimately worked to the fund's
detriment, as its position nearly created an international catastrophe. However, it also
worked to LTCM's benefit, as the Fed would not have saved them were they not so
extensively diversified and internationally important.
However, the financial well being of LTCM was of no direct concern to the supervisory
authorities of the United States. Rather, the FRBNY saved LTCM to prevent the potential
direct and indirect effects of LTCM's failure on other financial markets and institutions
around the world.17 Direct losses, such as those to credit positions and owners of LTCM's
capital, would likely have been controllable, but were not the concern of the FRBNY
anyway. However, the Fed was concerned about the consequences of LTCM's default on the
functioning of the financial system, i.e. the systematic effects associated with the
global market resulting from LTCM. Potentially, the default could have affected liquidity
to the degree that markets would have been unable to function properly. This might have
had serious negative effects on the positions and soundness of financial intermediaries,
including even those institutions that had no direct trading with LTCM. In addition, the
FRBNY feared that loss of confidence in the functioning of credit markets would lead to
extreme risk aversion, thereby threatening the viability of debt markets and ultimately
the ability of businesses to borrow and invest. For these reasons, the FRBNY was
motivated to keep LTCM liquid enough so as to avoid this calamity.
Central banks and supervisory authorities have recognized the importance of maintaining
financial stability in the past few decades. The increased interaction between large
institutions has increased the rapid spread of financial problems across institutions and
markets. Financial problems, such as sharp reduction of financial resources, may have
negative consequences on production, welfare and employment. Since the supervision of
registered investment institutions does not protect against investment risks, a large
equity base and trading position hedge fund, such as LTCM, may pose a threat to financial
stability. In this context, supervisory authorities were worried about the size of
trading positions, the potentially high leverage and the lack of disclosure by these
institutions. It leads one to ask; was LTCM an isolated incident? Could another firm pose
this sort of danger again? In national forums and in an international context,
authorities are discussing the improvement of disclosure of financial data by unregulated
participants in financial markets. This can be done on a voluntary basis with initiatives
towards self-regulation of groups of institutions or by internationally coordinating
regulations. Supervisory authorities support this idea, but doubt whether increased
disclosure is enough to fix the potential problems large hedge funds, such as LTCM, can
create.18 
-  Lessons Learned
LTCM's near default has caused banks to become more aware of the risks associated with
investing in hedge funds. The difficulty of analyzing and monitoring a hedge fund
contributes to the risk. Also, since hedge funds are not limited by regulations,
institutions operating hedge funds can assume more leverage. Another factor contributing
to risk is a hedge fund's reliance on properly functioning financial markets and models,
making systematic risk very prominent. To avoid another such a number of banks have
tightened their lending policy to such institutions. 
Advantages of hedge funds include an improvement of market liquidity (under normal
circumstances) and an improvement of market efficiency through value-at-risk (VAR)
trading. Disadvantages may be periodic increases in volatility, which the LTCM case
exemplified, and a concentration of risks in unregulated markets. If banks and securities
firms are more careful in their use of hedge funds, the systematic risks associated with
the use of hedge funds could be reduced. This is because the size of positions taken by
hedge funds increases the systematic risk in those markets.
The LTCM case brought to light a number of important issues. The Committee of G-10
banking supervisors made recommendations to help improve banks' risk management. A paper
on sound practices is geared towards guiding banks and supervisory authorities when
considering a credit relationship with hedge funds or other highly levered institutions.
The first recommendation is that organizations should only invest in institutions with a
sound lending strategy. In other words, the organization must consider the institutions'
desired risk/return ratio, diversification objectives, and risk management framework. The
second recommendation is that if a bank does decide to do business with highly leveraged
institutions, it should conduct a thorough and frequent analysis of the credit-worthiness
of the institution, i.e the risk profile and risk management of the institution. Finally,
banks should concentrate on risk measurement of derivative positions, collateral
management and the use of attendant covenants.19 
Summary
Ultimately, the cause of LTCM's near default was a combination of its excessive use of
leverage, the inefficiency of the Black-Scholes model under extreme market conditions,
the drying-up of liquidity in financial assets, social and psychological investment
factors, and global systematic risk. The Fed did not underestimate the importance of LTCM
to the international financial system, as shown by the FRBNY's US$3.625 billion
intervention. The most frightening aspect of the whole ordeal was how quickly and
efficiently one American firm, a hedge fund, was able to position itself as a real
potential threat to the global economy. It is difficult to believe that LTCM was actually
so special as to be the only firm that could ever accomplish such an obscene feat. The
private mutual funds industry may need to be further regulated, or at least controlled,
in order to avoid a reoccurrence. Banks and financial institutions learned a valuable
lesson from the LTCM fiasco, as these institutions will now be more cautious in doing
business with hedge funds.
Bibliography
1. Davis, Alfred H. R. and Pinches, George E., "Canadian Financial Management"
(Addison Wesley, 1997) p. 632
2. Federal Reserve Bank of Cleveland, May 1, 1999
3. Copyright: Institutional Investor Systems Inc., November 1996
4. Organization for Economic Cooperation and Development, "The LTCM crisis and its
Consequences for Banks and Banking Supervision", June 1999.
5. "The LTCM crisis and its Consequences for Banks and Banking Supervision"
6. "The LTCM crisis and its Consequences for Banks and Banking Supervision"
7. Copyright: Institutional Investor Systems Inc., November 1996
8. Copyright: Institutional Investor Systems Inc., November 1996
9. Copyright: Institutional Investor Systems Inc., November 1996
10. Capon, Andrew "What went wrong at Long Term Capital Management"
(Global Investor, London, October 1999)
11. Jacobs, Bruce I., "When seemingly infallible arbitrage strategies fail." 
(Journal of Investing, New York, Spring 1999)
12. Lewis, Michael "The Price of Behaving Rationally in a Market Meltdown"
(The New York Times Magazine, New York, January 24, 1999) p. 42
13. Capon, Andrew "What went wrong at Long Term Capital Management"
(Global Investor, London, October 1999)
14. "What went wrong at Long Term Capital Management"
15. Anonymous, "Finance and economics: Economic focus: When the sea dries up." (The
Economist, London, September 1999)
16. Lewis, Michael "The Price of Behaving Rationally in a Market Meltdown"
(The New York Times Magazine, New York, January 24, 1999) p. 32
17. Jacobs, Bruce I., "When seemingly infallible arbitrage strategies fail." 
(Journal of Investing, New York, Spring 1999)
18. Organization for Economic Cooperation and Development, "The LTCM crisis and its
Consequences for Banks and Banking Supervision", June 1999.
19. "The LTCM crisis and its Consequences for Banks and Banking Supervision"