Long-Term Capital Management
Long-Term Capital Management (LTCM) was a hedge fund formed in 1994 by John Meriwether, former vice chairman and head of bond trading at Salomon Brothers. LTCM was created to apply high-yield bond market investment strategies and arbitrage opportunities to a global portfolio. The hedge fund was notable for its high leveraged balance sheet, which had both positive and negative impacts on the financial markets.
The creation of LTCM ultimately marked a paradigm shift in the risks taken by financial institutions, with more risk assumed in each individual play as the size of LTCM’s portfolio grew. This remained true even after the collapse of the fund in 1998.
In 1998, LTCM was in the process of accumulating a large amount of assets. In one use of leverage, LTCM borrowed $4 billion from banks, allowing the hedge fund to invest $20 billion in the markets. This was a massive increase, in that the hedge fund held only $1.25 billion in assets just one year earlier. In particular, LTCM had a large presence in the high-yield bond market, which had been characterized by low default rates but high volatility.
This strategy became untenable as the high-yield bond market started to deteriorate. As the default rates and interest rates began to rise, LTCM experienced substantial losses on its portfolio of long positions and its leverage came back to haunt the fund. The nature of LTCM’s leveraged balance sheet meant that even small price changes could have a large impact on the fund’s value and its ability to meet margin calls.
Ultimately, LTCM was forced to liquidate its assets at a tremendous discount and with no apparent liquidity in 1998. The impact of the LTCM collapse on the global financial system was immense, with the Federal Reserve eventually intervening to save the markets from a systemic meltdown. After the intervention, 14 of the world’s leading financial institutions pooled $3.6 billion to purchase the assets of LTCM and wind down the fund.
The collapse of LTCM served as a warning to all investors and financial institutions, as well as a lesson for all players in the leveraged universe. The important thing to realize is that leverage is powerful but also extremely volatile and can be dangerous when not managed properly. As such, all investors should take the lessons from the LTCM collapse to heart when making any sort of investment decision.
