Tag Archives: Risky Debt

The Collapse of Long Term Capital Management; Hedge Funds and Leverage

After watching a short excerpt of a Warren Buffet speech, I thought I may quickly summarise the collapse of the famous Hedge Fund, Long Term Capital Management. But First, Watch this excerpt, it is both funny and informative.

I have sourced most of the information below from an excellent paper done by Gregory Connor and Mason Woo (LSE) called An Introduction to Hedge Funds. I will separately write an introduction to Hedge Fund Strategies article after this article to have a more detailed look at Hedge Funds.

Long Term Capital Management

During the late 90’s, the largest tremor through the hedge fund industry was the collapse of the hedge fund Long-Term Capital Management (LTCM). LTCM was the premier quantitative-strategy hedge fund, and its managing partners came from the very top tier of Wall Street and academia. These funds are commonly known as “quant funds” or quantum funds and they typically use ma thematic strategies based on past market performance to predict future performance. They are typically very short term and are capable of providing very high returns.

From 1995-1997, LTCM had an annual average return of 33.7% after fees. At the start of 1998, LTCM had $4.8 billion in capital and positions totalling $120 billion on its balance sheet [Eichengreen, 1999].

Long Term Capital Management Strategy and Leverage ratio

LTCM largely (although not exclusively) used relative value strategies, involving global fixed income arbitrage and equity index futures arbitrage. As an example, LTCM exploited small interest rates spreads, some less than a dozen basis points, between debt securities across countries within the European Monetary System. Since European exchange rates were tied together, LTCM counted on the reconvergence of the
associated interest rates.

Its techniques were designed to pay off many sets of small returns, with extremely low volatility. To achieve a higher return from these small price discrepancies, LTCM employed very high leverage. Before its collapse LTCM controlled $120 billion in positions with $4.8 billion in capital. In terms of calculating this leverage, this represented an extremely high leverage ratio (120/4.8 = 25). Banks were willing to extend almost limitless credit to LTCM at very low interest rates, because the banks thought that LTCM had latched onto a certain way to make money.

LTCM was not an isolated example of size-able leverage. At that time, more than 10 hedge funds with assets under management of over $100 million were using leverage at least ten times over [President’s Working Group, 1999].

The Collapse of Long Term Capital Management

In the summer of 1998, the Russian debt crisis caused global interest rate anomalies. All over the world, fixed income investors sought the safe haven of high quality debt. Spreads between government debt and risky debt unexpectedly widened in almost all the LTCM trades.

LTCM lost 90% of its value and experienced a severe liquidity crisis. It could not sell billions in illiquid assets at fair prices, nor could it find more capital to maintain its positions until volatility decreased and interest rate credit spreads returned to normal.

Emergency credit had to be arranged to avoid bankruptcy, the default of billions of dollars of loans, and the possible destabilisation of global financial markets. Over the weekend of September 19-20, 1998, the Federal Reserve Bank of New York brought together 14 banks and investment houses with LTCM and carefully bailed out LTCM by extending additional credit in exchange for the orderly liquidation of LTCM’s holdings.

This bail out of Long Term Capital Management is similar to the recent bail out by the New York Federal Reserve of Bear Sterns. I will not go into whether or not one was more justified than the other but I read an excellent article Brave New Fed which is worth reading if you are interested.

Since the collapse of LTCM, hedge fund leverage ratios have fallen substantially.The aftermath of the Russian debt crisis and LTCM debacle temporarily stalled the growth of the hedge fund industry. In 1998, more hedge funds died and fewer were created than in any other year in the 1990s [Liang, 2001].

The number of hedge funds as well as assets under management (AUM) declined slightly in 1998 and the first half of 1999. After that the growth of hedge funds resumed with no major changes to regulations but with guidelines for additional risk management. [Lhabitant, 2002; Financial Stability Forum, 2000].

To see an excellent written summary of the Warren Buffest speech, see Warren Buffett on long term Value Investing or to see another Warren Buffett Video, click here.