The flood of closures, almost amounting to a panic, caused a further widening of interest rate spreads. LTCM’s situation deteriorated rapidly; by the end of September the fund had lost almost 90 per cent of its capital in the course of nine months. The U.S. Federal Reserve had initiated a meeting with some of LTCM’s counterparties and on 23 September fourteen banks with claims on the fund agreed to take over LTCM as a joint venture and try to wind up the positions in a more orderly manner. The Federal Reserve’s motivation for initiating a solution to the problem was not the sizeable losses that might have been incurred by many of the banks concerned. Its concern instead was the financial system in general. If the banks that had provided loans were to close their large positions spontaneously in a market that was already illiquid and turbulent, other agents who were not directly involved would be hit. The steep price fall would probably have paralysed  BIS Review 23/1999  6  the financial markets for a time and this might have triggered a vicious circle of declining confidence and further closures—the Fed perceived a large systemic risk. The ultimate consideration was, of course, the potential hazard for the global economy. It is difficult to say what might have happened if the Federal Reserve had not acted. The banks that were involved had a strong interest in achieving a controlled settlement of their commitments and would probably have acted at some stage.
To begin with the strategy was notably successful; high profits were obtained with a low capital input. In 1995 and 1996 the annual profit was over 40 per cent. This performance and the confidence that the fund management enjoyed made many banks willing to provide loans or invest in the fund. In time, however, the financial markets moved in the opposite direction to what LTCM—and others—had expected. Russia’s debt moratorium on 17 August was followed by markedly increased financial turbulence as investors became more nervous and withdrew from other markets that could be perceived as risky. A uniform tendency developed, with falling share prices, widening interest rate spreads, growing unrest and decreased liquidity. There was a flight to quality of a kind that had not been observed before in the financial markets. Instead of narrowing, interest rate differentials became markedly wider. The diversity of risks on which LTCM had relied ceased to provide protection. The market movements were such that, if anything, it was a source of increased losses. The rumours of problems in LTCM contributed in turn to even greater turbulence in the financial markets. In that market prices would be depressed by a winding-up of positions, investors tried to close positions in those markets where they feared that LTCM was also involved. It can be mentioned, for example, that Risk Magazine estimated that LTCM’s positions in the interest swap market totalled 5 per cent of the global market, which says something about the size of the fund’s positions.