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Friday, June 17, 2011

Long Term Capital Management

By 1997, “after three years of strong profits for LTCM, the opportunities were drying up. There was too much money chasing the same investments. . . . In early 1998, LTMC decided to give a large portion of its capital back to its original investors because profitable opportunities were so hard to find. At the end of 1997, LTCM had nearly $7.5 billion under management, compared to $1 billion when it started, and it now returned $2.7 billion of that to investors. The partners also figured that they could, if necessary, simply leverage their portfolio further to compensate for the loss of capital, which would compound their personal gains. Greed was at the heart of what turned out to be a disastrous decision. . . . Unable to reproduce the returns of the first three years, LTCM took increasingly more risk, abandoning its purer arbitrage for the kinds of ‘directional’ investments Soros made and LTCM had so long disdained—such as trying to forecast interest rate and currency movements. More and more of these trades were unhedged.” Furthermore, “LTCM’s risk models—VAR and related statistical tools . . . –were misleading.” For example, diversification was little protection if there was a run on the banks. When Russia defaulted on August 17, 1997, LTCM’s hedges against its Russian investments were worthless. Furthermore, because all fixed income assets fell sharply in value, “diversification, it turned out, did not matter. The finely calculated relationships on which LTCM was built and which the firm always believed would hold started to come apart. VAR could  not account for such an unlikely but sweeping event—an event in which everyone wanted out at the same time and almost all investments fell significantly in price. The use of VAR itself precipitated much of the selling. Commercial banks under the jurisdiction of the Basel Agreements, which . . . set capital requirements based on the level of VAR (the lower the VAR, the lower the capital required), were forced to sell assets to raise capital.” LTCM lost $1.9 billion that August. Eventually, fourteen banks, organized by the Fed, put together loans of more than $3.5 billion to purchase 90 percent of the firm.” LTCM “did manage to sell down assets in an orderly fashion and by early 2000 it was essentially out of business” (Madrick, pp. 277-81).

The full essay is at Institutional Conflicts of Interest, available in print and as an ebook at Amazon.