The Dream Team Loses Big: The Fall of Long-Term Capital Management (Wall Street Profiles)

In this fifth installment of the Wall Street Profiles series, we look at the infamous Long-Term Capital Management (LTCM) hedge fund. It’s been almost 20 years since LTCM collapsed, and it’s now a distant memory to many investors. However, in some ways, it was a precursor to the much larger mortgage financial crisis that occurred 10 years later.

Putting the Best Minds on Wall Street Under One Roof

If you were going to bring together the smartest and most well-connected traders on Wall Street in the early 1990s to build a hedge fund, you couldn’t do much better than the team John Meriwether formed in 1994. Here were some of the partners at Long-Term Capital Management:

• John Meriwether: head of the bond arbitrage desk at Salomon Brothers (at the time, one of the pre-eminent fixed income trading firms, now part of Citigroup). He brought much of his very profitable bond trading team from Salomon Brothers to LTCM.
• Robert Merton: Harvard professor and future winner of the Nobel Prize in economics in 1997 for the Black-Scholes formula
• Myron Scholes: Stanford professor and future winner of the Nobel Prize in economics in 1997 for the Black-Scholes formula
• David Mullins, Jr.: Vice-Chairman of the Federal Reserve, working under Alan Greenspan

So at one hedge fund, you had the best minds in industry (Meriwether and his Salomon Brothers team), academia (Merton and Scholes), and government (Mullins, Jr.). Fresh off the USA Basketball Dream Team’s domination of the world in the 1992 Summer Olympics, Business Week touted the investment “Dream Team” that LTCM had created in 1994.

Investors flocked to put their money with LTCM. Remember that this was in the heyday of hedge funds, and index funds were not as popular then as they are today. LTCM raised $1 billion dollars for trading at its inception in 1994.

The Trading Strategy and the Early Years

The general class of trading strategy LTCM employed was called fixed income arbitrage. Arbitrage is when you have two equivalent or nearly-equivalent asset classes with different values in different markets. For example, if you can buy a textbook from your friend for cheap and immediately resell it on Amazon for a higher price, you’ve engaged in arbitrage. If you can live your same life in the rural Midwest as you can in New York City, then you can take advantage of “geographic arbitrage.”

There are rarely pure arbitrage opportunities (e.g. buying the exact same product for one price locally and selling it on Amazon) in the financial markets. But many fixed income instruments can be highly correlated with each other, and if the prices of two or more securities are significantly “out of whack”, you can buy the undervalued security and sell the overvalued security. When the two securities return to fair value (i.e. the undervalued security rises and the overvalued security falls), the fixed income arbitrageur makes a profit. This was the crux of the LTCM strategy.

Sometimes these differences in relative value are small, so to amplify their returns, LTCM employed significant leverage. When the strategy works, the returns are great. But if the strategy fails, you can suffer significant losses. LTCM modeled out how much they could potentially lose for their trades, and felt that they were not taking excessive risk. But this assumes that your models for the “worst case scenario” are correct.

LTCM did spectacularly well in their early years, earning 21% in 1994, 43% in 1995, 41% in 1996, and 27% in 1997. These were fantastic years, even during the 1990s bull market in equities.

The Rapid Decline of LTCM

During the 1997 Asian financial crisis, Thailand went into bankruptcy, causing a ripple effect and affecting the economies of several Asian countries, including Indonesia and South Korea. As part of a flight to safety, traders flocked towards more liquid securities and avoided less liquid securities. LTCM typically was long illiquid securities and short liquid securities, so this hurt them.

In 1998, Russia defaulted on its debt. This caused a further widening in the spread between liquid and illiquid securities, exacerbating the losses. Other hedge funds knew that LTCM was losing money, and positioned themselves to exacerbate the pain and profit on any future liquidation.

In September 1998, fearing that the collapse of LTCM could affect the financial stability of its major creditors (i.e. every major investment bank), the Federal Reserve arranged a bailout between LTCM and 14 investment banks. LTCM’s total losses were tallied to be $4.6 billion.

After LTCM

The Dream Team was dismantled after the 1998 bailout. All four of the biggest names at LTCM went on to other jobs after LTCM:

• John Meriwether was able to start another hedge fund, JWM Partners in 1999. It shut down in July 2009 after sustaining large losses during the financial crisis.
• Robert Merton continued as a professor at Harvard and is now a professor at neighboring MIT.
• Myron Scholes continues to be involved in industry and in academics, currently teaching an annual course at the Stanford Graduate School of Business, The Evolution of Finance.
• After LTCM, David Mullins spent time as the chief economist at Vega Asset Managment, according to Bloomberg.

Takeaways

If the best failed in such dramatic fashion, do you think you can beat the market?

If the Wall Street “Dream Team” was unable to beat the market, how can the retail investor who looks at the stock market for a few hours a week expect to beat the market?

Markets can be irrational longer than you can remain solvent

Based on historical models of valuation, the stock market is at a higher valuation than it has been in the past. But that doesn’t mean that the stock market won’t stay overvalued for a long time. The brilliant minds at LTCM figured that the securities they were buying and selling were mispriced. But they can stay mispriced for a long time, and they went bankrupt before they could be proven right.

The same thing happened during the tech bubble. People couldn’t understand how overvalued some of these tech stocks were becoming. Some people dared to short tech stocks in 1997, 1998, and 1999, only to have to cover their short positions at losses as the tech mania accelerated.

Hedge fund managers have a capped downside, but unlimited upside.

Hedge fund managers have a very strong incentive to take risk. If the fund succeeds, they will make huge profits, and they will attract a lot of investor money that will help them generate even more fees. If the fund fails, they can often stay in the industry. John Meriwether was able to start a second hedge fund less than two years after LTCM failed.

Further Reading

1. Roger Lowenstein’s best-selling book on LTCM, When Genius Failed
2. PBS NOVA did a 1-hour documentary on LTCM.
3. Wikipedia’s article on LTCM
4. Bloomberg’s “Where Are They Now?” article on LTCM.

What do you think? Do you think an all-star team of Wall Street traders, academics, and government leaders could beat the market? Or would they fail as LTCM did?

[Image Credit: JayHenry (Own work) [Public domain], via Wikimedia Commons]