Long Term Capital Management
During the late 90s, 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. 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] LTCM largely (although not exclusively) used relative value strategies, involving global fixed income arbitrage and equity index futures arbitrage. For 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 in small amounts, 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 retrospect, this represented an extremely high leverage ratio (120/4.8 = 25). Banks were willing to extend almost limitless credit to LTCM at very low no cost, because the banks thought that LTCM had latched onto a certain way to make money.
LTCM was not an isolated example of sizeable 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]. Since the collapse of LTCM, hedge fund leverage ratios have fallen substantially.
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.
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. Hearings were held on LTCM, resulting in recommendations for increased risk management at hedge funds, but without new legal restrictions on their practice [Lhabitant, 2002; Financial Stability Forum, 2000].
LTCM proved to be a bump, rather than a derailing of the hedge fund industry. The appeal of hedge fund investing remained, and the industry rebounded. Less than a year after the Federal Reserve Bank of New York unravelled LTCM, Calpers (California Public Employees’ Retirement System), the largest American public pension fund, announced they would invest up to US$11 billion in hedge funds [Oppel, 1999].
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