The firm's master hedge fund, Long-Term Capital Portfolio L.P., collapsed in the late 1990s, leading to an agreement on September 23, 1998 among 14 financial institutions for a $3.6 billion recapitalization (bailout) under the supervision of the Federal Reserve.[2]

LTCM was founded in 1994 by John W. Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Members of LTCM's board of directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives".[3] Initially successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis requiring financial intervention by the Federal Reserve, with the fund liquidating and dissolving in early 2000.

Founding

John W. Meriwether headed Salomon Brothers' bond trading desk until he resigned in 1991 amid a trading scandal.[4]
 

Myron S. Scholes (left) and Robert C. Merton were principals at LTCM.

 
The value of $1,000 invested in LTCM,[17]the Dow Jones Industrial Average and invested monthly in U.S. Treasuries at constant maturity.

Although much success within the financial markets arises from immediate-short term turbulence, and the ability of fund managers to identify informational asymmetries, factors giving rise to the downfall of the fund were established prior to the 1997 East Asian financial crisis. In May and June 1998 returns from the fund were -6.42% and -10.14% respectively, reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. Such losses were accentuated through the 1998 Russian financial crisis in August and September 1998, when the Russian Government defaulted on their government bonds. Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August, the fund had lost $1.85 billion in capital.

As a result of these losses, LTCM had to liquidate a number of its positions at a highly unfavorable moment and suffer further losses. A good illustration of the consequences of these forced liquidations is given by Lowenstein (2000).[18] He reports that LTCM established an arbitrage position in the dual-listed company (or "DLC") Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8-10% premium relative to Shell. In total $2.3 billion was invested, half of which was "long" in Shell and the other half was "short" in Royal Dutch.[19] LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge. This might have happened in the long run, but due to its losses on other positions, LTCM had to unwind its position in Royal Dutch Shell. Lowenstein reports that the premium of Royal Dutch had increased to about 22%, which implies that LTCM incurred a large loss on this arbitrage strategy. LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade.[20]

The company, which was providing annual returns of almost 40% up to this point, experienced a flight-to-liquidity. In the first three weeks of September, LTCM's equity tumbled from $2.3 billion at the start of the month to just $400 million by September 25. With liabilities still over $100 billion, this translated to an effective leverage ratio of more than 250-to-1.[21]

1998 bailout

 
On September 23, 1998, the chiefs of some of the largest investment firms of Wall Street—Bankers Trust,Bear Stearns, Chase Manhattan,Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Smith Barney—met on the 10th floor conference room of the Federal Reserve Bank of New York (pictured) to rescue LTCM.

Long-Term Capital Management did business with nearly everyone important on Wall Street. Indeed, much of LTCM's capital was composed of funds from the same financial professionals with whom it traded. As LTCM teetered, Wall Street feared that Long-Term's failure could cause a chain reaction in numerous markets, causing catastrophic losses throughout the financial system. After LTCM failed to raise more money on its own, it became clear it was running out of options. On September 23, 1998, Goldman Sachs, AIG, and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $3.75 billion and to operate LTCM within Goldman's own trading division. The offer was stunningly low to LTCM's partners because at the start of the year their firm had been worth $4.7 billion. Warren Buffett gave Meriwether less than one hour to accept the deal; the time period lapsed before a deal could be worked out.[22]

Seeing no options left the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets.[23] The principal negotiator for LTCM was general counsel James G. Rickards.[24] The contributions from the various institutions were as follows:[25][26]

• $300 million: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P.Morgan, Morgan Stanley,Salomon Smith Barney, UBS
• $125 million: Société Générale
• $100 million: Lehman Brothers, Paribas
• Bear Stearns declined to participate.

In return, the participating banks got a 90% share in the fund and a promise that a supervisory board would be established. LTCM's partners received a 10% stake, still worth about $400 million, but this money was completely consumed by their debts. The partners once had $1.9 billion of their own money invested in LTCM, all of which was wiped out.[27]

The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices, which would force other companies to liquidate their own debt creating a vicious cycle.

The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):[18]
• $1.6 bn in swaps
• $1.3 bn in equity volatility
• $430 mn in Russia and other emerging markets
• $371 mn in directional trades in developed countries
• $286 mn in Dual-listed company pairs (such as VW, Shell)
• $215 mn in yield curve arbitrage
• $203 mn in S&P 500 stocks
• $100 mn in junk bond arbitrage
• no substantial losses in merger arbitrage

Long Term Capital was audited by Price Waterhouse LLP. After the bailout by the other investors, the panic abated, and the positions formerly held by LTCM were eventually liquidated at a small profit to the rescuers.

Some industry officials said that Federal Reserve Bank of New York involvement in the rescue, however benign, would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf in the event of trouble. Federal Reserve Bank of New York actions raised concerns among some market observers that it could create moral hazard.[28]

LTCM's strategies were compared (a contrast with the market efficiency aphorism that there are no $100 bills lying on the street, as someone else has already picked them up) to "picking up nickels in front of a bulldozer"[29] – a likely small gain balanced against a small chance of a large loss, like the payouts from selling an out-of-the-money naked call option.

Aftermath
After the bailout, Long-Term Capital Management continued operations. In the year following the bailout, it earned 10%. By early 2000, the fund had been liquidated, and the consortium of banks that financed the bailout had been paid back; but the collapse was devastating for many involved. Mullins, once considered a possible successor to Alan Greenspan, saw his future with the Reservedashed. The theories of Merton and Scholes took a public beating. In its annual reports, Merrill Lynch observed that mathematical risk models "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited."[30]

After helping unwind LTCM, Meriwether launched JWM Partners. Haghani, Hilibrand, Leahy, and Rosenfeld all signed up as principals of the new firm. By December 1999, they had raised $250 million for a fund that would continue many of LTCM's strategies—this time, using less leverage.[31]
With the Credit Crisis, JWM Partners LLC was hit with 44% loss from September 2007 to February 2009 in its Relative Value Opportunity II fund. As such, JWM Hedge Fund was shut down in July 2009.[32]

In 1998, the chairman of Union Bank of Switzerland resigned as a result of a $780 million loss due to the collapse of Long-Term Capital Management.[1]