Long-term Capital Management (LTCM)

Founder of LTCM: John Meriwether

I just watched a lecture given by Eric Rosenfeld, one of the founding partners of Long-term Capital Management. LTCM imploded in 1998 following the Russian financial crisis. Partners of the firm include Nobel laureates such as Myron Scholes and Robert Merton.

One of the basic strategies behind LTCM's investment philosophy is to explore inefficiencies in the fixed income market. For example, let's consider a case where a 29-yr and a 30-yr bond have yields of 5.62% and 5.50% respectively. If you calculate the forward rate using these two yields, you need a negative forward rate to achieve such a term structure, which really does not make much economic sense. The reason behind this inverted term structure is because the 30-yr bond is much more liquid then the 29-yr bond. This means some investors are paying a 12 basis points liquidity premium to own the 30-yr bond. To take advantage of this pricing inefficiency, LTCM essentially shorts the over-priced 30-yr bond and long the 29-yr bond. So when do the yields coverage? Every six months, the Federal Reserve issues new 30-yr bonds, effectively making the old 30-yr bonds look "old and dusty". The decrease in trading activity removes the liquidity premium.

Why did LTCM collapse? Many people attribute it to poor risk management. While LTCM had a leverage of 300-to-1 at some point, Eric Rosenfeld argues that high leverage does not mean excessive risk taking. Nevertheless, when the Russian government defaulted on their newly-issued bonds (first payment), LTCM's investments went afloat. Swap spreads went sky-high (Avg daily sigma: 1bp, Aug 21st daily sigma: 21bp). LTCM lost $160M on a single trade on the morning of August 21st 1998. Things went downhill from that point onwards. The firm's mark-to-market policy drove them to liquidation.

A good book to read about the collapse of LTCM is "When Genius Failed: The Rise and Fall of Long-Term Capital Management".