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LTCM could be picky when it came to choosing investors. This was not a fund for your typical
dentist or millionaire next door. Former students of mine who have gone on to jobs at some of the
world‟s largest banks and investment companies have confided to me that their firms subcontracted
sizable portions of their portfolios to LTCM. By the end of 1995, bolstered by reinvested profits and
by newly invested funds, LTCM managed $3.6 billion of invested funds. However, the portfolio was
levered 28 to 1. For every $1 a client invested, the fund was able to borrow $28 from banks and
brokerage houses. Consequently, LTCM managed positions worth over $100 billion. Moreover,
because of the natural leverage inherent in the derivatives they bought, these positions were
comparable to investments of a much larger magnitude, estimated to be in the $650 billion range.
By 1997, however, when the fund‟s capital base peaked at $7 billion, managers realized that
profitable arbitrage opportunities were growing scarce. The easy pickings of the early days were over.
The partners began to intentionally shrink the fund by returning money to investors, essentially
forcing them out. Performance was sound in 1997, a 25% return, but with the payout of capital, the
fund‟s capital base fell to $4.7 billion.
Things unraveled disastrously in 1998. Each of LTCM‟s major investment strategies failed. Based
on sophisticated models and historical data, LTCM gambled that (1) stock market volatility would
stay the same or fall, (2) swap spreads—a variable used to determine who pays whom how much in
interest rate swaps—would narrow, (3) the spread of the interest rate on medium-term bonds over
long-term bonds would flatten out, (4) the credit spread—the interest rate differential between risky
bonds and high-grade bonds—would narrow, and (5) calm would return to the financial markets of
Russia and other emerging markets. However, in each case the opposite happened. Equity volatility
increased. Swap spreads widened. The yield curve retained its hump. Credit spreads grew. Emerging
markets deteriorated.
Though LTCM had spread its bets over a wide variety of positions, the hedge fund seemed to gain
no diversification benefit. Everything went wrong at once. Recent research has shown that
diversification does not protect speculative positions when markets behave erratically. Markets tend to
go awry in tandem.
In August 1998 alone, the fund suffered losses of $1.9 billion. Losses for the year so far were 52%.
Fund managers were confident that their strategies were sound and that time would both prove them
right and reward their prescience. But time is not a friend to a levered fund losing money. Banks and
brokerages itched for their loans back. How ironic it was that Long-Term Capital Management faced a
short-term liquidity crunch.
Leverage amplified LTCM‟s remaining $2.28 billion of equity into managed assets of $125 billion.
If the market continued to move against its positions, LTCM would be wiped out in short order, and
that is essentially what happened. On September 10, LTCM lost $145 million. The next day, it lost
$120 million. The following three trading days brought losses of $55 million, $87 million, and $122
million, respectively. On one day alone, Monday, September 21, 1998, LTCM lost $553 million. By
now traders at other firms could guess what LTCM‟s positions were, and by anticipating what LTCM
would eventually have to sell, they could gauge which securities were good bets to short. This selling
pressure added to LTCM‟s losses and woes.