Long-Term Capital Management

Long-Term Capital Management L.P.
Company type	Limited partnership
Industry	Hedge fund, Financial services
Founded	1994
Founder	John Meriwether
Defunct	2000
Fate	Wound down and ceased operations
Headquarters	Greenwich, Connecticut, United States
Key people	John Meriwether, Myron Scholes, Robert C. Merton
Products	Hedge fund investments, fixed income arbitrage, equity arbitrage, emerging markets investments

Long-Term Capital Management L.P. (LTCM) was a hedge fund characterized by significant leverage, established in 1994 by John Meriwether, who previously served as vice-chairman and head of bond trading at Salomon Brothers. Among its leading figures were Nobel Prize winners Myron Scholes and Robert C. Merton, honored in 1997 for their work on the Black–Scholes model of financial theory.

During its initial years, LTCM achieved impressive financial results, posting annualized returns near 21% in its first year, followed by 43% and 41% in the subsequent two years respectively. Nevertheless, in 1998, the fund incurred losses amounting to $4.6 billion within a four-month span, primarily due to extreme leverage and significant exposure to the 1997 Asian financial crisis and 1998 Russian financial crisis. This severe downturn caused the failure of its principal hedge fund, Long-Term Capital Portfolio L.P.

In reaction to the crisis, fourteen leading financial firms coordinated a $3.65 billion capital infusion overseen by the Federal Reserve Bank of New York, constituting one of the largest rescues ever undertaken for a hedge fund. LTCM was eventually wound down and ceased operations by early 2000.

Based in Greenwich, Connecticut, LTCM’s investment approach revolved around advanced strategies utilizing quantitative models and arbitrage opportunities. Despite initially commanding significant influence through expert management and pioneering financial instruments, its swift collapse underscored the dangers associated with highly leveraged tactics in international markets.

Founding

John Meriwether, who had led the bond arbitrage desk at Salomon Brothers, stepped down in 1991 following a trading controversy. His team had been responsible for generating between 80% and 100% of Salomon’s global profits during the late 1980s and early 1990s.

In 1993, Meriwether launched Long-Term Capital Management (LTCM), bringing on board prominent bond traders from Salomon such as Larry Hilibrand and Victor Haghani, alongside Nobel laureates Myron Scholes and Robert C. Merton. Other key members included Eric Rosenfeld, Greg Hawkins, William Krasker, Dick Leahy, James McEntee, Robert Shustak, and David W. Mullins Jr.

The firm was incorporated in Delaware with its main office located in Greenwich, Connecticut. Trading activities were conducted through Long-Term Capital Portfolio LP, a partnership registered in the Cayman Islands. LTCM maintained low operational expenses by collaborating with Bear Stearns for execution services and Merrill Lynch for client management.

Meriwether designed LTCM as a hedge fund to circumvent regulations imposed by the Investment Company Act of 1940, limiting investors to fewer than 100 individuals each possessing over $1 million in net worth. The initial funding predominantly originated from insiders within the financial sector. Merrill Lynch played a crucial role in raising several hundred million dollars from wealthy private investors, university endowments, and Italy’s central bank. By February 24, 1994, LTCM had successfully secured just above $1 billion in capital.

Trading strategies

The firm's primary investment methodology was based on convergence trading, utilizing quantitative algorithms to capitalize on price discrepancies from intrinsic value among globally traded liquid assets and across different asset categories, including strategies similar to the Fed model. Its fixed income activities covered a broad spectrum of instruments such as US Treasuries, Japanese Government Bonds, UK Gilts, Italian BTPs, and Latin American sovereign debt, but were not confined to these markets or government securities alone. During this era, LTCM stood as a dominant player on Wall Street.

Fixed Income Arbitrage

Short positions in US swap spread
Euro Cross-Swap trades
Long exposure to US mortgages with hedging
Japanese swap curve strategies
Italian swap spread positions
Arbitrage on fixed income volatility
On-the-run vs. off-the-run bond spread trades
Junk bond arbitrage opportunities

Equity

Shorting equity market volatility
Risk arbitrage transactions
Equity relative value approaches

Emerging Markets

Long positions in emerging market sovereign debt
Long exposure to emerging market currencies
Long emerging market equities hedged against the S&P 500

Other

Yield curve positioning
Shorting high-technology stocks
Convertible bond arbitrage
Index arbitrage strategies

Fixed income arbitrage

Fixed income instruments provide fixed interest payments and return principal at maturity. Bonds with similar terms and credit ratings serve as close alternatives, resulting in narrow price and yield correlations. Unlike derivatives calculated from standard LIBOR curves, government bonds necessitate theoretical frameworks to establish pricing relationships between comparable but distinct instruments.

A case in point is the most recently issued US Treasury bond—the benchmark—which typically trades at a premium due to enhanced liquidity and lower trading costs compared to older bonds with similar maturities. This liquidity premium is generally temporary until a new benchmark replaces it and trading activity shifts accordingly. A key LTCM strategy involved purchasing the older benchmark bond (for example, a 29.75-year maturity without premium) while shorting the newly issued 30-year benchmark that commands a premium. Over time, these valuations tend to converge as the benchmark premium diminishes.

When coupon rates are alike, this approach subjects the portfolio to changes in the yield curve: a flattening curve reduces yields on longer-dated bonds (increasing their prices) while raising yields on shorter maturities (decreasing prices). This dynamic could lead to losses if the 30-year bond LTCM shorted appreciates more relative to the 29.75-year bond held, even if relative valuations remain constant. Such risks were mitigated through portfolio-level hedging by taking offsetting steepener positions in similar securities.

Leverage and portfolio composition

To generate substantial profits from minimal price inefficiencies—often only a few basis points in Treasury convergence trades—LTCM utilized extensive leverage, building a portfolio vastly larger than its capital base. The firm depended heavily on borrowing securities through financing markets to facilitate short selling, making it reliant on counterparties within the government bond (repo) market for maintaining these positions. Should financing arrangements fail to be renewed, LTCM would be compelled to liquidate holdings and cover shorts at prevailing market prices regardless of fundamental valuations.

By early 1998, LTCM's equity capital stood at $4.7 billion, with borrowings exceeding $124.5 billion and total assets approximating $129 billion—yielding a debt-to-equity ratio above 25:1. Additionally, its off-balance sheet derivative contracts had a notional amount close to $1.25 trillion, predominantly consisting of interest rate swaps alongside other derivatives such as equity options.

John Quiggin’s Zombie Economics (2010) emphasizes that these derivatives, initially created for managing currency and interest rate exposures, facilitated unprecedented speculative activities at LTCM.

Confidential and non-transparent operations

Although LTCM revealed its general business approach, it maintained strict confidentiality regarding individual trades, distributing them across multiple banking institutions. This secrecy helped bolster investor trust as consistent profits were delivered, yet it concealed the actual level of risk involved.

Transparency further declined when LTCM broadened its scope from bond arbitrage to include equities and corporate merger arbitrage, complicating investors' ability to evaluate the fund's risk profile.

UBS involvement

According to US tax regulations, long-term capital gains were subject to a 20% tax rate, while ordinary income faced a 39.6% rate. LTCM employed sophisticated financial structuring to transform income into capital gains by partnering with UBS (Union Bank of Switzerland) in a deal that deferred foreign interest income for seven years, thereby qualifying for advantageous tax treatment. In 1997, LTCM acquired a call option on one million of its own shares—valued at $800 million—by paying UBS a $300 million premium in three installments. UBS then reinvested this premium back into LTCM for a minimum of three years. To manage its exposure, UBS purchased one million LTCM shares, effectively extending a $300 million loan to LTCM at LIBOR plus 50 basis points while holding a short put position on those shares. UBS’s objective was twofold: to gain access to an investment in LTCM unavailable to most investors and to enhance client relationships. LTCM quickly became UBS’s largest hedge fund client, generating annual fees of $15 million.

Shrinking opportunities and strategy diversification

In 1996, LTCM proposed launching a high-risk spin-off fund called LTCM-X aimed at Latin American markets, with UBS participating as both investor and warrant issuer.

As LTCM’s assets expanded and market inefficiencies diminished, capital deployment became increasingly difficult. James Surowiecki observed that LTCM’s dominance in illiquid markets impaired effective price discovery, as illustrated by the Danish bond market in September 1998.

Following a 27% gain in the fourth quarter of 1997, LTCM returned capital to investors and broadened its focus beyond fixed income assets. By 1998, the firm held substantial positions in merger arbitrage—speculating on corporate deal outcomes—and maintained net short positions on long-term S&P 500 volatility through options. LTCM had become a significant provider of S&P 500 vega exposure, fulfilling demand from corporations seeking protection against equity downside risk.

Initial doubts

Despite rapid growth and distinguished leadership, skepticism surfaced early regarding LTCM. Investor Seth Klarman criticized the fund’s heavy leverage and inadequate consideration of rare market disruptions. Software developer Mitch Kapor regarded quantitative finance more as belief than empirical science. Nobel Prize-winning economist Paul Samuelson along with economist Eugene Fama cautioned about risks stemming from extreme outliers and abrupt price shifts, particularly as LTCM expanded into equities alongside bonds.

Significantly, prominent investors Warren Buffett and Charlie Munger declined an investment opportunity with LTCM in 1993, expressing concerns about the fund’s aggressive leverage tactics.

Increasing risk-taking from 1997 onward

While LTCM achieved a 40% return in 1996, its profit margin dropped to 17% in 1997 due to heightened competition eroding arbitrage possibilities. To maintain performance levels, the fund shifted focus toward emerging-market debt and foreign currency positions despite internal reservations from senior managers like Myron Scholes, who questioned whether they held an informational edge in those markets.

In June 1998, just before the Russian financial crisis unfolded, LTCM experienced its largest monthly loss to date—a decline of 10%.

1997 Asian financial crisis

Although the 1997 Asian financial crisis was primarily concentrated in Asia, it sparked a global aversion to risk that impacted markets reliant on cross-border capital flows. This shift affected asset valuations worldwide and played a role in the difficulties encountered by LTCM during this timeframe.

1998 Russian financial crisis

LTCM’s deterioration commenced prior to the Russian government default on August 17, 1998, despite previously strong financial results. By the end of 1997, LTCM had returned $2.7 billion to its investors but simultaneously increased its leverage by securing $1.066 billion from UBS and $133 million from CSFB without scaling back its positions.

In May and June 1998, the fund experienced losses of -6.42% and -10.14%, reducing capital by $461 million. The withdrawal of Salomon Brothers from arbitrage trading in July further pressured securities held by LTCM downward while pushing up prices on those it was shorting, exacerbating losses to roughly -10% that month. Initially, LTCM considered this disruption temporary, anticipating a price rebound.

The Russian financial crisis in August-September 1998 triggered a widespread demand for liquidity, elevating prices of liquid securities that LTCM had short positions in and depressing the value of illiquid assets it owned. This liquidity premium risk was underestimated in LTCM’s model, resulting in losses totaling $1.85 billion by the end of August.

Other market participants employing similar strategies intensified these dislocations as they liquidated positions. Speculation about LTCM’s financial troubles led some traders to expect forced sales, further intensifying price volatility.

Diminished capital compelled LTCM to unwind holdings at unfavorable valuations, deepening losses. For instance, an arbitrage position involving dual-listed Royal Dutch Shell required a $2.3 billion bet on price convergence. Forced liquidation occurred when the premium expanded from 8–10% to approximately 22%, generating a $286 million loss on this pairs trade alone.

Despite historically delivering nearly 40% annualized returns, LTCM’s equity plummeted from $2.3 billion to $400 million by early September 1998. With liabilities surpassing $100 billion, its effective leverage exceeded 250-to-1, underscoring the severe financial fragility that led to its downfall.

1998 bailout

Long-Term Capital Management (LTCM) maintained extensive connections with leading Wall Street institutions, many acting as both investors and trading counterparts. As LTCM’s financial condition worsened, fears grew that its failure could cause widespread market instability.

After unsuccessful attempts to raise additional capital independently, on September 23, 1998, Goldman Sachs, AIG, and Berkshire Hathaway proposed acquiring LTCM’s partnership interests for $250 million, injecting $3.75 billion in capital and merging LTCM into Goldman’s trading operations. This offer was significantly below LTCM’s $4.7 billion valuation earlier that year. Warren Buffett gave Meriwether less than an hour to accept; however, negotiations ultimately collapsed.

With no other options available, the Federal Reserve Bank of New York coordinated a $3.625 billion rescue funded by major creditors to mitigate systemic risk. LTCM’s chief negotiator was general counsel James G. Rickards. Contributions included:

$300 million each from Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P. Morgan, Morgan Stanley, Salomon Smith Barney, and UBS
$125 million from Société Générale
$100 million each from Paribas and Lehman Brothers

Bear Stearns and Crédit Agricole declined participation.

In return, participating banks acquired a 90% ownership stake and agreed to form a supervisory board; meanwhile, LTCM partners retained 10%, valued at roughly $400 million but ultimately wiped out by liabilities. The partners lost their entire personal investment totaling $1.9 billion.

The intervention aimed to prevent a cascade of forced asset sales that could have depressed prices further and magnified losses across markets.

LTCM’s overall losses reached $4.6 billion, primarily from swaps ($1.6 billion), equity volatility trades ($1.3 billion), emerging markets ($430 million), developed-market directional bets ($371 million), dual-listed company pairs ($286 million), yield curve arbitrage ($215 million), S&P 500 equity positions ($203 million), and junk bond arbitrage ($100 million). Losses from merger arbitrage were minimal.

Audited by Price Waterhouse LLP, LTCM’s holdings were eventually liquidated at a modest gain for creditors following the bailout. Although described as a bailout, it effectively constituted an orderly wind-down under creditor oversight with no direct public funds at risk; participating firms also faced potential losses had LTCM collapsed outright.

The Federal Reserve’s involvement sparked debate about moral hazard—encouraging excessive risk-taking under expectations of central bank rescue (the "Greenspan put"). While no taxpayer funds were deployed, the Fed’s role emphasized its commitment to maintaining market stability.

LTCM’s approach was often compared to "picking up nickels in front of a bulldozer"—small incremental profits offset by the threat of catastrophic losses—highlighting the intrinsic risks within its strategies despite prevailing theories supporting market efficiency.

Aftermath

In 1998, the chairman of Union Bank of Switzerland stepped down following a $780 million loss incurred from writing put options on LTCM, which became significantly profitable as a result of LTCM's downfall.

After the rescue effort, Long-Term Capital Management resumed its activities and achieved a 10% return in the following year. By early 2000, the fund was fully liquidated, and the group of banks that had financed the bailout were reimbursed. The collapse had profound consequences for prominent individuals; Mullins, once considered a likely candidate to succeed Alan Greenspan at the Fed, saw his career prospects diminish. The risk models developed by Merton and Scholes came under intense public examination. Merrill Lynch's reports highlighted that excessive confidence in mathematical risk frameworks should be tempered with caution.

Following LTCM’s dissolution, John Meriwether established JWM Partners alongside key figures such as Haghani, Hilibrand, Leahy, and Rosenfeld. By December 1999, they secured $250 million to implement strategies similar to those used by LTCM but with lower leverage. Nevertheless, during the 2008 financial crisis, JWM Partners experienced a 44% decline in its Relative Value Opportunity II fund and subsequently closed in July 2009. Meriwether then initiated JM Advisors Management in 2010, maintaining investment approaches consistent with his LTCM and Salomon Brothers background.

Analysis

Historian Niall Ferguson partly attributed LTCM’s failure to its dependence on only five years of financial data within their models, leading to an underestimation of the risks posed by extreme market events:

A 2016 article from the CFA Institute by Ron Rimkusk further examined this issue, emphasizing deficiencies in LTCM’s Value at Risk (VaR) model. This model omitted earlier crises such as those in 1987 and 1994 and was unable to forecast the timing of rare catastrophic events, thereby limiting its utility as a robust quantitative risk assessment tool.

Bibliography

. Chapter 15: Long-Term Capital Management