If you’ve been looking for a long-term investment fund, you’ve probably come across Long-Term Capital Management L.P. LTCM is a highly leveraged hedge fund that received a $3.6 billion bailout from a group of 14 banks in 1998. The deal was brokered by the Federal Reserve Bank of New York. This article will discuss the firm’s investment models, fees, and liquidity exposure.
LTCM’s exposure to liquidity
The recent collapse of LTCM has triggered a flurry of questions about the firm’s exposure to liquidity. LTCM was a major lender to domestic commercial banks, which had direct lending and counterparty exposure to the firm. According to preliminary reviews, the banks had adequate collateral to cover any losses. Nonetheless, the firm may have been caught by the recent surge in risk aversion.
In addition, LTCM sought profits across a wide range of markets. It entered into extensive derivatives contracts, including swaps, forwards, and options. This increased LTCM’s exposure to liquidity. However, the company was not able to cover the losses it sustained from these positions.
While LTCM had a diversified portfolio, its strategy implied significant exposure to latent factor risk. As a result, the firm suffered a dramatic loss. By the end of August, it had lost more than $1.85 billion of capital.
LTCM’s investment models
Long-Term Capital Management (LTCM) is a hedge fund that specializes in high-leverage investing and the absolute return strategy. It was founded by John Meriwether, a former Salomon bond trader, in February 1994. Meriwether recruited two Nobel laureates and several other well-known market experts to build LTCM. Meriwether used sophisticated mathematical models to invest in stock and bond markets and to profit regardless of market direction. In its first 2 years of operation, the company generated over 40 percent of returns. In 1997, it was down to 17 percent.
The initial strategy employed by LTCM was to make “convergence trades,” where two assets are traded so that their prices are equal at maturity. Early trades included buying underpriced off-the-run US treasury bonds. These types of bonds are often less liquid than on-the-run treasury bonds and are less attractive to investors.
In May 1998, LTCM identified a five basis point spread between 29-year US Treasury bonds. It is expected that these yields would eventually converge. In contrast, on-the-run bonds are more liquid and investors tend to target specific maturities.
Its reliance on a rational market
Dr. Stiglitz described the Long Term Investments deal as “deliberately complicated.” He noted that the transaction involved giving away 75 percent of the upside potential of the stock. Moreover, it included a call and a put option. In essence, Long Term was giving away 75 percent of its upside potential to B & B.
The fees that Long Term Capital Management (LTCM) charged investors were some of the highest in the industry. These fees included a two percent administrative fee, and a twenty-five percent incentive fee. LTCM’s model assumed that markets would be relatively stable. However, during the Asian crisis, the market began to behave irrationally. This crisis began in Thailand and spread to other developed countries in Asia. It ultimately caused mayhem in the marketplace.
The failure of Long Term Capital Management, along with that of large banks and securities firms, has raised questions about risk management practices and regulation. There has been a recent trend of excessive risk-taking by large financial institutions. The failure of LTCM should get to serve as a wake-up call to public policymakers.
In the early years, Long Term Capital Management enjoyed remarkable success. The founders, who were famous for their reputation, consistently beat the market. In addition, the fund saw returns of up to 40%. This was impressive considering the fact that the two men running the firm were playing golf and attending conferences during work hours. In the early days, passively managed funds were almost unheard of.