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76-739: LTCM was founded in 1994 by John Meriwether , the former vice-chairman and head of bond trading at Salomon Brothers . Members of LTCM's board of directors included Myron Scholes and Robert C. Merton , who three years later in 1997 shared the Nobel Prize in Economics for having developed the Black–Scholes model of financial dynamics. LTCM was initially successful, with annualized returns (after fees) of around 21% in its first year, 43% in its second year and 41% in its third year. However, in 1998 it lost $ 4.6 billion in less than four months due to

152-457: A vicious cycle . The total losses were found to be $ 4.6 billion. The losses in the major investment categories were (ordered by magnitude): 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. Although termed a bailout, the transaction effectively amounted to an orderly liquidation of

228-691: A 10% loss, which was their biggest monthly loss to date. Although 1997 had been a very profitable year for LTCM (27%), the lingering effects of the 1997 Asian crisis continued to shape developments in asset markets into 1998. Despite the crisis originating in Asia, its effects were not confined to that region. The rise in risk aversion had raised concerns amongst investors regarding all markets heavily dependent on international capital flows, and this shaped asset pricing in markets outside Asia too. Although periods of distress have often created tremendous opportunities for relative value strategies, this did not prove to be

304-456: 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. 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 in

380-403: A bond also has an impact on the interest rate risk. Indeed, longer maturity meaning higher interest rate risk and shorter maturity meaning lower interest rate risk. If a central bank purchases a government security, such as a bond or treasury bill , it increases the money supply because a Central Bank injects liquidity (cash) into the economy. Doing this lowers the government bond's yield. On

456-424: A call and long the same amount of notional as underlying the call is equivalent to being short a put. So the net effect of the transaction was for UBS to lend $ 300 million to LTCM at LIBOR+50 and to be short a put on 1 million shares. UBS's own motivation for the trade was to be able to invest in LTCM – a possibility that was not open to investors generally – and to become closer to LTCM as a client. LTCM quickly became

532-586: A combination of high leverage and exposure to the 1997 Asian financial crisis and 1998 Russian financial crisis . The master hedge fund, Long-Term Capital Portfolio L.P. , collapsed soon thereafter, leading to an agreement on September 23, 1998, among 14 financial institutions for a $ 3.65 billion recapitalization under the supervision of the Federal Reserve . The fund was liquidated and dissolved in early 2000. John Meriwether headed Salomon Brothers ' bond arbitrage desk until he resigned in 1991 amid

608-408: A difference and investors may have had even a harder time judging the risk involved when LTCM moved from bond arbitrage into arbitrage involving common stocks and corporate mergers. Under prevailing US tax laws, there was a different treatment of long-term capital gains, which were taxed at 20.0 percent, and income, which was taxed at 39.6 percent. The earnings for partners in a hedge fund was taxed at

684-414: A forced liquidation. Victor Haghani, a partner at LTCM, said about this time "it was as if there was someone out there with our exact portfolio,... only it was three times as large as ours, and they were liquidating all at once." Because these losses reduced the capital base of LTCM, and its ability to maintain the magnitude of its existing portfolio, LTCM was forced to liquidate a number of its positions at

760-402: A highly unfavorable moment and suffer further losses. A vivid illustration of the consequences of these forced liquidations is given by Lowenstein (2000). He reports that LTCM established an arbitrage position in the dual-listed company (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

836-507: A national government was issued by the Bank of England in 1694 to raise money to fund a war against France. The form of these bonds was both lottery and annuity. The Bank of England and government bonds were introduced in England by William III of England (also called William of Orange), who financed England's war efforts by copying the approach of issuing bonds and raising government debt from

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912-497: A notional value of approximately $ 1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps . The fund also invested in other derivatives such as equity options . John Quiggin's book Zombie Economics (2010) states, "These derivatives, such as interest rate swaps, were developed with the supposed goal of allowing firms to manage risk on exchange rates and interest rate movements. Instead, they allowed speculation on an unparalleled scale." LTCM

988-439: A portfolio that was a significant multiple (varying over time depending on their portfolio composition) of investors' equity in the fund. It was also necessary to access the financing market in order to borrow the securities that they had sold short. In order to maintain their portfolio, LTCM was therefore dependent on the willingness of its counterparties in the government bond (repo) market to continue to finance their portfolio. If

1064-454: A premium paid to UBS of $ 300 million. This transaction was completed in three tranches: in June, August, and October 1997. Under the terms of the deal, UBS agreed to reinvest the $ 300 million premium directly back into LTCM for a minimum of three years. In order to hedge its exposure from being short the call option, UBS also purchased 1 million of LTCM shares. Put-call parity means that being short

1140-462: A proprietary view of the likelihood of success of mergers and other corporate transactions would be completed and the implied market pricing) and S&P 500 options (net short long-term S&P volatility). LTCM had become a major supplier of S&P 500 vega , which had been in demand by companies seeking to essentially insure equities against future declines. Despite the fund's prominent leadership and strong growth at LTCM, there were skeptics from

1216-513: A result, LTCM began investing in emerging-market debt and foreign currencies. Some of the major partners, particularly Myron Scholes, had their doubts about these new investments. For example, when LTCM took a major position in the Norwegian krone , Scholes warned that they had no "informational advantage" in this area. In June 1998 – which was before the Russian financial crisis – LTCM posted

1292-402: A set of coupons at specified dates in the future, and make a defined redemption payment at maturity. Since bonds of similar maturities and the same credit quality are close substitutes for investors, there tends to be a close relationship between their prices (and yields). Whereas it is possible to construct a single set of valuation curves for derivative instruments based on LIBOR-type fixings, it

1368-421: A trading scandal. According to Chi-fu Huang , later a Principal at LTCM, the bond arbitrage group was responsible for 80–100% of Salomon's global total earnings from the late 1980s until the early 1990s. In 1993 Meriwether created Long-Term Capital as a hedge fund and recruited several Salomon bond traders; Larry Hilibrand and Victor Haghani in particular would wield substantial clout and two future winners of

1444-463: Is an American hedge fund executive. Meriwether earned an undergraduate degree from Northwestern University and an MBA degree from the University of Chicago Booth School of Business . After graduation, Meriwether moved to New York City, where he worked as a bond trader at Salomon Brothers . At Salomon, Meriwether rose to become the head of the domestic fixed income arbitrage group in

1520-459: Is concentrated in the benchmark bond, and transaction costs are lower for buying or selling it. As a consequence, it tends to trade more expensively than less liquid older bonds, but this expensiveness (or richness) tends to have a limited duration, because after a certain time there will be a new benchmark, and trading will shift to this security newly issued by the Treasury . One core trade in

1596-522: Is not possible to do so for government bond securities because every bond has slightly different characteristics. It is therefore necessary to construct a theoretical model of what the relationships between different but closely related fixed income securities should be. For example, the most recently issued treasury bond in the US – known as the benchmark – will be more liquid than bonds of similar but slightly shorter maturity that were issued previously. Trading

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1672-402: Is that the bonds are exempt from state and local taxes. The bonds are sold through an auction system by the government. The bonds are buying and selling on the secondary market , the financial market in which financial instruments such as stock , bond , option and futures are traded. TreasuryDirect is the official website where investors can purchase treasury securities directly from

1748-481: Is the risk that the value of the currency a bond pays out will decline over time. Investors expect some amount of inflation, so the risk is that the inflation rate will be higher than expected. Many governments issue inflation-indexed bonds , which protect investors against inflation risk by linking both interest payments and maturity payments to a consumer price index. In the UK these bonds are called Index-linked bonds. In

1824-491: The 1998 Russian financial crisis in August and September 1998, when the Russian government defaulted on its domestic local currency bonds. This came as a surprise to many investors because according to traditional economic thinking of the time, a sovereign issuer should never need to default given access to the printing press. There was a flight to quality, bidding up the prices of the most liquid and benchmark securities that LTCM

1900-679: The Cayman Islands . The fund's operation was designed to have extremely low overhead; trades were conducted through a partnership with Bear Stearns and client relations were handled by Merrill Lynch . Meriwether chose to start a hedge fund to avoid the financial regulation imposed on more traditional investment vehicles, such as mutual funds , as established by the Investment Company Act of 1940  – funds which accepted stakes from 100 or fewer individuals each with more than $ 1 million in net worth were exempt from most of

1976-513: 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. The principal negotiator for LTCM was general counsel James G. Rickards . The contributions from the various institutions were as follows: 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

2052-481: The New York Racing Association (NYRA). He notably campaigned Buckhan, the winner of the 1993 Washington, D.C. International Stakes . Government bond A government bond or sovereign bond is a form of bond issued by a government to support public spending . It generally includes a commitment to pay periodic interest , called coupon payments , and to repay the face value on

2128-604: The Seven Dutch Provinces , where he ruled as a stadtholder . Later, governments in Europe started following the trend and issuing perpetual bonds (bonds with no maturity date) to fund wars and other government spending. The use of perpetual bonds ceased in the 20th century, and currently governments issue bonds of limited term to maturity. During the American Revolution , in order to raise money,

2204-523: The last great Russian default , after the 1917 Revolution. Meriwether himself, born in 1947, ruefully observed: "If I had lived through the Depression , I would have been in a better position to understand events." To put it bluntly, the Nobel prize winners had known plenty of mathematics, but not enough history. These ideas were expanded in a 2016 CFA article written by Ron Rimkusk, which pointed out that

2280-499: The maturity date. For example, a bondholder invests $ 20,000, called face value or principal, into a 10-year government bond with a 10% annual coupon; the government would pay the bondholder 10% interest ($ 2000 in this case) each year and repay the $ 20,000 original face value at the date of maturity (i.e. after 10 years). Government bonds can be denominated in a foreign currency or the government's domestic currency. Countries with less stable economies tend to denominate their bonds in

2356-609: The Canadian government offered a yield of 1.34%, while 10-year government bonds issued by the Brazilian government offered a yield of 12.84%. Governments close to a default are sometimes referred to as being in a sovereign debt crisis . The Dutch Republic became the first state to finance its debt through bonds when it assumed bonds issued by the city of Amsterdam in 1517. The average interest rate at that time fluctuated around 20%. The first official government bond issued by

Long-Term Capital Management - Misplaced Pages Continue

2432-448: The LTCM strategies was to purchase the old benchmark – now a 29.75-year bond, and which no longer had a significant premium – and to sell short the newly issued benchmark 30-year, which traded at a premium. Over time the valuations of the two bonds would tend to converge as the richness of the benchmark faded once a new benchmark was issued. If the coupons of the two bonds were similar, then this trade would create an exposure to changes in

2508-547: The Legends Behind It detail the events leading up to and following Long-Term Capital Management's demise. A year after LTCM's collapse, in 1999, Meriwether founded JWM Partners LLC . The hedge fund opened with $ 250 million under management and by 2007 had approximately $ 3 billion. From September 2007 to February 2009, during the Great Recession , his main fund lost 44%. On July 8, 2009, Meriwether closed

2584-639: The Nobel Memorial Prize, Myron Scholes and Robert C. Merton . Other principals included Eric Rosenfeld, Greg Hawkins , William Krasker, Dick Leahy, James McEntee, Robert Shustak, and David W. Mullins Jr. The company consisted of Long-Term Capital Management (LTCM), a Delaware -incorporated company based in Greenwich, Connecticut . LTCM managed trades in Long-Term Capital Portfolio LP, a partnership registered in

2660-404: The U.S. government started to issue bonds - called loan certificates. The total amount generated by bonds was $ 27 million and helped finance the war. A government bond in a country's own currency is strictly speaking a risk-free bond , because the government can if necessary create additional currency in order to redeem the bond at maturity . For most governments, this is possible only through

2736-642: The US these bonds are called Series I bonds . Also referred to as market risk , all bonds are subject to interest rate risk . Interest rate changes can affect the value of a bond. If the interest rates fall, then the bond prices rise and if the interest rates rise, bond prices fall. When interest rates rise, bonds are more attractive because investors can earn higher coupon rate, thereby holding period risk may occur. Interest rate and bond price have negative correlation. Lower fixed-rate bond coupon rates meaning higher interest rate risk and higher fixed-rate bond coupon rates meaning lower interest rate risk. Maturity of

2812-533: The United States, the Securities and Exchange Commission (SEC) has designated ten rating agencies as nationally recognized statistical rating organizations . Currency risk is the risk that the value of the currency a bond pays out will decline compared to the holder's reference currency. For example, a German investor would consider United States bonds to have more currency risk than German bonds (since

2888-460: The VaR model, one of the major quantitative analysis tool by LTCM, had several flaws in it. A VaR model is calculated based on historical data, but the data sample used by LTCM excluded previous economic crises such as those of 1987 and 1994. VaR also could not interpret extreme events such as a financial crisis in terms of timing. John Meriwether John William Meriwether (born August 10, 1947)

2964-623: 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 Fed dashed. 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." After helping unwind LTCM, John Meriwether launched JWM Partners . Haghani, Hilibrand, Leahy, and Rosenfeld signed up as principals of

3040-534: The case on this occasion, and the seeds of LTCM's demise were sown before the Russian default of 17 August 1998. LTCM had returned $ 2.7 bn to investors in Q4 of 1997, although it had also raised a total in capital of $ 1.066 bn from UBS and $ 133 m from CSFB . Since position sizes had not been reduced, the net effect was to raise the leverage of the fund. In May and June 1998 returns from the fund were -6.42% and -10.14% respectively, reducing LTCM's capital by $ 461 million. This

3116-413: The chairman of Union Bank of Switzerland resigned as a result of a $ 780 million loss incurred from writing put options on LTCM, which had become significantly in-the-money due to LTCM's collapse. 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

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3192-486: The company were unable to extend its financing agreements, then it would be forced to sell the securities it owned and to buy back the securities it was short at market prices, regardless of whether these were favorable from a valuation perspective. At the beginning of 1998, the firm had equity of $ 4.7 billion and had borrowed over $ 124.5 billion with assets of around $ 129 billion, for a debt-to-equity ratio of over 25 to 1. It had off-balance sheet derivative positions with

3268-444: The contrary, when a Central Bank is fighting against inflation then a Central Bank decreases the money supply. These actions of increasing or decreasing the amount of money in the banking system are called monetary policy . In the UK, government bonds are called gilts . Older issues have names such as "Treasury Stock" and newer issues are called "Treasury Gilt". Inflation-indexed gilts are called Index-linked gilts ., which means

3344-490: The currency of a country with a more stable economy (i.e. a hard currency ). All bonds carry default risk; that is, the possibility that the government will be unable to pay bondholders. Bonds from countries with less stable economies are usually considered to be higher risk. International credit rating agencies provide ratings for each country's bonds. Bondholders generally demand higher yields from riskier bonds. For instance, on May 24, 2016, 10-year government bonds issued by

3420-482: The day LTCM began trading, the company had amassed just over $ 1.01 billion in capital. The main strategy was to find pairs of bonds which should have a predictable spread between their prices, and then when this spread widened further to basically place a bet that the two prices would come back towards each other. The core investment strategy of the company was then known as involving convergence trading : using quantitative models to exploit deviations from fair value in

3496-444: The dollar may go down relative to the euro); similarly, a United States investor would consider German bonds to have more currency risk than United States bonds (since the euro may go down relative to the dollar). A bond paying in a currency that does not have a history of keeping its value may not be a good deal even if a high interest rate is offered. The currency risk is determined by the fluctuation of exchange rates. Inflation risk

3572-494: The early 1980s and vice-chairman of the company in 1988. In 1991, Salomon was caught in a Treasury securities trading scandal perpetrated by a Meriwether subordinate, Paul Mozer. Meriwether was assessed $ 50,000 in civil penalties. Meriwether founded the hedge fund Long-Term Capital Management in 1994. The fund collapsed in 1998. The books When Genius Failed: The Rise and Fall of Long-Term Capital Management and Inventing Money: The Story of Long-Term Capital Management and

3648-400: The end of August, the fund had lost $ 1.85 billion in capital. Because LTCM was not the only fund pursuing such a strategy, and because the proprietary trading desks of the banks also held some similar trades, the divergence from fair value was made worse as these other positions were also liquidated. As rumors of LTCM's difficulties spread, some market participants positioned in anticipation of

3724-399: The financial system. LTCM's strategies were compared to "picking up nickels in front of a bulldozer" – 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. This contrasts with the market efficiency aphorism that there are no $ 100 bills lying on the street, as someone else has already picked them up. In 1998,

3800-404: 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. Long-Term Capital Management did business with nearly every important person on Wall Street. Indeed, much of LTCM's capital was composed of funds from

3876-461: The fund's partners for $ 250 million, to inject $ 3.75 billion and to operate LTCM within Goldman's own trading division. The offer of $ 250 million 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 lapsed before a deal could be worked out. Seeing no options left,

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3952-499: The fund. Meriwether opened his third hedge fund, named JM Advisors Management, in 2010. The fund is expected to use similar strategies as both LTCM and JWM, namely highly leveraged "relative value arbitrage". By March 2011, however, the JM Advisors Macro Fund had raised only $ 28.85 million. Meriwether has been an owner of thoroughbred horses for a number of years and is a member of the board of directors of

4028-404: The fund. Both analyzed the company but turned down the offer, considering the leverage plan to be too risky. LTCM's profit percentage for 1996 was 40%. However, for 1997, it was "only" 17%, which was actually right at average for hedge funds. A big reason was that other companies were by now following LTCM's example; greater competition left fewer arbitrage opportunities for LTCM themselves. As

4104-688: The future than other European government bonds, which has influenced the development of pension and life insurance markets in the respective countries. A conventional UK gilt might look like this – "Treasury stock 3% 2020". On the 27 of April 2019 the United Kingdom 10Y Government Bond had a 1.145% yield. Central Bank Rate is 0.10% and the United Kingdom rating is AA, according to Standard & Poor's . The U.S. Treasury offered several types of bonds with various maturities. Certain bonds may pay interest, others not. These bonds could be: The principal argument for investors to hold U.S. government bonds

4180-439: The higher rate applying to income, and LTCM applied its financial engineering expertise to legally transform income into capital gains. It did so by engaging in a transaction with UBS ( Union Bank of Switzerland ) that would defer foreign interest income for seven years, thereby being able to earn the more favorable capital gains treatment. LTCM purchased a call option on 1 million of their own shares (valued then at $ 800 million) for

4256-625: The issue of new bonds, as the governments have no possibility to create currency. (The issue of bonds which are then bought by the central bank with newly created currency in the process of "quantitative easing" may be regarded as de facto direct state financing from the central bank, which is outlawed officially for independent central banks.) There have been instances where a government has chosen to default on its domestic currency debt rather than create additional currency, such as Russia in 1998 (the "ruble crisis" ) (see national bankruptcy ). Investors may use rating agencies to assess credit risk. In

4332-483: The largest client of the hedge fund desk, generating $ 15 million in fees annually. LTCM attempted to create a splinter fund in 1996 called LTCM-X that would invest in even higher risk trades and focus on Latin American markets. LTCM turned to UBS to invest in and write the warrant for this new spin-off company. LTCM faced challenges in deploying capital as their capital base grew due to initially strong returns, and as

4408-899: The magnitude of anomalies in market pricing diminished over time. James Surowiecki concludes that LTCM grew such a large portion of such illiquid markets that there was no diversity in buyers in them, or no buyers at all, so the wisdom of the market did not function and it was impossible to determine a price for its assets (such as Danish bonds in September 1998). In Q4 1997, a year in which it earned 27%, LTCM returned capital to investors. It also broadened its strategies to include new approaches in markets outside of fixed income: many of these were not market neutral – they were dependent on overall interest rates or stock prices going up (or down) – and they were not traditional convergence trades. By 1998, LTCM had accumulated extremely large positions in areas such as merger arbitrage (betting on differences between

4484-463: The market. Economist Eugene Fama found in his research that stocks were bound to have extreme outliers. Furthermore, he believed that, because they are subject to discontinuous price changes, real-life markets are inherently more risky than models. Fama became even more concerned when LTCM began adding stocks to their bond portfolio. Warren Buffett and Charlie Munger were two of the individual investors that Meriwether approached in 1993 to invest in

4560-826: 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. With the credit crisis of 2008, JWM Partners LLC was hit with a 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. Meriwether then launched a third hedge fund in 2010 called JM Advisors Management. A 2014 Business Insider article stated that his later two funds used "the same investment strategy from his time at LTCM and Salomon." Historian Niall Ferguson proposed that LTCM's collapse stemmed in part from their use of only five years of financial data to prepare their mathematical models, thus drastically under-estimating

4636-496: The positions held by LTCM with creditor involvement and supervision by the Federal Reserve Bank. No public money was injected or directly at risk, and the companies involved in providing support to LTCM were also those that stood to lose from its failure. The creditors themselves did not lose money from being involved in the transaction. Some industry officials said that Federal Reserve Bank of New York involvement in

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4712-473: 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. The company, which had historically earned annualized compounded returns of almost 40% up to this point, experienced a flight to liquidity . In

4788-534: The prices of the securities LTCM was short. According to Michael Lewis in the New York Times article of July 1998, returns that month were circa -10%. One LTCM partner commented that because there was a clear temporary reason to explain the widening of arbitrage spreads, at the time it gave them more conviction that these trades would eventually return to fair value (as they did, but not without widening much further first). Such losses were accentuated through

4864-484: The regulations that bound other investment companies. The bulk of the money raised, in late 1993, came from companies and individuals connected to the financial industry. With the help of Merrill Lynch, LTCM also secured hundreds of millions of dollars from high-net-worth individual including business owners and celebrities, as well as private university endowments and later the Italian central bank. By 24 February 1994,

4940-493: The relationships between liquid securities across nations, and between asset classes (i.e. Fed model -type strategies). In fixed income the company was involved in US Treasuries, Japanese Government Bonds, UK Gilts, Italian BTPs, and Latin American debt, although their activities were not confined to these markets or to government bonds . LTCM was the brightest star on Wall Street at that time. Fixed income securities pay

5016-604: 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 (see Greenspan put ). Federal Reserve Bank of New York actions raised concerns among some market observers that it could create moral hazard since even though the Fed had not directly injected capital, its use of moral suasion to encourage creditor involvement emphasized its interest in supporting

5092-471: The risks of a profound economic crisis: The firm's value at risk (VaR) models had implied that the loss Long Term suffered in August was so unlikely that it ought never to have happened in the entire life of the universe. But that was because the models were working with just five years' worth of data. If the models had gone back even eleven years, they would have captured the 1987 stock market crash . If they had gone back eighty years they would have captured

5168-421: 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

5244-423: The securities. This exposure to the shape of the yield curve could be managed at a portfolio level, and hedged out by entering a smaller steepener in other similar securities. Because the magnitude of discrepancies in valuations in this kind of trade is small (for the benchmark Treasury convergence trade, typically a few basis points), in order to earn significant returns for investors, LTCM used leverage to create

5320-421: The shape of the typically upward sloping yield curve : a flattening would depress the yields and raise the prices of longer-dated bonds, and raise the yields and depress the prices of shorter-dated bonds. It would therefore tend to create losses by making the 30-year bond that LTCM was short more expensive (and the 29.75-year bond they owned cheaper) even if there had been no change in the true relative valuation of

5396-560: The value of the gilt rises with inflation. They are fixed-interest securities issued by the British government in order to raise money. The issuance of gilts is managed by the UK Debt Management Office , an executive agency of HM Treasury . Prior to April 1998, gilts were issued by the Bank of England . Purchase and sales services are managed by Computershare . UK gilts have maturities stretching much further into

5472-420: The very beginning. Investor Seth Klarman believed it was reckless to have the combination of high leverage and not accounting for rare or outlying scenarios. Software designer Mitch Kapor , who had sold a statistical program with LTCM partner Eric Rosenfeld, saw quantitative finance as a faith, rather than science. Nobel Prize winning economist Paul Samuelson was concerned about extraordinary events affecting

5548-538: Was "long" in Shell and the other half was "short" in Royal Dutch. LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge because in their belief the present value of the future cashflows of the two securities should be similar. 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

5624-485: Was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. Because the Salomon arbitrage group (where many of LTCM's strategies had first been incubated) had been a significant player in the kinds of strategies also pursued by LTCM, the liquidation of the Salomon portfolio (and its announcement itself) had the effect of depressing the prices of the securities owned by LTCM and bidding up

5700-446: Was open about its overall strategy, but very secretive about its specific operations, including scattering trades among banks. And in perhaps a disconcerting note, "since Long-Term was flourishing, no one needed to know exactly what they were doing. All they knew was that the profits were coming in as promised," or at least perhaps what should have been a disconcerting note when looked at in hindsight. Opaqueness may have made even more of

5776-713: Was short, and depressing the price of the less liquid securities it owned. This phenomenon occurred not merely in the US Treasury market but across the full spectrum of financial assets. Although LTCM was diversified, the nature of its strategy implied an exposure to a latent factor risk of the price of liquidity across markets. As a consequence, when a much larger flight to liquidity occurred than had been anticipated when constructing its portfolio, its positions designed to profit from convergence to fair value incurred large losses as expensive but liquid securities became more expensive, and cheap but illiquid securities became cheaper. By

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