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The Epic Story Of How A 'Genius' Hedge Fund Almost Caused A Global Financial Meltdown

Dominoes fallingChristian Charisius/Reuters

Twenty years ago, one bond-trading hedge fund grew from launch to over $US100 billion in assets in less than three years. It saw yearly returns of over 40 per cent. It was run by finance veterans, PhDs, professors, and two Nobel Prize winners. Everyone on Wall Street wanted a piece of their profits.

But by 1998, that firm was primed to expose America’s largest banks to more than $US1 trillion in default risks. The demise of the firm, Long-Term Capital Management (LTCM), was swift and sudden. In less than one year, LTCM had lost $US4.4 billion of its $US4.7 billion in capital.

The entire story is recounted in Roger Lowenstein’s book, When Genius Failed‘, with details on the specific strategies and financial theories employed by Long-Term. It’s an absolute must-read for anyone working on Wall Street, so we’ve summarized the basics for you in ten slides.

This story has all the players — the Federal Reserve, which finally stepped in and organised a bailout, and all the major banks that did the heavy lifting: Bear Stearns, Salomon Smith Barney, Bankers Trust, J.P. Morgan, Lehman Brothers, Chase Manhattan, Merrill Lynch, Morgan Stanley, and Goldman Sachs.

In desperate need of a $US4 billion bailout, the crumbling firm was at the mercy of the banks it had once snubbed and manipulated.

Consider this a history lesson.

The idea for LTCM began with John Meriwether, who ran bond arbitrage at Salomon Brothers. He resigned from that bank after an employee was discovered deliberately deceiving the U.S. Treasury.

It all began with John Meriwether.

The groundwork for Long-Term Capital Management began when John Meriwether joined the investment bank Salomon Brothers in 1974.

Meriwether set up a bond arbitrage group within Salomon, and began hiring intellectuals to build formulas predicting market prices and finding outliers. The strategy was to buy or sell bonds when prices deviated from the norm, then wait for prices to converge again to make a profit.

The Arbitrage Group became known within Salomon for its clique-y culture, its confidence, and its substantial profits. Soon Meriwether was put in charge of all bond trading. Bond arbitrage started to spread across the financial industry. When Meriwether was forced to resigned after an oversight failure with one of his employees, he built his new hedge fund around these same principles.

Meriweather set up his own hedge fund for arbitrage using mathematical models to predict prices. Stocked with industry veterans and respected academics, the firm launched in 1994 with $US1.25 billion in capital.

Financial economist and Nobel Prize winner Myron Scholes was one of the first members of Long-Term Capital Management.

By the 1990s, the number of hedge funds in the U.S. had exploded, arriving at about 3,000 hedge funds from only about 200 in 1968. But Meriwether had high expectations for his hedge fund that would set it on an entirely different level.

First, he wanted to raise capital of $US2.5 billion. Second, LTCM's asking fees would be 25 per cent of profits on top of an annual two per cent charge on assets. Third, investors were required to keep their capital in for a minimum of three years. These standards were incredibly uncommon for a hedge fund to demand.

To justify these, Meriwether recruited respected academics who would bring credibility for the nascent firm, including Robert C. Merton, Myron Scholes, and David Mullins, then vice chairman of the Federal Reserve. Despite numerous rejections from investors including Warren Buffet, LTCM began to pick up speed, even adding foreign investors who did not traditionally deal with hedge funds.

By February 1994, Long-Term Capital launched with the largest amount of funding ever at $US1.25 billion.

In two years, LTCM had risen to over $US140 billion in assets. The firm guarded their trades to the extreme, refusing to give details to any banks or investors.

In the first year, Long-Term made almost no mistakes, earning 28 per cent when most other bond investors were losing money. Run by a team of all-star partners with record-level funding, Long-Term Capital Management was the new firm that everyone wanted to do business with.

Long-Term's edge came from its experience reading models and a secure base of financing. The team was skilled in finding pairs of trades, hedging their bets, and leveraging smaller profits for a bigger payout. People didn't really think of Long-Term as a hedge fund, but as a financial technology investment company.

However, Long-Term was very secretive about its operations, to the point where banks found it extremely frustrating to work with them. Partners rarely gave specifics on what strategies they were employing, and scattered trades between banks to avoid giving away too much information to any proprietary desk. Long-Term usually gave a broad overview of models and the economy, but not much else. The partners even bought back photos used in Business Week to erase themselves completely from the media.

The partners were also known to be condescending and conceited, always putting their own interests first. But 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.

Critics of Long-Term were worried about the dependency its models had on a completely rational market. If the markets did not behave as they did in the past, Long-Term could lose millions on its highly leveraged trades.

Seth Klarman was approached by Long-Term to buy a stake in the company, but turned them down.

Not everyone believed that Long-Term's models were the be-all end-all to investing.

Seth Klarman, general partner at Baupost Group, had turned down a stake in Long-Term. He believed not accounting for 'outlier' events and increasing leverage was incredibly reckless. Any serious mistake on Long-Term's part would wipe out a huge amount of its capital.

Mitchell Kapor and LTCM partner Eric Rosenfeld created and sold a statistics program together for hundreds of thousands of dollars. Afterwards, Kapor took a finance course with Merton at MIT, but saw quantitative finance as a faith, rather than science. Seeing the potential for disaster in these models, Kapor opted for the software industry instead.

Paul Samuelson, the first financial economist to win a Nobel Prize, was a mentor to Merton while at MIT. Since the conception of LTCM, Samuelson was concerned about what would happen if extraordinary events affected the market, and moved it out of its ideal predictability.

Eugene Fama, Schole's thesis advisor, found in his research that stocks were bound to have extreme outliers, which couldn't be explained by random distribution. Real-life markets are inherently more risky than models, because they are subject to discontinuous price changes. He became even more concerned when Long-Term eventually moved into equity.

Nonetheless, Long-Term wouldn't stop growing. By 1996, the firm had over 100 employees and $US140 billion in assets. That year they brought in total profits of $US2.1 billion. In 1997, Merton and Scholes were awarded the Nobel Prize in economic science for their model in determining derivative values.

With everyone on Wall Street moving into bond arbitrage, Long-Term began exploring equity arbitrage, swaps, volatility, and global markets.

A trader points to a stock chart on the floor of the New York Stock Exchange shortly before the closing bell in New York July 2, 2014.

Soon, everyone began catching onto Long-Term's bond arbitrage strategy. Each time Long-Term moved toward a trade, others would jump in, driving down the spread and effectively reducing opportunities for profit. It was time to expand.

The team started exploring equity and merger arbitrage. Partner Victor Haghani was dabbling in finding paired-share trades in related stocks. Another partner, Larry Hilibrand, began betting on company mergers to create and close spreads in stocks. Both began taking enormously leveraged positions in these bets.

Equity arbitrage was inherently more risky than bond arbitrage, because spreads could vary from four per cent to 10 per cent. LTCM was leaving its area of expertise, and entering a world that took others years to understand and predict.

At one point, Long-Term had $US40 million riding on each percentage point change of volatility in both the U.S. and Europe. It started investing in Brazilian bonds, Russian bonds, and Danish mortgages. Long-Term had more capital than it knew what to do with. It returned $US2.7 billion funds to outside investors, and continued to pour money into new markets.

The fall of Asian markets led to Long-Term's first big loss, which would snowball from there. Following the crisis, everyone began backing out of risky investments.

The Asian market crisis was the start to Long-Term's string of devastating losses.

In 1997, Thailand's financial defaults triggered a market crash in Asia, with one falling after another: Indonesia, the Philippines, Malaysia, South Korea. The International Monetary Fund tried to smooth things over, but it was running into some problems. Russia became the next country to fall.

Amid the global panic, investor sentiment began to change. Banks began to withdraw from more risky, illiquid investments. Craving safety, people flocked to Treasury bonds, causing spreads to widen. Volatility in the U.S. market began to rise. Long-Term was losing money on every bet it made.

Another deep concern for LTCM was that Salomon, which played a large role in its positions, began liquidating its assets after consistently mediocre returns. With Salomon's fall, other firms were abandoning arbitrage trades. Long-Term lost 14 per cent in the first half of 1998, its biggest loss yet.

Still, no one saw any real cause for alarm. Meriwether knew the firm had to have an unprofitable month at some point. Everyone was losing money in the current environment, and Long-Term still had $US128 billion in assets.

Russia soon followed Asia's decline, and Long-Term lost $US553 million in one day. Unfortunately, Long-Term had such large positions in its trade that it was impossible to sell.

The bad news came when many of Wall Street's executives were away on vacation. In August 1998, Russia defaulted on its debt. Three days later, markets all over the world started sinking. Investors began pulling out left and right. Swap spreads were at unbelievable levels. Everything was plummeting.

In one day, Long-Term lost $US553 million, 15 per cent of its capital. In one month it lost almost $US2 billion.

The firm held on to the belief that spreads would converge again, but had to start selling to avoid more catastrophic losses. Unfortunately, no one was buying, especially in such large quantities as Long-Term had. No one was willing to provide more funding to the floundering firm either.

After being turned down by a series of hedge fund managers, banks, and other investors, LTCM was down to $US500 million in assets, and barely able to clear trades. Banks began preparing for the possibility of default.

In only a few weeks, Long-Term was facing $US1 trillion in default risks. Meriwether tried to raise more money from investors to save their positions, but no one was willing to lend.

1998 Fed Chair Alan Greenspan knew he would be criticised for helping to bail out LTCM, but was worried about the impact it might have on the rest of the market if it went bankrupt.

If Long-Term defaulted, about fifty other counterparties would also be in trouble. More than $US1 trillion was at risk. UBS, who had taken on the risk of buying a warrant from Long-Term at the height of its glory, was facing a huge downfall.

By now, everyone knew about all of Long-Term's trades. Their secrets were out in the open, which meant everyone knew they were in dire trouble too. All the while, Long-Term was still taking hits like crazy. In 1998, it lost almost $US3 billion on swaps and volatility trades alone. The market was no longer following their models, and the partners were finally out of moves.

Finally, Bear Stearns stopped clearing Long-Term's trades. All efforts to raise capital were failing. Long-Term had approached Warren Buffet, George Soros, and several banks, looking to raise more money. It was then that the Federal Reserve agreed to step in.

Want to go over another Wall Street must-read?

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