The collapse of LTCM. Debt and Leverage: Financial weapon of mass destruction.

 

https://myinvestingnotes.blogspot.com/2009/12/debt-and-leverage-financial-weapon-of.html

LTCM lost its money through a combination of three critical, interconnected factors:

1. Extreme Financial Leverage (The Amplifier)

This was the core mechanism of their downfall. The firm took its $4 billion in investor capital and, through borrowing and derivatives, controlled a staggering $1.2 trillion in financial positions. This meant that even very small market moves were amplified into enormous gains or losses. As the text states, "with this kind of financial leverage even the most minute market move against you can wipe you out several times over."

2. A Key Triggering Event (The Catalyst)

The specific market shock that moved against LTCM was Russia's default on its bonds in 1998. LTCM owned many of these bonds. This was not just a loss on those specific bonds; it triggered a global "flight to quality." Investors abandoned riskier assets (like the ones LTCM was heavily invested in) and rushed into ultra-safe U.S. Treasuries. This caused the price gaps between different securities—which LTCM's models bet would narrow—to widen dramatically instead.

3. The Failure of Their Models (The Blind Spot)

LTCM's sophisticated mathematical models, designed by Nobel laureates, were based on historical data. These models failed to account for two critical realities:

• "Black Swan" Events: The models could not foresee an event as extreme and unprecedented (in their historical dataset) as a major sovereign default like Russia's.

• Liquidity Risk and Crowded Trades: The models advised "waiting out the storm," assuming they could hold positions until prices returned to "normal." However, when the crisis hit, everyone was trying to exit similar trades at the same time. This created a liquidity crisis—there were no buyers for LTCM's enormous, complex positions. Their attempt to sell only pushed prices further against them, creating a death spiral.

The Sequence of Collapse:

1. Leverage set the stage for catastrophic loss from a small market move.

2. Russia's default provided the unexpected shock that moved global markets against LTCM's concentrated bets.

3. Model failure led them to hold on as losses mounted, assuming normality would return.

4. Liquidity vanished when they finally tried to exit, locking in massive, irreversible losses that burned through their $4 billion capital in months.

In essence, LTCM lost its money because it used extreme leverage to make enormous, model-driven bets on market behavior, and those models catastrophically failed when a real-world crisis caused markets to behave in an "improbable" way while simultaneously eliminating their ability to escape their positions.

Debt and Leverage: Financial weapon of mass destruction

When Genius Failed
By Roger Lowenstein

When Genius Failed, by Roger Lowenstein, is the detailed history of the rise and tragic fall of Long-Term Capital Management (LTCM).LTCM was a hedge fund that brought the financial world to its knees when it lost $4 billion trading exotic derivatives.

In its heyday, LTCM was run almost entirely by PhD’s and other extremely high level academics-the best and brightest on Wall Street. Several of its members were Nobel economists- Myron Scholes and Robert Merton. These academics relied heavily upon statistical modeling to discover how markets behave. At first, these models performed beautifully and the fund was up over 30% each year for several years.

Many Wall Street banks became investors as they considered Long-Term to be making riskless profits! Of course this is foolhardy, but blind faith was bestowed upon LTCM because of the pedigree of its creators.

Roger Lowenstein explains how Long-Term became arrogant due to its success and eventually leveraged $4 billion into $100 billion in assets. This $100 billion became collateral for $1.2 trillion in derivatives exposure! With this kind of financial leverage even the most minute market move against you can wipe you out several times over. Talk about financial weapons of mass destruction! This risk did not deter Long-Term, though.

Finally in 1998, Russia defaulted on its bonds- many of which Long-Term owned. This default stirred up the world’s financial markets in a way that caused many additional losing trades for Long-Term.

By the spring of 1998, LTCM was losing several hundred million dollars per day. What did LTCM’s brilliant financial models say about all of this? The models recommended waiting out the storm.

By August 1998, LTCM had burned through almost all of its $4 billion in capital. At this point LTCM tried to exit its trades, but found it impossible, as traders all over the world were trying to exit as well.

With $1.2 trillion dollars at risk, the economy could have been devastated if LTCM’s losses continued to run its course. After much discussion, the Federal Reserve and Wall Street’s largest investment banks decided to rescue Long-Term. The banks ended up losing several hundred million dollars each.

What became of Long-Terms founders? Were they jailed or banned from the financial world? No. They went on to start another hedge fund!

http://www.stock-market-crash.net/book/genius.htm

Also read:
http://practical-ta.blogspot.com/?expref=next-blog
http://findarticles.com/p/articles/mi_m1316/is_9_32/ai_65160621/

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