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Long-Term Capital Management (LTCM) was established in 1994 by John Meriwether, a former head of Salomon Brothers’ mortgage securities trading, and funded by an array of financier groups including Goldman Sachs, Merrill Lynch, and Salomon Brothers. The group included two Nobel Prize-winning economists, Robert C. Merton and Myron Scholes, and partners David W. Mullins, Eric Rosenfeld, Larry Hilibrand, and Victor Haghani. LTCM quickly drew attention and capital with its promise of huge returns for investors, and by 1998 had amassed over$1billion in capital, using derivatives and arbitrage strategies that relied heavily on leverage and high-risk investments.
LTCM's goal was to exploit pricing anomalies in financial markets. It engaged in a range of arbitrage strategies and other competitive trades of derivatives, equities, and bonds. Where two investments entail highly similar risks, prices may differ from fair market value, potentially providing opportunities for arbitrage. Unfortunately, while LTCM found success in the early stages, its trading strategies neglected important factors like market liquidity and volatility.
In 1998, the fund moved aggressively into Russian debt, which it believed was undervalued. When Russia defaulted on August 17, this set off a downward spiral of losses for LTCM and a mini-crisis which threatened the stability of the global financial markets. Even after an initial bailout of $300 million from major U.S. banks, LTCM still had losses of about $4.6 billion and was forced to close.
The aftermath of the LTCM debacle highlighted the systemic risk posed by too-big-to-fail institutions and firms leveraging large amounts of debt. As a result, stricter regulations such as the Credit Rating Agency Reform Act, Sarbanes-Oxley, and the Dodd-Frank Act have since been implemented in order to protect investors and the financial system from future blowups.
Today, the collapse of LTCM remains a cautionary tale of the catastrophic consequences of over-leveraging a highly-concentrated trading portfolio In its heyday, LTCM was a highly respected and successful firm but hubris ultimately lead to its downfall. Although the lessons learned from its downfall are invaluable, the market volatility and potential systemic risk posed by such a large hedge fund is a reminder that, even with the most sophisticated risk management models and the brightest minds, risky arbitrage strategies can backfire.
LTCM's goal was to exploit pricing anomalies in financial markets. It engaged in a range of arbitrage strategies and other competitive trades of derivatives, equities, and bonds. Where two investments entail highly similar risks, prices may differ from fair market value, potentially providing opportunities for arbitrage. Unfortunately, while LTCM found success in the early stages, its trading strategies neglected important factors like market liquidity and volatility.
In 1998, the fund moved aggressively into Russian debt, which it believed was undervalued. When Russia defaulted on August 17, this set off a downward spiral of losses for LTCM and a mini-crisis which threatened the stability of the global financial markets. Even after an initial bailout of $300 million from major U.S. banks, LTCM still had losses of about $4.6 billion and was forced to close.
The aftermath of the LTCM debacle highlighted the systemic risk posed by too-big-to-fail institutions and firms leveraging large amounts of debt. As a result, stricter regulations such as the Credit Rating Agency Reform Act, Sarbanes-Oxley, and the Dodd-Frank Act have since been implemented in order to protect investors and the financial system from future blowups.
Today, the collapse of LTCM remains a cautionary tale of the catastrophic consequences of over-leveraging a highly-concentrated trading portfolio In its heyday, LTCM was a highly respected and successful firm but hubris ultimately lead to its downfall. Although the lessons learned from its downfall are invaluable, the market volatility and potential systemic risk posed by such a large hedge fund is a reminder that, even with the most sophisticated risk management models and the brightest minds, risky arbitrage strategies can backfire.