Long-Term Capital Management was a hedge
fund company founded by John Meriwether (a former bond
trader at Salomon Brothers bank) in 1994 and with Nobel Prize winners
Myron Scholes and Robert Merton on the board.
The company had developed complex mathematical models to take
advantage of arbitrage deals (termed convergence trades)
usually with U.S., Japanese, and European sovereign
bonds. The basic idea was that over time the value of long-dated
bonds issued a short time apart would tend to become identical,
and by a series of financial transactions (essentially amounting
to buying the cheaper 'off-the-run' bond and short-selling the more
expensive, but more liquid, 'on-the-run' bond) it would be possible
to make a profit as the difference in the value of the bonds narrowed
when a new bond came on the run.
Because these differences in value were minute, the fund needed
to take highly-leveraged positions in order to make a significant
profit. At the beginning of 1998, the firm had equity of $5 billion
and had borrowed over $125 billion.
The fund also invested in other derivative
security products such as equity options and mortgage securitisations.
The scheme unraveled in August and September 1998 when the Russians
defaulted on their sovereign debt (GKOs). Panicked investors sold
Japanese and European bonds to buy U.S. treasury bonds. The profits
that were supposed to occur as the value of these bonds converged
became huge losses as the value of the bonds diverged.
The company was providing returns of almost 40% up to this point,
and a "flight to liquidity" the company lost a possible $100 bn
and needed an Federal
Reserve Bank of New York organised bail-out of $3.5bn, apparently
in order to avoid a wider collapse in the financial markets. The
fear was that there would be a chain reaction, as one company liquidiated
its securities to over its debt leading to a drop in prices which
would force other companies to liquidate its debt creating a vicious
Ironically, in the end the basic idea of LTCM was correct, and
the values of sovereign bonds did eventually converge after the
company was wiped out.