Long-Term Capital Management (LTCM) was a U.S. hedge fund which failed spectacularly in the late 1990s, leading to a massive bailout by other major banks and investment houses.

LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Board of directors members included Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economics. Initially enormously successful with annualized returns of over 40% in its first years, in 1998 it lost $4.6 billion in less than four months and became a prominent example of the risk potential in the hedge fund industry. The fund folded in early 2000.

Founding members

In addition to Meriwether, Scholes and Merton, also joining the company as principals were Eric Rosenfeld, Greg Hawkins, Larry Hilibrand, Robert Shustak, Dick Leahy, Victor Haghani and James McEntee. On 24 February, 1994, LTCM began trading with $1,011,060,243 of investor capital.Lowenstein, R., 2000: When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House.

The fundamental errors

The company had developed complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades) usually with U.S., Japanese, and European government bonds. The basic idea was that over time the value of long-dated bonds issued a short time apart would tend to become identical. However, the rate at which these bonds approached this price would be different, and more heavily traded bonds such as US Treasury bonds would approach the long term price more quickly than less heavily traded and less liquid bonds.

Thus, 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.

As LTCM's capital base grew, they felt pressed to invest that capital somewhere and had run out of good bond-arbitrage bets. This led LTCM to undertake trading strategies outside their expertise. Although these trading strategies were non-market directional, i.e. they were not dependent on overall interest rates or stock prices going up (or down), they were not convergence trades as such. By 1998, LTCM had extremely large positions in areas such as merger arbitrage and S&P 500 options (net short long-term S&P volatility). In fact, some market participants believed that LTCM had been the primary supplier of S&P 500 vega, which had been in demand by US insurance companies selling equity indexed annuities products for the prior two years.Fact: date=February 2007

Because these differences in value were minute—especially for the convergence trades—the fund needed to take highly-leveraged positions to make a significant profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion. It had off-balance sheet derivative positions with 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.