Long-Term Capital Management Hedge Fund Crisis
How a 1998 Bailout Led to the 2008 Financial Crisis
Long-Term Capital Management was a massive hedge fund with $126 billion in assets. It almost collapsed in late 1998. If it had, that would have set off a global financial crisis.
LTCM's success was due to the stellar reputation of its owners. Its founder was a Salomon Brothers trader, John Meriwether. The principal shareholders were Nobel Prize-winning economists Myron Scholes and Robert Merton. These were all experts in investing in derivatives to make above-average returns and outperform the market.
Investors paid $10 million to get into the fund. They were not allowed to take the money out for three years, or even ask about the types of LTCM investments LTCM. Despite these restrictions, investors clamored to invest. LTCM boasted spectacular annual returns of 42.8 percent in 1995 and 40.8 percent in 1996.
Like many hedge funds, LTCM's investment strategies were based upon hedging against a predictable range of volatility in foreign currencies and bonds. When Russia declared it was devaluing its currency, it defaulted on its bonds. That event was beyond the normal range that LTCM had estimated. The U.S. stock market dropped 20 percent, while European markets fell 35 percent. Investors sought refuge in Treasury bonds, causing long-term interest rates to fall by more than a full point.
As a result, LTCM's highly leveraged investments started to crumble. By the end of August 1998, it lost 50 percent of the value of its capital investments. Since so many banks and pension funds had invested in LTCM, its problems threatened to push most of them to near bankruptcy. In September, Bear Stearns dealt the deathblow. The investment bank managed all of LTCM's bond and derivatives settlements. It called in a $500 million payment. Bear Stearns was afraid it would lose all its considerable investments. LTCM had been out of compliance with its banking agreements for three months.
Federal Reserve Intervention
To save the U.S. banking system, the Federal Reserve Bank of New York President William McDonough convinced 15 banks to bail out LTCM. They spent $3.5 billion in return for a 90 percent ownership of the fund.
The Fed started lowering the fed funds rate. It reassured investors that the Fed would do whatever was needed to support the U.S. economy. Without such direct intervention, the entire financial system was threatened with collapse.
Pros and Cons
A CATO Institute study says the Federal Reserve didn't need to rescue LTCM because it would not have failed. An investment group led by Warren Buffett offered to buy out the shareholders for just $250 million to keep the fund running. Shareholders were not happy with the price. He would have replaced management.
But the Fed intervened and brokered a better deal for the LTCM shareholders and managers. That was the precedent for the Fed's bailout role during the 2008 financial crisis. Once financial firms realized that the Fed would bail them out, they became more willing to take risks.
The Cleveland Fed countered by saying the Buffett deal was only for LTCM's assets, not its portfolio. That consisted of derivatives. Their failure would have damaged the global economy. Technically, the Fed didn't bail out LTCM. It used no federal funds. It merely brokered a better deal than the one Buffett offered.
Almost $100 billion worth of derivative positions could have unraveled, according to The Independent. Large banks throughout the world would have lost billions, forcing them to cut back on loans to save money to write down those losses. Small banks would have gone bankrupt. The Fed stepped in to soften the blow.
Unfortunately, government leaders did not learn from this mistake. The LTCM crisis was an early warning symptom of the same disease that occurred with a vengeance in the 2008 global financial crisis.