To The Moon

There are many things to be learned from the failures and successes of others. LTCM was the start of the 90s of the investment world, but it was short-lived and it didn’t bring its goals to fruition.

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Until 1991, John William Meriwether (born in 1947) was a bond trader at Salomon Brothers, one of the five biggest investment banks in the US at that time. This company was so influential that Salomon’s CEO was named “the King of Wall Street”.

During his time there, John W. Meriwether was the head of the firm’s bond trading desk until the company, through Paul Mozer who worked in Merithether’s office, was involved in a bond trading scandal, in which Salomon Brothers, a primary dealer between the US government and other market participants, bided multiple times for bonds, in order to obtain more US bonds, which were at demand at that time, ignoring the limit set by the US treasury to prevent market monopolization.

It’s worth to be noted that Meriwether’s group was responsible for 80% to 100% of Salomon’s global total earnings during the 1980s. Their differentiation from other similar offices was that they were more scientific that the others and they were using statistics and probability very heavily.

Due to this scandal, Salomon Brothers were fined $190'000'000, and the legendary value investor Warren Buffet, who owned 12% of the company then, had to step in as a CEO for the short-term and settle the situation.

Meriwether was charged a $50'000 charge in civil penalties and left the Salomon Brothers.

Founding Long-Term Capital Management

Two years after, in 1993, John W. Meriwether founded LTCM and recruited well-known financial experts and finance academics like Robert C. Merton and Myron Scholes, two out of three creators of the Black-Scholes model for pricing options contracts and Nobel laureates, David Wiley Mullins Jr, who was the 14th Vice Chair of the Federal Reserve from 1991 to 1994, and various other former Harvard Business School professors and Salomon’s employees. By simply announcing these names, the LTCM has all the respect and trust needed.

A year later, in 1994, LTCM had amassed funds from various high-net-worth individuals, university endowments, as well as the Italian central bank. Its starting investment capital was over $1'000'000'000.

“If you take John Meriwether, Eric Rosenfeld, Larry Hilibrand, Greg Hawkins, Victor Haghani, and the two Nobel prize winners, Merton and Scholes, they already have higher average IQ than any 16 people working together in one business in the country, including Microsoft…you combine that with the fact that those 16 had extensive experience in the field that they were operating. They would probably have an aggregate of 300 or 400 years of experience... The third factor.. that most of them had their very substantial net worths in the business”

— Warren Buffet

Investment Strategies

Since the company has employed many “superstars” of the finance industry, it could leverage complicated quantitative strategies, together with more plain and low-risk strategies, to achieve lost risk and high-reward investments. It used a complex mathematical model to identify small price discrepancies in the financial markets and take leveraged positions to exploit these discrepancies.

One strategy that the company would use is to trade the spread of two correlated two bonds. This strategy is similar to the Inter-Market Spread Trading Strategy described in the “Introduction to Futures Contracts and the Inter-Market Spread Trading Strategy” article.

The Black-Scholes formula did play a key role in the decision-making of the company when it came down to finding the “rational price”. The company often had 1000s of open positions at a time and with certainty could express the level of correlation between their positions. Another thing that the company had as certain was that market returns were following a normal distribution and that extreme events were not happening so often.

During 1997, other investment banks that were competitors to the LTCM had noticed their strategies they too were following the same techniques making arbitrage opportunities more scarce. LTCM then moved out of the circle of competence and into other arbitrage opportunities that they weren’t as familiar with as their fixed-income arbitrage.

Myron Scholes once described LTCM’s strategy as “sucking up nickels from all over the world”.

Default

Due to the fact that LTCM’s positions needed to be leveraged in order to generate enough rewards, the fund by the end of 1997 had equity of $4'700'000'000, and it had borrowed over $124'500'000'000 on that. Its debt-to-equity ratio was around 25-to-1 making it very vulnerable to sudden market fluctuations.

Their early successes were reported by the Wall Street Journal with “the fund’s returns hit 42.8% in 1995, then 40.8% in 1996, after fees”. This was against other hedge funds which were reporting 16% to 17% for the same period.

Seth Klarman, Paul Samuelson, Eugene Fama, as well as Warren Buffett, and Charlie Munger, were just a few of the early skeptics of the LTCM’s strategy, due to its highly leveraged positions. The oracle of Omaha even turned down an early-stage investment as well as during its final day's offer to invest in the fund due to its highly risky leverage plan.

The final nail to the coffin of the LTCM fund was put in on 17 August 1998, with the default of the Russian government. This event will trigger the chain of events that would send LTCM to the arms of the creditors for a bailout.

“Long-Term, which had calculated with such mathematical certainty that it was unlikely to lose more than $35 million on any single day, had just dropped $553 million — 15 percent of its capital — on that one Friday in August. It had started the year with $4.67 billion. Suddenly, it was down to $2.9 billion. Since the end of April, it had lost more than a third of its equity.”

— Roger Lowenstein

The fund was finally liquidated in the early 2000s. David Wiley Mullins Jr who was once considered Alan Greenspan’s successor to the FED, saw its future crumble. The financial models of Robert C. Merton and Myron Scholes took major criticism with Merrill Lynch writing that such models “may provide a greater sense of security than warranted; therefore, reliance on these models should be limited”.

Niall Ferguson once wrote in his book “The Ascent of Money” that LTCM’s major mistake was to develop their models and test its Value-at-Risk (VaR) implications by using at least 10 years' worth of data, instead of 5. With that, their models could be tested against events such as the 1987 US market crash.

LTCM’s strategy was described in the aftermath, contrary to Myron Scholes's previous comment as “picking up nickels in front of a bulldozer”.

Sources

1. When Genius Failed by Roger Lowenstein

2. Reincarnation on Wall Street: Screw-Ups Never Die

3. Long-Term Capital Management (Wiki)

4. US Treasury Auction Regulations (UOC)

5. The rescue of Long-Term Capital Management (PDF)

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