The LTCM crisis: what can we learn 20 years after?
LTCM, “Long Term Capital Management”, was a hedge fund created by John Meriwether in 1994. The mismanagement of the fund led to a major financial crisis in the late 90s. In the beginning, Meriwether had a simple strategy: being accompanied by the most brilliant minds of America. Hence, he gathered an all-star team of traders and academics composed of eminent professionals, professors, and the Nobel Prize recipients Robert Merton and Myron Scholes. This team convinced investors, including many large banks, to flock to the fund and to invest more than $1.3 billion in spite of the huge entry barriers Meriwether set. These experts team designed a strategy mainly based on convergence and relative-value trades, both combined with a high leverage effect.
In the first years this strategy scored a huge success: LTCM marketed itself as providing the highest returns, superior to 40% in 1995 and 1996, for a risk that had no equivalent among competitors. But the catastrophe occurred in 1998. In August 1998, Russia devalued the rouble and declared a moratorium on $13.5 billion of its Treasury debt: these decisions undermined LTCM’s profit sources and trashed its hedging strategies. Russia’s default was the first strike of a long series: then the so-called “flight to liquidity” across fixed-income markets precipitated the debacle of LTCM. The fund lost a lot when the banks raised doubts about the fund’s ability to survive. On 21st September, the Fed of NYC, for the first time, organised a rescue package under which a consortium of banks injected $3.5-billion into the fund and took over its management and saved the situation at the expense of heavy losses.
What can we learn 20 years after?
What has to be taken away from this debacle? One should keep in mind that this debacle is due to the pride of talented, skilled intellectuals who could not imagine they were wrong. Warren Buffet underlined that “[The members of this team] had probably the highest average IQ of any 16 people working together in one business, 400 years of experience in their jobs […] and they went broke. That is absolutely fascinating. If I wrote a book, it’s going to be called “Why do smart people do dumb things?””. Never before had any financial institution benefited from such an impeccable reputation. That’s this “over-confidence” which dragged the fund down. So professionals and investors should take that “ego risk” into account when they invest.