Roger Lowenstein
John Meriwether, an MBA graduate from the University of Chicago, ran a successful arbitrage group at Salomon Brothers, an investment bank. The arbitrage group was made up of a bunch of high-IQ people that liked to gamble and calculate the odds of everything. They were 100% confident in any trade they made, so they took huge risks. Although annoying, they were the most profitable group at Salomon.
In 1991, Meriwether was asked to leave Salomon Brothers because one of his subordinates, Paul Mozer, bought illegal amounts of US treasury bills. Having been forced to leave Salomon, Meriwether started his own hedge fund to set a new gold standard on Wall Street. Meriwether founded LongTerm Capital Management (LTCM) in 1994, and soon, some of his old colleagues at Salomon joined him. Their star team consisted of Hilibrand, Haghani, Merton, Scholes, and Mullins; some are future Nobel Prize Winners and some are the top in the academic field.
LTCM’s main strategy was bond arbitrage, which meant it would look for small price differences between similar assets and bet that their price would converge. For example, on-the-run (newly issued) bonds are generally more liquid than off-the-run bonds because they can be bought from Treasury Direct whereas off-the-run bonds can only be obtained from secondary markets. Because on-the-run bonds are more liquid, they usually trade at a premium. However, the returns are mostly the same, so there shouldn’t be a price difference, which means it should eventually converge. LTCM shorted the on-the-run bonds and went long on the off-the-run bonds. Although the price difference is small, LTCM used massive leverage to magnify the returns, and since their team consisted of famous founders, it wasn’t hard to raise capital. Based on their models, the risk of this strategy was near 0%.
In 1994, the firm made 28% while the S&P only made 1.3%. In 1995, the firm made 59% while the S&P made 37.6%.
In 1997, opportunities in bond arbitrage became scarce as others entered the competition. LTCM began to venture into other areas such as equity arbitrage and merger arbitrage, but it was hard to find pairs of equities that correlated with each other like bonds, so the risk was higher.
Investors began to demand safe (liquid assets) and abhor risky assets as a result of the 1997 Asian financial crisis and the 1998 Russian default. This meant everything LTCM shorted went up, and everything it bought went down. Alone in August, LTCM fell 45%. However, according to LTCM’s models and past experiences, they should continue betting on the chance of convergence, which will benefit them in the long run.
Source: JayHenry, https://commons.wikimedia.org/wiki/File:LTCM.png
As market conditions got worst, LTCM was desperately looking for more capital, so most Wall Street firms knew its holdings and strategies. Some banks even tried to force LTCM to liquidate by taking the opposite side, which would mean profit for them but trouble for LTCM (similar to GameStop and Melvin Capital).
In 1998, the Fed was afraid that LTCM’s collapse would bring the entire Wall Street down because if LTCM was forced to liquidate, then other financial organizations with similar holdings will be forced to liquidate as well. To avoid this, the Fed organized a bailout with 14 banks and pumped $3.6 billion into the fund to slowly liquidate it.
