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. 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. Despite these restrictions, people clamored to invest. LTCM boasted spectacular annual returns of 40% in 1995 and 1996. That was after management took 27% off the top in fees. LTCM successfully hedged most of the risk from the 1997 Asian currency crisis. It gave its investors a 17.1% return that year. But by September 1998, the company’s risky trades brought it close to bankruptcy. Its size meant it was too big to fail. As a result, the Federal Reserve took steps to bail it out.
Causes of the Crisis
Like many hedge funds, LTCM’s investment strategies were based upon hedging against a predictable range of volatility in foreign currencies and bonds. On August 17, 1998, Russia declared it was devaluing its currency. It also defaulted on its bonds. That event was beyond the normal range that LTCM had estimated. By August 31, the Dow Jones Industrial Average had dropped by 13%. Investors sought refuge in Treasury bonds, causing long-term interest rates to fall by more than a full point by September 30, 1998. As a result, LTCM’s highly leveraged investments started to crumble. By the end of August 1998, it lost 50% 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 death blow. 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 14 banks to bail out LTCM. They spent $3.5 billion in return for a 90% 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.
