Long-Term Capital Management, 1998

At a glance

What happened

LTCM made its money on convergence trades: buy the cheaper of two nearly identical instruments, sell the dearer one, and wait for the gap to close. Each trade earned very little, so the fund used enormous leverage, holding roughly $125bn of assets on about $4.7bn of capital by early 1998. When Russia defaulted in August 1998, investors everywhere rushed into the safest, most liquid assets and almost every one of LTCM's spreads widened at once. By late September its capital was nearly gone, and fourteen banks convened by the New York Fed put in about $3.6bn to take over and wind down the portfolio.

Why it went wrong

The trades looked diversified: off-the-run Treasuries, swap spreads, European bond convergence, long-dated volatility. But they shared a hidden factor. In every one the fund held the less liquid side, so a single rush for liquidity moved them all against it together. Leverage turned spread moves of tens of basis points into losses larger than the fund's capital. And because the dealers financing LTCM knew roughly what it held, the market could trade ahead of the unwind.

What it teaches

Diversification across strategies is not real if the strategies share a risk factor, and for relative value trades that factor is usually liquidity. Leverage decides how long you can afford to be wrong, which can matter more than being right: many of the spreads did converge, long after the fund was gone. A position the market knows about is one the market can trade against.

Key terms

Convergence trade

Buying the cheaper and selling the dearer of two near-identical instruments, expecting the gap to close.

On-the-run

The most recently issued and most liquid government bond of a maturity, which trades richer than older issues.

Flight to quality

A rush into the safest, most liquid assets, which widens every spread that pays for illiquidity at once.

Leverage ratio

Assets against capital, and so how far a position can move before the capital is gone.

Funding liquidity

The ability to keep financing a position — the thing that decides whether you can wait for convergence.

Crowded position

One whose size and holder are known to the market, so an unwind can be anticipated and traded against.

Where it sits in the course

Case studies like this one are used throughout risk management teaching, including FRM® preparation, as worked examples of liquidity and model risk; leverage and crowded trades. In OTC Learn the lesson runs in five steps: what happened, the position, why it broke, what it cost and what it teaches, followed by a worked example with the numbers. See the lesson outline.

The instruments behind it

OTC Learn lessons on the products this case turns on:

• Interest Rate SwapTrade fixed for floating payments
• Value at RiskOne number for tomorrow’s loss, and what it leaves out
• Asset SwapTurn a fixed-rate bond into a floating one