The collapse of LTCM raised questions about reliance on collateral and credit limits, and about a lack of stress testing. Work on monitoring the credit risk of derivatives counterparties, setting credit limits, and designing stress tests overlaps with these questions.

What happened

In September 1998, the US hedge fund Long-Term Capital Management (LTCM) ran short of funding because of its losses and faced the risk of being unable to pay its debts within days. On September 23, 14 financial institutions that were LTCM's counterparties and lenders agreed to put in new capital and keep LTCM going. Together they invested about USD 3.6 billion and, in return, received 90% of LTCM's equity and operating control1. The stake of LTCM's original investors fell to 10%.

The Federal Reserve Bank of New York (the New York Fed) provided the forum for this agreement. On October 1, 1998, William McDonough, president of the New York Fed, told a House committee that this was a private-sector solution to a private-sector problem, and that no public money was spent or committed2.

LTCM never actually stopped paying, so what would have happened can only be shown through estimates and judgments. LTCM itself estimated that its 17 largest counterparties could lose USD 3 billion to USD 5 billion in total. The president of the New York Fed explained his judgment. If many counterparties had closed out their positions at the same time, prices could have moved sharply, and some credit and interest rate markets could have stopped functioning34.

What kind of fund LTCM was

LTCM was a hedge fund established in early 1994. Its main office was in Connecticut, and the fund itself was a Cayman Islands partnership. Its principals included people well known in other fields as well as in the economic theory of financial markets5.

Its core strategy was the convergence trade. For example, when the yield spread of corporate bonds over Treasuries is wider than its past level, you buy the corporate bonds and sell Treasuries. If the gap narrows, you profit; if it widens, you lose. LTCM repeated this basic form across many interest rate products and markets, expecting that spreading its positions across many markets would let losses and gains offset one another6.

After fees, its returns were about 40% in 1995 and 1996 and just under 20% in 1997. At the end of 1997 it returned about USD 2.7 billion to investors, which cut its capital by about 36% to USD 4.8 billion. It apparently did not reduce the size of its positions, so its leverage rose accordingly7.

About 80% of its positions were in government bonds of the Group of Seven (G7) major countries, including Japan, the United States, and the United Kingdom. Its positions also extended to corporate bonds, mortgage-backed securities, emerging-market bonds, and equities. It also held futures on about 12 exchanges worldwide and OTC derivatives (swaps, forwards, and options) with dozens of counterparties. Many of the positions were financed through repurchase agreements (repos) and securities lending contracts7.

Size at the end of August 1998 Value
Capital (January 1, 1998; the figure the report used) USD 4.8 billion
Total assets (August 31) More than USD 125 billion
Assets divided by capital More than 25 times
Notional amount of exchange-traded contracts (end of August) More than USD 500 billion
Notional amount of swaps (end of August) More than USD 750 billion
Notional amount of OTC derivatives such as options (end of August) More than USD 150 billion

The values in this table are those given in the report of the President's Working Group on Financial Markets8. LTCM was the most highly leveraged of the large hedge funds then reporting to the Commodity Futures Trading Commission (CFTC), with assets nearly four times those of the next largest hedge fund9.

How leverage magnifies gains and losses

When assets are many times capital, a move in the value of the assets becomes a gain or loss that is many times larger relative to capital. Consider a hypothetical example in which a fund's assets are 25 times its capital. These are not LTCM's actual positions or results. Suppose capital is 10 billion yen and assets are 25 times that, or 250 billion yen, and that all the assets move by the same percentage. Interest, fees, and collateral payments are ignored.

Case Gain or loss on assets (billion yen) Gain or loss relative to capital Capital after the gain or loss (billion yen)
Assets rise 1% 250 × 1% = +2.5 +25% 10 + 2.5 = 12.5
Assets fall 1% 250 × 1% = −2.5 −25% 10 − 2.5 = 7.5
Assets fall 4% 250 × 4% = −10 −100% 10 − 10 = 0

For the same 1% move, capital grows by a quarter if assets rise and shrinks by a quarter if they fall. With a 4% fall, capital is wiped out in this example. The higher the multiple, the more capital rises or falls on a small price move.

From summer 1998 to September

On August 17, 1998, Russia announced a devaluation of the ruble and a moratorium on its debt. Investors moved to avoid risk and seek liquid assets, a "flight to quality," and risk spreads and other spreads widened sharply in markets around the world10.

Jul 31Capital of USD 4.1 billionAug 17Russia announces a debt moratoriumAugUSD 1.8 billion loss. Capital of USD2.3 billionSep 18Principals seriously concernedabout making paymentsSep 21Counterparties try to gathercollateral; default possible asearly as the 23rdSep 2314 firms agree to invest about USD3.6 billion
Figure 1Timeline from summer 1998 to September 23
Figure description

The timeline follows the summer capital level, Russia's announcement, the loss and the fall in capital, the principals' concern, the counterparties' collateral calls, and the agreement to invest. The filled circles mark Russia's announcement and the agreement to invest. Month-level and day-level events are mixed, so the spacing is not to scale.

Date Event
July 31, 1998 LTCM's capital was USD 4.1 billion, down about 15% from the start of the year10.
August 17 Russia announced a ruble devaluation and a debt moratorium10.
August LTCM lost USD 1.8 billion, and its capital fell to USD 2.3 billion, a decline of more than 50% since the start of the year. LTCM told investors it was seeking an injection of capital10.
September 18 Its efforts to raise funds were not succeeding, and LTCM's principals became seriously concerned about whether they could keep making payments through further price declines11.
September 20 New York Fed officials, together with a Treasury official, visited LTCM's offices and were briefed on its positions and funding12.
September 21 Bear Stearns, the prime broker, asked for collateral against the exposure, and counterparties also tried to gather collateral through margin. LTCM could have defaulted as early as September 2311.
September 22 The four firms with the strongest concerns began to look for ways to avoid a default, and a funding proposal later called the "consortium approach" became the main option11.
September 23 An offer to buy LTCM from another group of investors did not materialize, the talks resumed, and 14 firms agreed to invest about USD 3.6 billion1.

A prime broker is a firm that handles clearing and financing for its clients in one package. The New York Fed provided a forum for the talks and urged the financial institutions involved to look for the solution that would cause the least disruption overall11. According to the president's testimony, New York Fed officials did not take part in the discussion of the terms of the investment13.

What the reports said caused it

The President's Working Group on Financial Markets issued its report in April 1999. It was sent to Congress under the joint signatures of the Secretary of the Treasury and the heads of three bodies: the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission (SEC), and the CFTC. The U.S. General Accounting Office (GAO) issued a separate report in October 1999.

Market changes and models

The report of the President's Working Group on Financial Markets says that spreads widened at the same time, broadly, and for a long period across the world. This went beyond what the risk management models of LTCM and others had assumed. The assumption that price movements across markets (correlations) were low also proved wrong, and positions spread across the world were less diversified than they appeared. Market liquidity also fell, and positions could not be reduced quickly10. LTCM was diversified across world markets but was not well diversified in its strategy. It was betting that liquidity, credit, and volatility spreads would narrow from historically high levels. It underestimated the likelihood that spreads would widen worldwide at the same time14.

Size, leverage, and little information

The report says that the large size of LTCM's positions and its high leverage made the problem of market liquidity worse. The information LTCM gave to its lenders and counterparties consisted of items such as balance sheets and income statements, which did not reveal the substance of its risks or its concentration in particular markets15.

Counterparty risk management

The report asks whether LTCM's counterparties had been lulled into a false sense of security by collateral arrangements alone. The current credit risk was in most cases covered by collateral. However, the potential future exposure from future price movements was likely not adequately assessed, the report states16. Each counterparty set a credit limit for its dealings with LTCM, but nothing constrained LTCM's overall size and leverage17.

The GAO report concluded that LTCM was able to build such large positions mainly because banks, securities firms, and futures commission merchants did not adhere to their own risk management standards. According to the regulators, three factors were behind this: excessive confidence in the principals' reputations, looser credit standards during a long economic expansion, and competition to win hedge fund business18.

What the examinations found

In the examinations that followed, Federal Reserve examiners found that banks had relied on collateral for current exposures without adequate due diligence and that their credit stress tests were insufficient. The SEC found that securities firms' credit decisions often departed from their own policies and that stress testing was not adequately performed at all firms19.

What changed afterward

According to the report of the President's Working Group on Financial Markets, banks and securities firms tightened their credit risk management policies for highly leveraged counterparties right after the LTCM crisis. In the fourth quarter of 1998, withdrawing capital and tightening credit standards held back the hedge fund industry as a whole. By the time of the report, however, these terms had begun to loosen. The report says that market history shows even painful lessons recede from memory with time20.

Calling the control of excessive leverage the central issue, the report recommended measures. The recommendations were more disclosure by hedge funds, stronger counterparty risk management by financial institutions, and stronger supervision by the authorities. They also included progress on risk-based capital regulation and legislation to support close-out netting in bankruptcy21.

After the agreement to invest, the Office of the Comptroller of the Currency (OCC) and the Federal Reserve supplemented their guidance for examiners in early 1999. The guidance stressed the importance of stress testing and of banks understanding the nature of their counterparty risks. A group of leading financial institutions in the industry also issued a report recommending improvements in counterparty risk management23. The GAO also stated, however, that the authorities continued to focus on the soundness of individual firms and markets and did not look at links across industries. It added that the SEC and the CFTC lacked authority over some affiliates of securities firms and futures commission merchants, which made it hard to detect systemic risks like LTCM24.

Counterparty risk management as it stands today is covered in What Is Counterparty Credit Risk?.

The 2008 financial crisis is covered in The Collapse of Lehman Brothers (2008).

Notes

  1. Report of the President's Working Group on Financial Markets, "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management" (April 1999), pp. 13–14 (PDF pp. 22–23). ↩ ↩2

  2. Statement by William J. McDonough, President of the Federal Reserve Bank of New York, before the House Committee on Banking and Financial Services (October 1, 1998), the last paragraph of "What did the New York Fed do?" ↩

  3. Report of the President's Working Group on Financial Markets, p. 17 (PDF p. 26; LTCM's estimate of a total loss of USD 3 billion to USD 5 billion, and USD 300 million to USD 500 million each for some firms). ↩

  4. McDonough's testimony, "The New York Fed's Judgments." ↩

  5. Report of the President's Working Group on Financial Markets, p. 10 (PDF p. 19), "A. Background" (established in "early 1994," a "Delaware limited partnership," the fund a "Cayman Islands partnership"), and the description of the principals' backgrounds in the same section. ↩

  6. McDonough's testimony, "Background" (the example of the yield difference between corporate bonds and Treasuries). For the definition of the convergence trade, see footnote 13 on p. 10 (PDF p. 19) of the report of the President's Working Group on Financial Markets. ↩

  7. Report of the President's Working Group on Financial Markets, p. 11 (PDF p. 20; returns in 1995 and 1996, the return of about USD 2.7 billion and capital of USD 4.8 billion at the end of 1997, about 80% of positions in G7 government bonds, futures on about 12 exchanges, OTC derivatives with dozens of counterparties, and positions financed through repos and securities lending). ↩ ↩2

  8. Report of the President's Working Group on Financial Markets, pp. 11–12 (PDF pp. 20–21). The multiple is assets on August 31, 1998 divided by the USD 4.8 billion of capital on January 1, 1998. ↩

  9. Report of the President's Working Group on Financial Markets, p. 14 (PDF p. 23), "C. The LTCM Fund Achieved Extraordinary Levels of Leverage and Risk." ↩

  10. Report of the President's Working Group on Financial Markets, p. 12 (PDF p. 21; Russia's announcement of August 17, "flight to quality," the widening of spreads, the move beyond the models' assumptions, and the figures for July 31 and August). ↩ ↩2 ↩3 ↩4 ↩5

  11. Report of the President's Working Group on Financial Markets, p. 13 (PDF p. 22; September 18, September 21, the "Core Group of four" on September 22, and the New York Fed providing a place for the talks). ↩ ↩2 ↩3 ↩4

  12. McDonough's testimony, toward the end of "Background" (on Sunday, September 20, New York Fed officials and a Treasury official visited LTCM's offices). ↩

  13. McDonough's testimony, "What did the New York Fed do?" ("we did not participate in the discussion about terms and conditions"). ↩

  14. Report of the President's Working Group on Financial Markets, p. 16 (PDF p. 25; "not very well diversified as to strategy," "underestimated the likelihood"). ↩

  15. Report of the President's Working Group on Financial Markets, pp. 14–15 (PDF pp. 23–24). ↩

  16. Report of the President's Working Group on Financial Markets, p. 15 (PDF p. 24). ↩

  17. Report of the President's Working Group on Financial Markets, p. 16 (PDF p. 25; "none of its investors, creditors, or counterparties provided an effective check on its overall activities"). ↩

  18. U.S. General Accounting Office, "Long-Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk" (GAO/GGD-00-3, October 1999), the first paragraph of "Results in Brief." ↩

  19. GAO/GGD-00-3, the section on weaknesses found in later examinations (the paragraphs on the findings of Federal Reserve examiners and of the SEC). ↩

  20. Report of the President's Working Group on Financial Markets, p. 31 (PDF p. 40). ↩

  21. Report of the President's Working Group on Financial Markets, Executive Summary (pp. viii–ix; PDF pp. 8–9) and pp. 29–32 (PDF pp. 38–41). ↩

  22. Report of the President's Working Group on Financial Markets, p. 36 (PDF p. 45), "3. Enhanced Private Sector Practices for Counterparty Risk Management" ((a) to (k)). ↩

  23. GAO/GGD-00-3, the second paragraph of "Results in Brief" and the section on the responses of the authorities and the industry. ↩

  24. GAO/GGD-00-3, "Results in Brief" and the abstract (links across industries, and the authority of the SEC and the CFTC). ↩