High Return Investments

Long-Term Capital Management

Long-Term Capital Management was a hedge fund company founded by John
Meriwether (ex-Salomon Brothers) in 1994 and with The Bank of Sweden Prize
in Economic Sciences in Memory of Alfred Nobel winners Myron Scholes and
Robert Merton on the board.

The company had developed a complex computer model to take advantage of
arbitrage deals (termed convergence trades) usually with U.S., Japanese, and
European sovereign bonds. The basic idea was that over time the value of
these bonds would tend to become identical, and by a series of financial
transactions, it would be possible to make a profit as the difference in the
value of the bonds narrowed.

Because these differences in value were minute, the fund needed to take
highly-leveraged positions in order to make a significant profit. At the
beginning of 1998, the firm had equity of $5 billion and had borrowed over
$125 billion.

The scheme unraveled in August and September 1998 when the Russians
defaulted on their sovereign debt (GKOs). Panicked investors sold Japanese
and European bonds to buy U.S. treasuries. The profits that were supposed to
occur as the value of these bonds converged, became huge losses as the value
of the bonds diverged.

The company was providing returns of almost 40% up to this point, and a
"flight to liquidity" the company lost a possible $100 bn and needed an
Federal Reserve Bank of New York organised bail-out of $3.5bn, apparently in
order to avoid a wider collapse in the financial markets. The fear was that
there would be a chain reaction, as one company liquidiated its securities
to over its debt leading to a drop in prices which would force other
companies to liquidate its debt creating a vicious cycle.

Ironically, in the end the basic idea of LTCM was correct, and the values of
sovereign bonds did eventually converge after the company was wiped out.

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