Long-Term Capital Management: When Geniuses Borrow Too Much

The story

In 1994, a former Salomon Brothers bond trader named John Meriwether started an investment fund called Long-Term Capital Management, or LTCM. A fund like this, called a hedge fund, collects money from wealthy investors and big institutions and tries to earn high returns. LTCM's team was dazzling. It included top Wall Street traders and two famous economists, Myron Scholes and Robert Merton, who shared the Nobel Prize in economics in 1997.

LTCM's strategy used complex math to find tiny price differences between investments that were very similar, like two government bonds with slightly different dates. The bet was that the prices would move back together over time. Each bet earned only a small amount, so to make big profits LTCM borrowed huge sums of money to make the bets much larger. This is called leverage. It is like using a long lever to lift something heavy: a small push becomes a big movement, in either direction.

At first, it worked beautifully. The fund returned about 20 percent in 1994, 43 percent in 1995, 41 percent in 1996 and 17 percent in 1997. At the end of 1997, LTCM gave about $2.75 billion back to its investors but kept its bets just as large, which meant borrowing even more. By then it had roughly $30 of debt for every $1 of its own money. It also had derivatives contracts, which are financial agreements whose value depends on other investments, with a face value of more than a trillion dollars.

Then, on August 17, 1998, Russia stopped paying some of its debts. Investors around the world panicked and rushed to the safest investments they could find. Prices that LTCM had bet would move together instead moved apart, almost everywhere at once. Because LTCM had borrowed so much, even small price moves caused enormous losses. The fund lost 44 percent of its value in August alone. By the end of that month, it had lost about half its capital.

The danger was not just to LTCM's investors. Many of the world's biggest banks had lent to LTCM or traded with it. If the fund were forced to sell everything at once, prices could crash and spread the damage. In September 1998, the Federal Reserve Bank of New York called together the heads of major banks. On September 23, fourteen financial firms agreed to put in about $3.6 billion in exchange for 90 percent of the fund. Fed Chairman Alan Greenspan stressed that no government money was used. "This agreement was not a government bailout," he told Congress, adding that Federal Reserve funds were never provided.

LTCM's partners, who had invested much of their own wealth, lost most of it. The banks slowly sold off the fund's positions and got their money back by the end of 1999, and the fund was closed in early 2000. In total, LTCM lost about $4.6 billion in under four months.

The lesson is old but easy to forget. Borrowing can make good times better, but it makes bad times far worse, and it can turn a bad month into a disaster. Smart models are built on the past, and the future does not always cooperate. For a family or a small business, it is wise to ask not just how much you could earn, but how much you could survive losing.