LTCM (Long Term Capital Management) was a hedge fund which established itself in 1994. The firm was unique because it was comprised of many Nobel prize-winning economists like Myron Scholes (Co-Founder of the Scholes-Black options pricing model) and Robert Merton (Founder of Sociology of Science) and highly successful bringing in an annual return of 40% after the fund managers took their share. To invest in the fund, you must pay a minimum if 10 million dollars and agree to let your money stay in the firm for a minimum of 3 years, yet investors still invested in it. There was so much money in the hedge fund, that if it were to go bankrupt the global economy would be severely damaged.
The issue first appeared in 1998 when multiple events occurred which LTCM had not prepared for like the devaluation of the Russian currency and the Dow Jones stock dropping by 13%. These events led to interest rates falling by more than a point, which if not prepared for, could easily lead to bankruptcy for a hedge fund, as hedge funds make their profit off of capital which they borrow with interest. The interest rate fall caused LTCM to lose more than 50% of its capital. This sent the financial world into panic mode, as many banks had put millions and millions of dollars into LTCM. LTCM was on the verge of bankruptcy and there seemed to be no way out.
This was until the Federal Reserve intervened. The Reserve convinced 14 banks to leave the LTCM by paying them 3.5 billion dollars in exchange for 90% of LTCM. While this is the offer which was taken, there were alternatives. Business magnate Warren Buffet offered to buy out the fund for 250 million dollars, which was far below what the shareholders were willing to settle for. The Federal Reserve ended up saving the world of finance from collapsing, but this would not be the last time the world of finance would be put into this kind of peril. Many argue that the LTCM blowup was a precursor to the Global Financial Crisis of 2008 exactly 10 years later.
Sources:
https://www.thebalance.com/long-term-capital-crisis-3306240
https://www.investopedia.com/terms/l/longtermcapital.asp
https://www.britannica.com/biography/Myron-Scholes
https://www.britannica.com/biography/Robert-K-Merton
I wonder what could have happened if LTCM fell and there was no recovery. Many in Wall Street feared a fall back rivaling the great depression. Luckily, as you said, the Federal Reserve was able to step in. But what if they didn't? Was it big enough to set off a chain reaction? Many thought it was and there could have been big consequences. At least we won't have to worry about a problem like that for a bit.
ReplyDelete