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The company had developed complex mathematical models 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 long-dated bonds issued a short time apart would tend to become identical. However the rate at which these bonds approached this price would be different, and that more heavily traded bonds such as United State Treasury Bond s would approach the long term price more quickly that less heavily traded and more illiquid bonds.
Thus by a series of financial transactions (essentially amounting to buying the cheaper 'off-the-run' bond and short-selling the more expensive, but more liquid, 'on-the-run' bond) it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond came on the run.
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 $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion. It had off-balance sheet derivative positions amounting to $1.25 trillion, most of which were in fixed income derivativesIn finance, a derivative security or derivative is a contract that specifies the right or obligation between two parties to receive or deliver future cash flows (or exchange of other securities or assets) based on some future event. Another way of definin such as interest rate swapA swap is an agreement between two counterparties to exchange something (one "leg" of the swap) for something else (the other "leg"). These "things" can be anything that has a financial value, but in the financial world one leg is typically a stock or oths.
The fund also invested in other derivative securityIn finance, a derivative security or derivative is a contract that specifies the right or obligation between two parties to receive or deliver future cash flows (or exchange of other securities or assets) based on some future event. Another way of definin products such as equity optionA stock option is a specific type of option with a stock as the underlying instrument (the security that the value of the option is based on). Thus it is a contract to buy (known as a " call" contract) or sell (known as a " put" contract) shares of stock,s and mortgage securitisations.
The downfall of the fund started in May and June 1998 when net returns fell to -6.42 and -10.14 per cent reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998.
The scheme finally unraveled in August and September 1998 when the Russians defaulted on their sovereign debt ( GKO s). Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August the fund had lost $1.85 billion in capital.
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 $3.625 bn, 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 liquidated its securities to cover its debt leading to a drop in prices which would force other companies to liquidate its debt creating a vicious cycle. The total losses were found to be $4.6 billion.
In the end the basic idea of LTCM was correct, in that the values of sovereign bonds did eventually converge after the company was wiped out. Nonetheless, the incident confirms an insight often (though perhaps apocryphally) attributed to the economist John Maynard KeynesJohn Maynard Keynes [kens], 1st Baron Keynes of Tilton ( June 5, 1883 in Cambridge April 21, 1946 in Sussex) was an English economist, whose radical ideas had a major impact on modern economic and political thought. He is particularly remembered for advoc, who is said to have warned investors that although markets do tend toward rational positions in the long run, "the market can stay irrational longer than you can stay solvent."
On a related point, LTCM's downfall confirmed for the financial community the need to keep in mind liquidity risk while making Value-At-Risk calculations - because illiquidity was one of the primary reasons for the downfall.
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