Case discussion on the fall of Long Term Capital Management

. Short introduction

Long Term Capital Management is an example of how hubris, leverage and unpredictable market conditions can all coalesce to form a negative outcome. Charlie Munger, vice chairman of Berkshire Hathaway once termed this a “lollapalooza effect.” Here , several biases and tendencies all combined to move markets in a single direction. In the case of Long-Term Capital Management, market conditions turned so dire, that the company through leverage went bankrupt. As a result, a consortium of other banks where required to essentially “bailout” Long Term Capital Management from what appeared on the surface to be smart arbitrage trades.

2. What happened?

Long Term Capital Management was founded by Robert Merton and Myron Scholes who designed the Black-Scholes option pricing model which is still in use by financial professions today. As Nobel laureates and pioneers within the financial services industry, very few questioned the prowess of the hedge fund and its ability to deliver alpha for investors. Long Term Capital Management was a hedge fund that essentially used arbitrage to take advantage of small pricing inefficiencies within the market. As these pricing inefficiencies where very small, the company employed leverage to help increase their investment returns. The model relied heavily on past market performance, which was difficult, considering that market conditions can fluctuate dramatically. By using leverage when these market conditions deteriorated, the company not only experience investment losses but also had to cover the collateral backing their trades. At its height Long Term Capital Management would borrower 100% of this collateral to finance its trades leading to very extreme leverage within the organization. After large amounts of success during its initial years, market conditions deteriorated substantially. Default on Russian government bonds, negative market sentiment, and the unwinding of Wall Street positions looking to copy the success of Long Term Capital Management all led to its eventual bankruptcy and bailout.

3. Why/how was it able to happen?

This all occurred due in part to extreme amounts of leverage along with hubris on the part of the hedge fund founders. Both founders where highly regarding in the financial services industry and had a very strong track record of success. As a result, investors did not conduct as much due diligence in to the hedge fund processes and operations as they normally would. Here, the relied and trusted the reputation of Robert Merton and Myron Scholes and rarely challenged them until it was too late. Likewise, Robert Merton and Myron Scholes both believe that their models would work even under extremely adverse market conditions. This hubris ultimately proved fatal as the company succumb to the pressure of its massive debt load.

4. What actions have been taken to prevent this from happening again (lessons learned from the event)?

Standards related to leverage have been implements to help lower the likelihood of default by major financial institutions that pose a system risk to the financial system. In addition, higher capital ratios and collateral percentages are now being required to further reduce the likelihood of an extreme shock to the system and to the market. In addition, actions have been taken to provide oversight in the trade of hedge funds and their leverage. For one, hedge funds are often required to submit filings to the SEC detailing their trades and their amount of leverage. Banks are also improving their risk management policies to better mitigate the impact of client leverage on their operations. Specifically, banks no longer allow hedge funds to borrower 100% against their collateral.

5. What should Risk Managers take away from this case?

Risk managers should fully understand “tail risk” within their financial models. Although not likely, managers should understand the implications to the business should an extremely unlikely be negative situation occurring. Risk managers should prepare contingency plans and proactive use solutions to eliminate circumstances in which an adverse economic situation can bankrupt or severely hinder the organization. Risk managers should also be able to lower the amount of leverage in their operations to ensure the future stability of their enterprise. Specifically , many risk managers must adhere to certain covenants within their debt offerings that have specific regulations specific to debt ratios, interest coverage ratios, and loan to value ratios.