Long-Term Capital Management: The Original Enron? Three years before energy industry giant Enron Corp. sought protection from creditors and came under the harsh light of scrutiny for the complex web of off-balance sheet deals that masked the firm's huge debt, a very similar scenario unraveled among some of Wall Street's most celebrated financial players. But while Enron unsuccessfully sought eleventh-hour aid from the power brokers it has bankrolled in Washington D.C., a "who's who" of global financial institutions stepped up to bail out hedge fund Long-Term Capital Management (LTCM) in September 1998. Not coincidentally, the bankers arguably had more to lose from the impending collapse of LTCM than they faced in the more recent debacle.

While they are, of course, very different institutions, the mistakes made by LTCM and Enron are strikingly similar. The near collapse of LTCM ultimately taught bankers around the globe to pay closer attention to the hedge funds they backed; perhaps those lessons should have been extended to their complex dealings with Enron, as well.

LTCM was headed by legendary Wall Street trader John Merriwether. He assembled a dream team made up of high-profile traders, two Nobel laureates honored for their expertise in derivatives, and a former governor of the U.S. Federal Reserve Bank.

Right from the start, LTCM made it clear the business would be built on borrowed funds.

In its original prospectus, LTCM warned investors it would employ "tons of leverage and have a lot of volatility in earnings," says Leslie Rahl, a principal at Capital Market Risk Advisors, a New York consulting firm that specializes in derivatives.(1)

At first, the hedge fund's complex investment models appeared to work spectacularly well. The fund reported returns of 42.8% in...

At the beginning of 1998, LTCM had capital of $4.8 billion, a portfolio of $200 billion (borrowing capacity in terms of leverage) and investments in derivatives with a notional value of $1.25 trillion.(2)
On top of that truly astounding leverage, the mistakes that led to LTCM's downfall included: badly misjudging market dynamics; speculation in high-risk equities and instruments that were not market neutral; investments in risky emerging markets; a common market theory that more or less unified all its investments; too much reliance on the Value at Risk" (VAR) model; a lack of liquidity in reserve; and inadequate "stress testing" in its market models.

LTCM's model functioned on assumptions that the financial markets would generally be rational; i.e., that there would always be a sufficient number of buyers and sellers of any given instrument to enable them to make the trades their model forecast. But in the spring of 1998, the markets were unraveling. LTCM was first hit by a downturn in the mortgage-backed securities market. A number of hedge funds were forced to sell emerging market positions to balance their funds.(3) At the same time, Salomon Brothers was moving out of its trading business. There were not enough buyers, and the market dropped. LTCM's net assets declined.

The hedge fund also took positions in other types of trading that were more sensitive to the performance of the general financial markets, among them risk arbitrage and emerging-market cash bonds. LTCM followed the bullish line of thought that the volatility in U.S. And European stock markets would stabilize and return to "normal" levels.(4) Four years later, that rationalization still hasn't occurred.

For LTCM, the crisis was further aggravated in August 1998, when Russia…