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Long-Term Capital Management (LTCM) was one of the largest hedged fund institutions based in US with over $126 billion in assets. The firm was established by John Meriwether in 1994. Fundamentally, LTCM had a substantial part of the investments made in extremely risky arbitrage trading which was the main acumen during the time.
From a market capitalization of $1 billion in 1994; Long-Term Capital Management had increased its market value to $4.8 billion by 1997(8). At the peak of its activities, Long-Term Capital Management had a control over $1.2 trillion in financial derivatives trading alone. LTCM had marketed itself so well to the extent that it was the preferred investment hedge fund across the world. The collapse of LTCM began on August 16, 1998, when a stunning record loss of over $800 million was realized from speculative trading.
Within a short period of time, on the second day which was on 17th August 1998, the Russian government to devalued its currency and a consequent default was announced. Therefore, investors panicked and avoided by directing their investments in less risky asset like the Treasury bonds.
Due to rational trading by the investors which involved the shifting investments to less risky assets within the shortest time possible in response the Russian default, the following Monday LTCM realized another massive loss of more than $553 million in all stock markets and by the end of August 1998, LTCM had dropped on Dow Jones by approximately 357 points and an addition of 512 point on 31st August when the stock market crashed. The discussed below are 3 key the factors which caused the collapse of the LTCM 1998 crisis.
Long-Term Capital Management and the Russian Sovereign Default
The failure to pay off the LTCM debt by the Russian government has been in the spotlight as the basic factor that immensely contributes to the fall of the fund. The federal government of Russia defaulted on paying its obligation to timely. As a result, a problem in the market arose where the LTCM was unable to recover the Russian debt timely to avoid economic panic. Precisely, the reason behind this was the Russian government had devalued its currency and suspended any further payment to LTCM.
The aftermath consequences led to Russian government stopping the selling and trading of its currency on the international stock exchange. Therefore, making it difficult for the hedge fund to recover its funds in a timely manner in move that could have salvaged LTCM from collapsing.
Long-Term Capital Management and Poor Liquidity and portfolio management
The second most immediate cause of the LTCM mayhem has been linked to poor liquidity and portfolio management of international fixed incomes in the market. Due to the devastating situation in Russia, the challenges grew even bigger day by day. The resultant effects of the bailout were to force financial institutions managers to resort to other alternatives which were simply to direct their investment in purely liquid assets that could be traded quickly to increase the assets and liquidity position of their companies.
Firms were forced to shift their investment to the US owing to big panic that had hit the Russian market. So great was the panic that many of the investors actually moved their money into Treasury bonds. However, in the most liquid part that is associated with high risks. Nonetheless, the huge investment in current US Treasury bills could not yield the anticipated outcomes as the market as the stock market trading against the “off-the-run bonds” to the extent that the prices fall historically and therefore becoming cheaper than ever. The drop in the prices resulted in losses that gravely affected
Long-Term Capital Management.
Long-Term Capital Management and the 1977 Asian financial crisis
The collapse of Asian markets in 1997 has been as one of the historic global financial crunches whose effects later culminated into the Long-Term Capital Management 1998 crisis. Before 1998, Asian markets and economies and received a lot of investment in stock markets that was done through financial derivatives and speculative trading.
However, due to inflation and other economic challenges in Asia, many of the countries such as Japan and others where Long-Term Capital Management had invested in stock exchange, begun to devalue their currencies. Consequentially, the move weakens the Asian economy even more. For instance, the collapse of the giant Thai baht caused ripples effects to all companies that were connected to it and massive bank failures was reported. Ripple effects led to the destabilization of the international financial systems considerably. Consequently, the effects of the Asian market turmoil in 1997 formed the brooding ground for Russian crisis that late culminated into the fall of Long-Term Capital Management.