25 years of LTCM collapse: No lessons learnt as US bank crises show

Past events and crises show how lessons have not been learnt and also history gets repeated.

The decade of 2020 started with multiple anniversaries that shaped developments in macroeconomics and financial markets. The year 2020 marked 25 years of the World Trade Organisation (WTO). The year 2021 marked 50 years of the collapse of Bretton Woods. The year 2022 marked 25 years of South East Asian crisis. The year 2023 marks 25 years of the collapse of Long Term Capital Management (LTCM) and also the Russian macroeconomics crisis.

These events and crises show how lessons have not been learnt and also history gets repeated in different ways. In the case of WTO, the world is moving from multilateral trade to a cold war kind of period where the world is fragmented into two blocks: the US and China. In the case of Bretton Woods,  the world is struggling to find an alternate monetary system since its collapse and has seen multiple crises. As for the South East Asian crisis, South Asian countries are making similar mistakes. In this article, we will argue how the LTCM failure adds to the list of lessons not learnt from the crisis.

LTCM was a US-based hedge fund founded by John Meriwether in 1994, who was previously the vice-chairperson and head of bond trading at investment bank Salomon Brothers. The cut-throat corporate culture of Salomon Brothers has been documented by Michael Lewis in his book “The Liar’s Poker”.  Salomon Brothers prioritised profits over everything and this eventually led to its decline and takeover by Travelers Group in 1997.

High-risk Arbitrage

A hedge fund is like a pooled fund that seeks funds mainly from high networth individuals. Hedge funds specialise in financial arbitrage and invest the pooled funds in these high-risk arbitrages. Arbitrage lies at the heart of financial markets, where you buy a financial security cheap and sell it expensive. Or, short-sell a security whose prices are expected to fall in future. Hedge funds specialise in finding these arbitrage positions across stocks, bonds, currencies, commodities and so on. They trade in complex derivatives to work on the arbitrage positions. Apart from arbitrage, hedge funds also use high leverage to amplify the returns. Leverage means using more borrowing compared to own capital to buy assets. The combination of high leverage plus high arbitrage defines the core activity of a hedge fund.

Apart from being a hedge fund, LTCM also had a distinguished team. It had Robert Merton and Myron Scholes who were awarded the Nobel Prize for Economics in 1997 for their research on financial derivatives. They were joined by David Mullins who was the vice-chair of the Federal Reserve from 1991 to 1994.

In the initial years, LTCM was highly profitable. As per a Wall Street Journal article, “the fund’s returns hit 42.8 percent in 1995, then 40.8 percent in 1996, after fees. That far outpaced hedge funds’ average performance of 16 percent and 17 percent, respectively.” However, the tide turned soon. By 1997, LTCM strategies were not showing the desired results. Other investors started to copy LTCM and returns started declining.  In order to continue its high profits strategy, LTCM started to take higher risks by investing in emerging markets. However, the 1997 South East Asian crisis followed by the 1998 Russian crisis created financial instability in emerging markets. The hedge fund which had invested heavily in Russian government debt, just melted away.

Collapse of Asset Value

Why did the LTCM fail? Like all financial entities that fail, the value of LTCM’s assets declined sharply and it had to repay the liabilities. The high leverage which was amplifying profits was now amplifying losses. The problems did not end there. As LTCM was highly interconnected, there were concerns that its failure will spread to the financial sector. In the case of banks and regulated entities, Federal Reserve acts as the lender of last resort. How does it provide funds to a hedge fund? Amidst high drama, the Federal Reserve Bank of New York had a discussion with large financial groups on Wall Street. The fund was finally bailed out by a 14-member group which collectively bought it for $3.65 billion.

What is interesting is that the LTCM crisis shows that both financial firms and financial regulators keep making the same mistakes. The indirect bailout by Federal Reserve was criticised by economists for incentivising the “Too Big to Fail” system where every financial entity will be bailed out as it was too big to fail. The critics worried that it will lead to even higher risk-taking in the financial system.

Same Mistakes Repeated

This warning proved true as for the next 10 years US-based investment banks invested aggressively in highly risky housing markets using high leverage. Their bets came off during the 2008 crisis. The investment banks, like hedge funds, were not well regulated. As a result, the Federal Reserve and the US government had to provide an even bigger bailout to save the financial system.

Fast forward to the present and we saw the failure of four large regional US banks. Once again, we see the combination of leverage, complexity and lack of regulation leading to the downfall of banks. Banks are highly leveraged entities and are regulated extensively. Post the 2008 crisis, the US decided to impose tighter regulations on the banks. In 2019, the US eased those tight regulations for banks that were below a threshold. This led to the four banks evading regulations, taking aggressive bets and failing eventually.

Summing up, even though LTCM failed 25 years ago, its ghost continues to linger and haunt financial policy. The lesson from LTCM's failure was that financial entities of all types and sizes could pose systemic risks. Policymakers should have a comprehensive understanding of the various financial players and their business models. Policies should act against the building up of leverage and complexity. We have not seen learning of these lessons in the last 25 years. Will the next 25 years be any different?

Amol Agrawal is faculty at Ahmedabad University. Views are personal and do not represent the stand of this publication.