Editing Long-Term Capital Management (section)

== Downturn ==

[[File:LTCM.png|right|thumb|350px|The value of $1,000 invested in LTCM,<ref>{{Harvnb|Lowenstein|2000|p=xv}}</ref> the [[Dow Jones Industrial Average]] and invested monthly in U.S. Treasuries at constant maturity.]]

===Riskier investments starting in 1997===

LTCM's profit percentage for 1996 was 40%.  However, for 1997, it was "only" 17%, which was actually right at average for hedge funds.  A big reason was that other companies were by now following LTCM's example; greater competition left fewer arbitrage opportunities for LTCM themselves.<ref name="Too Interconnected to Fail?"/>

As a result, LTCM began investing in emerging-market debt and foreign currencies.  Some of the major partners, particularly Myron Scholes, had their doubts about these new investments.  For example, when LTCM took a major position in the [[Norwegian krone]], Scholes warned that they had no "informational advantage" in this area.<ref name="Too Interconnected to Fail?"/>

In June 1998 – which was before the Russian financial crisis – LTCM posted a 10% loss, which was their biggest monthly loss to date.<ref name="Too Interconnected to Fail?"/>

===1997 Asian financial crisis===
{{Main|1997 Asian financial crisis}}
Although 1997 had been a very profitable year for LTCM (17%), the lingering effects of the 1997 Asian crisis continued to shape developments in asset markets into 1998. Despite the crisis originating in Asia, its effects were not confined to that region. The rise in risk aversion had raised concerns amongst investors regarding all markets heavily dependent on international capital flows, and this shaped asset pricing in markets outside Asia too.<ref>{{Cite news |last=O'Rourke |first=Breffni |date=1997-09-09 |title=Eastern Europe: Could Asia's Financial Crisis Strike Europe? |work=RadioFreeEurope/RadioLiberty |url=http://www.rferl.org/content/article/1086424.html |access-date=2015-08-22 |archive-date=2016-04-14 |archive-url=https://web.archive.org/web/20160414062916/http://www.rferl.org/content/article/1086424.html |url-status=live }}</ref>

===1998 Russian financial crisis===
{{Main|1998 Russian financial crisis}}
Although periods of distress have often created tremendous opportunities for relative value strategies, this did not prove to be the case on this occasion, and the seeds of LTCM's demise were sown before the Russian default of 17 August 1998. LTCM had returned $2.7 bn to investors in Q4 of 1997, although it had also raised a total in capital of $1.066 bn from UBS and $133 m from [[Credit Suisse First Boston|CSFB]]. Since position sizes had not been reduced, the net effect was to raise the leverage of the fund.

In May and June 1998, returns from the fund were -6.42% and -10.14% respectively, reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the [[arbitrage]] business in July 1998. Because the Salomon arbitrage group (where many of LTCM's strategies had first been incubated) had been a significant player in the kinds of strategies also pursued by LTCM, the liquidation of the Salomon portfolio (and its announcement itself) had the effect of depressing the prices of the securities owned by LTCM and bidding up the prices of the securities LTCM was short. According to [[Michael Lewis]] in the New York Times article of July 1998, returns that month were circa -10%. One LTCM partner commented that because there was a clear temporary reason to explain the widening of arbitrage spreads, at the time it gave them more conviction that these trades would eventually return to fair value (as they did, but not without widening much further first).

Such losses were accentuated through the [[1998 Russian financial crisis]] in August and September 1998, when the Russian government defaulted on its domestic local currency bonds.<ref>{{Cite book |last=Bookstaber |first=Richard |title=A Demon Of Our Own Design |title-link=A Demon Of Our Own Design |publisher=John Wiley & Sons |year=2007 |isbn=978-0-470-39375-8 |location=USA |pages=[https://archive.org/details/demonof_boo_2007_00_3446/page/97 97–124]}}</ref> This came as a surprise to many investors because according to traditional economic thinking of the time, a sovereign issuer should never need to default given access to the printing press. There was a flight to quality, bidding up the prices of the most liquid and benchmark securities that LTCM was short, and depressing the price of the less liquid securities it owned. This phenomenon occurred not merely in the US Treasury market but across the full spectrum of financial assets. Although LTCM was diversified, the nature of its strategy implied an exposure to a latent factor risk of the price of liquidity across markets. As a consequence, when a much larger flight to liquidity occurred than had been anticipated when constructing its portfolio, its positions designed to profit from convergence to fair value incurred large losses as expensive but liquid securities became more expensive, and cheap but illiquid securities became cheaper. By the end of August, the fund had lost $1.85 billion in capital.

Because LTCM was not the only fund pursuing such a strategy, and because the proprietary trading desks of the banks also held some similar trades, the divergence from fair value was made worse as these other positions were also liquidated. As rumors of LTCM's difficulties spread, some market participants positioned in anticipation of a forced liquidation. Victor Haghani, a partner at LTCM, said about this time "it was as if there was someone out there with our exact portfolio,... only it was three times as large as ours, and they were liquidating all at once."

Because these losses reduced the capital base of LTCM, and its ability to maintain the magnitude of its existing portfolio, LTCM was forced to liquidate a number of its positions at a highly unfavorable moment and suffer further losses. A vivid illustration of the consequences of these forced liquidations is given by Lowenstein (2000).<ref name="Lowenstein 2000">{{Harvnb|Lowenstein|2000|p= }}</ref> He reports that LTCM established an arbitrage position in the [[dual-listed company]] (DLC) [[Royal Dutch Shell]] in the summer of 1997, when Royal Dutch traded at an 8%–10% premium relative to Shell. In total $2.3 billion was invested, half of which was "long" in Shell and the other half was "short" in Royal Dutch.<ref>{{Harvnb|Lowenstein|2000|p=99}}</ref> LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge because in their belief the present value of the future cashflows of the two securities should be similar. This might have happened in the long run, but due to its losses on other positions, LTCM had to unwind its position in Royal Dutch Shell. Lowenstein reports that the premium of Royal Dutch had increased to about 22%, which implies that LTCM incurred a large loss on this arbitrage strategy. LTCM lost $286 million in equity [[Pairs trade|pairs trading]] and more than half of this loss is accounted for by the Royal Dutch Shell trade.<ref>{{Harvnb|Lowenstein|2000|p=234}}</ref>

The company, which had historically earned annualized compounded returns of almost 40% up to this point, experienced a [[flight to liquidity]]. In the first three weeks of September, LTCM's equity tumbled from $2.3 billion at the start of the month to just $400 million by September 25. With liabilities still over $100 billion, this translated to an effective leverage ratio of more than 250-to-1.<ref>{{Harvnb|Lowenstein|2000|p=211}}</ref>