The Nobel-laureate fund
New York had to rescue
On 23 September 1998, fourteen financial firms agreed to inject $3.6 billion into a hedge fund whose collapse also threatened their own books. Its name, Long-Term Capital Management, meant little to the public; its partners nonetheless included two Nobel laureates in economics.
Thirty dollars of debt for every dollar of capital
Long-Term Capital Management was founded in February 1994 under John Meriwether, a former vice chairman of Salomon Brothers. Among its partners were Robert Merton and Myron Scholes, awarded the 1997 Nobel Prize in economics for their method of valuing options. The bet fits in one sentence: exploit tiny price gaps between neighbouring securities that were expected to close over time. To make such small gains count, the fund multiplied them with borrowing: at the end of 1997 it held about thirty dollars of debt for every dollar of capital.
The machine assumed calm markets. In August 1998 Russia devalued its currency and stopped paying its debt. Investors rushed toward the safest securities, and the gaps the fund expected to see close widened instead. It lost 44% of its value in August alone. On 18 September its managers called William McDonough, president of the Federal Reserve Bank of New York. On the evening of the 22nd the major banks were gathered there; the deal was struck the next day around 6 p.m. Fourteen firms put in about $3.6 billion in exchange for 90% of the fund, while two other invitees declined.
The Federal Reserve did not lend a dollar. Before Congress on 1 October, Alan Greenspan stressed it: no federal funds committed, no promises made, no bank pressured. The Fed only brought the creditors together, for fear that a hasty liquidation of positions so vast would unsettle already strained markets.
The risk the models could not see
The fund's models relied on the history of prices: they measured how markets had behaved, not how they would behave if every player wanted out at once. Yet other institutions held similar positions, so each sale worsened the loss of the next. The danger lay not in any single bet but in their resemblance, magnified by leverage.
The outcome is less dark than its legend: the positions were unwound in stages under new management, and the banks recovered their stake in full before the end of 1999, while the original partners bore most of the loss. The episode nonetheless leaves an open question: how large can a leveraged private player become before it is too entangled with others to fail without consequence? The 2008 crisis would raise it again on a far greater scale.
A risk is measured on the past, but it is paid for the day everyone wants out through the same door.