Long-Term Capital Management history
A giant hedge fund in Greenwich, Connecticut, the nearcollapse of which in September 1998 shook Wall Street and drew public attention to the role of hedge funds in the marketplace. The fund was established in 1994 by John W. Meriwether, a bond trader at SALOMON BROTHERS who had hired a team of mathematicians and economists from academia to give his unit an edge in the fierce competition for arbitrage opportunities.
When Meriwether left Salomon Brothers in 1994 after a trader he supervised was caught manipulating bids on TREASURY BONDS, most of his intensely loyal traders followed him to Long- Term Capital. He also recruited, as partners, Robert C. Merton and Myron S. Scholes, who later were awarded the 1997 Nobel Memorial Prize in economic science, and David W. Mullins, a former vice chairman of the Federal Reserve Board. As a group, the fund’s partners believed passionately in rational, efficient markets, and their trading strategies reflected those beliefs.
The celebrity-studded fund, whose investors included top banks and institutions from around the world, was enormously successful at first. Trading largely with borrowed money, the fund produced returns, net of its own fees, of 43 percent in 1995 and 41 percent in 1996. But in 1997, as arbitrage opportunities faded and Asian currency devaluations roiled markets, it earned just 17 percent after its own fees. As that year ended, the fund’s still-optimistic partners decided to return roughly $2.3 billion to their outside investors, paring the fund’s capital to about $4.7 billion, from roughly $7 billion at its peak.
It was an ill-timed decision. The fund’s core strategy was to bet that volatile security prices in markets around the world would gradually become more stable. But in 1998 global markets grew ever more treacherous. By August, when Russia defaulted on its debt, risk-averse investors were buying only the most liquid Treasury bonds, driving down the prices of virtually everything else. Meriwether’s capital, which totaled $3.7 billion at mid-August, was simply melting away. By mid-September, the fund was on the brink of collapse. Since it owed money to almost every major bank on Wall Street, its dire condition drew the attention of the Federal Reserve Bank, which feared that the fund’s failure would trigger a marketwide panic. On September 23, 1998, after long negotiating sessions at the Federal Reserve Bank of New York, a consortium of 14 American and European investment firms agreed to inject $3.6 billion into the fund, in exchange for most of the partners’ equity. By that point, every dollar invested in the fund had shrunk to 23 cents, net of fees.
The rescue, which drew widespread public criticism, kept the fund afloat for another year, but its returns were meager. The stock and bond markets became very unsettled during the months following the collapse, and GOLDMAN SACHS, one of the fund’s trading partners, had to postpone its initial public offering as a result. By early 2000, the consortium had retrieved its capital, and the fund was essentially liquidated. By then, Meriwether and many of his partners were once again managing other people’s money from their offices in Greenwich.
Further reading
- Dunbar, Nicholas. Inventing Money: The Story of Long- Term Capital Management and the Legends Behind It. New York: John Wiley & Sons, 2000.
- Lowenstein, Roger. When Genius Failed: The Rise and Fall of Long-Term Capital Management. New York: Random House, 2000.
Diana B. Henriques
