# Lessons from Long-Term Capital Management

This week I want to talk about the collapse of Long-Term Capital Management in the late 1990s. This is such an important story to talk about because it teaches us some very important lessons that every businessperson should know. WATCH NOW

VIDEO SUMMARY

Long-Term Capital Management was a hedge fund. This was a huge hedge fund that was wildly successful when it started. In its first three years it returned 21%, 43%, and 41%. They were making so much money, everyone on Wallstreet wanted to get into this hedge fund. Two of the principals in the hedge fund were finance geniuses Myron Scholes and Robert Merton. Their names might sound familiar because they won the Nobel Prize for Economics in 1997 for creating the famous Black-Scholes pricing model for valuing derivatives.

The strategy of the firm was all about math. They would develop mathematical formulas to perform arbitrage. Arbitrage means you would find two similar assets that are priced slightly different. Theoretically, similar assets should be the same price, and if there is a difference they will typically converge to the same price over time. You could buy one long and sell one short, and make money as they converge. If the market drops, you are losing money on one trade, but it does not matter because you are making money on the other trade, so there is very low risk.

One problem with arbitrage type trades is it usually involves very small percent gains. So you need a large amount of trades to make a lot of money. To make this happen, Long-Term Capital Management borrowed the money and took on a lot of leverage. They quickly amassing Billions of dollars in assets.

When I read about this story, to me this is a story of arrogance. These guys were the smartest guys in the room. They had mathematical models that seemed to make them money no matter what happened in the markets. They had so much confidence, they borrowed enormous amounts of money, that eventually led to their downfall. At the beginning of 1998, Long-Term Capital Management had \$4.7B of equity and borrowed \$124.5B making a debt-to-equity ratio of 25 to 1.

The fund ran into a problem when there were two back-to-back currency crisis, the Asian currency crisis in 1997 and the Russian currency crisis in 1998. No one expected you could have two major currency crisis back-to-back. The markets went wild, and Long-Term Capital Management started losing money.