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
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.
What is ironic in hindsight, is the math was good, except for the leverage. If they could have held their positions a few years until the markets calmed down, the portfolio would have recovered. The problem is that markets can remain irrational longer than you can remain solvent. They just could not hold their positions, because they had to pay off the debt they took out. In September 1998, in one month, equity in the hedge fund collapsed from $2.3B to $400M. They still owed all their liabilities, creating a leverage ratio of 250-to-1. Long-Term Capital Management collapsed. The hedge fund was so big, and so many people lost their money, that it created a loss of confidence and led to a larger collapse in the US stock market. The reason I wanted to talk about this event is we have been talking lately about how to make good business decisions. Something I keep saying is decisions are data plus judgement. This is a perfect example. Long-Term Capital Management had all the data. They had the math that told them, if you invest like this, you will make all this money. But what they did not have was the judgement to say, “Maybe we should not use so much leverage.” If they had reasonable leverage, they could have unraveled their positions and been able to survive. So you can have all the data, all the math, all the technology, but you need the judgement of good people to make a good business decision. Otherwise, all your technology is worthless.
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Neither Zach De Gregorio or Wolves and Finance shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.