Financial Management of Risks 431spread—the interest rate differential between risky bonds and high-grade
bonds, would narrow, and (5) calm would return to the financial markets of
Russia and other emerging markets. However, in each case the opposite hap-
pened. Equity volatility increased. Swap spreads widened. The yield curve re-
tained its hump. Credit spreads grew. Emerging markets deteriorated.
Though LTCM had spread its bets over a wide variety of positions, they
seemed to gain no diversification benefit. Everything went wrong at once. Re-
cent research has shown that diversification does not protect speculative posi-
tions when markets behave erratically. Markets tend to go awry in tandem.
In August 1998 alone, the fund suffered losses of $1.9 billion. Losses for
the year so far were 52%. Fund managers were confident that their strategies
were sound, and that time would both prove them right and reward their pre-
science. But time is not a friend to a levered fund losing money. Banks and bro-
kerages itched for their loans back. How ironic, Long-Term Capital Management
faced a short-term liquidity crunch.
Leverage amplified LTCM’s remaining $2.28 billion of equity into man-
aged assets of $125 billion. If the market continued to move against them,
LTCM would be wiped out in short order, and that is essentially what hap-
pened. On September 10, LTCM lost $145 million. The next day, they lost $120
million. The following three trading days brought losses of $55 million, $87
million, and $122 million, respectively. On one day alone, Monday, September
21, 1998, LTCM lost $553 million. By now traders at other firms could guess
what LTCM’s positions were, and by anticipating what LTCM would have to
eventually sell, they could gauge which securities were good bets to short. This
selling pressure added to LTCM’s losses and woes.
At this point, in September 1998, any of several banks could bankrupt
LTCM by calling in its loans. The Federal Reserve, which is the central bank of
the United States, and is responsible for guarantying the stability of the Amer-
ican banking system, monitored the predicament. Though LTCM’s equity was
shrinking precipitously, on account of their borrowed funds and the inherent
leverage of their derivatives positions, the notional principal of their positions
was about $1.4 trillion. To put this quantity into perspective, the gross national
product of the United States was about $8.8 trillion in 1998. Total bank assets
in the United States stood at $4.3 trillion. It was feared that if LTCM went
bankrupt, they would probably default on their derivative positions, triggering
a domino effect of defaults and bankruptcies throughout the world’s financial
markets. It was decided, that LTCM was too big too fail.
The Federal Reserve orchestrated a plan for LTCM’s creditors to buy the
company’s portfolio. Each of 14 banks ponied up money in exchange for a slice
of the portfolio. The $3.65 billion paid by the bank syndicate for the portfolio
was clearly greater than the value of the portfolio by then, but this infusion of
capital prevented defaults that would have cost the banks much more. The
money was used to pay off debts and shore up the trading accounts so that ex-
isting positions would perform without default. Very little was left over for the