430 Planning and Forecasting
understanding of what the prices of various financial instruments shouldbe,
LTCM would identify instruments that were priced too high or too low. Once
such an opportunity was identified, they would buy or sell accordingly, hedg-
ing long positions with matching shorts. As the prices in the financial market-
place trended toward the fair equilibrium dictated by the financial models,
the prices of the assets held long would rise, and the prices of the instru-
ments sold short would fall, thereby delivering to LTCM a handsome profit.
LTCM’s deals were generally not naked speculation, but hedged exploitation
of arbitrage opportunities. With price risk thought to be hedged out, LTCM
and their investors felt comfortable borrowing heavily to lever up the impact
of the trades on profits. The creditors, banks and brokerages mostly, happily
obliged.
LTCM opened its doors in 1994, with an initial equity investment of $150
million from the founding partners, and an investment pool of$1.25 billion in
client accounts. Success was immediate and pronounced. They thrived in the
tumultuous market of the mid-1990s. Apparently, as some of the institutions
described above lost fortunes during this period, it was LTCM that managed to
be on the receiving end. The fund booked a 28% return in 1994, a whopping
59% in 1995, followed by another 57% return in 1996. Word of this success
spread, and new investors were clamoring to get into LTCM.^3
LTCM could be picky when it came to choosing investors. This was not a
fund for your typical dentist or millionaire next door. Former students of mine
who have gone on to jobs at some of the world’s largest banks and investment
companies have confided to me that their firms subcontracted sizable portions
of their portfolios to LTCM. By the end of 1995, bolstered by reinvested prof-
its and by newly invested funds, LTCM managed $3.6 billion of invested funds.
However, the portfolio was levered 28 to 1. For every $1 a client invested, the
fund was able to borrow $28 from banks and brokerage houses. Consequently,
LTCM managed positions worth over $100 billion. Moreover, because of the
natural leverage inherent in the derivatives they bought, these positions were
comparable to investments of a much larger magnitude, estimated to be in the
$650 billion range.
By 1997, however, when the fund’s capital base peaked at $7 billion,
managers realized that profitable arbitrage opportunities were growing scarce.
The easy pickings of the early days were over. The partners began to intention-
ally shrink the fund by returning money to investors, essentially forcing them
out. Performance was sound in 1997, a 25% return, but with the payout of cap-
ital, the fund’s capital base fell to $4.7 billion.
Things unraveled disastrously in 1998. Each of LTCM’s major invest-
ment strategies failed. Based on sophisticated models and historical data,
LTCM gambled that (1) stock market volatility would stay the same or fall,
(2) swap spreads—a variable used to determine who pays whom how much in
interest rate swaps, would narrow, (3) the spread of the interest rate on
medium-term bonds over long-term bonds would f latten out, (4) the credit