Long Term Capital Management Collapse
In the 1990s, Long-Term Capital Management (LTCM) functioned as the largest hedge fund in the United States. It was founded by well-known Wall Street traders and Nobel prize-winning economists. The extreme success LTCM found from 1994-1998 attracted $1 billion plus in investor capital, and yielded fantastic returns for several years from its arbitrage strategy. This put it in the “too-big-to-fail” category. In 1998, LTCM’s leveraged strategies failed due to Russian debt default, and the US government intervened to coordinate the fund’s bail out rather than risk a global financial crash. The bailout involved creating a loan fund from a group of Wall Street banks, and it succeeded in bailing out LTCM and liquidating the fund without further issues.
Lessons Learned
- Stress Testing of Liquidity Risk – Risk management policies must be rigorous and involve procedures that deal with managing crises since no amount of preparation can predict all of the fluctuations of a real-world financial market.
- Market Risk – Illiquid markets create bid/offer spreads that diverge dramatically. Market prices will be driven by self-interest and self-preservation.
- Credit Risk – Solid, enforceable credit policies are mandatory. Changes from such policies should involve approval from the highest levels of management.
- Governance Risk – Regulatory bodies should not be depended upon for good governance. Instead, firms should assume this responsibility themselves.
- Operational Risk – Guard against the public disclosure of internal documents as these may be taken out of context and blown out of proportion, resulting in financial panic.
- Reputational Risk – The perception of the market, customers, and counterparties in regards to risk appetite should be closely guarded. Stress tested processes that includes capital should be allocated as a means of protecting shareholders, stakeholders, and investor capital should negative publicity arise.
Lessons not learnt – Cambridge