The Incredible Untold Story about How the Financial World Almost Ended

The Incredible Untold Story about How the Financial World Almost Ended

by Sverre Rørvik Nilsen aka finansakrobat

Everybody has heard the stories of the blowup of super hedge fund LTCM in the late 1990s, but as far as I know, no one has ever talked publicly about what it was like inside the fund as it was blowing up — until now.

Each Friday evening, Howard Lindzon, venture investor and owner of the social network StockTwits, and I sit down and talk about finance while we sip on a drink. The show is called Stocks and Scotch, and our aim is to share big ideas about important things in finance.

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A little over one week ago, our guest was Jim Rickards, famous to many as the writer of the bestseller Currency Wars. The stories Jim told about his time at LTCM are jaw dropping, and some of the allegations are of downright criminal behavior by a named Goldman Sachs trader.

As per Wikipedia, this is what is widely known about the LTCM blowup:

Long-Term Capital Management L.P. (LTCM) was a hedge fund management firm based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high financial leverage. The firm’s master hedge fund, Long-Term Capital Portfolio L.P., collapsed in the late 1990s, leading to an agreement on September 23, 1998 among 14 financial institutions for a $3.6 billion recapitalization (bailout) under the supervision of the Federal Reserve.

LTCM was founded in 1994 by John W. Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Members of LTCM’s board of directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a “new method to determine the value of derivatives”. Initially successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis, requiring financial intervention by the Federal Reserve, with the fund liquidating and dissolving in early 2000.

What is much less widely known is how terrible this would have been for the global economy. As Jim put it on Stocks and Scotch:

“What is widely known is that we lost $4 billion in a month. That is no big deal. That happens all the time; a hedge fund goes down.”

“But what was different about LTCM was that we had swap trading lines with all the major banks in the world. Our balance sheet at the time was a little over $100 billion, but our extended balance sheet, notional values of swaps, was about $1.3 trillion.”

“We were in the process of going insolvent, and we were in the position of handing back $1.3 trillion in positions to the banks. They would have scrambled to cover those positions. That would have led to a catastrophic meltdown.”

“The expectation was that had LTCM not been rescued, all the markets in the world would have closed.”

“We don’t have to guess what would have happened. We met with the Federal Reserve Bank of New York. The chairman of the NY Fed came to our offices one day, and we went through our book. He just listened. We had senior officials from the Treasury and the NY Fed in our offices for a private briefing. At the end of it, Peter [Fisher] said: ‘We knew you guys would destroy the fixed-income markets, but we did not know you would also destroy the stock market.’

“Peter went back to New York the next day and had breakfast with the heads of Goldman Sachs Group Inc (NYSE:GS), JPMorgan Chase & Co. (NYSE:JPM), Morgan Stanley (NYSE:MS), and Salomon Brothers and said: ‘you have to do something about it because this is going to collapse in a matter of days and every stock market in the world is going to close.'”

If you want to hear the rest of the amazing story from Mr. Rickards, as well as a discussion of the Twitter IPO, view the video above.


This was previously published on Inside Investing at the CFA Institute.

Copyright © 2008–2013 Sverre Rørvik Nilsen aka finansakrobat
All Rights Reserved.
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Sverre is a financial entrepreneur working out of Oslo, Norway. He is running two financial startups. One is a trading platform, the other a newswire. He also consults for a number of different clients. He has a weekly webshow alongside Howard Lindzon at Stocktwits.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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The CFA Institute Enterprising Investor blog is a forum for delivering practical analysis of current issues in finance and investing. The blog is written for investment professionals and aims to elevate the most interesting and compelling commentary and perspectives from the sea of opinions and research; to contextualize the many educational offerings of CFA Institute; and to provoke debate and an exchange of ideas among serious investment practitioners about topics of the day. The CFA Institute Market Integrity Insights blog is a forum for providing analysis and commentary on the integrity of global capital markets. From regulatory reform and corporate governance to insider trading and financial reporting, our content experts explore timely issues in financial regulation and other issues affecting the global capital markets. In addition, CFA Institute publishes a variety of blogs covering our live events programming around the world, including the CFA Institute Annual Conference, now in its 65th year; the European Investment Conference; the Middle East Investment Conference; and the Asia Pacific Investment Conference. Please note that the content of these blogs should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
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