Long-Term Capital Management - 1998 Bailout

1998 Bailout

Long-Term Capital Management did business with nearly everyone important on Wall Street. Indeed, much of LTCM's capital was composed of funds from the same financial professionals with whom it traded. As LTCM teetered, Wall Street feared that Long-Term's failure could cause a chain reaction in numerous markets, causing catastrophic losses throughout the financial system. After LTCM failed to raise more money on its own, it became clear it was running out of options. On September 23, 1998, Goldman Sachs, AIG, and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $3.75 billion and to operate LTCM within Goldman's own trading division. The offer was stunningly low to LTCM's partners because at the start of the year their firm had been worth $4.7 billion. Warren Buffett gave Meriwether less than one hour to accept the deal; the time period lapsed before a deal could be worked out.

Seeing no options left the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. The principal negotiator for LTCM was general counsel James G. Rickards. The contributions from the various institutions were as follows:

• $300 million: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P.Morgan, Morgan Stanley, Salomon Smith Barney, UBS
• $125 million: Société Générale
• $100 million: Lehman Brothers, Paribas
• Bear Stearns declined to participate.

In return, the participating banks got a 90% share in the fund and a promise that a supervisory board would be established. LTCM's partners received a 10% stake, still worth about $400 million, but this money was completely consumed by their debts. The partners once had $1.9 billion of their own money invested in LTCM, all of which was wiped out.

The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices, which would force other companies to liquidate their own debt creating a vicious cycle.

The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):

• $1.6 bn in swaps
• $1.3 bn in equity volatility
• $430 mn in Russia and other emerging markets
• $371 mn in directional trades in developed countries
• $286 mn in equity pairs (such as VW, Shell)
• $215 mn in yield curve arbitrage
• $203 mn in S&P 500 stocks
• $100 mn in junk bond arbitrage
• no substantial losses in merger arbitrage

Long Term Capital was audited by Price Waterhouse LLP. After the bailout by the other investors, the panic abated, and the positions formerly held by LTCM were eventually liquidated at a small profit to the rescuers.

Some industry officials said that Federal Reserve Bank of New York involvement in the rescue, however benign, would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf in the event of trouble. Federal Reserve Bank of New York actions raised concerns among some market observers that it could create moral hazard.

LTCM's strategies were compared (a contrast with the market efficiency aphorism that there are no $100 bills lying on the street, as someone else has already picked them up) to "picking up nickels in front of a bulldozer" – a likely small gain balanced against a small chance of a large loss, like the payouts from selling an out-of-the-money naked call option.