Long-Term Capital Management -Arbitrage Gone Wrong

 

Long-term capital management (LTCM) was a hedge fund launched in the USA with a strategy exploit the arbitrage between securities. It was founded in 1993 by renowned economists and Wall Street traders but led to near downfall of the worldwide finance structure. This is cause of their high-risk arbitrage trading systems.

The Good times

The fund was initially successful but the financial crisis in Asia caused a huge impact on them. The primary trading strategy of LTCM was to take advantage of the price inefficiencies among similar securities. The firm was smart enough to make the best of the capital gains tax that was prevalent in the US. The long-term capital gains were taxed at 20% whereas income was taxed at 39.6%. LTCM devised a financial plan to convert its income to capital so that it can enjoy a lesser tax liability and also maximize it long-term appreciation. It entered into an agreement with Union Bank of Switzerland that would defer its foreign income for seven years, thus it helped them to gain more from capital gains. LTCM witnessed a quick growth in its income. They traded with everyone on Wall Street.

The Glitches in the Investment Strategy

Since the instances or opportunities for arbitrage trading are minimal, they had to look out for other ways to maintain its portfolio. It borrowed money to create a portfolio which was several times the actual number of investors it held. It was forced to sell its securities to buy back the short selling arrangements it had in the market. These activities were performed without a look at it from the valuation perspective and thus it affected the whole portfolio.

Their Debt equity ratio was also not in a favorable position. The fund also had a big chunk of investments in the derivatives which were off-balance sheet. Most of the derivatives were interest rate swaps.

1997 Asian Crisis

LTCM had a good profit margin in 1997, but the Asia crisis has begun to have its effects on other regions as well. Investors started becoming more cautious when it came to making their investment decisions. The financial markets were heavily dependent on international funds and hence the crisis in Asia had a widespread effect on the security prices outside.

At this juncture, the liquid and highly priced securities became more expensive and the less liquid securities became cheaper. The strategy designed to gain from the arbitrage trading of these securities failed, thus incurring heavy losses. Even though LTCM had a diversified strategy, the shift from illiquid to liquid a lot more than what they had expected.

Bail Out

The funds started liquidating one after the other and caused a further decline in prices of the remaining stock. The markets were debating a forced liquidation. Wall Street feared that LTCM going into liquidation will lead to a never-ending reaction in the financial markets. There were some big investment companies that tried to strike a deal but none worked. Finally, The Federal Reserve Bank of New York decided to bail out to avoid further havoc with the financial system.