Risk, Return and the Illusion of Safety

On the morning of Wednesday 23 September 1998, Berkshire Hathaway, AIG and Goldman Sachs offered to buy out the partners of Long-Term Capital Management for about $250 million and to put about $3.75 billion into the fund. LTCM said it could not legally accept the terms in the hour allowed, and the offer lapsed. That evening, at the Federal Reserve Bank of New York, fourteen banks and brokers agreed to inject about $3.6 billion for 90% of the fund and run it down. Eleven of them put in about $300 million each. Bear Stearns declined to join. No public money was spent, but the Fed had convened the meeting, and its president, William McDonough, and the head of its markets desk, Peter Fisher, had visited LTCM on the Sunday and seen its positions. They concluded that if the fund defaulted suddenly, its counterparties would all try to close out and replace their trades at once, in thin markets, and the losses would spread well beyond LTCM.

Four years earlier LTCM had been the most admired fund in the world. John Meriwether, who had built Salomon Brothers' bond-arbitrage desk, founded it in 1994 with his former team, two of the most famous academics in finance, Myron Scholes and Robert Merton, and a former vice chairman of the Federal Reserve, David Mullins. It raised about $1.25 billion, the largest hedge-fund launch to that date (reported), and returned about 43% after fees in 1995 and 41% in 1996 (reported). At the start of 1998 it held about $125 billion of assets on about $4.7 billion of capital, plus derivatives with more than $1 trillion of notional value. In about four months it lost about $4.6 billion, almost all of it. This chapter uses LTCM to explain how financial firms measure risk, why the measures fail when they matter most, and why the safest-looking positions are often the most dangerous.