Managing Hedge Fund Risk and Financing: Adapting to a New Era

LTCM (1998)

Long-Term Capital Management (LTCM) was bailed out by a consortium of 14 banks in 1998 after being caught in a cash flow crisis when economic shocks resulted in excessive mark-to-market losses and margin calls. The fund suffered from a combination of funding and asset liquidity. Asset liquidity arose from LTCM's failure to account for liquidity becoming more valuable (as it did following the crisis). Since much of its balance sheet was exposed to liquidity risk premium, its short positions increased in price relative to its long positions. This was essentially a massive, unhedged exposure to a single risk factor. LTCM had been aware of funding liquidity risk. Indeed, it estimated that in times of severe stress, haircuts on AAA-rated commercial mortgages would increase from 2 percent to 10 percent, and similarly for other securities. In response to this, it had negotiated long-term financing with margins fixed for several weeks on many of its collateralized loans. Because of an escalating liquidity spiral, however, LTCM could ultimately not fund its positions, in spite of the numerous measures it took to control funding risk.

Endnote

1. Ludwig Chincarini, “The Amaranth Debacle: A Failure of Risk Measures or a Failure of Risk Management?” The Journal of Alternative Investments, Winter 2007: 91.