What happened to LTCM (Long-Term Capital Management)?

Question

I recently learned about the LTCM fiasco and I find it ludicrous. From Wikipedia:

Initially successful with annualized return of over 21% (after fees) in its first year, 43% in the second year and 41% in the third year, in 1998 it lost $4.6 billion in less than four months due to a combination of high leverage and exposure to the 1997 Asian financial crisis and 1998 Russian financial crisis.

How was this possible, given that among the C-level executives of this company, you could've found folks who won the Nobel prize in economics? Were they completely blind to the risk they exposed themselves to?

Then, about this:

... for a $3.6 billion recapitalization under the supervision of the Federal Reserve. The fund liquidated and dissolved in early 2000.

Did the Federal Reserve and the banks effectively bail out the shareholders of LGTM?

Answer 1

The FED didn't bail them out. The FED brokered (in somewhat strong-arm fashion) a deal for a group of banks to step in and take over LTCM's portfolio of trades. LTCM's investors recovered about 10 cents on the dollar from the previous year's mark. The banks then held the risk on the portfolio. I believe they made a small profit when all was said and done, but probably nothing worth the risk they took.

Remember that it's easy for people to write about things with the benefit of hindsight and make everything seem like it was oh so obvious at the time. It wasn't. They were smart but they (a) used to much leverage (b) expanded into markets they really shouldn't have been in because they had so much capital. Everyone is much smarter about this stuff now and that's in no small part to the example LTCM provided.

I spoke about the situation once with someone who was instrumental in the wind-down of their portfolio. They summarized things (with the benefit of hindsight) as such if iirc:

• The fund was doing great and making lots of money, but was employing lots of leverage (which is risky) in order to do so. These specific trades were in US Treasuries. Lots of other funds were doing these same type of trades because they were successful trades, so the trades were crowded. The market is now acutely aware that leverage PLUS popular trade equals "Danger Will Robinson!" People always knew that leverage was dangerous, but until LTCM failed there wasn't as much of a focus on the crowded nature of trades like there is now from risk managers.
• As a result of doing so well, and having so much capital, and their main trades being sort of crowded, the fund decided to "diversify" into other trades. Unfortunately for them, some of these were outside of their areas of expertise.
• These other trades weren't as solidly in their area of expertise as their original trades. They were now long Russia risk and short some equity volatility products. And when I say some, I mean way too much. And that's what happens when you are feeling big for your britches, have a lot of capital, and play in a market where you're not an expert.
• And then we had the Russian crisis and it was all downhill from there. They needed to liquidate their other trades to raise capital (because of the money they were losing on their Russia positions) but they were so big that they just pushed the market and made things worse for themselves and for a lot of other funds. Liquidations begat more liquidations. The market had never seen anything like that in US Treasuries, but the situation had never happened before because people hadn't been taking huge positions via leverage.