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A Silver Jubilee

A Silver Jubilee

October 23, 2023

According to Wikipedia, a Silver Jubilee marks a 25th anniversary. It could denote a wedding anniversary, the 25th year of a monarch's reign, or anything that has completed or is entering a 25-year mark. It is also known as the silver anniversary, as many people exchange or give presents made of silver to commemorate 25 years. Today we will talk about the 25-year anniversary of the failure of Long-Term Capital Management, LTCM. What was Long-Term Capital Management and why are we commemorating the demise of a hedge fund 25 years after the fact? Great questions, let's explore the reasons for today’s post together.

Long-Term Capital Management was a large hedge fund, led by Nobel Prize-winning economists and renowned Wall Street traders. LTCM was founded in 1994 by John Meriweather after his successful bond trading career at Salomon Brothers. LTCM also had Myron Scholes and Robert Merton on its team, who received the 1997 Nobel Memorial Prize in Economic Sciences. David Mullins, Jr., who had previously served as the vice chairman of the Federal Reserve under Alan Greenspan, was also an employee.

LTCM literally had the “smartest guys in the room” running their fund. This attracted a great amount of attention from Wall Street investors. LTCM was profitable, for both its early investors and its founders, drawing over $1 billion of investor capital by promising that its arbitrage strategy would yield outsized returns while managing downside risk. You can see in our first chart below, which has been truncated on the right so as not to spoil the ending, that a dollar invested in the fund would have nearly quadrupled from March 1994 to March 1998.

Just like anything else that seems too good to be true, the fund continued to attract investors and new deposits. The management team had created an investment formula that seemingly could not lose unless a 3X standard deviation event occurred, sometimes known as a Black Swan event. Not only did Wall Street banks such as Bear Stearns and Lehman Brothers invest heavily, but so did other financial institutions such as the insurance conglomerate AIG… notice a pattern here? These institutions also borrowed money to invest creating significant leverage in the financial system. All of this worked great…until it didn't.

LTCM was using 25x or more leverage in 1998. This means that a 4% loss on a trade could deplete the firm's capital, forcing it to either raise money or fail. LTCM was investing heavily in emerging markets bonds when Russia defaulted on its bonds in 1998. As a result of the unexpected default, there was a huge flight to quality U.S. Treasury bonds. This meant significant losses for LTCM and all its trading partners.

This created a potential chain reaction within the entire financial system. The NY Fed, then headed by future Treasury Secretary Timothy Geithner, organized a bailout of $3.63 billion, and a more significant crisis was averted for the time being. However, flash forward just 10 years, and we know that a very similar crisis, with many of the same players, came to pass.

This time the object of investor's affections was subprime mortgages. It was thought that these could not lose value since residential real estate “never goes down in value”. Of course, this led to the Great Financial Crisis and even more significant bailouts by both the Federal Government and the Federal Reserve Bank. It seems that some people and institutions never learn, especially when huge potential profits are being dangled in front of them.

History shows us that people are drawn to the “attractive improbability”. However, we believe that the road to long-term financial success can be reached by striving toward the “less attractive probability”.  You do this through disciplined diversification, regular rebalancing, dollar cost averaging, and letting your financial plan be your guide, rather than the latest hot stock or hot area of the market.

And how did this saga turn out for the investors of LTCM? As Paul Harvey used to say, the full chart tells us the “rest of the story”.

The Federal Reserve Bank has a history of raising interest rates until something breaks. You can see this outlined in the chart below. This is not a new phenomenon, as this chart goes back 60 years. You will note that there is a strong correlation between the Federal Reserve Bank raising rates and episodes of economic crisis or dislocation.

We know that over the last 18 months, The Fed has raised interest rates 11 times by a total of 5 1/4%. They are threatening to do more if inflation does not come down to their 2% target in a reasonable timeframe. What will break next? That is the big question. We know that since the Fed started its interest rate increase campaign, there has already been stress in the British pension system and bond market, the Japanese currency market, and the U.S. regional banking system this spring.

While the failure of LTCM 25 years ago is certainly nothing to celebrate, it does provide a cautionary tale that we should be paying close attention to, given the uncertainty in today's financial and economic markets. The CFPs of Impel Wealth Management will continue to monitor events diligently. We will do our best to guide you, our trusted friends and clients, through these uncertain and sometimes unchartered economic waters. As always, do not hesitate to reach out to your financial advisor if you have additional questions about you and your family's unique situation. We are here to help.

© 2023 Jesse Hurst

The views stated are not necessarily the opinion of Cetera and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.

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