Name: The INSANE Story of How a Hedge Fund Collapsed the Wall Street | Long Term Capital Management (LTCM)
Uploaded: 2024-10-02T13:56:17.000Z
Duration: 11 min 41 s
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Have you heard about the story of Icarus?

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He was given a pair of wings that allowed him to fly and he took full advantage.

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Unfortunately for him, he got a little carried away.

Despite warnings not to, he tried to fly as high as he could, so high that the sun started to melt the wax that held his wings together.

Within seconds, his wings fell apart and he plunged to his death.

This famous fable of the dangers of hubris can be easily applied to the story of long-term capital management, a huge hedge fund which dominated the financial market in the 1990s.

Like Icarus, they found themselves riding high, with profits through the roof, and eventually they went too far and plunged to their collapse.

In this video, we will go through the amazing story of long-term capital management and discover the incredible lessons we can learn from the rise and fall of this former Wall

Long-term capital management, or the LTCM, was a hedge fund founded in 1994 by trader

Hedge funds manage the pooled investments of small groups of mostly wealth investors.

Unlike mutual funds, hedge funds are subject to very little regulation, meaning that there are virtually no limits to the size of the fund or where it can be invested.

This lack of regulation makes hedge funds a ripe environment for investment in risk care financial products, such as derivatives.

Like all other hedge funds, LTCM managed their investments with a strategy called arbitrage.

To demonstrate this, imagine that one company sells different stocks in two markets.

As both stocks represent the same company, you'd expect them to be the same price.

However, sometimes the price of the stock in one market may dip below the other, due to market overreaction.

When this occurs, you have an opportunity to quickly buy the stock before the prices reach equilibrium again, after which, you can sell that stock at a profit.

Although it's a common strategy, LTCM took it to another whole new level.

They used economic calculations and predictions, as well as the latest computer software to recognize the opportunities and exploit them quickly.

Using this strategy, LTCM became the largest hedge fund ever.

Hedge funds bet on tiny discrepancies between the present and the future, which means that they need large position size to make significant profits.

Despite the huge amount of funds LTCM received from their investors, it wasn't enough to earn the greatest profits.

So LTCM borrowed heavily and encouraged investors to make even larger investments.

Many banks were more than happy to lend huge amounts of loans to LTCM, because they have a pretty good track record and arbitrary strategy seems to carry little risk.

To give you just a small example of how much LTCM could borrow through leveraging, consider that with only 1 billion dollars as the investment capital, they could leverage up to 30 billion dollars to trade.

Institutions like investment banks were glad to issue big loans, because they thought profits were almost guaranteed.

As history tells over and over again, banks made such investments because their greed are bigger than the underlying risk.

As more and more banks were rushing in to issue loans, LTCM's leverage rate skyrocketed, leaving the company at enormous risk if things started to go wrong.

Many people believe there is a gap between the knowledge of high-minded academics and the conditions of the real world.

Their plan was to apply the expert knowledge and theories of mathematicians and economists to the real Wall Street.

So they recruited some of the biggest names in economics and trading, hiring people like

Nobel Prize winner Myron Scholes and Robert Merton to sit on their board of directors.

More and more investors were enticed into investing in LTCM.

Even universities were persuaded to invest in the fund.

One of the main reasons people were so interested in investing in LTCM was because the rocks are mathematicians and economists in LTCM believe they had eliminated all the risk altogether and investing with LTCM is virtually risk-free.

Their arrogance was filled by incredibly complex mathematical formulas based on careful historical analysis of the market.

By scrutinizing how the market had reacted to events in the past, they hoped to predict how it would react in the future.

This gave them the ability to recognize and circumnavigate risks and crises before they even occurred.

This academic approach was a major lure for investors and contributed to LTCM's enormous success at the early stage.

In the 1990s, it was a fashionable thing on Wall Street to invest in hedge funds.

Investors saw them as new, exciting, and most importantly, incredibly profitable financial products.

But even in this love affair with hedge funds fever, LTCM stood out, both in terms of popularity and leveraging.

During the mid-1990s, LTCM was four times larger than its closest hedge fund rival.

They also controlled more assets than huge investment banks like Lehman Brothers and

Banks around the world were practically fighting to lend to LTCM for their trading leverages.

Everyone wanted to get a piece of their pie, so they all fought to offer leverage packages with ridiculously low interest rates, only for LTCM.

Even with such special low interest rates to borrow, LTCM was still paying $200 million a year just as the interest payment.

For all the love LTCM was getting on Wall Street, it appears much healthier than it actually was.

Although they reported their assets and liabilities quarterly, these reports weren't always transparent and often provided only generalized summaries and hid important key points.

LTCM's success could not last forever, and soon, the signs of danger become unmistakable.

Despite the popularity of academic models used by LTCM, they had one fatal flaw, human errors.

The models assumed the financial system was a rational, predictable entity, directed by rational, predictable people.

Due to their poor nature, humans are irrational and panic easily, a fact which caused enormous problems for LTCM.

These problems began in the 1997 Asian financial crisis, as the booming tiger economies like

Taiwan and South Korea took a big downturn.

In times of uncertainty, the normal thing to do would be to invest in bonds.

Their models were telling them to increase their share of riskier assets like equities.

So instead of buying more safety hedges, they started adding more risky stocks.

They had already seen a slight dip in profits once the crisis hit in the summer of 1997, but they continued to follow their models.

LTCM never had a losing year since it was founded.

But now, they didn't even know they were not far from the brink of collapse.

The models that the mathematicians and economists at LTCM developed were based on one single principle.

If disrupted, markets will always revert to their mean or the natural position.

This was the reason that LTCM chose risky strategies during the Asian financial crisis.

They saw the downturn as a small blip in the market which would always eventually stabilize and earn them a whole lot of money in the process.

However, this didn't happen as models suggested.

The market didn't return to normal and instead, most people continued to act irrationally, selling more stocks and buying more bonds.

But LTCM's models told them to continue taking risks.

LTCM suffered several months worth of losses for the first time in its history.

As problems and losses started to mount up, the ridiculously high leverage rate of LTCM became a milestone.

They had to follow the models and take even more risks in hope of earning enough just to pay back their mounting fees and debts.

Because of their high leverage, reversing course was no longer an option.

Eventually, the models failed completely.

According to LTCM's models, the probability of losing everything in a single year was only 1 in septillion, or 10 to the power of 24.

In other words, it was virtually impossible.

And yet, in August 1998, the impossible has happened.

The Russian government defaulted on its debts and devalued its currency.

It wasn't just that the Russian economy was tanking, but no one, not even the IMF, had stepped in to help them.

This incident caused a massive sell-off in the global financial markets, especially the stock market.

This was catastrophic news for LTCM because their models heavily invested in global equity markets.

In one single day on August 17, 1998, LTCM lost $533 million.

Due to their huge debts and lack of capital, LTCM needed to sell quickly to stay solvent.

But no one wanted what they had to offer.

The fewer buyers there are in the market, the more severe the losses for the seller.

By the end of August, LTCM had lost 45% of its capital.

On top of that, they had reached a leverage rate of 55 times more than the original capital and stuck with $125 billion in assets, which they couldn't sell.

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The INSANE Story of How a Hedge Fund Collapsed the Wall Street | Long Term Capital Management (LTCM)

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