Long-Term Capital Management case study

1: A guide to analyzing how communication works in the LTCM case

The LTCM case is at the boundary where engineering meets financial economics. Long-Term Capital
Management was a hedge fund that was exceptionally successful for several years in the 1990s, but
almost crashed in 1998 when the Russian government defaulted on their bonds. After the Federal Re-
serve intervened, fearing that LTCM's collapse would destabilize financial markets, LTCM was re-
capitalized by a consortium of banks that held investments in LTCM. This case illuminates ways in
which communication with clients and counterparties affects the success and failure of financial organ-
izations, and how that communication affects financial markets.

To get a handle on how communication worked in the LTCM case, your team must first resist the siren
call of Lowenstein (2000). By this I mean that although your team should read Lowenstein for data
about the events in the case, you should resist relying on Lowenstein’s interpretation of those facts.
His interpretation emphasizes how the personal failings of the LTCM partners (greed, secrecy, hubris,
gambling) and risk-taking left LTCM vulnerable to Russia’s bond default in August 1998. While this em-
phasis on personal failings and risk-taking may be useful for understanding why LTCM failed, it is of li-
mited use in understanding how communication worked during LTCM’s life as an organization.

At this point, you may be wondering why we’re examining communication in LTCM. What originally got
me interested in organizational communication at LTCM was reading MacKenzie’s work on the “sociolo-
gy of arbitrage.” MacKenzie (2003) claims that arbitrage is essentially a social activity, based on know-
ing the people and cultures of financial organizations (372). (For a synopsis of MacKenzie’s work,
please see the two entries in the annotated bibliography in this document.) He analyzes how financial
organizations communicate to create a financial market and argues that social relationships with coun-
terparties and investors are crucial for such organizations and for the market.

MacKenzie’s work suggests a useful approach to analyzing communications in the LTCM case: focus on
communication across organizational boundaries. For instance, your team may want to examine how
communication shaped the behavior of the market as a whole; how LTCM communicated with counter-
parties and investors; or how LTCM communicated with the Federal Reserve and potential investors
during the collapse. Your team may want to examine LTCM’s communication throughout the hedge
fund’s lifetime, or to focus more closely on a particular set of events, such as the Federal Reserve-
orchestrated rescue.

In analyzing the LTCM case, your team shouldn’t feel constrained to agree with MacKenzie’s argument
as a whole and should not limit yourself to his analytical approach. Use MacKenzie (2003) or MacKenzie
(2006) as a beginning point, to get the team focused on the social rather than the purely financial ele-
ments of the case. Your team is then likely to find that most of the “data”—description of communica-
engrc 3350 Ahlers  LTCM case 2

tive events—is in Lowenstein (2000), Haubrick (2007), or other sources. As you analyze the data about
communicative events, your team is likely to develop its own analytical framework.

As part of that analytical framework, your team should explain the financial events that led to LTCM’s
collapse. This explanation should be appropriately detailed and should take into account the differing
interpretations of those financial events. By “appropriately detailed,” I mean that the explanation
should include such specifics as what hedge funds are; the general strategy that LTCM used to make
money; why LTCM began investing in equities, and the significance of this shift for risk-taking; why the
Russian bond default affected LTCM, although the firm had only a small position in the bonds; and so
forth.1 If your analysis mentions LTCM’s “financial models,” you should explain what those models were
and how they worked (e.g., do you mean commonly-used models of risk assessment, such as value-at-
risk, or do you mean more esoteric models known only to LTCM?).

By “take into account the differing interpretations,” I mean that your explanation should be grounded
in a knowledge of the arguments set forth by Lowenstein (2000), The President’s Working Group on Fi-
nancial Markets (1999, 10-22, 29-31), Perold (1999a), and by either MacKenzie (2003) or MacKenzie
(2006, 211-242). In particular, examine arguments about LTCM’s degree of risk-taking and leverage. In
your team’s analysis, you might conclude that LTCM was over-leveraged or not so; took unreasonable
risks or did not take such risks—but either way, your conclusions should be grounded in evidence and
should consider the opposing arguments.

2 : Required texts from the annotated bibliography

Your team should read Perold (1999a); either MacKenzie (2003) or MacKenzie (2006, 211-242); the Pres-
ident’s Working Group on Financial Markets (1999, 10-22, 29-31); and relevant chapters from Lowens-
tein (2000). I recommend that the team read Perold and MacKenzie before reading Lowenstein (2000),
and that most or all team members read MacKenzie. All of the required texts must be incorporated into
the progress report.

3 : Annotated bibliography

Gladwell, Malcolm. 2002. Blowing up: How Nassim Taleb turned the inevitability of disaster into an
investment strategy. (April 22 & 29): 162-165, 167-168, 170-173.
Available at http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm.

1
In your team’s presentation to the class, explain these events in terms accessible to an audience that may not be
familiar with hedge funds. To help you make the explanations accessible, I recommend meeting with me to review
your team’s slides and talk outline. In your team’s reports, write for me.
engrc 3350 Ahlers  LTCM case 3

This article on Nassim Taleb synopsizes the argument about normal v. "fat tail" distributions (167) and
applies it to the collapse of LTCM. Of particular interest for our purposes is the discussion here of how
“fat-tailed” distributions are caused by the social (rather than purely mathematical) attributes of fi-
nancial markets: “in the markets, unlike in the physical universe, the rules of the game can be
changed. Central banks can decide to default on government-backed securities” (167).

Greenspan, Alan. 1998. Statement before the Committee on Banking and Financial Services, U.S.
House of Representatives, October 1. Federal Reserve Bulletin 84: 1046-1050.
Available at http://www.federalreserve.gov/boarddocs/testimony/1998/19981001.htm.
In his statement to Congress, Greenspan describes how “emulation” of LTCM’s bond trades lessened
the profits to be made from such trades, leading LTCM to riskier trades in equities, and explains why
the Federal Reserve decided to work with the banking consortium to re-capitalize LTCM.

Haubrich, Joseph G. 2007. Some lessons on the rescue of Long-Term Capital Management. Federal
Reserve Bank of Cleveland. Policy Discussion Papers 19 (April): 1-12.
Available at http://www.clevelandfed.org/research/PolicyDis/pdp19.pdf.

This policy paper from one of the Federal Reserve Banks focuses on whether the rescue of LTCM was
the best alternative, a question that may be tangential to your team’s analysis. For our purposes, the
most useful part of the paper is the discussion of alternate versions of the Buffet offer (4-5). You may
also find the background offers useful details.

Isa, Rosmah Mat and Rashid Ameer. 2007. Hedge fund performance and managerial social capital.
The Journal of Risk Finance 8(3): 246-259.
Electronic copy available from the Cornell libraries (search by journal title).

Isa and Ameer (2007) examine 25 hedge funds to determine how the “social capital” of hedge fund
managers affects fund performance. Social capital is defined extensively, including networks (teams
within hedge funds; managers’ social networks), personal relationships, and “cognitive capital,” or
shared mental maps. Results of their statistical analysis suggest that managers’ “networking and cogni-
tive skills” contribute to the performance of hedge funds.

Lowenstein, Roger. 2000. When genius failed: The rise and fall of Long-Term Capital Manage-
ment. New York: Random House.
You can check out this book from the Cornell libraries.

Lowenstein’s account of LTCM’s rise and fall includes details about how the firm communicated with
counterparties, investors, the Federal Reserve, and the consortium that re-capitalized the firm, as well
as the internal communications of the firm and their use of financial models. According to Lowenstein,
LTCM tried to limit the amount of information given to counterparties and to investors, "parceling out"
engrc 3350 Ahlers  LTCM case 4

services among banks, so that the banks could not figure out LTCM's trading strategies (see, e.g., 44-
48; 59; 81-84; 107-108). Despite LTCM’s attempts to control information, their trading strategies and
degree of leverage was generally known in the financial community (80-82; 96), which decreased their
profits in bond arbitrage and led them to take bigger risks in equities (97-102).

As described by Lowenstein, LTCM had an "inner circle" of Meriwether, Hilibrand, Rosenfeld, and Hag-
hani (traders from Salomon) and an "outer circle" of the other partners, which affected communication
within the partnership--including communication about risk management. The key traders were Hagha-
ni and Hilibrand, and the models were widely used in the financial community: “Other Wall Street
firms had also found their way to MIT, and most of the big banks were employing similar models” to the
“same couple of dozen spreads in bond markets” (59). LTCM’s advantage was more experience in read-
ing the models (59). The traders “debated . . . about what the models implied and whether to do what
the models recommended,” and they tried to adjust the models to account for unexpected events (75).

As LTCM approached collapse, information about LTCM's trades became more widely known, in part
because Meriwether had to tell investors about LTCM’s financial problems, and in part because LTCM
revealed more trading information to banks as they "scavenged" for capital (164). Alerted to LTCM's
situation, rival trading firms began to sell, either to profit at LTCM's expense or simply to protect
themselves. When the Fed intervened and asked LTCM's creditors to help prevent collapse, the banks
realized that they must all work together: "If any one bank acquired it, it would be in the same spot as
Long-Term--the whole Street would be shooting at it" (190). Representatives of the different banks
reached a consensus, under a tight deadline, of how to handle the financial crisis. Lowenstein’s ac-
count of the last weeks of the firm (143-218), combined with the accounts of Haubrich (2007), Perold
(1999a) and Meriwether’s letter to investors (Perold 1999b), could be the basis of a case study in itself.

MacKenzie, Donald. 2003. Long-Term Capital Management and the sociology of arbitrage. Economy
and Society. 32 (3): 349-380.
To locate a digital copy, search the library catalog for the journal title.

MacKenzie examines what he terms the "performativity" of economics (in this case, financial markets):
"economics creates the phenomena it describes," rather than simply describing what already exists
(350-351). He argues that LTCM's failure exemplifies this performativity: "LTCM's success led to wide-
spread imitation," resulting in what was, in effect, a single portfolio of "partially overlapping arbitrage
positions" held across trading firms. In other words, communication about the trades led to a different
market.

According to MacKenzie, this “superportfolio” contributed to LTCM’s collapse. When Russia defaulted
on its bonds in August 1998, banks and hedge funds that held the same trades as LTCM began to sell,
resulting in losses. Contrary to LTCM’s expectations, the falling prices did not lead other traders to
buy: “the widening of spreads was self-feeding rather than self-limiting” (363). At the end of August,
LTCM had lost 44% of its capital—but still had about $2 billion of capital above what was being used to
engrc 3350 Ahlers  LTCM case 5

fund trades. Given the availability of this capital, MacKenzie argues that LTCM was “a long way from
being bankrupt” (365).

However, when the public learned of the extent of LTCM’s losses—via Meriwether’s September 2, 1998
letter to investors, which was leaked to Bloomberg—panic ensued. LTCM’s assets “became impossible
to sell at anything other than distressed prices” (365). LTCM’s counterparties reacted by demanding
capital (365-366). Consequently, LTCM faced bankruptcy.

This potential bankruptcy, MacKenzie argues, was not caused by risky trading strategy or by over-
reliance on mathematical models. Many of LTCM’s trades did not rely on “sophisticated” modeling, and
“although models were important in how its trades were implemented and in assessing the risks in-
volved,” LTCM’s traders were aware that such models were a necessarily imperfect guide (359). LTCM’s
leverage was comparable to that of large investment banks (360); their risk model relied on “conserva-
tive estimates” of the future value of their portfolio (358), and, rather than relying entirely such risk
models as value-at-risk, LTCM stress-tested their portfolio against a hypothetical stock market crash
and other scenarios (359). Because they had taken these measures, LTCM’s partners “believed them-
selves to be running the fund conservatively . . . . After the fund’s crisis, it was commonly portrayed as
wildly risk-taking, but I have found almost no one inside or outside LTCM who can be proved to have
expressed that view prior to the crisis” (359).

MacKenzie concludes that in arbitrage, “business depends upon mundane forms of social interaction
with personally known others” (371) and that financial markets are inherently social: “The financial
markets are not an imperfectly insulated sphere of economic rationality, but a sphere in which the
‘economic’ and the ‘social’ interweave seamlessly. In respect to arbitrage, the key risks may be ‘so-
cial’ risks from patterns of interaction within the financial markets, rather shocks from the ‘real econ-
omy’ or from events outside the markets” (373).

MacKenzie, Donald. 2006. An engine, not a camera: How financial models shape markets. Cam-
bridge: MIT Press. 15-20, 105-118, 211-242.
You can check out this book from the Cornell libraries.

MacKenzie's recent book covers much of the same material as his 2003 article, but might be worth look-
ing up for three kinds of information. The first is a fuller explanation of the concept of "performativity"
(15-20). The second is a detailed discussion of “normal” v. “fat-tailed” distributions (105-118). The
third is a fuller description of the history of LTCM (211-218), including more material (primarily from
interviews with LTCM partners) to support MacKenzie’s claim that Meriwether’s understanding of orga-
nizational relationships was “[a]t least equally important” as his use of mathematical models (216).

Perold, André F. 1999a. Long-Term Capital Management, L. P. (C). Harvard Business School Pub-
lishing.
Available on course reserve at the Engineering Library.
engrc 3350 Ahlers  LTCM case 6

Perold offers a concise yet detailed account of LTCM’s choices in late August 1998, focusing on the
partners’ meeting of August 23, 1998. Of particular use are the chronology of events leading up to the
August 23 meeting, the explanation of “two-way marking to market,” and the list of the firm’s invest-
ments as of August 21, 1998. (Please note that charts from Perold cannot be used for presentations or
reports, per the copyright restrictions given on the first page of Perold 1999a.)

Perold, André F. 1999b. Long-Term Capital Management, L. P. (D). Harvard Business School Pub-
lishing.
Available on course reserve at the Engineering Library.

Perold (1999b) consists of the text of Meriwether’s September 2, 1998 letter to investors.

United States Department of the Treasury. The President's Working Group on Financial Markets.
1999. Hedge funds, leverage, and the lessons of Long-Term Capital Management. 10-22,
29-31.
Available at http://www.treas.gov/press/releases/reports/hedgfund.pdf.

This report on LTCM by the President's Working Group on Financial Markets (1999) describes the events
that led to LTCM’s demise; assesses LTCM’s degree of leverage and risk; describes LTCM’s relationships
with its counterparties and the risks to those counterparties in the case of LTCM’s default; and ques-
tions financial organizations’ reliance on such risk models as value-at-risk (10-22). The report also dis-
cusses the degree of leverage and risk in investment banks and security firms (29-31).

LTCM’s portfolio is described in detail. About 80% of its investments were in government bonds while
the remainder were in securities, exchange-traded futures, and derivatives (11). LTCM’s size, leverage,
and trading strategies “made it vulnerable to the extraordinary market conditions” created by Russia’s
bond default:

Russia’s actions sparked a “flight to quality” in which investors avoided risk and sought out liquidity. As a re-
sult, risk spreads and liquidity premiums rose sharply in markets around the world. The size, persistence, and
pervasiveness of the widening of risk spreads confounded the risk management models employed by LTCM and
other participants. Both LTCM and other market participants suffered losses in individual markets that greatly
exceeded what conventional risk models, estimated during more stable periods, suggested were probable.
Moreover, the simultaneous shocks to many markets confounded expectations of relatively low correlations
between market prices and revealed that global trading positions like LTCM’s were less well-diversified than
assumed. Finally, the “flight to quality” resulted in a substantial reduction in the liquidity of many markets,
which, contrary to the assumptions implicit in their models, made it difficult to reduce exposures quickly
without incurring future losses. (12)

According to the President’s Working Group, LTCM’s capital was reduced from $4.1 billion on July 31,
1998 to $2.3 billion at the end of August 1998. Capital losses continued through the first two weeks of
engrc 3350 Ahlers  LTCM case 7

September. LTCM’s counterparties and creditors reacted to these losses by demanding capital: “pre-
viously flexible credit arrangements became more rigid and the daily mark-to-market valuations for
collateral calls by counterparties became more contentious” (12-13). The PWG observes that these
counterparties and creditors had the most to lose in a LTCM default, and that they “had played an im-
portant role in allowing LTCM to build up such large positions” (13). Following this, the consortium’s
re-capitalization of LTCM is briefly described.

The PWG concludes that LTCM made risky investments and did not communicate the degree of that risk
to counterparties and investors. Evidence for risk included LTCM’s degree of leverage; the likelihood
that “the LTCM Fund’s exposure to certain market risks was several times greater than that of the trad-
ing portfolios typically held” by other hedge funds (12), and the size of the firm—with more than $125
billion in assets, LTCM was “nearly four times the assets of the next largest hedge fund” (14). LTCM
disclosed “minimal information” about their trades, “such as balance sheets and income statements
that did not reveal meaningful details about the Fund’s risk profile and concentration of exposures in
certain markets” (15).

However, the PWG also observes that counterparties and investors contributed to the risk by exercising
“minimal scrutiny of the Fund’s risk-management practices and risk profile” (15). All parties used risk-
management models, such as value-at-risk and future scenario-testing, that were flawed by their re-
liance on recent data (15), and none of the parties considered the possibility that spreads would con-
tinue to widen (16). The President’s Working Group on Financial Markets notes that the use of these
risk models “raises the issue of how events assumed to be extreme and very improbable should be in-
corporated into risk-management and business practice” (16).