Long-Term Capital Management was founded in March 1994 by John Meriwether, a former Salomon Brothers trading star, along with a small group of associates, most notably economists Robert Merton and Myron Scholes, who received the Nobel Prize in economics in 1997. The fund initially specialized in high-volume arbitrage trades in bond and bond-derivatives markets but gradually became more active in other markets and more willing to speculate. The fund thus started as an arbitrage fund but gradually became more like a macro fund. LTCM was very successful: by the end of 1997 it had achieved annual rates of return of around 40 percent and had nearly tripled its investors’ money. That track record and the prestige of its associates made LTCM very popular with investors, and the companies and individuals investing in LTCM “read like a who’s who list of high finance.” LTCM was the darling of Wall Street. In effect, the management of LTCM had taken a major gamble: they made the firm much riskier, in the hope of bolstering the returns to shareholders.
LTCM GETS INTO DIFFICULTILES
Unfortunately, LTCM’s luck ran out not long afterwards. Most markets were edgy during the first part of 1998, but market conditions deteriorated sharply in the summer and led to major losses for LTCM in July. Disaster then struck the next month, when the Russian government devalued the ruble and declared a moratorium on future debt repayments. Those events led to a major deterioration in the creditworthiness of many emerging-market bonds and corresponding large increases in the spreads between the prices of Western government and emerging market bonds. Those developments were very bad for LTCM because the fund had bet massively on those spreads’ narrowing. To make matters worse, the fund sustained major losses on other speculative positions as well. As a result, by the end of August LTCM’s capital was down to $2.3 billion and the fund had lost over half of the equity capital it had had at the start of the year.
LTCM’s situation continued to deteriorate in September, and the fund’s management spent the next three weeks looking for assistance in an increasingly desperate effort to keep the fund afloat. However, no immediate help was forthcoming, and by September 19 the fund’s capital was down to only $600 million. The fund had an asset base of $80 billion at that point, and its leverage ratio was approaching stratospheric levels—a sure sign of impending doom. No one who knew LTCM’s situation really expected the fund to make it through the next week without outside assistance. That was when the Federal Reserve intervened with a bailout and a short term solution.
LTCM’s downward spiral was due poor organizational structure, un-clannish culture, selfish motives and their complete inability to cope with a volatile environment.
Right from 1994 through mid-1998, LTCM generated astonishing returns on their business. They raised a capital of $1.25 billion from investors and assembled a network of banks that were ready to provide financing at favorable terms. Over a period of just five weeks, the markets collapsed pushing the once invincible LTCM into deep debt, both for the organization and partners who had invested for personal gain. External Environment:
The environment includes all elements outside the boundary of the organization. LTCM, being the leader in trading business then, did not however consider the external environment. The markets LTCM was doing business with were highly complex and volatile. Changes happened frequently if not every day. Where the environment is unfriendly, complex and volatile, there needs to be contingency plans in place at organizations playing in those fields. LTCM, right from its inception did not think of the environment as an area subject to change or were they just being ignorant about it? There was formal control over employees, no integrating roles, no...