John Meriwether and Erick Rosenfeld created Long-Term Capital Management

John Meriwether and Erick Rosenfeld created Long-Term Capital Management (LTCM) in 1994. Nobel-Prize winning economists Robert Molten and Myron Scholes were the principal shareholders of LTCM. They were all famous experts of investing in derivatives to make above-average returns as well as outperform the market (Adrian, Borowiecki & Tepper, 2018). LTCM became the most popular hedge fund of its times. It represented hope for many in the sense that markets would eventually be tamed. This is because LTCM was a hedge fund. Security Exchange Commission (SEC) does not regulate hedge funds and are only accessible to large and accredited investors. The following essay shows that lack of disclosure to increase transparency and enhance market discipline contributed to the collapse of LTCM.
The Purpose of Hedge Funds
Hedge funds have been there since 1940’s. However, the promise of high absolute returns attracted widespread of attention towards hedge funds by investors, regulators and academics. In the United States alone, the hedge fund increased from around 200 in 1968 to approximately 3,000 in 1990 (Adrian, Borowiecki ; Tepper, 2018). LTCMs offered a considerably high annual return of 42.8% in 1995 and 40.8% in 1996. This caused the firm’s capital to grow from $1 billion to $7 billion in a span of fewer than 3 years considering the fact that they were charging annual fees of 2% of each investment and 25% on the profits made from the investment (Jorion, 2000). Hedge funds such as LTCM are constructed to take advantage of various identifiable market opportunities. They are illiquid since they allow investors to keep their money in the fund in a lock period of at least one year. The lock period of LTCM was 3 years and each investor were to contribute at least $10 million to the fund. Besides, hedge funds use different investment strategies (Lowenstein, 2000). LTCM applied a mathematical model to predict prices.
The Fall of LTCM
In 1998, LTCM exposed American largest banks to high risks of more than $1 trillion in default. The demise that befell the firm was sudden swift. The company lost $4. 4 billion of its $4.7 billion in less than a year (Shirreff, 2002). During its first year, LTCM did very well earning an annual return of 28% while most of the bond investors were losing money. Its highly reputable partners with record-level funding, the form became one that every person wanted to do business with. The partners were highly skilled in determining ways of trading, hedging their bets as well as leverage small profits for big payout (Adrian, Borowiecki & Tepper, 2018). For that reason, many did not perceive LTCM as more of a hedge fund but a financial technology investment company. However, the team was very secretive about its operations something that made the banks find it frustrating to work with the company. The partners rarely gave any specifications about the strategies they employed. In fact, they scattered trades between different banks so that they would not give away too much information. LTCM only gave a broad overview of the models they applied. According to Lowenstein (2000), the partners went to the extreme of “repurchasing the rights to photographs that had run in Business Week to keep their pictures from public view” pg. 58. They wanted to keep off from the media completely. Besides, the partners always put their interests first but because LTCM was thriving, no one gave attention to what they were doing. This was made worse by the fact that the SEC does not regulate hedge funds.
With time, people were moving towards LTCM’s bond arbitrage and that is when the company decided to explore equity arbitrage, volatility swaps as well as global markets. However, the equity arbitrage was riskier than bond arbitrage since the spread varied between 4% to 10%. Besides, by venturing into equity arbitrage, the firm was leaving its area of expertise and trying something that took people many years to understand and predict. Lowenstein (2000) explains that there was a time that the firm had a “staggering $40 million riding on each percentage point change in equity volatility in the United States and an equivalent amount in Europe” pg. 126. LTCM had more capital than they anticipated especially when they strategy investing into Russian bonds, Brazilian bonds and Danish Mortgages that they had to return approximately $2.7 billion to the outside investors. The company continued venturing into new markets.
LTCM’s first big loss was experienced in 1997 when financial defaults of Thailand triggered Asian Market. The International Monetary Fund could not do anything about it and saw Asian markets falling one by one followed by the Russian’s. There was a global panic that forced many investors to change to Treasury bonds. In addition, banks withdrew from illiquid and risky investments such as LTCM. The firm lost with every volatility increase in the United States. Similarly, Salomon’s fall had a significant negative impact on LTCM (Adrian, Borowiecki & Tepper, 2018). When Salomon started liquidating its assets, many firms started abandoning the arbitrage business. During the month f August 1997, LTCM experienced the worst loss after Russia defaulted its debt. It lost more than $2 billion in August only and it was on the verge of being declared bankrupt. However, the Alan Greenspan the Fed Chairperson was more scared of the repercussion LTCM could have on the other market if it was declared bankrupt than the criticism he would get for bailing the firm out. He embarked on a strategy to put together at least $3.65 bailout (Lowenstein, 2000). After hefty negotiations, eleven Wall Street major banks agreed to contribute towards the bailout. Among the eleven banks was Lehman a key player in the 2008 financial crisis.
LTCM’s Role in 2008 Financial Crisis
Research shows that bailing out LTCM had something to do with the 2008 global financial crisis. the bail out facilitated by the Fed comprised of $3.65 billion to buy LTMC’s assets which comprised of leveraged assets valued at $100 billion and derivatives with a notional value of $1 trillion (Shirreff, 2002). This was a far too much of a risk for the Fed to get involved. There was no reasonable explanation of how LTCM as young as it was had managed to be entrusted with derivatives worth $1 trillion. The Fed’s decision to bail out such a company was a big mistake and created a precedent in which investors were not afraid of making bad investment decisions. Investors were more reckless in the years that followed which led to the 2008 financial crisis (Adrian ; Shin, 2010). In other words, investors and firms were aware that the Fed would bail them out in case of any losses which motivated them to invest in riskier investments.
The 2008 financial crisis was the second worst economic crisis after the 1929 Great Depression. Like the LTCM, financial market deregulation caused the financial crisis was caused since banks could trade derivatives with hedge funds. Banks were demanded more mortgages that would support the highly profitable sales they made from the derivatives. Besides, the banks created interest loans that even the subprime borrowers could afford. The Fed increased the fed fund rate in 2004 as the banks reset the interest rates for the new mortgages (Adrian ; Shin, 2010). With time, the supply of mortgages surpassed the demand causing the house prices to go down. This trapped the homeowners who could neither afford the payments nor sell their houses. As the value of derivatives came crumbling down, banks refused to lend to each other causing a financial crisis that led to the Great Recession.
Changes After the 2008 Financial Crisis
After the 2008 financial crisis, there was a financial regulation reform to prevent another economic crisis. In 2010, the United States established the Dodd-Frank Act reform as well as the Consumer Protection Act. The Dodd-Frank Act created a systematic risk council to oversee market activities and identify any risk in such activities. The Financial Stability Oversight Council was established and was charged with the responsibility of monitoring the US financial stability and detect any risk that may arise from material financial distress (Guynn, Polk ; Wardwell LLP, 2010). The Act empowered the Federal bank to establish additional prudential policies such as enhanced public disclosure requirements and contingent capital requirements. In other words, the Dodd-Frank Act brought about the regulation of the financial markets in the United States.
Recent Development of Financial Regulation
The most recent development of financial regulation is the fair value measurement and disclosure. FASB ASC 820 and IFRS 13 requires companies to reports at fair value. Fair value refers to the price that would be received if an asset was sold or the price that would be paid on a liability transfer in an ordinary transaction of between parties in a market during a measurement date. In other words, fair value is an exit price that focuses on the market value rather than the companies specified book value (Christensen and Nikolaev, 2013). This ensures that all assumptions of risk have been put into consideration when determining the exit price of an asset or liability. The fair value measurement standard was established to enhance disclosures related to fair value so that the users of the financial statements could be in a better position to accurately assess the valuation methods as well as the inputs used in measuring the fair view. Besides, it seeks to increase consistency and comparability in the measurement of fair value and accompanying disclosures.
Conclusion
From the above analysis, it is evident that the collapse of LTCM resulted from moral hazards associated with deregulation in the financial markets. Lack of disclosure to increase transparency and enhance market discipline led to reckless investing in which investors only cared about the high returns they received from the investments. The partners to LTCM put their interest first and took advantage of the reputation they held regarding financial markets. They never disclosed the investment models they applied. On the other hand, bailing out of the LTCM motivated investors to invest recklessly because they knew that the federal bank would come to their rescue. This led to the 2008 financial crisis. To prevent such crises, Dodd-Frank Act was enacted providing regulations to the financial markets. Finally, the establishment of fair value measurement standard in accounting enhances disclosure in financial activities and it is a recent development to the regulation of financial markets.