Landmark failures: LTCM and 2008 · RiskAtoms Academy

By the end you will be able to

1Explain how leverage, correlation and liquidity combined in the near-collapse of LTCM (1998) and in the 2008 crisis.
2Calculate how leverage and a jump in correlation turn small losses into the loss of all capital.
3Identify the controls and assumptions that failed at each stage of both stories.
4Name the reforms that followed each failure.

Why it matters

In 1998 a hedge fund run by some of the cleverest people in finance nearly brought down Wall Street. Ten years later the banks themselves made the same mistakes on a far larger scale. Not the same trades: the same three forces.

Core explanation

Three forces that feed each other

L1.1.10: A short history of financial crises told both stories in outline. This lesson opens them up to see the mechanics a risk manager must watch. Three forces recur:

Leverage

Borrowing to hold far more assets than your capital. Small falls in asset prices become large falls in capital.

Correlation

Positions that look independent in calm times move together in a crisis. Diversification vanishes when you need it.

Liquidity

Assets that cannot be sold without crashing their price, and funding that lenders can withdraw overnight.

Each makes the others worse. Losses on a leveraged book force selling; selling into a crowded market pushes prices down; lower prices bring more losses and calls for collateral, and lenders pull back just when cash is needed most. Watch for all three as you step through LTCM. At each stage, spot what failed.

TimelineLTCM, 1994 to 1999

1 / 6 · spotted 0 of 6

1994–1997

Small gaps, big balance sheet

Long-Term Capital Management, founded by the bond trader John Meriwether, made convergence trades: buying a slightly cheap bond and selling a slightly dear, near-identical one, and waiting for the gap to close. The gaps were tiny, so the fund borrowed heavily through repo and derivatives. Its counterparties, impressed by its partners, asked for little margin.

Spot it

What turned tiny price gaps into large profits?

2008: the same forces, inside the banks

In 2008 the leverage sat on the balance sheets of banks and investment banks, the correlated assets were mortgage securities, and the liquidity that vanished was the short-term funding the whole system ran on: repo, commercial paper and money market funds.

TimelineThe 2008 crisis, 2004 to 2011

1 / 6 · spotted 0 of 6

2004–2006

Mortgages become AAA securities

US lenders made large numbers of subprime and other risky mortgages. Banks pooled them into securities and sliced the pools so that the top slices earned AAA ratings. The ratings assumed that defaults in different regions would not all rise together. Banks, insurers and funds around the world bought, often with borrowed money.

Spot it

Which assumption made so many mortgage slices AAA?

Force	LTCM, 1998	Banks, 2007–08
Leverage	More than 25 to 1, little margin	Up to 40 to 1 at investment banks
Correlation	Unrelated trades all lost in a flight to quality	Mortgage defaults rose together nationwide
Market liquidity	Crowded trades with no buyers	Mortgage securities could not be valued or sold
Funding liquidity	Lenders demanded more collateral	Repo and commercial paper dried up; runs on Northern Rock and Bear Stearns
Controls	Lenders did not see total positions	Weak governance and risk management (FCIC)

Barings is a different kind of failure

Barings (1995), in L1.7.12: Derivatives disasters and their lessons, was not about leverage or correlation but about one trader and missing controls. It returns as a culture case in L2.3.08: Risk culture and incentives.

Try it

A stylised fund with $5bn of capital holds many convergence trades. In calm times only a few go wrong at once. Start at 25× leverage with 10% of trades going wrong, then slide that share to 100%, as in a flight to quality. Then add a fire sale. Finally, cut leverage to 5× and try again. Illustrative numbers.

Try itLeverage, correlation and a crowded exit

Leverage (assets ÷ capital)25× (assets $125bn)

Share of trades that go wrong together10% (calm)

Loss on each trade that goes wrong3.0% of its size

Selling into a crowded market

The fund's $5bn of capital after the stress

capital left trade losses fire-sale losses

Trade losses$0.38bn

Fire-sale losses$0.00bn

Total loss$0.38bn

Capital left$4.63bn

Share of capital lost7.5%

Leverage after26.9×

Try moving the middle slider to 100%.

Worked example

LTCM's arithmetic, and the stylised fund

The first steps use LTCM's own figures for the start of 1998, rounded, from the President's Working Group report. The rest use the stylised fund above. Amounts in US dollars.

How leverage turned a bad month into a near-collapse

Step 1 of 6

1
Leverage at the start of 1998
$125bn of assets ÷ $4.7bn of capital = about 26.6×. A fall of 3.8% in its assets would use up all its capital.

Regulatory lens

After LTCM, the President's Working Group (1999) and the Basel Committee urged banks to manage their exposure to highly leveraged counterparties better: know the client's whole position, set limits and collect margin. After 2008 the response went much further. Basel III (2010) added a leverage ratio that ignores risk weights and two liquidity rules, the Liquidity Coverage Ratio and the Net Stable Funding Ratio. G20 leaders agreed to clear standard OTC derivatives centrally, the US passed the Dodd-Frank Act (2010), and supervisors made stress tests routine. L2.7.04: Basel III and its finalisation introduces Basel III.

Sparks

SparkThe bank that said no

Bear Stearns famously declined to put money into the LTCM rescue in 1998. Ten years later, in March 2008, it was Bear that needed a rescue.

SparkAAA every working day

The Financial Crisis Inquiry Commission found that in 2006 alone Moody's rated about 30 mortgage-related securities AAA every working day, and that 83% of the mortgage securities it rated AAA that year were later downgraded.

Key takeaways

Leverage, correlation and liquidity feed each other: losses force sales, sales cut prices, and lenders pull back.
LTCM ran more than 25 to 1; its many trades were one bet on calmer markets, and it lost about half its capital in August 1998.
In 2008 banks ran leverage up to 40 to 1, AAA mortgage securities proved highly correlated, and short-term funding vanished.
In both cases lenders and boards did not see, or did not control, the risks being taken.
The reforms that followed target each force: counterparty limits and margin, a leverage ratio, liquidity rules, central clearing and stress tests.

Reaction

Check what stuck

Glossary

Leverage: Holding assets worth many times your own capital, funded by borrowing. Measured here as assets ÷ capital.
Convergence trade: A trade that bets the price gap between two similar securities will narrow, buying the cheap one and selling the dear one.
Correlation: How closely two things move together. In a crisis, positions that normally move independently often fall together.
Flight to quality: A rush by investors out of anything risky or hard to sell and into the safest, most liquid assets.
Crowded trade: A trade held by many similar investors, so that they all try to sell at once.
Market liquidity: The ability to sell an asset quickly without pushing its price down much.
Funding liquidity: The ability to borrow or roll over funding when you need it.
Repo: A short-term loan backed by securities: sell the securities with an agreement to buy them back, often the next day.
Haircut: The amount by which a lender values collateral below its market price, so the borrower must put up some capital of its own.

Deep Dives & Origins

Deep Dives

Lowenstein, R., When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House, 2000. Beginner, narrative.
Brunnermeier, M. K., “Deciphering the Liquidity and Credit Crunch 2007–2008”, Journal of Economic Perspectives 23(1), 2009. Intermediate.

Origins

President's Working Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, April 1999.
Basel Committee on Banking Supervision, Banks' Interactions with Highly Leveraged Institutions, January 1999.
Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report, January 2011.
Bank of England, Financial Stability Report, October 2007 (on Northern Rock and the funding markets).
Basel Committee on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems, December 2010.

Watch this lesson

Video version

Prefer to watch? The same lesson as a 12-minute video will sit here, made from this page's script.