Long-Term Capital Management: The Original Enron?
Three years before energy industry giant Enron Corp. sought protection from creditors and came under the harsh light of scrutiny for the complex web of off-balance sheet deals that masked the firm's huge debt, a very similar scenario unraveled among some of Wall Street's most celebrated financial players. But while Enron unsuccessfully sought eleventh-hour aid from the power brokers it has bankrolled in Washington D.C., a "who's who" of global financial institutions stepped up to bail out hedge fund Long-Term Capital Management (LTCM) in September 1998. Not coincidentally, the bankers arguably had more to lose from the impending collapse of LTCM than they faced in the more recent debacle.
While they are, of course, very different institutions, the mistakes made by LTCM and Enron are strikingly similar. The near collapse of LTCM ultimately taught bankers around the globe to pay closer attention to the hedge funds they backed; perhaps those lessons should have been extended to their complex dealings with Enron, as well.
LTCM was headed by legendary Wall Street trader John Merriwether. He assembled a dream team made up of high-profile traders, two Nobel laureates honored for their expertise in derivatives, and a former governor of the U.S. Federal Reserve Bank.
Right from the start, LTCM made it clear the business would be built on borrowed funds.
In its original prospectus, LTCM warned investors it would employ "tons of leverage and have a lot of volatility in earnings," says Leslie Rahl, a principal at Capital Market Risk Advisors, a New York consulting firm that specializes in derivatives.(1)
At first, the hedge fund's complex investment models appeared to work spectacularly well. The fund reported returns of 42.8% in...
Even if LTCM had adequately assessed the volatility of a given asset, there's still no guarantee that it would have been rewarded for doing so. While there were ready buyers for private option contracts, there were few takers when the value of the asset tanked. Thus, the price of the asset could continue to move downard, exposing LTCM to expensive payouts as the price of the asset continues its
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