ENDING THE LTCM CRISIS TOOK JUST ONE BAILOUT. WE SHOULD BE SO LUCKY NEXT TIME. / THE WALL STREEET JOURNAL

Ending the LTCM Crisis Took Just One Bailout. We Should Be So Lucky Next Time.

Future crises may involve many funds making similar bets

By Telis Demos

The recent collapse of Archegos Capital Management, headed by Bill Hwang, left, got different responses than those to LTCM a quarter-century ago. PHOTO: MICHAEL NAGLE/BLOOMBERG NEWS

This is part of a three-part Heard on the Street series on the 25th anniversary of Long-Term Capital Management’s collapse.

Twenty-five years ago, the impending collapse of Long-Term Capital Management was so worrying to Wall Street that 14 of the biggest firms collectively coughed up billions of their own cash to rescue it.

At the time, the gathering of leading investment bankers at the behest of the Federal Reserve felt like an extraordinary intervention. 

But looking back a quarter-century, and in light of all that followed, the resolution of the LTCM crisis now seems quaint: All it took was rescuing one firm.

Of course, Wall Street has never been in the charity business. 

What pried open the wallets of Goldman Sachs, J.P. Morgan, Merrill Lynch, UBS and others was fear about the broader fallout its collapse could bring. 

There was the direct exposure, as LTCM had borrowed from Wall Street to leverage its bets, as well as the indirect risk of what might happen to the broader market in a fire sale.

With the enormous growth of the size of banks since then, and reforms to how markets operate in the wake of subsequent crises, the collapse of one hedge fund may on its own be far less likely to cause such a singular crisis. 

Yet hedge funds collectively still have the power to unnerve the markets and regulators. 

And that is a much tougher problem to tackle.

One remarkable thing about LTCM was its scale relative to Wall Street. 

At the end of 1997, LTCM had $129 billion in assets, including what it used leverage to purchase, according to the U.S. Treasury at the time. 

Investment bank J.P. Morgan back then had roughly $260 billion in total assets. 

Today, diversified banking giant JPMorgan Chase has almost $3.9 trillion in total assets.

Hedge funds have changed, too. 

LTCM was making “convergence” arbitrage bets in the prices of various instruments. 

Today’s large hedge-fund firms are often more like investment institutions, with many so-called pods of traders and analysts using different strategies. 

“The emphasis on multistrategy is something that has really evolved in the last 10 years, and is a stark contrast to LTCM,” says Kenneth Heinz, president of HFR, a hedge-fund data and analysis provider.

Yet diversification within individual firms hasn’t necessarily resulted in diversification across hedge funds, in what are sometimes called “crowded trades.” 

The overall growth of hedge funds—whose capital has grown to nearly $4 trillion today, from less than $400 billion in 1998, according to HFR—means that the collective trading among them can be extremely significant.

“My worry today wouldn’t be just an LTCM in isolation, but also many funds that adopt similar strategies and see correlated failures,” says Jeremy Kress, an assistant professor at the University of Michigan’s Ross School of Business.

The International Monetary Fund, in a recent review of vulnerabilities among nonbank financial intermediaries, noted some measures showing that portfolios of investment funds have become more similar to each other over the past two years compared with previous years, “raising the threat of correlated liquidity shocks.”

Consider the very different responses to the recent collapse of one fund, versus the unwinding of a strategy across many. 

The fallout from the collapse of Archegos Capital Management cost Wall Street billions. 

But it didn’t merit the intervention of the Federal Reserve. 

And even troubled Credit Suisse was able to absorb its $5.5 billion loss, though it was severely weakened by it.

Yet when hedge funds as a group sold government bonds during the Covid-19 panic in March 2020, it was part of a major systemic problem that forced the Federal Reserve into action by buying Treasurys. 

Hedge funds “materially contributed to the Treasury market disruption during this period,” according to the Financial Stability Oversight Council. 

More recently, the return of a major Treasury trade among hedge funds has drawn warnings from global financial authorities.

Monitoring of private funds has expanded since the 2008 global financial crisis, with many hedge funds having to file regular reports. 

The Fed, for example, tracks leverage across hedge funds in its financial-stability reports. 

But there are also some key gaps: Archegos was a family office, and not subject to the same requirements of hedge funds investing for clients. 

It also made use of a kind of derivative bet on stocks that wasn’t subject to some reporting rules.

There are proposals to fix these blind spots, as well to revise how the Treasury market functions. 

But they are still making their way through Washington. 

If only things were so simple as getting bankers together in a room.