A fund run by Nobel laureates blew up $4.6B because 25x leverage left no room for error

Long-Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether, the former head of bond trading at Salomon Brothers. Its board included Myron Scholes and Robert C. Merton, who won the 1997 Nobel Prize in Economics for the Black-Scholes model. The strategy was convergence arbitrage — betting that mispriced but related securities would drift back together — small, supposedly low-risk edges amplified by enormous borrowing.

The amplification was extreme. By early 1998 LTCM had about $4.7 billion of equity but had borrowed more than $124 billion — a debt-to-equity ratio over 25 to 1 — and held derivative positions with a notional value around $1.25 trillion. For years the trades paid off handsomely. Then in 1998 the Asian and Russian financial crises hit; Russia defaulted on its debt. Instead of converging, spreads blew apart, liquidity evaporated, and positions that were meant to be uncorrelated all lost money at once.

By September 1998 LTCM had lost $4.6 billion in under four months and was on the verge of collapse. Because its web of derivatives touched nearly every major bank, regulators feared a fire sale could cascade through the global financial system. On September 23, 1998, the Federal Reserve Bank of New York brokered a $3.65 billion rescue funded by 14 Wall Street firms — a private bailout to avert a systemic crisis. The fund was wound down and dissolved by early 2000.