The Nobel Laureates Who Almost Took Down Wall Street

In August 1998, the Russian government defaulted on domestic ruble-denominated sovereign debt and devalued the ruble. The default, when it came, triggered a global liquidity crisis substantially larger than the immediate Russian economic exposure justified. The reason was a single, largely unknown, Connecticut-based hedge fund called Long-Term Capital Management — abbreviated LTCM — which had built positions of approximately one and a quarter trillion dollars in notional exposure on an equity capital base of approximately four and a half billion dollars, an effective leverage ratio in the hundreds.

Two of LTCM's principals had won Nobel Prizes in Economics — Myron Scholes and Robert Merton, both for the development of the Black-Scholes options pricing model. The fund's trading strategies relied on identifying small statistical mispricings across international bond markets, hedging the underlying directional risk, and harvesting the gradual convergence of the mispricings as small profits. The strategy required substantial leverage to generate meaningful returns. The leverage required substantial market liquidity to operate. The Russian default destroyed the liquidity.

The Cascading Liquidation. When LTCM's positions began to lose value as global bond-market correlations broke down, the fund needed to liquidate quickly. The size of the positions — measured against the daily trading volume of the markets the fund operated in — meant that liquidation pushed prices further against the fund, generating additional losses, requiring additional liquidation. The cascade, contained within a relatively obscure private hedge fund, threatened to produce billions of dollars of counterparty losses across the major Wall Street investment banks that had served as prime brokers and trading counterparties.

The Rescue. The Federal Reserve, recognizing the systemic risk of LTCM's disorderly failure, organized a roughly three-and-a-half-billion-dollar bailout in September 1998. A consortium of fourteen of the largest investment banks contributed to recapitalize the fund and unwind its positions over an extended period rather than under crisis conditions. The fund was eventually wound down without producing the systemic collapse that had appeared possible.

The Lesson Hidden in the Leverage. What LTCM demonstrated was that highly sophisticated quantitative strategies, executed at sufficient scale and leverage, could generate systemic risk equivalent to that of major regulated financial institutions while operating outside the regulatory framework that applies to such institutions. The post-1998 regulatory response was limited; the structural issue — that hedge funds could accumulate balance-sheet leverage at scales comparable to investment banks without comparable supervision — remained.

The lesson was eventually re-learned, with substantially larger costs, in the 2008 financial crisis, in which the equivalent role of LTCM was played by the entire shadow banking system simultaneously. The 1998 episode was, in retrospect, the rehearsal. The 2008 episode was, in retrospect, the performance. The shadow-banking question — at what scale and with what regulatory framework should non-bank financial institutions be permitted to operate — remains unresolved, twenty-eight years after LTCM's principals first demonstrated the answer's importance.