Long-Term Capital Management

Long-Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether, a former Salomon Brothers bond trader, with a team that included two Nobel laureates in economics — Myron Scholes and Robert Merton. The fund specialized in convergence arbitrage: identifying small price discrepancies between closely related securities and betting that the discrepancy would vanish. With enormous leverage — ratios exceeding 25:1 — LTCM turned small spreads into apparently spectacular returns.

The fund collapsed in 1998, not because its models were wrong about the convergence of individual trades, but because its models were blind to the network. When Russia defaulted on its debt in August 1998, global investors fled to quality simultaneously, causing the very spreads LTCM had bet against to widen dramatically. What the VaR models missed was correlation breakdown: in crises, historically uncorrelated assets become perfectly correlated as everyone rushes for the same exit. LTCM's positions, dispersed across bond markets worldwide, were suddenly a single concentrated bet on the availability of risk appetite.

The Federal Reserve orchestrated a bailout not to save LTCM but to prevent the cascading failures of its counterparties — a preview of 2008 in miniature. LTCM is the Rosetta Stone of modern financial crises: it demonstrated that sophistication in modeling individual positions is no defense against ignorance of network topology.