Long-Term Capital Management LP

A U.S. hedge fund that became a household name when it collapsed in the fall of 1998. The hedge fund wrongly bet that interest rates would rise. Instead, in August 1998 Russia devalued its ruble and defaulted on some of its debt, which produced a worldwide flight to the safety of the U.S. Treasury bond. As buyers flooded into the market, bond prices increased and interest rates decreased. At the same time, large investors sold risky debt instruments, further depressing prices. Both of those actions were directly counter to Long-Term Capital’s expectations. The hedge fund was founded by two men. John Meriwether was a pioneer of fixed-income arbitrage trading at Salomon Brothers, and was prominently featured in the book, Liar’s Poker. Meriwether was caught in Salomon’s government bond trading scandal in 1991. The other founder was David W. Mullins, Jr., who previously had been named an assistant Treasury secretary in 1988 and afterwards was named vice chairman of the Federal Reserve Board. The fund also had two partners who were Nobel Prize-
winning economists: Myron Scholes and Robert Merton. They won a Nobel Prize for Economics in 1997 for their work on the Black-Scholes options pricing formula.

After the events that devalued the Long-Term Capital Management LP, government officials and the Federal Reserve Bank of New York arranged for a large group of financial institutions to invest $3.5 billion in the fund in order to prevent its losses crippling the financial system. Treasury officials from around the world, however, were afraid that the turmoil would lead to a credit crunch, and as a result many major industrial countries lowered interest rates in a concerted action. In the U.S., the Federal Reserve lowered interest rates three times during the fall of 1998, something that the Fed rarely does with such frequency. One of those reductions even occurred between meetings, which is very uncommon.