I have to admit I’m a bit vague on the specifics of what happened in the LTCM blow-up. In my mind, it has always been inextricably linked with Russia’s debt default, although this many years later I’m not even sure that LTCM owned any Russian debt. (Maybe LTCM simply owned spread product, which gapped out in general in the wake of Russia’s default.) In any case, the general consensus, at least as I’ve understood things, has been that LTCM had a strategy which worked until it didn’t — that they were picking up small profits and leveraging those into large profits, while leaving themselves open to a large market reversal associated with some kind of event risk.
But here’s Eliezer Yudkowsky:
While LTCM raked in giant profits over its first three years, in 1998 the inefficiences that LTCM were exploiting had started to vanish – other people knew about the trick, so it stopped working.
LTCM refused to lose hope. Addicted to 40% annual returns, they borrowed more and more leverage to exploit tinier and tinier margins. When everything started to go wrong for LTCM, they had equity of $4.72 billion, leverage of $124.5 billion, and derivative positions of $1.25 trillion.
This actually rings much more true to me. The real killer of LTCM was not Russia, it was the fact that their strategies simply weren’t working any more. And that rather than look for other strategies, they reacted by piling on the leverage. Does anybody know if this is true? Did LTCM’s leverage rise sharply in its final year of operation?