1998 LTCM Collapse & Russia Default

Long-Term Capital Management was the most sophisticated hedge fund of its era. Founded in 1994 by Salomon Brothers legend John Meriwether with two Nobel laureates (Myron Scholes and Robert Merton) on the board, LTCM pursued convergence trades, buying cheap securities and shorting expensive ones where academic models suggested prices would converge. Returns were 40% annually with seemingly minimal volatility from 1994 through early 1998. The cracks opened in Russia. Asian Crisis contagion had driven up Russian sovereign yields despite IMF support. On August 17, 1998, Russia devalued the ruble and defaulted on its GKO government bonds, the first major sovereign default in a G20-adjacent economy. Credit spreads globally blew out. LTCM's portfolio of convergence trades all moved the wrong way simultaneously. Leverage amplified the losses catastrophically. By September, LTCM had lost $4.6 billion, consuming 95% of its equity. Counterparty exposure threatened 14 major banks. The New York Fed stepped in. On September 23, 1998, New York Fed President William McDonough convened 14 major Wall Street firms at the Fed's New York headquarters. Over two days, they agreed to inject $3.625 billion in exchange for 90% of LTCM's equity, effectively acquiring the fund to unwind its positions in an orderly manner. This was the first time the Fed had coordinated private bailout of a hedge fund; the moral hazard precedent was explicit. The episode taught durable lessons about hidden leverage, model risk, and systemic importance. LTCM's $1.25 trillion notional derivatives exposure, on $4.7 billion of equity, represented leverage of 250:1 in economic terms. The assumption that uncorrelated trades provided diversification proved false when the same liquidity stress affected all trades simultaneously. Model-driven strategies are only as robust as their assumption that historical correlations persist. The Fed's response confirmed that the financial system had institutions too big to fail beyond just commercial banks. Each subsequent crisis, 2008, 2020, 2023, replayed versions of the LTCM response.