Explain the three major catalysts that caused LTCM to fail

Question

What will be an ideal response?

Answer 1

LTCM failed because of a chain reaction involving three major catalysts: exogenous macroeconomic shocks, endogenous, hedge-fund-related reactions, and feedback effects that jeopardized LTCM's creditworthiness and threatened its sources of financing.
Exogenous shocks: Widening yield spreads because of the Asian Tiger crisis (1997), Russian Ruble crisis (1998), and other economic and political unrest (e.g., China, Indonesia, and Iraq).
Endogenous shocks: Market spreads moved chaotically, causing LTCM's principal measure of risk (i.e., Value at Risk) to underestimate the company's exposures. These movements were mainly the result of other hedge funds that replicated LTCM's portfolio being forced to sell their asset positions to improve liquidity and reduce exposures. The forced liquidations caused spreads to move dramatically against LTCM. In June and July of 1998, Salomon Brothers also began to liquidate its proprietary bond arbitrage business, also causing spreads to move disadvantageously.
Feedback shocks: LTCM's counterparties tried to protect themselves, causing market liquidity to evaporate. Many of LTCM's counterparties aggressively marked positions to market in an attempt to recover what they could from LTCM before it failed. This aggressive mark-to-market pricing caused a systematic decline in LTCM's net asset value for virtually every position in its portfolio. LTCM was also threatened with the loss of its clearing agent. Because of LTCM's secrecy regarding its positions, many counterparties looked at only their small part of LTCM's world and, therefore, did not realize that LTCM's overall level of risk was much lower than the sum of the individual exposures. Finally, rumors of LTCM's failure caused some counterparties to worry about the venue for the bankruptcy proceedings and their post-failure rights.