In 1998, two crises collided. Russia, struggling after the collapse of the Soviet Union, defaulted on its debt and devalued its currency. On the other side of the world, a hedge fund staffed by famous traders and Nobel Prize-winning economists suddenly found its sophisticated bets collapsing. In Part 13 of Great Financial Crises, we look at Russia's default and the near failure of Long-Term Capital Management (LTCM).
Russia's fragile recovery
After the Soviet Union broke up in 1991, Russia went through a painful transition to a market economy. By the mid-1990s, inflation had come down and foreign investors were buying high-yielding Russian government bonds, known as GKOs.
But problems were growing. Tax collection was weak, budget deficits were large and the government relied on short-term borrowing. Falling oil and commodity prices, along with the Asian crisis in 1997 (Part 12), hurt Russia's export earnings and spooked investors. Interest rates on Russian debt soared.
August 1998: default and devaluation
In August 1998, despite an international support package, Russia devalued the rouble and stopped payments on much of its domestic government debt, declaring a moratorium on some foreign debt payments by banks. The rouble collapsed in the following weeks, inflation surged and several Russian banks failed.
A major government defaulting on debt in its own currency shocked investors. Around the world, they rushed to the safest assets, such as US Treasury bonds, and away from anything risky or hard to sell.
LTCM: the "smartest guys" in finance
Long-Term Capital Management was founded in February 1994 by John Meriwether, a former vice chairman of Salomon Brothers. Its partners included economists Myron Scholes and Robert Merton, who shared the 1997 Nobel Prize in economics for their work on option pricing.
LTCM's main strategy was to find small price differences between similar securities, such as different government bonds, and bet that they would converge. Each trade earned tiny profits, so LTCM used enormous leverage to magnify returns.
According to the Federal Reserve's history essay, it returned 20% in 1994, 43% in 1995, 41% in 1996 and 17% in 1997. At the end of 1997, it had about $30 of debt for every $1 of capital. It even returned capital to investors without reducing its positions, which pushed leverage higher.
When spreads widened instead
LTCM's models assumed that unusual price gaps would narrow over time. After Russia's default, investors fled to safety and the gaps widened sharply instead. LTCM lost 44% of its value in August 1998 alone, according to the Fed's essay.
Because so many banks had lent to LTCM or traded with it, and because its positions were huge, a disorderly collapse risked forcing fire sales across markets.
The rescue
- In mid-September 1998, LTCM informed the Federal Reserve Bank of New York of its problems.
- The New York Fed brought together the fund's major creditors and counterparties.
- A buyout offer led by Warren Buffett's group was not accepted before its deadline.
- On 23 September 1998, fourteen financial firms agreed to invest about $3.6 billion in exchange for 90% ownership of the fund. Two invited firms declined.
The Fed's essay stresses that the Fed brought parties together but did not lend money or put public funds at risk. The partners' stakes were largely wiped out. The consortium was repaid in full by the end of 1999, and the fund was wound down.
The Federal Reserve also cut interest rates three times in autumn 1998 to calm markets.
Why it matters
LTCM showed that a single, highly leveraged private fund could pose a risk to the entire financial system, an issue that became central in 2008. It also exposed the limits of risk models based on historical data, which can fail when markets behave in unusual ways, especially when liquidity disappears.
Critics argued that the Fed's involvement, even without public money, encouraged risk-taking by signalling that big institutions would be rescued, a "moral hazard" concern.
Lessons for investors today
- Leverage turns small losses into disasters. Thin profit margins plus heavy borrowing leave little room for error.
- Models are not reality. Rare events happen more often than many models assume.
- Liquidity can disappear. In a panic, it may be impossible to sell positions at fair prices.
- Brilliance does not guarantee safety. Even Nobel laureates can be undone by overconfidence.
In Part 14, we look at the dot-com bubble, when internet excitement drove the Nasdaq to dizzying heights before a crash.
Sources
- Federal Reserve History – Near Failure of Long-Term Capital Management
- CFA Institute – The untold story of how the financial world almost ended
Great Financial Crises: the full series
- Part 1: Tulip Mania (1637)
- Part 2: The Mississippi and South Sea Bubbles (1720)
- Part 3: The Panic of 1907
- Part 4: The Wall Street Crash and Great Depression
- Part 5: Weimar Hyperinflation (1923)
- Part 6: The 1970s Oil Shocks and Stagflation
- Part 7: The Latin American Debt Crisis (1982)
- Part 8: Black Monday (1987)
- Part 9: Japan's Bubble and Lost Decades
- Part 10: The Savings and Loan Crisis
- Part 11: The Mexican Peso Crisis (1994)
- Part 12: The Asian Financial Crisis (1997)
- Part 13: Russia's Default and LTCM (1998) (you are here)
- Part 14: The Dot-Com Bubble (2000)
- Part 15: Argentina's Collapse (2001)
- Part 16: The Global Financial Crisis (2008)
- Part 17: Iceland's Banking Collapse (2008)
- Part 18: The Eurozone Debt Crisis
- Part 19: The Covid Crash (2020)
- Part 20: The 2023 Banking Turmoil
This series is for education only and is not investment advice. Figures are taken from the sources listed and other commonly cited historical records, and may vary slightly between sources.
