In 1998, the smartest traders on Wall Street ran the most sophisticated hedge fund ever built.
Long-Term Capital Management was the stuff of legend…
Nobel Prize winners. Ex-Fed vice chairman. ½ of the guys who literally built the Black-Scholes model that every option trader uses today.
And they started with a track record that made other fund managers green with envy.
In 1995, their first full year in business… they posted returns of 59%.
What’s more, they did this trading bonds… a market that was actually negative on the year.
They were well on their way to becoming the greatest bond fund in history…
Except that returns can be deceiving….
Their actual investment returns in 1995 were just 2.45%. The other 57 percentage points came entirely from borrowed money.
Because they were running leverage of 25 to 1, meaning for every $1 of their own capital, they had borrowed $24 more to bet with.
The strategy made perfect sense on paper. The price gaps between the bonds they were buying and selling were tiny… we’re talking fractions of a percentage point.
You can't build a business on those tiny wins, not even at their scale.
So they borrowed, and borrowed and borrowed, until those tiny gaps turned into enormous profits.
Like a child on a seesaw who can lift a grown adult if the plank is long enough, leverage let them move weights far beyond their own strength.
And for a few years, it worked.
The problem with a seesaw is what happens when someone jumps off the other end.
And in the summer of 1998, Russia defaulted on its debt.
The bonds LTCM had carefully… mathematically… Nobel-Prize-winningly assumed would converge... didn't converge.
In fact, the opposite happened… they diverged.
And because LTCM had borrowed so much money to make those bets, losses that would have been painful at 1x became catastrophic at 25x.
Wiping the fund out, and almost causing a 2008-style event to occur 10 years early.
Bcause when a leveraged trade goes wrong - you don't get the luxury of waiting it out.
If you own shares in a company and the price drops 30%, you can sit on your hands. You're still the owner. The position is yours for as long as you want to hold it.
But when you've borrowed money to buy those shares, your lender doesn't care about your long-term thesis. They care about getting their money back.
So they force you to sell… usually at exactly the wrong moment, when prices are already in freefall.
This is the hidden cost of leverage that nobody explains clearly enough. It's not just that your losses are bigger. It's that you lose control of when you exit. An unlevered investor who holds through a crash can recover. Whereas a levered investor who gets margin called at the bottom cannot.
Remember, LTCM's founders were not stupid people.
They were arguably the most credentialed investment team ever assembled.
But the leverage they used meant that when they were wrong (and eventually, everyone is wrong in this game) yet there was no margin for error.
A 2.45% return amplified to 59%, and losses that might have been survivable at normal size became an existential crisis at 25x.
The Federal Reserve had to organize a $3.6 billion bailout from 14 banks to prevent the fund's collapse from cascading through global markets.
All from borrowing too much to exploit price gaps measured in fractions of a percent.
The lesson isn't that leverage is always bad. Used carefully, in the right context, it can be a legitimate tool.
But the seesaw works both ways. And the heavier the weight on the other end, the harder the fall when you lose your balance.
Oliver
P.S.