From Kimberly Amadeo,
Your Guide to US Economy.
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A. Long-Term Capital Management (LTCM) was a very large hedge fund ($126 billion in assets) that nearly collapsed in late 1998. Like many hedge funds, its investment strategies were based on a fairly regular range of volatility in foreign currencies and bonds. When Russia declared it was devaluing its currency and basically defaulting on its bonds, it moved beyond the regular range that LTCM had counted on. In response, the U.S. stock market dropped 20%, while European markets fell 35%. Investors sought refuge in Treasury bonds, causing interest rates to drop by over a full point.

As a result, LTCM’s higly leveraged investments started to crumble. By the end of August 1998, it lost 50% of the value of its capital investments. Since so many banks and pension funds were invested in LTCM, its problems threatened to push most of them to near bankruptcy.

To save the U.S. banking system, then-Federal Reserve Chairman Alan Greenspan personally convinced 14 banks to remain invested in the hedge fund, averting disaster. In addition, the Fed started lowering the Fed Funds rate as a reassurance to investors that the Fed would do whatever it took to support the U.S. economy. Without such direct intervention, the entire financial system was threatened with a collapse.

There is growing concern that the large role of hedge funds in today’s markets could cause a repeat of that panic. However, the September 2006 financial distress of Amaranth Advisors, a fund nearly twice the size of LTCM, had little effect on global stock markets. (Source: IMF, World Economic Outlook, Interim Assessment, "Chapter III: Turbulence in Mature Financial Markets” December 1998; IMF Report: "International Contagion Effects from the Russian Crisis and the LTCM Near-Collapse”, April 2002; European Central Bank, “Financial Stability Report” December, 2006.)

Hedge Funds FAQ

• What Are Hedge Funds?
• Who Invests in Hedge Funds?
• How Do Hedge Funds Impact the Stock Market?
• How Do Hedge Funds Impact the Economy?
• What Was the LTCM Hedge Fund Crisis?