"Long-Term Capital Management collapsed in 1998 because its Nobel-laureate-designed models assumed asset returns were normally distributed and that correlations were stable. Both assumptions were wrong. The fund lost $4.6 billion in four months and required a Federal Reserve-orchestrated bailout."
The Setup
Long-Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether (former vice-chairman of Salomon Brothers' bond-trading desk) and staffed with academic stars including Myron Scholes and Robert Merton — both Nobel laureates in economics for their work on options pricing. The fund's strategy was 'convergence trading': identifying small price discrepancies between similar bonds and betting that the discrepancies would shrink over time.
The discrepancies were small, so LTCM used massive leverage — borrowing roughly 25 to 30 dollars for every dollar of equity. Small price moves on the underlying bonds, multiplied by that leverage, produced healthy returns. In its first three years the fund returned more than 20% per year after fees.
The Statistical Foundation
LTCM's risk models, built on standard quantitative finance principles, assumed that bond-yield spreads were approximately normally distributed and that correlations between asset classes were stable. Under these assumptions, the leverage was supposedly safe: even a 'large' move (say, 5σ under normality) would only happen with vanishing probability, and the fund had set aside enough capital to weather it.
The assumption was wrong in two ways that compounded. First, bond-yield spreads have fat tails — large moves happen more often than the normal predicts. Second, correlations between asset classes are not stable; under stress, they converge toward 1 (everything sells together). The fund's risk model treated these two preconditions as if they were satisfied. Both were silently violated, and the consequences were waiting.
What Happened in 1998
In August 1998, Russia defaulted on its government debt. The default itself was a moderate-size event by historical standards, but it triggered a global flight to quality: investors dumped risky assets and bought safe ones (US Treasuries and German Bunds), causing the bond spreads LTCM was betting on to widen dramatically rather than converge. Worse, the correlations the model had assumed were stable spiked toward 1; every position LTCM held started losing money simultaneously.
Within a few weeks, LTCM had lost more than $4 billion. Because of the leverage, the losses were many multiples of the fund's actual capital. The Federal Reserve organized a $3.6 billion bailout among 14 major banks to prevent LTCM's forced liquidation from cascading through the financial system. The fund was wound down over the following year.