From 1994 to 1996, LTCM were extremely successful during the first couple years. In 1994, it earned 28% after fees in 10 months. The strategy worked excellently for LTCM in 1995 and 1996, it produced 43% and 41% return on equity and had amassed an investment capital of $7.5 billion. LTCM placed large bets on convergence of European interest rates within the European Monetary System.
By 1997, since the European common currency, the Euro, was going to be issued in January 1999, the credit spreads between European countries were going to narrow down and were considered to be lower than the average over the period 1986 to1993. Convergence trades became less profitable. LTCM’ return obviously shrunk to only 19%. At the same time, the return of U.S stocks gained 33%. People became less interested in LTCM because it had same risk level as equities but lower return.
At end of 1997, in order to achieve the higher returns again, Meriwether retuned about $2.7 billion capital to investors while keeping total assets at $125 billion. He tried to increase the returns to investors that remained in the fund by cutting down the capital base and raising the leverage ratio, which also increased the risks.
In May and June of 1998, since the downturn in the mortgage-backed securities market, the value of equity went down by 16%, which led to a big drop in LTCM's capital from $4.7 to $4.0 billion. The trouble began from here.
On August 17th 1998, Russia government devalued the ruble and announced a moratorium on 281