Hedge Fund Crisis and Financial Contagion

Abstract

This article examines the spillover effects of the collapse and bailout of Long-Term Capital Management (LTCM) on the stocks of a large sample of exposed and unexposed banks and brokerage houses to search for evidence of financial contagion. The basic finding is that the LTCM crisis led to widespread losses for financial institutions, including even regional and local banks and those with no known exposure to hedge funds. However, after controlling for characteristics that influence firms' vulnerability to an exogenous economic shock, the authors find that the unexposed banks and brokerage houses remain virtually unscathed by the crisis. Hence, the results suggest that the market response to the financial turmoil at LTCM was rational, and the crisis only affected firms with exposure to hedge fund activities.