When Genius Failed: The Rise and Fall of Long-Term Capital Management

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When Genius Failed: The Rise and Fall of Long-Term Capital Management

With a new Afterword addressing today’s financial crisis

A BUSINESS WEEK BEST BOOK OF THE YEAR

In this business classic—now with a new Afterword in which the author draws parallels to the recent financial crisis—Roger Lowenstein captures the gripping roller-coaster ride of Long-Term Capital Management. Drawing on confidential internal memos and interviews with dozens of key players, Lowenstein explains not just how the fund made and lost its money but also how the personaliti


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When Genius Failed: The Rise and Fall of Long-Term Capital Management

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3 Responses to “When Genius Failed: The Rise and Fall of Long-Term Capital Management”

  1. reader 1001 says:
    272 of 298 people found the following review helpful
    4.0 out of 5 stars
    The gang that couldn’t hedge stright, October 8, 2000
    By 

    A somewhat didactic narrative history of the hedge fund Long Term Capital Management. Nicholas Dunbar covers the same subject in his book “Inventing Money.” Both books present a blizzard of details about who did what and when. Too much detail. The general reader would better served by a medium sized article. Nevertheless if you’re a finance buff interested in the nitty-gritty then read both books. Dunbar has a physics background and his book is more technical, while Lowenstein comes from journalism and his narrative flows better.

    LCTM began operating in 1994, set up by John Meriwether formally head of the bond-arbitrage group at Solomon Brothers. He put together a star-studded cast that included three (1997) Nobel prize winners in economics. Their basic strategy was something called convergence arbitrage. In essence this strategy says buy two bonds that you think will track one another. Go long on the cheap one and short on the other; you make money if the spread narrows. In theory you are protected from changing prices as long as the two vary in the same way. To make the big bucks LCTM was after they took a gigantic number of highly leveraged arbitrage positions all over the world. To get high leverage you borrow for the position, like buying a stock on margin. LCTM got really high leverage by avoiding something called the “haircut,” which is an extra margin of collateral banks usually demand, but forgave LCTM. Why would banks they do such a thing? Because they were blinded by the glitter of the cast, and in some cases the banks themselves were investors in LCTM. By 1997 convergence arbitrage opportunities in bonds began to dry up, everyone was doing it. So LCTM applied their strategy to stocks. Find two stocks that will track on another and go long and short with borrowed money. This is not easy. Stocks are less amenable to mathematical analysis than bonds, and after all these were the bond guys from Solomon, they were out of their depth. You might ask how can you borrow most of your stock position when the Federal Reserve requires 50% margin (Regulation T). Answer: don’t really buy the stocks, instead buy derivative contracts that simulate stocks, an end run around Regulation T. Even with all this leverage LCTM would claim that the fund was no more risky than the stock market, meaning a stock index. In 1998 the markets went against LCTM, with the “flight to quality” (US government bonds) as investors panicked. The fund suffered from what reliability engineers call “common mode error.” Spreads got wider not narrower across the board, and LCTM’s capital base began to shrink as their positions lost money. At a certain point they would have to start liquidating positions, and the market impact of such large scale selling would cascade across their portfolio. The fund would “blow up.”

    The above gives a flavor of the material Lowenstein provides, only in much greater detail. If that’s what you want, buy the book. Is this a tale of human folly or just plain bad luck? Answering that question is not easy, one needs to grasp a large amount of technical finance theory, and understand what happened in the particular case of LCTM. This book will help.

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  2. O. Buxton "Olly Buxton" says:
    91 of 101 people found the following review helpful
    3.0 out of 5 stars
    Entertaining dose of schadenfreude – but inferior product, May 30, 2003
    By 
    O. Buxton “Olly Buxton” (Highgate, UK) –
    (REAL NAME)
      

    This review is from: When Genius Failed: The Rise and Fall of Long-Term Capital Management (Paperback)

    A couple of years ago I read Nick Dunbar’s account of the LTCM collapse “Inventing Money”, and a friend recently lent me this book. They make an interesting comparison.

    Dunbar – a physicist by trade – is more interested in the theoretical economics that went into the risk arbitrage fund in the first place and how this came unstuck. He gives a long description of the Black-Scholes model, what it says, and how it was used to pull off the risk “free” trades which made Long Term so much money for three or four years.

    Lowenstein, by contrast, barely mentions either the Black-Scholes model (he barely touches on option pricing at all, as a matter of fact) or the Italian convergence trades which eventually blew the gaffe on the fund, but instead tells the human story, exposes the inevitable egos, and indulges in more than a little smuggery (this book is long on wisdom after the fact) in dissecting the naivety of the LTCM hedging and trading strategy and the people who ran it.

    As long as he sticks to the egos and the posturing, When Genius Failed is a dandy read: the negotiations amongst the Wall Street top brass as the fund is going under rate with anything served up in Barbarians at the Gate, and as this is a large part of the book, it rips along quite nicely.

    But the schadenfreude grates: One of the lessons of the whole fiasco was that the smart money is with the guy who can predict the future: any old mug can be a genius with hindsight. Lowenstein spends a lot of his time wisely pointing out what the traders should have done.

    Additionally, Lowenstein employs some metaphors which indicate he might not have much of a grip on his subject: for one, he states “a bit of liquidity greases the wheels of markets; what Greenspan overlooked is that with too much liquidity, the market is apt to skid off the tracks.” It’s a poor metaphor, because it isn’t excess liquidity which causes markets to skid, rather, it’s the sudden disappearance of it. As this is the fundamental lesson of the Long Term story, it’s a bad mistake to make for the sake of a smart-alec aphorism.

    Similarly, in the epilogue states, with regard to the putative diversification in the fund “the Long-Term episode proved that eggs in separate baskets *can* break simultaneously”. Again, this conclusion is not supported by the text, which observes several times that in a market crash, liquidity drains and the correlation risk of instruments in the market goes to one: that is to say, it turns out all your eggs are in the same basket after all. Diversity wasn’t the problem; the problem was you wrongly thought you had it.

    For these reasons I prefer Dunbar’s more academic work: it may not be such a sizzling read, but nor does it misguidedly kick a fund when it’s down.

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  3. Bruce I Jacobs says:
    72 of 82 people found the following review helpful
    5.0 out of 5 stars
    Drama on Wall Street, October 1, 2000
    By 

    In 1994, bond arbitrage guru John Meriwether, late of Salomon Brothers, launched a hedge fund. Its partners included two soon-to-be Nobel laureates and an ex-vice chairman of the Federal Reserve. The fund was to exploit highly quantitative techniques to bet on (primarily) bond spreads throughout the world, using large amounts of leverage to magnify small returns from supposedly low-risk positions. By early 1998, each dollar invested in the fund had grown to $4.11. By early fall 1998, that $4.11 was down to 33 cents. The fund’s potential bankruptcy so threatened the world economy that the U.S. Federal Reserve had to step in to broker a rescue.

    The tale of the rise and fall of Long-Term capital was coming to its end as I was putting to press my own book on option-based trading strategies and their effects on market volatility (Capital Ideas and Market Realities). The whole adventure constituted a perfect capstone to my story, which goes back to the crash of 1929, showing how strategies that purport to eliminate the risk of investing can end up exploding in the face of their followers and investors generally.

    Now Roger Lowenstein, formerly a journalist at the Wall Street Journal and author of a biography on Warren Buffett, has devoted a whole book to LTC. Drawing largely on contemporaneous reporting and on his own personal interviews with many of the principal and supporting players (although not, alas, Meriwether himself), Lowenstein manages to create a real page-turner out of the unfolding events, even for readers who already know the ultimate outcome.

    Part of the tension, it seems to this reader, stems from the unresolved (and probably unresolvable) ambiguity about the real nature of the story. On the one hand, it seems to play out as a classic tragedy: Its larger-than-life protagonists hubristically pit themselves against the gods of the marketplace and fall hard. Certainly, for many of the players involved, it was a tragedy. Meriwether not only lost his money but his reputation. Nobel laureates Robert Merton and Myron Scholes found their lives’ works on modern finance theory rocked to the core. Many of those instrumental in engineering LTC’s rescue (including Goldman Sachs’ Jon Corzine) ended up subsequently losing their own jobs. LTC’s employees, who had been encouraged to invest their bonuses from the firm’s fat years back into the firm itself, lost it all when the firm collapsed; nor did they get the $500,000 bonuses secured by the LTC partners as part of the bailout package.

    On the other hand, one can also view the whole affair as great comedy (especially if one is on the outside looking in). After all, a scene with 140 lawyers in one room is worthy of the Marx brothers. Then you have the Fed descending, at the eleventh hour, like some deus ex machina, to restore order and stability; not to mention Wall Street’s viciously competitive masters of the universe gathered on folding metal chairs around the New York Fed’s boardroom table, trying to rescue the world from themselves. Even LTC’s partners bounce back. Meriwether (J.M. to friends, and throughout the book) starts a new hedge fund, bringing in several old LTC colleagues. Merton and Scholes are still teaching and consulting. A week after LTC was bailed out, many of the principals gather at the Pierre Hotel in New York to celebrate Scholes’ remarriage; a wedding, of course, is the classic comedic emblem of reconciliation and renewal.

    The vibrancy of any play, whether comedy or tragedy, often rests on the quality of its villains. Lowenstein singles out a few individuals for special opprobrium. These include Victor Haghani and Lawrence Hilibrand, who basically ran LTC’s trades and pushed the firm into ever larger, more highly leveraged positions, and into areas such as merger arbitrage in which the firm had no demonstrated expertise. Hilibrand comes across in a particularly bad light, especially when he shows up at the bailout negotiations with his own private lawyer and threatens to derail the whole process because “there was nothing in it for him.”

    The person one might expect to hold the center of the story, J.M. himself, plays a strangely muted role. Lowenstein describes him as “an unlikely star, too bashful for the limelight.” Even his contributions in furtherance of LTC’s eventual downfall seem to be more sins of omission than sins of commission. That is, he failed to rein in his uber traders, Haghani and Hilibrand, and he failed to heed the warnings of his more temperate (and, as it turned out, more realistic) colleagues. Of course, J.M. did set the tone for the firm-the air of infallibility that was to prove its downfall.

    The book emphasizes how LTC’s greed, arrogance and even foolhardiness made it susceptible to a market crisis. But was this crisis purely a result of exogenous events, such as the turmoil in Asia and Russia, as Lowenstein suggests? If so, how did these troubles overwhelm markets in fundamentally sound Western…

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