When Genius Failed: The Rise and Fall of Long-Term Capital Management
A Froogal Stoodent Review
If you're interested, you can find this book at Amazon.
Fifth in a series of reviews by The Froogal Stoodent
In his book When Genius Failed, author Roger Lowenstein describes, as the subtitle puts it, The Rise and Fall of Long-Term Capital Management.
That means it reads like a novel—but it’s true.
Lowenstein, a veteran financial journalist who spent a decade reporting for The Wall Street Journal, really nails this one. This is a tale of greed, hubris, and the dangerous entanglement of Wall Street banks with an overreaching hedge fund.
It’s also a classic tragedy, wherein the traders’ greatest strength was also their biggest weakness—one that ultimately lead to their downfall.
If you’ve never heard of Long-Term Capital Management, it was a hedge fund that famously blew up in the late 1990s.
Well, what’s so special about that? you might wonder. Aren’t hedge funds—and all companies, in fact—constantly either failing or getting bought out? Like Enron, for example?
Yes…but not every hedge fund has two Nobel laureates as partners!
Long-Term Capital Management, or LTCM, was founded in 1994. As Lowenstein describes them, the founders were an insular clique of ultra-nerds who initially found their way into an arbitrage trading desk at the Salomon Brothers bank in the late 1970s and early 1980s.
What is arbitrage trading? In general, it’s when you take advantage of an opportunity where something is less expensive in one place than in another. Think of a smoker who lives near a state line, and drives to the next state to buy cigarettes because they’re quite a bit cheaper there.
In the case of Salomon’s Fixed Income Arbitrage Group, they were doing something similar with bonds, betting that prices on similar bonds would converge. This mispricing was very slight—rarely more than a couple cents per bond—but if you traded enough of them, you could make millions.
And make millions they did. The group’s successes were so extreme that Salomon Brothers wound up getting most of its profit from the Arbitrage Group’s trades.
Let me repeat that: a leading international bank got most of its profits from the Arbitrage Group’s trades!
In a 1991 scandal involving a rogue government bond trader, Salomon’s CEO was forced to resign. Rising star John Meriwether, the head of Salomon’s Fixed Income Arbitrage Group, was also asked to resign.
Though Meriwether—J.M.—was known as an ethical and buttoned-down manager, he was high-profile and the company needed a high-level person to take the fall (aside from the CEO, I guess). Meriwether, along with most of Salomon’s executives, didn’t believe he had actually done anything wrong, especially since he had immediately reported the situation to his boss. Nonetheless, J.M. got the ax.
A very private person, J.M.’s name was nonetheless splashed on the front pages of newspapers and magazines. That experience may have contributed to LTCM’s notorious culture of secrecy.
With egg on his face from that scandal, J.M. recruited some of his fiercely loyal colleagues from Salomon’s Arbitrage Group to come work for him on a new venture. The long-simmering plan was to re-create the Arbitrage Group, independent of Salomon—or any other institution. That way, the group of nerds had free reign to do as they wished.
The hedge fund got the boring name of Long-Term Capital Management. But their story is, of course, anything but boring.
Remember the aforementioned culture of secrecy at LTCM? It was built in from the very beginning. Though J.M. remained a respected figure on Wall Street, he had trouble raising funds for his new venture, in large part because he refused to reveal any details whatsoever about LTCM’s approach.
Imagine trying to raise over two billion dollars—billion, with a b—without even telling investors what you’re going to do with their money!
Tough sell, right?
Of course it is! At least, until you get a respected economics professor from Harvard and another from Stanford to vouch for you. Robert C. Merton and Myron Scholes, two leading academic economists, became limited partners in the new startup.
And, when LTCM also managed to recruit David W. Mullins Jr., the vice chairman of the U.S. Federal Reserve, that got the firm all the cachet it needed. With that much star power in its corner, LTCM was off to the races.
Earlier, I fibbed a little bit. LTCM didn’t have any Nobel laureates as partners—at least not yet. The academic economists, Merton and Scholes, were recruited before they won the Nobel Prize in economics. But before LTCM’s time was up, the two economists did win the Nobel.
While the initial fundraising didn’t actually reach J.M.’s lofty goal of $2.5 billion, they did manage to raise the not-insignificant sum of $1.25 billion.
And with that, the tale unfolds the only way it can—with extraordinary success, followed by a colossal failure that threatened to take down the entire banking system.
Lowenstein identifies the two main financial sins of the people who ran the doomed hedge fund:
Debt
Ideological prison
Financial Sin Number 1 is fairly straightforward—they used leverage to magnify their gains. For every dollar they actually had, they made $25 worth of trades.
Leverage is like a magnifying glass. When things are going well, you look like a genius! But when things are going poorly, you get wiped out fast enough to make your head spin.
This story illustrates the dangers of leveraged trading. Or leveraged anything. And it’s the main reason why I refuse to consider leveraged mutual funds.
Yes, such funds exist, such as RYTTX (leveraged S&P 500 fund) or DXQLX (leveraged Nasdaq-100 fund). Yes, it’s possible for them to make you wealthier, faster, than an ordinary fund like SPY or QQQ. The emphasis here is on possible—because the other possibility is that these funds will lose value faster than the ordinary index funds as well.
Oh, and the leveraged funds cost you more, too [in the form of a much, much higher expense ratio than the comparable unleveraged funds, like SPY or QQQ].
But even these funds—RYTTX and DXQLX—only have about 2x leverage (that is, they make $2 worth of trades for every $1 they have in actual assets). LTCM had 25x leverage as a major goal. That’s right; 25x leverage was an integral part of their strategy!
Intellectually, and over the very long run, such a strategy actually does make sense. Remember that the bonds they traded would result in small gains of only a few cents, if the trades worked out as expected.
But as many wise investors have observed, and as LTCM discovered the hard way: “the market can stay irrational longer than you can stay solvent.”
If you want to take the Froogal Stoodent’s advice, stay away from leveraged funds. They do have their place in the world, and I’m not trying to say they’re entirely bad. But they’re like planishing hammers: if you have to ask what it is or what it’s good for, you’re not ready for it.
LTCM’s Financial Sin Number 2 is far more interesting, and nuanced. These guys believed so strongly in the efficient market hypothesis that they couldn’t conceive of something that wasn’t included in their statistical model.
Speaking of the statistical model, the fund started operation in 1994. While LTCM included lots of data in their model, including data from bond markets around the world, Lowenstein reports that they somehow didn’t include data from the Black Monday crash in October 1987!
I can’t wrap my head around how these ‘smart’ people neglected to include data from such a massive shock to the economic system…especially when they were working together at Salomon when it happened, just 7 years earlier!
But hey, I’m just not as brilliant as J.M. and his crew…
—
When Genius Failed is absolutely worth a read! It’s well-written, easy to read, and contains extraordinarily valuable lessons. Not just financial lessons; life lessons!
As the story unfolds, you’ll witness the hubris, the short-term thinking, and the greed that afflicted even these brilliant men.
And they were brilliant! Certainly smarter than me, a onetime PhD student in my own right. But in my observations of the world, I’ve found that sheer intelligence is overrated.
Especially when hubris and greed, along with some early success, lead you to think you’re smarter than everybody else. And these dangerous emotions afflict the intelligent just as much as anybody else. Perhaps even more, because brilliant people often seem to think they’re immune to the bad stuff.
But when hubris and greed start to hijack the better judgment of traders and investors, the markets will soon step in and serve up a heaping helping of humble pie.
And that’s exactly what happened to the partners of LTCM.
While tales of this famous flop often conclude with references to the Federal Reserve’s involvement in a bailout, Lowenstein’s book shows that’s a misleading statement.
What actually happened was that the President of the New York Fed summoned the CEOs of the banks that were entangled with LTCM. Many of them—though not all—agreed to put up money themselves to bail out the fund. And, when everything shook itself out over time, each of the 14 banks pretty much broke even.
So, despite the common implication, the Fed was only involved as sort of a host and mediator. Unlike 2009, no taxpayer money was actually involved in the bailout of LTCM.
But it does make you wonder if that event set a dangerous precedent for the Fed…
—
Usually, I do “notes and quotes” for these reviews. I won’t include pithy quotes here, because it isn’t that kind of book. This one flows smoothly, the way many novels do—this style of book is often called “narrative nonfiction.”
No particular quotes really stuck out to me while I was reading When Genius Failed, but as I said above, it’s definitely worth reading.
You can support this blog—at no cost to you—by buying it on Amazon here.
Or, check out my other book reviews in this series:
1. Debt: The First 5000 Years by David Graeber
2. Rich Dad Poor Dad by Robert Kiyosaki
3. The Clash of the Cultures by John C. Bogle
4. Principles (Life and Work) by Ray Dalio
5. When Genius Failed by Roger Lowenstein
6. The Practicing Stoic by Ward Farnsworth
7. Gold: The Once and Future Money by Nathan Lewis
8. The Changing World Order by Ray Dalio
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