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When Genius Failed: The Rise and Fall of Long-Term Capital Managementx$8.07
  (206 reviews)
Best Price: $8.07
John Meriwether, a famously successful Wall Street trader, spent the 1980s as a partner at Salomon Brothers, establishing the best--and the brainiest--bond arbitrage group in the world. A mysterious and shy midwesterner, he knitted together a group of Ph.D.-certified arbitrageurs who rewarded him with filial devotion and fabulous profits. Then, in 1991, in the wake of a scandal involving one of his traders, Meriwether abruptly resigned. For two years, his fiercely loyal team--convinced that the chief had been unfairly victimized--plotted their boss's return. Then, in 1993, Meriwether made a historic offer. He gathered together his former disciples and a handful of supereconomists from academia and proposed that they become partners in a new hedge fund different from any Wall Street had ever seen. And so Long-Term Capital Management was born. In a decade that had seen the longest and most rewarding bull market in history, hedge funds were the ne plus ultra of investments: discreet, private clubs limited to those rich enough to pony up millions. They promised that the investors' money would be placed in a variety of trades simultaneously--a "hedging" strategy designed to minimize the possibility of loss. At Long-Term, Meriwether & Co. truly believed that their finely tuned computer models had tamed the genie of risk, and would allow them to bet on the future with near mathematical certainty. And thanks to their cast--which included a pair of future Nobel Prize winners--investors believed them. From the moment Long-Term opened their offices in posh Greenwich, Connecticut, miles from the pandemonium of Wall Street, it was clear that this would be a hedge fund apart from all others. Though they viewed the big Wall Street investment banks with disdain, so great was Long-Term's aura that these very banks lined up to provide the firm with financing, and on the very sweetest of terms. So self-certain were Long-Term's traders that they borrowed with little concern about the leverage. At first, Long-Term's models stayed on script, and this new gold standard in hedge funds boasted such incredible returns that private investors and even central banks clamored to invest more money. It seemed the geniuses in Greenwich couldn't lose. Four years later, when a default in Russia set off a global storm that Long-Term's models hadn't anticipated, its supposedly safe portfolios imploded. In five weeks, the professors went from mega-rich geniuses to discredited failures. With the firm about to go under, its staggering $100 billion balance sheet threatened to drag down markets around the world. At the eleventh hour, fearing that the financial system of the world was in peril, the Federal Reserve Bank hastily summoned Wall Street's leading banks to underwrite a bailout. Roger Lowenstein, the bestselling author of Buffett, captures Long-Term's roller-coaster ride in gripping detail. Drawing on confidential internal memos and interviews with dozens of key players, Lowenstein crafts a story that reads like a first-rate thriller from beginning to end. He explains not just how the fund made and lost its money, but what it was about the personalities of Long-Term's partners, the arrogance of their mathematical certainties, and the late-nineties culture of Wall Street that made it all possible. When Genius Failed is the cautionary financial tale of our time, the gripping saga of what happened when an elite group of investors believed they could actually deconstruct risk and use virtually limitless leverage to create limitless wealth. In Roger Lowenstein's hands, it is a brilliant tale peppered with fast money, vivid characters, and high drama. On September 23, 1998, the boardroom of the New York Fed was a tense place. Around the table sat the heads of every major Wall Street bank, the chairman of the New York Stock Exchange, and representatives from numerous European banks, each of whom had been summoned to discuss a highly unusual prospect: rescuing what had, until then, been the envy of them all, the extraordinarily successful bond-trading firm of Long-Term Capital Management. Roger Lowenstein's When Genius Failed is the gripping story of the Fed's unprecedented move, the incredible heights reached by LTCM, and the firm's eventual dramatic demise. Lowenstein, a financial journalist and author of Buffett: The Making of an American Capitalist, examines the personalities, academic experts, and professional relationships at LTCM and uncovers the layers of numbers behind its roller-coaster ride with the precision of a skilled surgeon. The fund's enigmatic founder, John Meriwether, spent almost 20 years at Salomon Brothers, where he formed its renowned Arbitrage Group by hiring academia's top financial economists. Though Meriwether left Salomon under a cloud of the SEC's wrath, he leapt into his next venture with ease and enticed most of his former Salomon hires--and eventually even David Mullins, the former vice chairman of the U.S. Federal Reserve--to join him in starting a hedge fund that would beat all hedge funds. LTCM began trading in 1994, after completing a road show that, despite the Ph.D.-touting partners' lack of social skills and their disdainful condescension of potential investors who couldn't rise to their intellectual level, netted a whopping $1.25 billion. The fund would seek to earn a tiny spread on thousands of trades, "as if it were vacuuming nickels that others couldn't see," in the words of one of its Nobel laureate partners, Myron Scholes. And nickels it found. In its first two years, LTCM earned $1.6 billion, profits that exceeded 40 percent even after the partners' hefty cuts. By the spring of 1996, it was holding $140 billion in assets. But the end was soon in sight, and Lowenstein's detailed account of each successively worse month of 1998, culminating in a disastrous August and the partners' subsequent panicked moves, is riveting. The arbitrageur's world is a complicated one, and it might have served Lowenstein well to slow down and explain in greater detail the complex terms of the more exotic species of investment flora that cram the book's pages. However, much of the intrigue of the Long-Term story lies in its dizzying pace (not to mention the dizzying amounts of money won and lost in the fund's short lifespan). Lowenstein's smooth, conversational but equally urgent tone carries it along well. The book is a compelling read for those who've always wondered what lay behind the Fed's controversial involvement with the LTCM hedge-fund debacle. --S. Ketchum
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Customer Reviews
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The gang that couldn't hedge stright
By A21PREXEN6AEXS on 2000-10-08
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.
When Authors Fail
By A3B2RLCI84S2TP on 2000-11-21
Roger Lowenstein's book is a lie and should be avoided. The quality of the story is comparable to the book F.I.A.S.C.O. another lie. Lowenstein's writing is typical of the hatchet job on Wall Street that ignorant journalists frequent dump on the public. His style resembles the movie making method of Oliver Stone who is very adept at weaving lies with reality to make a dishonest point. The point of Roger's book is that derivatives cause volatility and leverage with derivatives cause financial meltdowns. LTCM is the extreme example of this pattern and causality. To argue this point is to have a politically incorrect viewpoint. But Roger is clueless. Roger's description of how financial mathematics is used on Wall Street is wrong. He injects strange normative statements into his discussions, for example describing The University of Chicago's Graduate School of Business in the 1960s and 1970s as a "cauldron of neoconservative ferment" (page 34) as if financial mathematics is some kind of political or economic opinion. If using mathematics to price options is an economic opinion, let's see Roger buy and sell plain vanilla call options without the Black-Scholes model. Also, Roger is ignorant of the structure of basic financial instruments. While he describes swaps and options, the way he uses the term derivative indicates he does not have any idea how they are different. And while he believes derivatives can cause a financial meltdown he does not describe in any sensible way how it happens. Contrary to the theme of his book, Long Term Capital Management's story is a shining vindication of the robustness of mathematics in finance. Roger shows how much leverage and hubris is necessary to destroy finely applied mathematical tools. LTCM did make a lot of money before ratcheting up the leverage that blew them up. Only after taking leverage to the unique extreme experienced only by Jack Walsh's Kidder Peabody did LTCM disintegrate. LTCM's mistake was taking on positions when no opportunities were presented. If LTCM had made their capital liquid in early 1998 waiting for arbitrage opportunities, imagine what could have been their profitability with idle capital ready to position after the Russian debt debacle. LTCM's mistake was not with using mathematics to make position decisions. LTCM's mistake was hubris, a lack of patience and bad business judgment, very human qualities that not mathematical. Don't bother with How Genius Fails. Instead read Nicholas Dunbar's book Inventing Money. Inventing Money is a much better book about financial mathematics and LTCM. And it is honest.
Logicians Snared in their Lair
By A23SB6VGGB9E8U on 2001-07-17
By now Long-Term Capital Management's tale is well known. A group of hot bond arbitrage traders joined forces with a pair of future Nobel Prize winning academics to form a hedge fund that promised it had conquered the ogre of risk. As profits grew, greedy bankers and brokers stood in line to provide financing on the finest of terms. Yet, like other speculators before them, they failed. The markets, as G. K. Chesterton wrote, lay "a trap for logicians . . .. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait." While the hedge fund's history is familiar, Lowenstein's conclusions are worthy of examination by both historians and investors. 1. Long-Term Capital Management's (LTCM) profits look less impressive in light of the losses that followed. The "profits" used by bankers and brokers to justify their loans and investments in the fund were not "earned", merely borrowed against the day the tide turned. 2. LTCM saw the cycle was turning, yet refused to limit its exposure. As spreads markets withered, the partners opted to increase their leverage to maintain returns. 3. The fund had faith in diversification. Its history serves as ample notification that eggs in different baskets can and do all break at the same time. 4. One can be big - read illiquid; one can be leveraged, but to be both is begging for trouble. No one can be right every trading day. 5. Traders are not computer chips. They are motivated by emotions; they run in herds, they retreat in hordes. Uncertainty will never conform itself to a numeric straitjacket despite the risk defining desires of the academic community. This book tells a timeless tale. Markets are cunning animals, there to exploit investors' mistakes and hubris.
Drama on Wall Street
By A1A1CWVBNU0YE7 on 2000-10-02
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 economies? In my opinion, the book lets LTC off the hook in failing to explain how the very strategies it followed helped to create the perfect storm that ended up swamping the firm. The argument in my book, based on decades of debate with options experts in the industry and in academia, is that LTC provides yet another illustration of the market's susceptibility to certain large-scale trading strategies. These strategies tend to attract a lot of capital because they appear to offer a haven from the vicissitudes of market risk; given leverage and derivatives, they can command hundreds of billions (even trillions) of dollars of assets. Under adverse market conditions, however, the "rules" of these strategies call for dumping all these assets on the market-all at once. We saw this in the crash of 1987, and again in the turbulence of 1989, 1991,1994 and 1997. All in all, however, When Genius Failed is a classic tale of greed and fear on Wall Street. Lowenstein tells it well, especially in the later chapters, which give readers a blow-by-blow account of the bailout negotiations. What's more, he brings out the story's particular pertinence for today's investors: Even with all the brains and all the computers in the world, investors can't control, let alone predict, human nature. Bruce I. Jacobs (cimr@jlem.com), Principal, Jacobs Levy Equity Management, and author of Capital Ideas and Market Realities (Blackwell, 1999)
Stalled Thinking by Geniuses Leads to Staggering Losses!
By A1K1JW1C5CUSUZ on 2000-09-24
There's an old saying to the effect that every army prepares to fight the last war, rather than the next one. In financial circles, the equivalent is to create models that optimize decisions in light of the history of financial markets. That is great, as long as the future is like the past. As soon as the future becomes different, this 'rear-view mirror' vision of the future can create terrible crashes. That's what happened with Long Term Capital Management (LTCM). The cost was almost a meltdown in the financial markets around the world. This cautionary tale should stand as a warning to regulators, investors, academicians, and traders about avoiding the same mistakes in the future. One particular reason to be so concerned is that John Meriwether and his crew of geniuses were back in business as of 1999, as reported by the book (apparently with some of the same investors as in LTCM).You may recall that Mr. Meriwether appeared in the book, Liar's Poker, by challenging John Gutfreund, CEO of Salomon Brothers, to one hand of liar's poker for ten million dollars. Mr. Gutfreund correctly declined, but lost face. Mr. Meriwether later had to leave Salomon Brothers after the firm was found to have failed to notify the Federal Reserve promptly after discovering that it had been violating rules on bidding for government securities. In this book, you will learn more about Mr. Meriwether and his love of brilliant people, betting on everything in sight, and taking outside bets when the odds seemed to be in his favor. This approach can work well when the odds can be known, but that is not the case in the financial markets. Mr. Meriwether did not make himself available to the author. Roger Lowenstein is our most talented financial writer (you may remember him from his days at The Wall Street Journal and for his wonderful biography on Warren Buffett), and he has produced an outstanding work that will be a cautionary tale for future generations about the financial myopia of the 1990s. Long Term Capital Management was built around consensus in the financial markets. The firm attracted the thinkers in the financial markets with the greatest reputations (including future Nobel Prize laureates, Robert Merton and Myron Scholes -- of Black-Scholes option pricing fame, and the top talent from the arbitrage area at Salomon Brothers), a top regulator (the vice-chairman of the Federal Reserve Board), famous investors from the top investment banks and consulting firms, and lines of credit from every major financial institution in these markets. The firm planned to invest by finding small mispricings of one security versus another (such as the interest rate on one bond maturity versus another compared to history, an option versus the underlying stock for the time remaining on the option, a bond yield in a foreign currency versus the currency futures, and the price of a stock versus a hostile takeover bid price for the company). Here, it hoped to proverbally make lots of nickels by borrowing lots of money to make these trades. Although other firms took similar risks (and many also took enormous losses in 1998), LTCM stood out for two things: It had no independent evaluation of its risk to control what it was doing (the traders monitored themselves -- a little like letting the fox guard the hen house) and it took on vastly more debt than others did compared to its equity base. At the firm's peak, it had borrowed over $100 billion against a base of $4 billion in equity and had derivative (option) positions for an exposure of another $1 trillion. This enormous finanical leverage magnified the size of any gains or losses it took. Part of what had been deceptive is that the firm had been regularly and spectacularly profitably for most of its initial four years. What the firm had neglected was to consider what might happen to historical price differentials in a market crisis (particularly a 'stress-loss liquidation'). In 1998, an unprecedented financial crisis occurred following the Asian meltdown and Russia's refusal to pay its debt. In the panic that followed, there were many sellers and few buyers. Tens of billions evaporated quickly in these abritrage trades. LTCM moved slowly to unwind the trades, believing that things would come back to normal. Soon, it was too late, and the New York Federal Reserve supported a shotgun wedding of the firms that would lose the most if LTCM died to put another $4 billion in the firm until it could be wound down. The aftermath was not much fun for anyone. Mr. Lowenstein does an excellent job of describing what occurred at the level of a college-level course in finance. If you have a higher level of knowledge than that about trading, you can skip most the explanation of what happened and why. The crash exposed several major weaknesses in the financial system. One, the lenders were too lax. Two, the risk review of the firm was essentially nonexistent, although it reported risk levels monthly (apparently based on incorrect assumptions). Three, the Federal Reserve doesn't know what goes on with hedge funds, until they are about to blow up the financial markets. Four, Wall Street goes along with reputations more than due diligence. Five, excess risk compared to current market conditions creates excess losses. Six, modeling historical trends is a dangerous way to make money unless you use small amounts of leverage to hedge against the risk of unexpected market volatility. After reading this interesting book, I hope you will also ask yourself if you know what the risk level is with your financial investments for the current market. If you don't know, I hope you will quickly find out. And have your testing done against the potential risk of something extreme happening, not just with history. Certainly, the 80-90 percent losses that many Internet stocks have suffered in the last year or so should be an indication of how much risk can occur even in a successful industry. Good luck with avoiding large losses in pursuing financial gains!
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