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When Genius Failed: The Rise and Fall of Long-Term Capital Management (Paperback)
by Roger Lowenstein
| Category:
Hedge fund, Bond trading, Greed, Risk, Financial markets |
| Market price: ¥ 168.00
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¥ 138.00
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 Good for Gifts |
| MSL Pointer Review:
An excellent engrossing story of finance, greed and ego and a riveting account of the life and death of a business in a tragical way. |
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Author: Roger Lowenstein
Publisher: Random House Trade Paperbacks
Pub. in: October, 2001
ISBN: 0375758259
Pages: 288
Measurements: 8.0 x 5.2 x 0.7 inches
Origin of product: USA
Order code: BA00091
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- Awards & Credential -
National Bestseller (in North America) ranking #991 in books on Amazon.com as of December 24, 2006. |
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- MSL Picks -
There are great lessons for all of us to take from the story of Long-Term Capital Management ("LTCM"). This is a great read for anyone interested in timeless human lessons in arrogance. It's a story about how rationality can lose out to ego and pride. It's a story about knowing your weaknesses. It's a story about how smart people can be blinded by the supposed "genius" of others. And it's a reminder that we are never as smart as we think we are.
But most of all this is a story about human fallibility and although all the action takes place in the world of finance there are plenty of good lessons for people from all walks of life to take from this saga.
By now the story of LTCM is well known. In 1991 John Meriwether (or JM, as he was known to his friends and as Lowenstein refers to him in the book) headed up the fixed income desk at Salomon Brothers and is credited with making that bank millions upon million of dollars in bond trading and mortgage backed securities. Unfortunately for him, he was caught up in a nasty little problem caused by one of his traders who falsified a US treasury bill bid. In the fall out that followed he was forced out.
Not content to sit on his millions, JM took a handful of his trusted master traders and set up a hedge fund - LTCM. LTCM was to be no ordinary hedge fund. Not only did JW recruit his trusted and proven traders from Salomon Brothers - traders who all had big reputations for making money and being successful in the bond markets - but he also managed to recruit Robert Merton and Myron Scholes to his team. During the life of LTCM, Merton and Scholes shared the Nobel Prize in economics. They are still considered to be two of the founders of modern finance theory and have stellar academic reputations. Not content to stop there, JM also recruited David Mullins to the LTCM team. Mullins was the then vice chairman of the US Federal Reserve.
In the first few years LTCM was tremendously successful and made huge (and I mean HUGE) amounts of money for its investors and for its partners and staff.
Lowenstein does an excellent job of describing these early days at LTCM. And it is a compelling story - JM, feeling that his reputation is tarnished by the scandal at Salomon Brothers, recruits a bunch of hotshot traders, a few academics and a regulator, sets up a brand new monster hedge fund and proceeds to make more money than anyone dreamed was possible. I'm sure that he was feeling pretty happy with himself about then.
Lowenstein also does a reasonable job of explaining the trading strategies of LTCM but he does sacrifice much of the detail in order to tell the human story (he is, after all, a journalist by trade). Lowenstein never really fully explains the "volatility" trades made by LTCM and also glosses over some of the more "vanilla" trading strategies. For example, he never really explains what derivatives actually are or how a basic swap actually works. If you have an interest in the nitty-gritty trading strategies then you would be better off reading Inventing Money by Nicholas Dunbar. However, if your eyes start to glaze over at the mention of derivatives and bond arbitrage or if you aren't really that interested in that side of things and only want a general feel for what was going on, then this will be the better book for you as the focus is more on the human story.
Perhaps the important things to note about LTCM's strategy are:
(1) that the background of the LTCM traders was in bonds - and more specifically bond arbitrage. This is what they knew and this is what they were very, very good at; and
(2) LTCM used large amounts of leverage. For every dollar that an investor gave them to invest, they went out and borrowed another 30 dollars (sometimes more) and then invested the lot. This leverage greatly enhanced LTCM's profits when things went right (i.e. the first few years), but obviously exposed them (and their lenders) to huge losses if things went wrong (as they did at the end).
In a sense LTCM was a victim of its own success. Flush with huge amounts of money to invest, LTCM ran out of investments to make. It exhausted all of the possible trading strategies in its area of expertise. A little under a year before things all went wrong, LTCM even returned some capital to its original investors on the basis that it couldn't find enough places to invest it. At the time these investors were most unhappy as they were very satisfied with the returns they had been earning.
By now the LTCM traders really thought they were the masters of the universe. They thought they could do no wrong. They started to branch out into other areas of trading such as equity trading (including volatility bets), emerging markets, yield curve arbitrage and even straight directional trades. In other words, they didn't stick to what they knew best.
In 1998 things went to custard for them. Asian currencies went bad. Russia defaulted on some bonds and share markets took a bit of a tumble. But what also happened, and what LTCM had not expected to happen, was that there was a general flight to quality and a lack of liquidity in ALL markets. What the master traders had not banked on was that in times of real crisis, all markets are correlated and, in particular, the risk across all markets is correlated.
As LTCM's positions in the market were so large, they could not find anyone to buy them - there was no liquidity. They were stuck with their book - and that was not a good thing.
I won't ruin the punch-line, but I will say this about Lowenstein's book:
1. it's a rollicking good read; and 2. you don't have to work in financial markets to appreciate the timeless human lessons it contains.
(From quoting Paul Gargan, UK)
Target readers:
MBAs, finance majors, and anyone else who is interested in M & A, LBO, investment banking, the Wall Street, and financial markets.
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Roger Lowenstein, author of the bestselling Buffett: The Making of an American Capitalist, reported for The Wall Street Journal for more than a decade, and wrote the Journal's stock market column "Heard on the Street" from 1989 to 1991 and the "Intrinsic Value" column from 1995 to 1997. He now writes a column in Smart Money magazine, and has written for The New York Times and The New Republic, among other publications. He has three children and lives in Westfield, New Jersey.
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From Publisher
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.
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Introduction
The Federal Reserve Bank of New York is perched in a gray, sandstone slab in the heart of Wall Street. Though a city landmark building constructed in 1924, the bank is a muted, almost unseen presence among its lively, entrepreneurial neighbors. The area is dotted with discount stores and luncheonettes - and, almost everywhere, brokerage firms and banks. The Fed's immediate neighbors include a shoe repair stand and a teriyaki house, and also Chase Manhattan Bank; J. P. Morgan is a few blocks away. A bit further, to the west, Merrill Lynch, the people's brokerage, gazes at the Hudson River, across which lie the rest of America and most of Merrill's customers. The bank skyscrapers project an open, accommodative air, but the Fed building, a Florentine Renaissance showpiece, is distinctly forbidding. Its arched windows are encased in metal grille, and its main entrance, on Liberty Street, is guarded by a row of black cast-iron sentries.
The New York Fed is only a spoke, though the most important spoke, in the U.S. Federal Reserve System, America's central bank. Because of the New York Fed's proximity to Wall Street, it acts as the eyes and ears into markets for the bank's governing board, in Washington, which is run by the oracular Alan Greenspan. William McDonough, the beefy president of the New York Fed, talks to bankers and traders often. McDonough especially wants to hear about anything that might upset markets or, in the extreme, the financial system. But McDonough tries to stay in the background. The Fed has always been a controversial regulator-a servant of the people that is elbow to elbow with Wall Street, a cloistered agency amid the democratic chaos of markets. For McDonough to intervene, even in a small way, would take a crisis, perhaps a war. And in the first days of the autumn of 1998, McDonough did intervene-and not in a small way.
The source of the trouble seemed so small, so laughably remote, as to be insignificant. But isn't it always that way? A load of tea is dumped into a harbor, an archduke is shot, and suddenly a tinderbox is lit, a crisis erupts, and the world is different. In this case, the shot was Long-Term Capital Management, a private investment partnership with its headquarters in Greenwich, Connecticut a posh suburb some forty miles from Wall Street. LTCM managed money for only one hundred investors, it employed not quite two hundred people, and surely not one American in a hundred had ever heard of it. Indeed, five years earlier, LTCM had not even existed.
But on the Wednesday afternoon of September 2-3, 1998, Long-Term did not seem small. On account of a crisis at LTCM, McDonough had summoned - invited," in the Fed's restrained idiom-the heads of every major Wall Street bank. For the first time, the chiefs of Bankers Trust, Bear Stearns, Chase Manhattan, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Smith Barney gathered under the oil portraits in the Fed's tenth-floor boardroom-not to bail out a Latin American nation but to consider a rescue of one of their own. The chairman of the New York Stock Exchange joined them, as did representatives from major European banks. Unaccustomed to hosting such a large gathering, the Fed did not have enough leather-backed chairs to go around, so the chief executives had to squeeze into folding metal seats.
Although McDonough was a public official, the meeting was secret. As far as the public knew, America was in the salad days of one of history's great bull markets, although recently, as in many previous autumns, it had seen some backsliding. Since mid-August, when Russia had defaulted on its ruble debt, the global bond markets in particular had been highly unsettled. But that wasn't why McDonough had called the bankers.
Long-Term, a bond-trading firm, was on the brink of failing. The fund was run by, John W. Meriwether, formerly a well-known trader at Salomon Brothers. Meriwether, a congenial though cautious mid-Westerner, had been popular among the bankers. It was because of him, mainly, that the bankers had agreed to give financing to Long Term-and had agreed on highly generous terms. But Meriwether was only the public face of Long-Term. The heart of the fund was a group of brainy, Ph.D.-certified arbitrageurs. Many of them had been professors. Two had won the Nobel Prize. All of them were very smart. And they knew they were very smart.
For four years, Long-Term had been the envy of Wall Street. The fund had racked up returns of more than 40 percent a year, with no losing stretches, no volatility, seemingly no risk at all. Its intellectual supermen had apparently been able to reduce an uncertain world to rigorous, cold-blooded odds-they were the very best that modern finance had to offer.
Incredibly, this obscure arbitrage fund had amassed an amazing $100 billion in assets, all of it borrowed-borrowed, that is, from the bankers at McDonough's table. As monstrous as this leverage was, It was by no means the worst of Long-Term's problems. The fund had entered into thousands of derivative contracts, which had endlessly intertwined it with every bank on Wall Street. These contracts, essentially side bets on market prices, covered an astronomical sum-more than $1 trillion worth of exposure.
If Long-Term defaulted, all of the banks in the room would be left holding one side of a contract for which the other side no longer existed. In other words, they would be exposed to tremendous-and untenable-risks. Undoubtedly, there would be a frenzy as every bank rushed to escape its now one-sided obligations and tried to sell its collateral from Long-Term.
Panics are as old as markets, but derivatives were relatively new. Regulators had worried about the potential risks of these inventive new securities, which linked the country's financial institutions in a complex chain of reciprocal obligations. Officials had wondered what would happen if one big link in the chain should fall. McDonough feared that the markets would stop working, that trading would cease; that the system itself would come crashing down.
James Cayne, the cigar-chomping chief executive of Bear Stearns, had been vowing that he would stop clearing Long-Term's trades which would put it out of business-if the fund's available assets fell below $500 million. At the start of the year, that would have seemed remote, for Long-Term's capital had been $4.7 billion. But during the past five weeks, or since Russia's default, Long-Term had suffered numbing losses-day after day after day. Its capital was down to the minimum. Cayne didn't think it would survive another day.
The fund had already gone to Warren Buffett for money. It had gone to George Soros. It had gone to Merrill Lynch. One by one, it had asked every bank it could think of. Now it had no place left to go. That was why, like a godfather summoning rival and potentially warring- families, McDonough had invited the bankers. If each one moved to unload bonds individually, the result could be a worldwide panic. If they acted in concert, perhaps a catastrophe could be avoided. Although McDonough didn't say so, he wanted the banks to invest $4 billion and rescue the fund. He wanted them to do it right then-tomorrow would be too late.
But the bankers felt that Long-Term had already caused them more than enough trouble. Long-Term's secretive, close-knit mathematicians had treated everyone else on Wall Street with utter disdain. Merrill Lynch, the firm that had brought Long-Term into being, had long tried to establish a profitable, mutually rewarding relationship with the fund. So had many other banks. But Long-Term had spurned them. The professors had been willing to trade on their terms and only on theirs-not to meet the banks halfway. The bankers did not like it that now Long-Term was pleading for their help.
And the bankers themselves were hurting from the turmoil that Long-Term had helped to unleash. Goldman Sach's CEO, Jon Corzine, was facing a revolt by his partners, who were horrified by Goldman's recent trading losses and who, unlike Corzine, did not want to use their diminishing capital to help a competitor. Sanford I. Weill, chairman of Travelers/Salomon Smith Barney, had suffered big losses, too. Weill was worried that the losses would jeopardize his company's pending merger with Citicorp, which Weill saw as the crowning gem to his lustrous career. He had recently shuttered his own arbitrage unit-which, years earlier, had been the launching pad for Meriwether's career-and did not want to bail out another one.
As McDonough looked around the table, every one of his guests was in greater or lesser trouble, many of them directly on account of Long-Term. The value of the bankers' stocks had fallen precipitously. The bankers were afraid, as was McDonough, that the global storm that had begun so innocently with devaluations in Asia, and had spread to Russia, Brazil, and now to Long-Term Capital, would envelop all of Wall Street.
Richard Fuld, chairman of Lehman Brothers, was fighting off rumors that his company was on the verge of failing due to its supposed overexposure to Long-Term. David Solo, who represented the giant Swiss bank Union Bank of Switzerland (UBS), thought his bank was already in far too deeply, it had foolishly invested in Long-Term and had suffered titanic losses. Thomas Labrecque's Chase Manhattan had sponsored a loan to the hedge fund of $500 million; before Labrecque thought about investing more, he wanted that loan repaid.
David Komansky, the portly Merrill chairman, was worried most of all. In a matter of two months, the value of Merrill's stock had fallen by half-$19 billion of its market value had simply melted away. Merrill had suffered shocking bond-trading losses, too. Now its own credit rating was at risk.
Komansky, who personally had invested almost $1 million in the fund, was terrified of the chaos that would result if Long-Term collapsed. But he knew how much antipathy there was in the room toward Long-Term. He thought the odds of getting the bankers to agree were a long shot at best.
Komansky recognized that Cayne, the maverick Bear Stearns chairman, would be a pivotal player. Bear, which cleared Long-Term's trades, knew the guts of the hedge fund better than any other firm. As the other bankers nervously shifted in their seats, Herbert Allison, Komansky's number two, asked Cayne where he stood.
Cayne stated his position clearly: Bear Stearns would not invest a nickel in Long-Term Capital.
For a moment the bankers, the cream of Wall Street, were silent. And then the room exploded.
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Publishers Weekly (MSL quote), USA
<2006-12-24 00:00>
In late September 1998, the New York Federal Reserve Bank invited a number of major Wall Street investment banks to enter a consortium to fund the multibillion-dollar bailout of a troubled hedge fund. No sooner was the $3.6-billion plan announced than questions arose about why usually independent banks would band together to save a single privately held fund. The short answer is that the banks feared that the fund's collapse could destabilize the entire stock market. The long answer, which Lowenstein (Buffett) provides in undigested detail, may panic those who shudder at the thought of bouncing a $200 check. Long-Term Capital Management opened for business in February 1994 with $1.25 billion in funds. Armed with the cachet of its founders' stellar credentials (Robert Merton and Myron Scholes, 1997 Nobel Prize laureates in economics, were among the partners), it quickly parlayed expertise at reading computer models of financial markets and seemingly limitless access to financing into stunning results. By the end of 1995, it had tripled its equity capital and total assets had grown to $102 billion. Lowenstein argues that this kind of success served to enhance the fund's golden legend and sent the partners' self-confidence off the charts. As he itemizes the complex mix of investments and heavy borrowing that made 1994-1997 profitable years, Lowenstein also charts the subtle drift toward riskier (and ultimately disastrous) ventures as the fund's traditional profit centers dried up. What should have been a gripping story, however, has been poorly handled by Lowenstein, who obscures his narrative with masses of data and overwritten prose. |
The Economist (MSL quote), UK
<2006-12-24 00:00>
This book is story-telling journalism at its best. |
Barron's (MSL quote), USA
<2006-12-24 00:00>
Strongly reported and cleanly written... Lowenstein adds fresh detail, personality, and even drama to the tale. |
A reader, USA
<2006-12-24 00:00>
Turning topics like bond arbitrage, volatility selling, and "flight to liquidity" into a crisp, condense, top-selling book is probably Lowenstein's crowning achievement with When Genius Failed. He's a very talented writer with a knack for fleshing out a diverse array of colorful characters, and that makes this book appealing both to the interested layman, as well as all but the most curmudgeonly financial professional.
The book takes us back to Saloman's bond arbitrage desk, where the enigmatic John Meriwether first mastered some of the convergence strategies he and the brain trust would later use to great effect in Greenwich.
Then we learn some about how the fund's management was constructed, all the various places they drew money from, and ultimately observe the masters in action, placing their token efficient market bets that yield spreads just couldn't get any wider. All this leads up to 1998, where even early in the year certain cracks in the hull began to appear; namely concerns over vanishing opportunities in the bond arbitrage market (the rifraff had become wise to some of the professors' token strategies, thereby eliminating their effectiveness), and LTCM's extensions into fields beyond its expertise, particularly merger arbitrage. All this leads to the perfect storm of 1998, when the fund's short volatility positions exploded in a summer storm of apocalytic proportions. Lowenstein chronicled the actual debacle superbly.
One quibble is Lowenstein's cautioning reptition of how dangerous it is for traders/investors to use historical patterns to get a read on how the market might look in the future. While I agree that it's dangerous to bet 10,000% of your equity on the likelihood of a particular pattern repeating, one can't really trade without a healthy understanding of historical precedent. In the financial markets, history does repeat itself more often than not. So, I think LTCM's debacle was more the result of its gargantuan margin than a horrible, fatal flaw in its trading models.
All that aside, this is a great book, as fun to read as it is informative. Highly Recommended. |
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