When Genius Failed: The Rise and Fall of Long-Term Capital Management Paperback – October 9, 2001

In this book, Roger Lowenstein presents an excellent detailed narrative of the rise and fall of Long-Term Capital Management. The book is aimed at a layman and does not require understanding of complex financial instruments - but that knowledge makes the story even more intriguing.LTCM was an elite hedge fund started by John Meriwether, the head of the arbitrage group at Salomon Brothers. The fund recruited top professional talent with extensive contacts and, uniquely, top academics from MIT, Harvard, and other universities, including Robert Merton and Myron Scholes, who would later (in 1997) share the Nobel Prize in Economics for developing a model for pricing derivatives, known as the Black-Scholes formula. Led in part by these gentlemen, LTCM had a highly quantitative method to its trading. It started in bond arbitrage, betting that spreads between bonds of similar type would converge, and it achieved fantastic results in the first three years of its operation. So, where did things go wrong?Due to their extensive contacts, LTCM's partners were able to secure unprecedented levels of financing from banks all over Wall Street. Not only was LTCM able to leverage itself highly, but it did so cheaply. All the banks wanted a piece of the action, so LTCM was able to secure very low cost of debt and essentially no haircuts for collateral. This means that LTCM was able to achieve even higher levels of leverage than normally possible.Furthermore, as bond arbitrage opportunities started to melt away due to influx of competitors, LTCM plunged into unexplored waters: merger arbitrage, bets on equities via derivatives, bets in emerging markets, etc. The firm essentially started to shift away from convergence bets to directional bets, which are inherently speculative. In other words, LTCM began to meddle outside its area of expertise.Not only was LTCM highly levered and making risky bets, its partners shared one major flaw: hubris. They whole-heartedly trusted their mathematical models and abstract systems. Merton and Scholes were faithful followers of the efficient market hypothesis and refused to believe in any behavioral finance mumbo-jumbo. Their models predicted that LTCM could not lose a significant amount of capital in any one day. Only a castrophic event, a statistical freak - one in trillions - could cause serious damage to the fund. Even when Eugene Fama, Scholes' thesis advisor, published a paper detailing "fat tails" in the distribution of market returns, Scholes dismissed the idea. Fama demonstrated that the market does not follow a log-normal distribution (as assumed by Black-Scholes) - instead, outlier events such as large market crashes are significantly more likely to occur. Additionally, so confident were the partners in their creation that they did not hesitate to put millions of their own capital into the fund. Usually, when partners put up their own money, they are much more risk averse since their own hard-earned dollars are at stake. LTCM's partners, however, exhibited THAT much confidence in themselves.When Russia defaulted on its debt on August 17, 1998, investors everywhere ran from investment risk in the market, buying up the safest investments - US Treasurys. This widened the swap spreads and raised credit premiums, which went completely against LTCM's positions. Since LTCM was heavily leveraged, its losses were staggering: on August 21st alone, LTCM lost $553 million. In the four hellish weeks that followed, it lost the remaining $2.9 billion of equity. It was unable to unwind its positions, because there were no buyers - liquidity had tried up. Meriwether and his crew attempted to raise capital from anyone and everyone, but no one was interested - rumors of LTCM's losing positions were floating around and scaring off investors that could save the fund.The second half of the book describes the bailout process for LTCM. Goldman Sachs and Warren Buffett attempted to purchase the fund's positions for a miniscule price, all while Goldman was taking advantage of its knowledge of LTCM's trades - it was constantly squeezing LTCM's positions, further lowering the fund's value. Finally, the Fed guided most Wall St banks to a private rescue, in which only one bank refused to participate and later paid the price dearly: Bear Stearns.Lowenstein describes all the events in great detail - he has clearly done a tremendous amount of research. My only gripe is that I often did not feel immersed in the situation. Michael Lewis in his Liar's Poker creates a vivid image of each character and really makes you feel like you're there in the story. This book is more factual and less immersive in a way. But don't get me wrong, that's a minor issue, more of a personal preference.I highly recommend the book to anyone in finance or anyone interested in financial history. The fall of LTCM presents a classic case of what Lowenstein calls the "human factor." At the end of the day, financial models can't predict greed, hubris, and the behavior of various individuals. And no matter how hard you try to diversify, during a crisis, correlation often goes to one.Pros:+ easy read for anyone, even those with little finance knowledge+ great explanation of LTCM's flaws, including a discussion on "fat tails"+ excellent detail on LTCM's strategies and positions+ reminds the reader of a very important point that many finance gurus forget: the human factorCons:- could use a bit more language and imagery to immerse the reader into the story

Were the individuals who initiated and ran Long Term Capital Management geniuses, as the title of this book indicates? When reading the book, the reader is led to believe, via their quoted statements, that they themselves thought they were geniuses. Did the eventual behavior of the markets convince them otherwise? Did the downfall of LTCM inject them with an overwhelming dose of humility? Without knowing them this would be hard to say. But one can say with a large degree of confidence that no amount of intellectual ability will negate the fact that the financial markets are a collective, emergent entity. The markets do not care about the accolades or credentials of the traders that invest in them. The only reason for displaying these credentials is to convince investors to take part in a financial scheme, whether it is a private investment group, a new business, or some other entity that requires expertise in finance. When reading this book, it is apparent that the prospective investors in LTCM viewed its proprietors with an uncritical adulation, and did not ask the probing questions that they should have before they made the decision to invest. They should have ignored the fact that a few of these proprietors were their former professors or tutors, and concentrated instead on the content of their proposals, for it is only this that is relevant. If indeed the investors were overly impressed by the titles and awards possessed by the members of LTCM, then they clearly made a mistake. They should have only been concerned with the content of the proposals made by LTCM. If they did not have the mathematical knowledge to understand the proposals, they should have either obtained it on their own or have withdrawn their investment. The list of investors is quite amazing when viewed in retrospect: Sumitomo Bank, Dresdner Bank, Liechtenstein Global Trust, Julius Baer, Republic New York Corporation, Banco Garantia, Michael Ovitz, Phil Knight, Robert Belfer, James Cayne, St. John's University, Yeshiva University, University of Pittsburgh, Paragon Advisors, PaineWebber, Donald Marron, Black & Decker, Continental Insurance of New York, and Presidential Life Corporation are examples. The interest of these institutions and investors is fascinating given that derivatives trading and sophisticated mathematical modeling was relatively new at the time. Their decision to invest therefore had weak historical precedent, and therefore it is easy to believe the author's contention that this decision was based on their uncritical adulation of the LTCM members. The "mystique" of these members was taken "to a very high extreme", writes the author.The author attempts to give the reader insight into the personalities of the LTCM members, and his descriptions of them work to a certain degree. Such insight is necessary to gain a proper understanding of their behavior. But a description of their overt behavior and demeanor still leaves the reader wanting as to whether their appearance, i.e. the way they portrayed themselves to others, did reflect what they truly believed inside. Was their behavior part of their salesmanship, a conscious strategy to portray themselves as savvy business people who had great insight into the workings of the financial markets, masking their hidden insecurities on these workings? Or was their behavior reflective of what they truly were, i.e. individuals who through their training in finance and mathematics, were confident in themselves and in the concept of LTCM. For example, was John Meriwether indeed a quiet, private individual with a "steel-trapped" mind as the author portrays him, or was this merely a facade that Meriwether thought would give him a sphinx-like aura of mystery? And if the latter is true, why did Meriwether think that such behavior was necessary? What historical precedent did he follow in this regard? Does such behavior result in better financial contracts? A better understand of the markets? The markets of course do not care about the personalities of the traders that participate in them. The markets do not hold any special affection for a James McEntee, who "traded from his gut." Nor do they care about the commentary of a Seth Klarman, who accused the mathematical models of LTCM as being blind to "outlier events." And they certainly do not respect the boasting of a Greg Hawkins, who proclaimed that LTCM made more money because its members "were smarter."The book is interesting even from a contemporary perspective, in that it brings out the still ongoing tension between those who prefer a more mathematical/scientific approach to trading and those who "trade from the gut." The financial modelers still refer to the latter as "uniformed speculators", "noise traders", or "nonscientific, old-fashioned gamblers." The gut-traders still scold the modelers as a "dressed-up form of gambling" or as "pure academics" and "not applicable to the real world." The debate between these two groups though is evolving, due in part to the rapid automation of the financial markets. More trust is being given to machines that can not only crunch the numbers but can also exercise the "intuitive judgment" that some traders still insist is the way to go in trading. It will be interesting to see if these machines can deal with the markets in a manner that is superior to what humans have done for centuries. Genius arising from silicon will compete with genius arising from carbon. But one thing is certain: if machine trading results in instabilities in the markets, with huge losses to the institutions that own them, there is little doubt that these failures will be protected by the same boards of governance that rescued LTCM. To paraphrase the author, high finance rewards success, but in the twenty-first century, failure will be protected as well.