Patrick Wong
9/10
The full title of Roger Lowenstein’s book is “When Genius Failed: The Rise and Fall of Long-Term Capital Management” (2000). It takes us through the origins, history, and demise of the prominent hedge fund in the 1990s, Long-Term Capital Management. The fund is well known for a few reasons. First, it is comprised of some of the best minds in business which includes traders from the very successful Arbitrage Group at Solomon Brothers, elites in academia, and Nobel Prize winners. One of the Nobel Prize winners is Myron Scholes who is more known for his role in developing the Black Scholes formula that is used to value options. The partners of the fund are well respected in the business world. However, it is a gift and a curse. The fund is very successful in its early years. Unfortunately, the arrogance of its partners, due to their successes, is a main reason the fund accumulates large positions that eventually lead to its downfall. While the fund keeps its strategies and positions completely secret, other large financial institutions eagerly provide Long Term Capital Management (“LTCM”) funding for its business because of blind faith in the reputations of the “geniuses” that run the fund and the big returns earned in the years leading up to its collapse. Consequently, the hedge fund becomes too big to fail. Eventually, a large number of major banks reluctantly bail the fund out at the direction of the Federal Reserve in order to prevent a collapse of the financial system in 1998. Lowenstein is thorough in describing the credentials and successes of the individuals that run LTCM. He also does an excellent job detailing the decisions and atmosphere of LTCM that lead to its demise. The most fascinating parts of the book are when LTCM desperately tries to secure capital from external investors to save it. Although you know the outcome, Lowenstein does an excellent job depicting the events so you feel you are a part of the mad scramble to save LTCM.
Lowenstein’s book starts with the beginning of the career of John Meriwether, the founder of LTCM. Meriwether, also known as JM, starts his career in the Arbitrage Group of Solomon Brothers and becomes a rising star quickly. At the time, most Wall Street banks are hesitant to hire from academia. However, Meriwether comes from academia and believes there is an advantage from bringing in the brightest minds from the country’s top universities. When Meriwether has a leadership position, he recruits some of the best minds in academia. Some of his key additions to the Arbitrage team are Eric Rosenfeld, MIT-trained Harvard Business School assistant, Victor J. Haghani, an Iranian American with a Masters degree in finance from the London School of Economics, and Lawrence Hilibrand, who had two degrees from MIT (Lowenstein 11). With these intelligent men under his command, the group builds models based on historical bond prices. From their perspective, prices will always converge to their historical averages over time although there may be volatility in the short run. Accordingly, they have complete faith in relying on the models. If a position loses money, the traders simply increased their position even more as their models predict that the prices will return in their favor for a large profit. While there are fatal flaws to the strategy that come into play later, it is a strategy that is very successful for the Arbitrage Group.
Under Meriwether, the traders in the Arbitrage Group spend all their time together including personal time outside of work. Moreover, the group is very secretive and basically an entire entity separate from the rest of Solomon Brothers. Lowenstein does an excellent job depicting these characteristics and how the traders basically worship Meriwether. Meriwether’s reign at Solomon comes to an end in 1989 when one of his traders submits a false bid to the US Treasury to gain an unauthorized share of the government bond auction (Lowenstein 19). Consequently, the top leadership of Solomon Brothers is forced to resign due to the scandal. Although Warren Buffett steps in as the interim CEO and tries to find a way to keep Meriwether as he generated the most money for the firm, the trader is under Meriwether’s supervision. Consequently, he resigns as well.
In 1993, Meriwether has the idea to create a hedge fund that will replicate his Arbitrage Group at Solomon Brothers. For this purpose, he creates LTCM. Moreover, he wants LTCM to be much bigger with much larger fees. Like the Arbitrage Group, the fund’s strategy is to find “nickels”. In other words, it will look for trades with small profits. However, it will use leverage to multiply small profits into large profits. On the other hand, it puts the firm at risk if rare events occur that will result in magnified losses. Nevertheless, the risk is disregarded as models show that such event is highly unlikely. Of course, he also poaches his former traders from Solomon Brothers which include Rosenfeld, Haghani, and Hilibrand. He also brings in Harvard’s Robert Merton, a leading scholar in finance, and Myron Scholes, an economist who helped derive the Black Scholes formula. In the words of Lowenstein, Merton and Scholes are the economics version of “Michael Jordan and Muhammad Ali” (Lowenstein 31). An interesting part of the book is when LTCM goes on “road shows” to raise capital. It has trouble as it is secretive about its strategies and will not reveal them to potential investors. Lowenstein does a good job detailing the process and rejections from well known business men. The first rejection comes from Warren Buffett. Nevertheless, their individual names and reputations eventually win over investors from everywhere and the fund is able to raise an impressive $1.25 billion.
LTCM is very successful and continues to attract capital as investors fight over its business. Nevertheless, Lowenstein does an excellent job outlining the factors that will lead to the fund’s demise. First, there is a lack of strong controls or oversight from Meriwether over his traders. Specifically, partners Haghani and Hilibrand are able to enter any large positions they want despite protests from others at the fund. The massive success of the fund makes its partners overconfident in its abilities. As a result, they start applying their models to areas outside of their expertise, such as equities and mergers. A great example in the book that illustrates the above flaws is when Haghani enters into a trade for the equity of Royal Dutch/ Shell that is ten times the size of the same trade entered into by Goldman Sachs. Regardless, the fund experiences tremendous success. First, a troubled Solomon Brothers is sold for $9 billion to symbolize LTCM surpassing it in every possible way. Moreover, its partners Merton and Scholes win the Nobel Memorial Prize in Economic Sciences. Lowenstein points out an interesting quote from Merton after he learns of the award: “It’s a wrong perception to believe that you can eliminate risk just because you can measure it.” It foreshadows the downfall of LTCM.
However, the success breeds more arrogance. The partners take out huge loans to invest back in the fund. As such, much of their wealth is tied into the success of LTCM. The fund receives so much capital that there is not enough good investments for it to purchase. Instead of remaining selective, LTCM decides to enter into riskier investments with Brazilian, Russian, and Danish bonds instead of refraining from making additional investments and thus turning down investors. These additional factors add on to the causes of the spectacular fall of LTCM. The problems begin with Solomon Smith Barney’s Arbitrage group selling its positions. As LTCM has similar positions, the flood of the positions into the market causes the market price to drop. The details during the rapid decline of LTCM are fascinating in the book. In a month, the fund’s capital drops to $1.5 billion, losing 6/10 of its $4 billion capital. On a single Friday, it loses $553 million. The main cause of the losses is that the fund built up massive, undiversified positions. In addition, the only diversification it has is geographical. It basically holds the same trades in different geographies. In addition, LTCM fail to realize that the economy is global by the late 1990s. Consequently, the problems of one economy are not exclusive and affect the economies around the world. The Asian economic crisis and the Russian default on its bonds in 1997 and 1998 spread to the economies around the world and all of LTCM’s positions. In the end, the geniuses of LTCM fall victim to not following the simplest principal of investing and arbitrage, diversification.
In my opinion, LTCM’s scramble to acquire capital to stay solvent is the exhilarating part of the book. While I know the end, I cannot stop myself from feeling like I am a part of the drama and wondering if LTCM can secure investors to save itself. Even in their darkest hour, the partners of LTCM remain arrogant. For example, they offer publishing moguls, the Ziff brothers, to cut their fee, but only for 3 years, in return for their investment (Lowenstein 167). However, there is no mercy on Wall Street. When a financial institution is in trouble, especially for a group as arrogant as the LTCM partners, the other financial institutions will execute trades to make profits and accelerate the demise of the troubled entity. While Goldman Sachs and its CEO John Corzine come in to “aid” LTCM, it also makes money at the same time by executing trades that hurt LTCM. Eventually, LTCM requires a bailout. One of the interesting moments is when Warren Buffett offers a lowball offer of $250 million to purchase the hedge fund then infuse $3.75 billion to stabilize LTCM. In the plan, $3 billion of the capital infusion comes from Buffett’s company Berkshire Hathaway. Moreover, Buffett only gives a short amount of time for the offer to be accepted. Naturally, the offer is rejected.
Of course, the Federal Reserve is forced to help in the situation and convince 14 major banks to bail LTCM out with $3.5 billion or $250 million per participant in exchange for ownership of the fund. While the other financial institutions are hesitant, they eventually cave as allowing LTCM to fail would cost them even more money as the fund had significant trades with everyone. As such, LTCM is deemed too big to fail as its bankruptcy would cause significant losses throughout Wall Street and threaten the entire financial system. Lowenstein does an excellent job describing the logistical nightmare of getting so many financial institutions to agree to the bail out. It requires the approval from 14 different Board of Directors and significant legal work to finalize the agreement. Hilibrand is the last individual to sign. He is in tears and reluctant but Meriwether is able to pull him aside and convince him it is for the greater good of the financial system.
Lowenstein’s “When Genius Failed: The Rise and Fall of Long-Term Capital Management” is excellent in depicting the epic collapse of LTCM. It is a fascinating story for any reader and a must read for anyone in the field of finance. The key takeaways I have from the book are the dangers of overconfidence, blind trust in reputations, and overleveraging. No matter how intelligent you may be, overconfidence is a problem. The partners of LTCM are the best in the field. Nevertheless, they enter into massive positions without true diversification. In addition, they move away from their core competency in fixed income. Their success in it gives them a false sense of security and confidence to try their hand in equities and mergers. If “geniuses” in a field can fall victim to overconfidence, anyone can and one must remember to stick to his strengths and perform proper due diligence before making important decisions. Another danger is having blind trust in other people based on reputation. In the words of Lowenstein, “Ironically, only a very intelligent gang could have put Wall Street in peril. Lesser men wouldn’t have gotten the financing or attracted the following that resulted in such a bubble.” (Lowenstein 218) LTCM’s investors did not understand the fund’s strategies. Moreover, they did not even have a clue on how leveraged it was until the collapse. Consequently, a lesson from this story is to not blindly invest unless you understand the strategies and agree with them. The final peril is leveraging too much. It is not a problem when the economy is doing well. However, there will be times that economic conditions are strained and overleveraging can cause a firm to fail. Unfortunately, Wall Street does not learn its lesson from the fall of LTCM in 1998. Ten years later, another financial crisis takes down a couple of Wall Street’s giants. The biggest casualty is the bankruptcy of Lehman Brothers. In an updated version of the book, Lowenstein adds a great epilogue to comment on the most recent financial crisis and the lessons not learned from the collapse of LTCM. He makes a great point in noting that the bailout of LTCM may have encouraged financial institutions to leverage believing that the government or others will bail them out in the event of a possible bankruptcy. As such, Lowenstein does a brilliant job linking his story about LTCM to current events.
Source:
Lowenstein, Roger. When Genius Failed: The Rise and Fall of Long-Term Capital Management. New York:
Random House, 2000. Print.
About Pat Wong
Patrick is a contributor for Rookerville. He is an avid sports fan. Before joining Rookerville, he was part of a defunct New York Yankees message board, NYYankeefans, where he was its top poster and was inducted in its Hall of Fame for his contributions. Patrick is also a passionate fan of movies. He has enjoyed reading movie reviews over the years and is excited about the opportunity to review movies.