When Genius Failed

Amazon.com
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--This text refers to an out of print or unavailable edition of this title.

Product Description:
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.

The gang that couldn't hedge stright, October 8, 2000

Reviewer:

"reader1001" (Livermore, CA USA) - See all my reviews

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 1997 Nobel prize winners in economics, Robert Merton and Myron Scholes. 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.

Logicians Snared in their Lair, July 17, 2001

Reviewer:

Craig L. Howe (Darien, CT United States) - See all my reviews

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, Robert Merton and Myron Scholes, 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.

Great Book if you are slightly interested in Finance, February 18, 2005

Reviewer:

W. Lin "Da Geek" (Los Angeles) - See all my reviews

This book showed most of the average American the dark side of Wall Street: greed and ego. When they clashed, things would get downright ugly. In sum, the author described vividly how one of the most powerful hedge fund rose to the top of the mountain in the first 4 years of its existence and grounded to the earth in a matter of 5 weeks. This book also does a great job in describing human interactions: treat others like you would want to be treated by them. Hilibrand, one of the most interesting persons in the book, was a great example of this maxim. He was uncooperative at first, and most of the Wall Street submits to him because he had the power at the time. However, once Long Term's aura diminished, he would have to literally beg others for help. What did he receive for begging? humiliations and rejections. Thus, I learned that I better treat people equally with dignity because you never know when you are going to lose your aura and would need other people's help. Warren Buffet said the best: "you should fear the market when everyone is greedy, and you should be greedy when everyone else fears the market." This book taught me exactly that.

Riveting, February 13, 2005

Reviewer:

Patrick S. Pope "Scott Pope" (Chicago, IL) - See all my reviews

When Genius Failed is an exciting account of a Hedge fund that brought together the smartest people in the business, skyrocketed to amazing highs and lost everything in a few short months. This is best business narrative I have read.

Lowenstein does an excellent job of adding color and excitement to a financial calamity of immense proportions. What is somewhat amazing is that he was able to get such detailed information about the inner workings of Long Term Capital and the emotions among its various constituents.

Even readers far removed from Wall Street will find the drama and players quite exciting.
In addition to the enormous financial losses, there is a great deal of interpersonal drama. As colorful as any Hollywood script, there is an eclectic cast of characters: The Nobel prize winners, the professors, the Iranian, the Jew, and the Irish catholic who went from the south side of Chicago to become one of the greatest bond traders in history and the ring leader of LTCM.

As the fund is loosing hundreds of millions per day, the partners become increasingly unable to deal with events because the fund was driven by sophisticated mathematical models that did not address the chain of events leading to its demise. As the fund seeks to be rescued, some of the world's wealthiest and most powerful figures are brought into the fray. At one point, Warren Buffet was vacationing with Bill Gates when he conducted a three hour long satellite-phone call to discuss the bailout. To add to the anxiety, the phone kept disconnecting as the boat they were sailing on was getting too close to the sides of a fjord, blocking the signal. In scenes like this, the author does an excellent job of adding color and heightening the drama.

While this is best of the bond trading books, you should read Liars Poker and one of the books on Drexel first. Liars Poker describes the initial group at Salomon, including the central character, John Meriwether, who went on to create LTCM. Some of the individuals from Salomon also went to work for Drexel Burnham Lambert, which went bankrupt four years before LTCM was created. Reading books about each of the three organizations paints a much more complete picture of the pivotal characters and their bond trading exploits.

A Must Read for New Managers, February 9, 2005

Reviewer:

Robert Caudy (Washingtonville, NY) - See all my reviews

I will not give too much detail about the story itself, since if you are here then you are familiar with LTCM's demise. I was on Wall Street when the story broke in 1998, as an equity trader with one of the firms mentioned in the book. I have only now just read this book (Jan 05), because I started a hedge fund in March of 2004, and I wanted to get more details about the LTCM blowup.

With that said, I can say that the book is a must read for any money manager or trader, especially when using leverage. I have been managing a highly leveraged portfolio since March 04, and I have had great success. While one knows the "possibility" of a devastating loss (initially), one can get quite comfortable and confident after a period of success. This book literally scared the crap out of me. As the LTCM portfolio was dropping and the partners were scrambling for capital, I realized how close that situation is to any of us who manage leverage. While their size added to the problem, it had nothing to do with what I believe is the most valuable quote in the book: "Markets can remain irrational longer than you can remain solvent" --Keynes

At any rate, it is wonderfully written book and I highly recommend it. As I said, it will be especially useful for new managers. Trading and managing client money is so much different than trading a firm's capital. Read and be careful.

when hubris flailed, January 17, 2005

Reviewer:

Justice Litle "trader75" (NV) - See all my reviews

This is a great story. Not so much due to the breathtaking scope of financial disaster, but rather the timeless human lessons presented in such fascinating detail. If it were a movie, the plot would be dismissed as unrealistic. The heroes (anti-heroes?) of LTCM make choices so obtuse, they literally boggle the mind. You would think the most sophisticated players in the most sophisticated markets in the world would have a keen grasp of simple things, like position sizing. These guys are nobel prize winners, ubergeeks with multiple PhDs, the high quants of Salomon. You would assume they had an assortment of complex and finely tuned algorithms, implemented in real time via massive computing power, to determine the proper size of positions. And yet, when LTCM came a cropper, it was in large part simply because their positions were too big. Not just too big: ridiculously, massively, insanely big. Technical details aside, the how of their failure is not as interesting as the why. As in Why, Oh Why did these guys think they were invincible?

Conviction cuts both ways. Without it, you can't achieve anything truly noteworthy. With too much of it, you're likely to drive yourself over a cliff. These guys' conviction levels made UFO cults look downright modest. When you feel strongly about something, you increase the size of your bet. If you feel very strongly, maybe you bet a significant portion of your net worth. But what do you call it when you bet not only a few hundred times your net worth, but that of your friends and clients as well- when you act with a certainty greater than that of the sun coming up tomorrow? At least they walked the walk; by doubling down on their own personal stakes, the partners went out of their way to ensure they had more exposure than anyone. True believers to a man.

The details are complex, but the heart of the story is simple. Genius did not just fail, it got hijacked and turned against itself. A sufficiently intelligent and creative person can convince him(or her)self of anything, no matter how outlandish, given strong enough emotional motivation to do so. Rationality was outflanked by ego, smarts subsumed by pride... in the normal world there are checks and balances on this sort of thing. If you start thinking you are a modern day Icarus, you are usually brought back to earth by various limits and circumstances -friends and family if you are lucky- before inflicting too much damage. But if the people around you actively encourage your hubris -if they whisper sweet nothings in your ear and hoist you on high- there's no telling how far your delusions may take you.

In the end, all the credentials and intelligence, all the skills and smarts presented on a silver platter, didn't mean a damn thing. This is instructive and eye opening; the emperor has no clothes. Those outside Wall Street typically assume that those inside know what's going on. That the monolothic skyscrapers, the PhDs in mathematics and physics, the rows of supercomputers mean something. That these people have some intrinsic grasp of reality that the rest of us do not, that they know exactly what they are doing at all times. But they don't. Or if they do, they can still fall prey to the reign of emotions and the folly of the human heart. This lesson is never fully learned; bigger giants will fall.

This isn't to paint all market players with the same brush. Just because LTCM flamed out in spectacular fashion doesn't mean every hedge fund is one bad day away from disaster. There are managers out there, running billions of dollars, whose success is measured in decades. But they are successful in the long term because they understand risk, they understand fallibility, and they know not to fly too close to the sun. Markets are like the ocean; you don't try to tame the ocean. You respect it... or you pay the price.