Liar's Poker, Indeed
A few years ago, probably not five Americans in a thousand could say what a hedge fund is -- an investment partnership serving the interests of an exclusive hundred or fewer clients. But in the flush mid-'90s, Long-Term Capital Management quickly established itself as the most successful hedge fund on the scene. In no time at all, the fund was a major player in the world's financial markets. And for a few years it enjoyed the very best of times. And then, quite suddenly, over the summer and fall of 1998, amid a global financial crisis that Secretary of the Treasury Robert Rubin characterized as the most turbulent in half a century, Long-Term Capital Management came to taste the very worst of times.
How did a financial institution that few Americans had heard of find itself suddenly facing its imminent demise -- and threatening, to boot, to undermine the stability of the world's financial markets? How did a company boasting legendary trading talent, two Nobel Prize-winning economists, and a former officer of the Federal Reserve come to such a predicament? Roger Lowenstein, formerly a financial journalist for The Wall Street Journal and today a columnist for SmartMoney, has written a riveting narrative and the most comprehensive account to date of the hedge fund's short and spectacular career, When Genius Failed: The Rise and Fall of Long-Term Capital Management.
In its first heady years, LTCM, a Greenwich, Connecticut, hedge fund employing fewer than 200, posted record gains. Its profits soared like a hot-air balloon carried aloft by the trade winds. The fund quickly quadrupled its initial investment stake (a record $1.25 billion). LTCM was the envy of Wall Street.
But in December of 1997, the Thai currency crashed and 56 of Thailand's top 58 finance houses were forced to close overnight. The crash triggered an economic recession that rippled across Asia. And when, months later, Russia announced it was defaulting on its foreign loan payments, fear in Washington and in the financial markets was palpable. Wealthy individual investors and institutional traders undertook increasingly frantic efforts to find safe havens for their funds, havens high enough to ride out the anticipated tidal backlash.
For six harrowing months in 1998 -- from April through September -- the hedge fund was in free fall, losing tens and even hundreds of millions of dollars daily. LTCM dropped like an elevator with snapped cables. In that improbably brief stretch, the fund lost $5 billion -- a sum representing more than 90 percent of its operating capital. But that was only part of the story, only part of the immediate danger: The hedge fund's leveraged derivative bets, it gradually emerged, exposed the fund and the financial houses that had so heedlessly lent LTCM the money to extend its financial bets to potential losses of $100 billion. There was hardly a bank that could hope to escape unscathed.
It took a controversial last-minute Fed-orchestrated bailout by a banking consortium to pull LTCM back from the brink of collapse. The banks ultimately allowed that they were wiser to swallow the bitter medicine of bailing out LTCM from bankruptcy than to brave the fallout that the fund's ruin might wreak on even the largest banks and investment houses.
Lowenstein relates this chapter of recent financial history with sure-handed skill and a keen eye for drama. And When Genius Failed tells us more than LTCM's story, for the hedge fund's partners were more knowledgeable about the new finance and more practiced at working with the new financial instruments than anyone else on Wall Street. The traders at the core of LTCM had, after all, ushered in that financial revolution with stunning success as arbitrage traders at Salomon Brothers in the 1980s. (Indeed, they were the very same characters Michael Lewis memorialized in Liar's Poker, the "Young Professors" hired and trained by John Meriwether, himself probably the best-known trader of his generation.) And Robert C. Merton and Myron Scholes, partners at LTCM who in 1997 won Nobels for their contributions to economics, had themselves authored the ideas forming the intellectual framework of contemporary financial thought and practice. As a unit, LTCM's partners were commonly regarded as the sharpest financial minds at work among the Wall Street powers.
When Genius Failed, then, offers a superb capsule history of the last generation's financial innovations. Lowenstein has written a bracing cautionary tale, too. For it isn't the least of the ironies attending the LTCM partners' fall from grace that, to a man, they were committed to (and had staked their personal fortunes on) realizing the ideals of managed risk in finance. But in their devotion to a hyper-rational faith in their mathematical models, they lost sight of the real, human, and unpredictable dangers in the markets they plied. Together, they unwittingly helped shape conditions of financial crisis on an almost unimaginable scale.
Lowenstein allows, however, that there is plenty of blame to be shared. The failures of accountability were systemic. John Meriwether, as always unwaveringly loyal to his traders, failed to rein in his partners' most extravagant gambles. The banks, made greedy by LTCM's gaudy profits, recklessly threw their money at the hedge fund traders, no questions asked. And even Alan Greenspan, the chairman of the Fed, comes in for a share of criticism for turning a blind eye to the need for regulating the derivative markets and hedge fund operators. When Genius Failed provides a shrewd, skeptical take on high finance today. It is a gripping, satisfying read.