When Genius Failed: The Rise and Fall of Long-Term Capital Management

When Genius Failed: The Rise and Fall of Long-Term Capital Management

by Roger Lowenstein


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Product Details

ISBN-13: 9780375758256
Publisher: Random House Publishing Group
Publication date: 10/09/2001
Edition description: Reprint
Pages: 304
Sales rank: 80,104
Product dimensions: 5.20(w) x 8.00(h) x 0.66(d)

About the Author

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.

Read an Excerpt


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 midwesterner, 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 TravelersSalomon 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.

Table of Contents

Chapter 1: Meriwether
Chapter 2: Hedge Fund
Chapter 3: On the Run
Chapter 4: Dear Investors
Chapter 5: Tug-of-War
Chapter 6: A Nobel Prize
Chapter 7: Bank of Volatility
Chapter 8: The Fall
Chapter 9: The Human Factor
Chapter 10: At the Fed

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When Genius Failed: The Rise and Fall of Long-Term Capital Management 4.1 out of 5 based on 0 ratings. 45 reviews.
Guest More than 1 year ago
There's an old saying to the effect that every army prepares to fight the last war, rather than the next one. In financial circles, the equivalent is to create models that optimize decisions in light of the history of financial markets. That is great, as long as the future is like the past. As soon as the future becomes different, this 'rear-view mirror' vision of the future can create terrible crashes. That's what happened with Long Term Capital Management (LTCM). The cost was almost a meltdown in the financial markets around the world. This cautionary tale should stand as a warning to regulators, investors, academicians, and traders about avoiding the same mistakes in the future. One particular reason to be so concerned is that John Meriwether and his crew of geniuses were back in business as of 1999, as reported by the book (apparently with some of the same investors as in LTCM). You may recall that Mr. Meriwether appeared in the book, Liar's Poker, by challenging John Gutfreund, CEO of Salomon Brothers, to one hand of liar's poker for ten million dollars. Mr. Gutfreund correctly declined, but lost face. Mr. Meriwether later had to leave Salomon Brothers after the firm was found to have failed to notify the Federal Reserve promptly after discovering that it had been violating rules on bidding for government securities. In this book, you will learn more about Mr. Meriwether and his love of brilliant people, betting on everything in sight, and taking outside bets when the odds seemed to be in his favor. This approach can work well when the odds can be known, but that is not the case in the financial markets. Mr. Meriwether did not make himself available to the author. Roger Lowenstein is our most talented financial writer (you may remember him from his days at The Wall Street Journal and for his wonderful biography on Warren Buffett), and he has produced an outstanding work that will be a cautionary tale for future generations about the financial myopia of the 1990s. Long Term Capital Management was built around consensus in the financial markets. The firm attracted the thinkers in the financial markets with the greatest reputations (including future Nobel Prize laureates, Robert Merton and Myron Scholes -- of Black-Scholes option pricing fame, and the top talent from the arbitrage area at Salomon Brothers), a top regulator (the vice-chairman of the Federal Reserve Board), famous investors from the top investment banks and consulting firms, and lines of credit from every major financial institution in these markets. The firm planned to invest by finding small mispricings of one security versus another (such as the interest rate on one bond maturity versus another compared to history, an option versus the underlying stock for the time remaining on the option, a bond yield in a foreign currency versus the currency futures, and the price of a stock versus a hostile takeover bid price for the company). Here, it hoped to proverbally make lots of nickels by borrowing lots of money to make these trades. Although other firms took similar risks (and many also took enormous losses in 1998), LTCM stood out for two things: It had no independent evaluation of its risk to control what it was doing (the traders monitored themselves -- a little like letting the fox guard the hen house) and it took on vastly more debt than others did compared to its equity base. At the firm's peak, it had borrowed over $100 billion against a base of $4 billion in equity and had derivative (option) positions for an exposure of another $1 trillion. This enormous finanical leverage magnified the size of any gains or losses it took. Part of what had been deceptive is that the firm had been regularly and spectacularly profitably for most of its initial four years. What the firm had neglected was to consider what might happen to historical price differentials in a market crisis (particularly a 'stress-loss liquidation'). In 1998, an unprece
Guest More than 1 year ago
Lowenstein has captured the factors that led to the failure of a major brain trust. More importantly, he provides a lucid guide to classic models in psychology, logic, and risk management that can be applied to our own investing activities. All that - and a great read, too.
Carmenere on LibraryThing 7 months ago
This book is aptly named as it delivers just what the title implies. Young John Meriwether began his career as a high school math teacher. After only one year of teaching he enrolled in the University of Chicago and began work to attain a business degree after which he was hired by the investment giant, Solomon Bros. Just as inflation was changing the way bonds were sold and held, Meriwether entered the field in the mid 1970¿s as a bond trader. Being one to adapt to a situation he found a niche for himself working within a division of Solomon and with other egghead intellectuals or quants, if you will. The quants, using quantitative methods , historic data and computer models, played the market to their advantage. Meriwether soon left his division of Solomon to create his own firm, Long Term Capital Management. By using an increasingly large amount of leverage to purchase bonds and work the spread Long Term became quite a significant power on Wall Street in just a short period of time. Still, Meriwether, his ultra private partners, and Nobel Prize winner mathematicians could not have foreseen the world events that transpired in the later part of the 1990¿s which had a negative effect on their investments. They had sent themselves on a course for disaster.This book could have been just another rehashing of Wall Street greed but it is more than that. Lowenstein offers up enough information about the major players to humanize them, each with their own foibles, ambitions and wants. The reader who is not familiar with John Meriwether and Long Term Capital Management will be on the edge of their seat as the story unfolds watching each personality react to dire situations.
ElectricRay on LibraryThing 7 months ago
A couple of years ago I read Nick Dunbar's account of the LTCM collapse "Inventing Money", and a friend recently lent me this book. They make an interesting comparison.Dunbar - a physicist by trade - is more interested in the theoretical economics that went into the risk arbitrage fund in the first place and how this came unstuck. He gives a long description of the Black-Scholes model, what it says, and how it was used to pull off the risk "free" trades which made Long Term so much money for three or four years.Lowenstein, by contrast, barely mentions either the Black-Scholes model (he barely touches on option pricing at all, as a matter of fact) or the Italian convergence trades which eventually blew the gaffe on the fund, but instead tells the human story, exposes the inevitable egos, and indulges in more than a little smuggery (this book is long on wisdom after the fact) in dissecting the naivety of the LTCM hedging and trading strategy and the people who ran it.As long as he sticks to the egos and the posturing, When Genius Failed is a dandy read: the negotiations amongst the Wall Street top brass as the fund is going under rate with anything served up in Barbarians at the Gate, and as this is a large part of the book, it rips along quite nicely.But the schadenfreude grates: One of the lessons of the whole fiasco was that the smart money is with the guy who can predict the future: any old mug can be a genius with hindsight. Lowenstein spends a lot of his time wisely pointing out what the traders should have done.Additionally, Lowenstein employs some metaphors which indicate he might not have much of a grip on his subject: for one, he states "a bit of liquidity greases the wheels of markets; what Greenspan overlooked is that with too much liquidity, the market is apt to skid off the tracks." It's a poor metaphor, because it isn't excess liquidity which causes markets to skid, rather, it's the sudden disappearance of it. As this is the fundamental lesson of the Long Term story, it's a bad mistake to make for the sake of a smart-alec aphorism. Similarly, in the epilogue states, with regard to the putative diversification in the fund "the Long-Term episode proved that eggs in separate baskets *can* break simultaneously". Again, this conclusion is not supported by the text, which observes several times that in a market crash, liquidity drains and the correlation risk of instruments in the market goes to one: that is to say, it turns out all your eggs are in the same basket after all. Diversity wasn't the problem; the problem was you wrongly thought you had it.For these reasons I prefer Dunbar's more academic work: it may not be such a sizzling read, but nor does it misguidedly kick a fund when it's down.
browner56 on LibraryThing 7 months ago
This book traces the rise, fall, and rescue of Long-Term Capital Management, perhaps the most celebrated (and infamous) hedge fund in history. It is a remarkable account of how a lot of really smart people¿from the fund¿s partners to its bankers to the regulators charged with protecting the public¿s interest¿did some things that, with the luxury of hindsight, proved to be very foolish. It is a story with few heroes, but one with many lessons to be learned. However, beyond merely offering a cautionary tale of how greed, hubris and myopia almost brought down the entire financial system, Lowenstein also provides the reader with an excellent description of the myriad investment strategies that continue to be employed by the hedge fund industry today. At the very least, this is a book that will challenge what you think you know about leverage, liquidity and diversification.
cfiedler on LibraryThing 10 months ago
This is an awesome chronicling of the rise and billion dollar fall of the guys from Solomon brothers. Roger did some great investigative journalism.
shawnd on LibraryThing 10 months ago
I remember this to be captivating. I am not especially interested in hedge funds or Wall Street. I was interested in a current non-fiction about business and especially some dramatic turn of business events; I liked Barbarians at the Gate. This has about 2/3 of the movement, pace, and drama of that, or perhaps half, but it's enough.I was especially surprised about the unique characters of some of the geniuses these hedge funds have and this one had. It's always fascinating to here about the maladaptive and weird personalities of these chess masters or math minds.I would suggest this book to anyone who likes business, even though it's about finance a bit.
piefuchs on LibraryThing 10 months ago
A wonderful account of the fall of LTCM. Well written and detailed - one of the better business books I have read.
name99 on LibraryThing 10 months ago
Roger Lowenstein does a good job of telling this sort of story, making it far more interesting than the usual journalist's book about some business venture. But ultimately this is a depressing and frustrating book. Not only do the principals involved not really get their just desserts, the mathematicians of finance involved don't seem to learn anything from the experience.It seems to me that, among other things, the following could be added to the mathematics* replace normals in certain situations with fatter-tailed curves* construct finite universe models (ie models in which there is only so much demand and supply, and in which huge trades will result in a drying up of liquidity)* dynamic rather than static models, ie models that, rather than assuming a stable equilibrium (thermodynamics), try to model exactly how things change (including, in the simplest case, how things approach equilibrium). Such a model might include different types of environments, leading to different dynamics, for example a bear market environment, a bull market environment and a panic environment. Thus we get something closer to statistical mechanics.On the other hand, it may well be that the mathematicians know exactly how to make better models, but are also well aware that in spite of the rhetoric, the system will usually bail them out when something goes wrong, so why not take risks with high upside and limited downside?
sthitha_pragjna on LibraryThing 11 months ago
The best account I have hitherto read of leverage, lack of liquidity, and the meltdown of LTCM, as the dislocation and irrationality of the markets lasted longer than the rationality and solvency of their margins. Caveat emptor of securities.
mynameisvinn on LibraryThing 11 months ago
possibly the best finance book i've read. explains many arcance financial topics with brilliance. very well written
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sbrita More than 1 year ago
This is more a great story than an insightful education on how mutual funds and derivatives work. Only a very small percentage of us, probably less than 1%, will ever trade equity risk or margin spreads on bonded debt, but thats what LTCM did. Its a great story of hubris - the smartest guys on wall st - imploding to great degree. The book gives good insight into how reckless traders can get and how unregulated the trading system is with Hedge Funds and other private investing groups. The bottom line is - they lost $5 billion but mostly only hurt the banks. After losing it all they still were able to raise another $250-million and start another fund. I think it was a mirror image of what happened 10 years after with the 2008 crash. The Fed stepped in and saved the banks. The book definitely does not paint a decent portrait of the established investment houses; they come off and nothing short of greedy and sadistically cruel to their companions who are falling apart - but thats wall st. Would recommend more for the story line than actual learning about hedge investments and how they all blew up . . .but you'll get the basics.
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