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

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

4.1 35
by Roger Lowenstein

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With a new Afterword addressing today’s financial crisis


In this business classic—now with a new Afterword in which the author draws parallels to the recent financial crisis—Roger Lowenstein captures the gripping roller-coaster ride of Long-Term Capital Management. Drawing on confidential internal


With a new Afterword addressing today’s financial crisis


In this business classic—now with a new Afterword in which the author draws parallels to the recent financial crisis—Roger Lowenstein captures the gripping roller-coaster ride of Long-Term Capital Management. Drawing on confidential internal memos and interviews with dozens of key players, Lowenstein explains not just how the fund made and lost its money but also how the personalities of Long-Term’s partners, the arrogance of their mathematical certainties, and the culture of Wall Street itself contributed to both their rise and their fall.

When it was founded in 1993, Long-Term was hailed as the most impressive hedge fund in history. But after four years in which the firm dazzled Wall Street as a $100 billion moneymaking juggernaut, it suddenly suffered catastrophic losses that jeopardized not only the biggest banks on Wall Street but the stability of the financial system itself. The dramatic story of Long-Term’s fall is now a chilling harbinger of the crisis that would strike all of Wall Street, from Lehman Brothers to AIG, a decade later. In his new Afterword, Lowenstein shows that LTCM’s implosion should be seen not as a one-off drama but as a template for market meltdowns in an age of instability—and as a wake-up call that Wall Street and government alike tragically ignored.

Editorial Reviews

From the Publisher
“A riveting account that reaches beyond the market landscape to say something universal about risk and triumph, about hubris and failure.”—The New York Times

“[Roger] Lowenstein has written a squalid and fascinating tale of world-class greed and, above all, hubris.”—Business Week

“Compelling . . . The fund was long cloaked in secrecy, making the story of its rise . . . and its ultimate destruction that much more fascinating.”—The Washington Post
“Story-telling journalism at its best.”—The Economist

Our Review
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.

--Gregory Tietjen

New York Times Book Review
A delightful portrait . . . Mr. Lowenstein has done a masterly job.
Chicago Tribune
A significant contribution to the craft of biography as well as an illuminating and comforting story for investors everywhere.
The singular achievement of Lowenstein's excellent biography.. is that it burnishes the Buffett myth while deconstructing it with heavy doses of reality.
Business Week
Lively, smoothly written, and elaborately researched, Buffett is likely to stand as the definitive biography.
Financial Times
Thoroughly researched and perceptive . . . a highly readable account.
Los Angeles Times
Lowenstein has accomplished something remarkable.
Publishers Weekly - Publisher's Weekly
In late September 1998, the New York Federal Reserve Bank invited a number of major Wall Street investment banks to enter a consortium to fund the multibillion-dollar bailout of a troubled hedge fund. No sooner was the $3.6-billion plan announced than questions arose about why usually independent banks would band together to save a single privately held fund. The short answer is that the banks feared that the fund's collapse could destabilize the entire stock market. The long answer, which Lowenstein (Buffett) provides in undigested detail, may panic those who shudder at the thought of bouncing a $200 check. Long-Term Capital Management opened for business in February 1994 with $1.25 billion in funds. Armed with the cachet of its founders' stellar credentials (Robert Merton and Myron Scholes, 1997 Nobel Prize laureates in economics, were among the partners), it quickly parlayed expertise at reading computer models of financial markets and seemingly limitless access to financing into stunning results. By the end of 1995, it had tripled its equity capital and total assets had grown to $102 billion. Lowenstein argues that this kind of success served to enhance the fund's golden legend and sent the partners' self-confidence off the charts. As he itemizes the complex mix of investments and heavy borrowing that made 1994-1997 profitable years, Lowenstein also charts the subtle drift toward riskier (and ultimately disastrous) ventures as the fund's traditional profit centers dried up. What should have been a gripping story, however, has been poorly handled by Lowenstein, who obscures his narrative with masses of data and overwritten prose. Agent, Melanie Jackson. Author tour. (Sept.) Copyright 2000 Cahners Business Information.
Library Journal
This is a marvelous, unauthorized chronicle of the rise, fall, and re-emergence of Long-Term Capital Management, a private hedge fund that in September 1998 benefited from a Federal Reserve-orchestrated $3.6 billion bailout. Based primarily on interviews with key players from the six banks that participated in the rescue of the firm, Lowenstein, who previously wrote Buffett: The Making of an American Capitalist, presents a well-crafted, easy-to-follow text. Readers will better appreciate the inner workings of the firm; the nuances of the individual partners; primary differences among investing in stocks, bonds, and derivatives; the fallacy of the efficient market hypothesis; the impact of computers on financial trading; and the importance of moderation. Recommended for both academic and public libraries. [Previewed in Prepub Alert, LJ 5/15/00.]--Norman B. Hutcherson, Kern Cty. Lib., Bakersfield, CA Copyright 2000 Cahners Business Information.\
Gary Weiss
Lowenstein has written a squalid and fascinating tale of world-class greed and, above all, hubris...we probably won't get a better account about the events that roiled the markets in 1998.
Business Week
Lowenstein does a masterly job of explaining both the theories used and how the fund succeed brilliantly in 1995 and 1996 . . . he makes a convincing argument...Lowenstein [is] one of the best financial journalists there is...
New York Times Book Review
This book is story-telling journalism at its best...Mr. Lowenstein's description of what went wrong is detailed and readable.

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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.

Meet 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.

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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. 35 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.
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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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