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The Rise and Fall of Long-Term Capital Management

Long-Term Capital Management (LTCM), founded in 1993, was a hedge fund management firm which commanded more than $100 billion in assets at the height of its existence, making it the world’s largest (ever!) investment fund.

And then, in August 1998, LTCM collapsed – just as spectacularly and rapidly as it rose.

In “When Genius Failed,” Roger Lowenstein draws on numerous interviews and discussions with everyone involved in the story to see what went wrong – after going so right so long.

Who Should Read “When Genius Failed”? And Why?

If you have some money set aside, and you are thinking about investing in a hedge fund – or even if you have a lot of money set aside, and you are thinking about investing in a hedge fund of funds – “When Genius Failed” may help you separate the facts from the fiction better than any other theoretical work.

After all, this happened – and even some of the smartest guys in the world couldn’t stop it from happening.

Which immediately calls to mind Nassim Nicholas Taleb and his ideas and contemplations about things such as randomness, fragility, and risk calculation.

In other words, here’s another book which proves them.

About Roger Lowenstein

Roger Lowenstein is an American writer and financial journalist.

Born in 1954 to famous lawyer Louis Lowenstein, Roger graduated from Cornell University and then spend more than ten years writing for “The Wall Street Journal.”

In 1996 he published his first book, “Buffett: The Making of an American Capitalist,” four years after which “When Genius Failed” followed. In 2004, Lowenstein published “Origins of the Crash,” which was described as “a crucial account of an era of excess and folly.”

Since then, he has published three more books: “While America Aged,” “The End of Wall Street” and “America’s Bank.”

Lowenstein is also the director of Sequoia Fund. Since 2016, he is also a member of the Board of Trustees of Lesley University.

“When Genius Failed PDF Summary”

In 1977, John William Meriwether – now considered a pioneer of fixed income arbitrage – formed the arbitrage group at Salomon Brothers.

A firm believer in mathematical market models, Meriwether hired the very best minds he could find, who basically used the arbitrage group to test their theoretical models.

In time, their confidence rose so high that they essentially started employing the martingale betting strategy: they doubled their bets every time a trade went against them.

They couldn’t be wrong – the trade going against their models was just such an improbable event that – most surely – it wouldn’t happen again.

However, improbable things happen all the time, and it was certainly difficult for Meriwether to predict that in 1991, a scandal (which he had little or nothing to do about) would force him out of Salomon Brothers.

So, three years later, Meriwether founded his own hedge fund, the Long-Term Capital Management.

Once again, he rummaged the academia and got the very best minds in the world on the Board of LTCM.

And when we say “the very best minds” – we really think that: Robert C. Merton and Myron Scholes.

These two will share the 1997 Nobel Memorial Prize in Economics for developing a new method to determine the value of derivatives” which is now known as the Black-Scholes-Merton formula, but which was colloquially known back then as “The Midas formula”

You get the reference, right?

According to Greek mythology, Midas was the guy who could turn anything he touched into gold.

Well, supposedly, so could Merton and Scholes’ formula!

Simply put, one could use it to hedge against losing a bet on the market, since the formula was able to work out how to place another bet in the opposite direction.

Essentially, this meant taking the risk out of trading, which essentially meant that banks were fighting each other on who is going to lend LTCM more money.

Hell, even St. John’s University put in $10 million dollars!

And the more money LTCM had, the more money it could make for its investors.

As expected, the initial success of LTCM dwarfed its competitors: it had annualized return of 21% in the first year of its existence, 43% in the second, and 41% in the third.

Just for comparison, what this means in real-world terms: during the mid-1990s, LTCM was twice bigger than the second largest mutual fund in the world, and a staggering four times as large as its closest hedge fund rival!

And then – it all went downhill!

The 1997 Asian crisis and the 1998 Russian default caught Merton and Scholes – and LTCM – by surprise. And the losses LTCM experienced were totally unexpected!

How unexpected?

Well, let’s just say that, according to the mathematical models (and, as you know, math is always right), there was only one in septillion chances that LTCM could lose everything in a single year.

And yet – that’s exactly what happened!

The calculations said that there was no way that LTCM could lose more than $35 in a single day.

During 1998, it started losing millions on a daily basis!

The lesson:

If Wall Street is to learn just one lesson from the Long-Term debacle, it should be that the next time a Merton proposes an elegant model to manage risks and foretell odds, the next time a computer with a perfect memory of the past is said to quantify risks in the future, investors should run—and quickly—the other way.

Key Lessons from”When Genius Failed”

1.      Long-Term Capital Management Was a Hedge Fund with a Lot of Hubris
2.      Apparently, There Is No Such Thing as a Midas Formula
3.      Humans Are Irrational – and, Consequently, So Is the Market

Long-Term Capital Management Was a Hedge Fund with a Lot of Hubris

Founded in 1994 by John W. Meriwether, Long-Term Capital Management (LTCM) described itself as “the financial technology company.”

For a reason – to them, as opposed to everyone else, trading wasn’t an art, but a science.

Meriwether hired the very best financial minds in the world at the moment – Myron S. Scholes and Robert C. Merton (who shared the Nobel Prize in Economic Studies in 1997) – and acted like it.

Scholes and Merton had devised a formula – colloquially known as the Midas formula – which should have essentially eliminated risk from trading.

Everybody was using it, but, obviously, no one better than its inventors.

The result?

LTCM had annualized returns of over 40% in its second and third year, and banks were fighting to lend it money.

Some people at Wall Street tried to raise some red flags, but LTCM saw pink: they believed they were smarter than everybody and that they were the first ones to break the system.

Apparently, There Is No Such Thing as a Midas Formula

However, two crises – the 1997 Asian financial crisis and the 1998 Russian default – resulted in the swift collapse of LTCM barely five years after it was founded.

Apparently, just like Midas’ touch, the Midas formula had one essential flaw: it couldn’t take into consideration the extent of the irrationality of the market and its speed (calculations were sometimes out-of-date few moments before they were even made).

In other words – it worked fine until it worked.

And then – it didn’t work at all.

Humans Are Irrational – and, Consequently, So Is the Market

The reason why both Warren Buffett and Charlie Munger claim that Benjamin Graham’s “The Intelligent Investor” is the essential book for traders is fairly simple.

Because the book is down-to-earth and instead of postulating some kind of a Midas formula, it promotes common-sense deeply rooted within the anecdote of Mr. Market as the wildly emotional guy you wouldn’t want to have as your partner.

Even though Merton disparaged the idea that investors could turn collectively irrational at some point, it seems that Mr. Market had the last laugh.

Because it can happen.

In fact, everything can.

The fact that you haven’t seen a black swan doesn’t mean that it doesn’t exist.

Like this summary? We’d like to invite you to download our free 12 min app, for more amazing summaries and audiobooks.”

“When Genius Failed Quotes”

Wall Street never polices itself in good times. Click To Tweet

To John Meriwether and his traders, money management was less an 'art' requiring a series of judgments than it was a 'science' that could be precisely quantified. Click To Tweet

The professors spoke of opportunities as inefficiencies; in a perfectly efficient market, in which all prices were correct, no one would have anything to trade. Click To Tweet

Long-Term fooled itself into thinking it had diversified in substance when, in fact, it had done so only in form. Click To Tweet

Long-Term was developing a sense of proportion all its own; like a man who pays for dinner with $100 bills and never asks for change, it had lost the habit of moderation. Click To Tweet

Our Critical Review

“When Genius Failed” doesn’t say anything new – the market is volatile, and there are no mathematical models which can circumvent this – but it relays this by means of the emblematic didactic story and in such a compelling manner that this book reads more like a thriller than a financial analysis.

Pick it up – and you will not be able to put it down until you reach the last page.

Emir Zecovic

Emir is the Head of Marketing at 12min. In his spare time, he loves to meditate and play soccer.