When Genius Failed chronicles meteoric rise and fall of Long Term Capital Management. Once dubbed as a fund that could do no wrong and would always stay ahead of market no matter the circumstances, LTCM’s demise was sudden and turbulent. Lowenstein has recounted the story with great detail.
If you are a serious reader of finance this book is a ‘must read’ on your list. We normally are aware of the happenings in the equity market. The ticker tape that runs incessantly at the bottom of all the business and news channels always keeps us abreast of the markets in general. But the world of bond trading is a much larger, shadowy and murky world, one where fortunes are made and lost in very short time. The partners of Long Term Capital Management were the stars of this world. Led by John Meriwether of the Salomon Brothers, the fund had a stupendous start. Studded with such high profile names as Merton and Scholes, winner of Noble Prize for their work on pricing of derivatives, LTCM gave serious backing to the mathematical models advanced by them.
The fund made some serious money in initial years. In first four years the fund gave a whopping 400% plus returns. But the going was too good to last and the fund collapsed in the fall of 1998 threatening to pull the financial system along with it before it was bailed out by banks at the behest of Fed. So what went so spectacularly wrong?
- LTCM relied on the basic tenet that markets always work in a rational manner. It bet that the pricing differences found in similar type of assets are aberration and will disappear over time as market corrects its mistake. They scooped the nickels out of thin air i.e. using leverage they used a small amount of capital to generate higher returns using theses arbitrage models. It worked fine till 1998 when market turned against them.
- The market can remain irrational for more than we can remain solvent and LTCM learnt this lesson very dearly. After Russia defaulted in 1998, there was a general flight to safety and liquidity dried up just as it happened in 2008 again. LTCM’s positions turned negative and the massive leverage became millstone around their neck.
- LTCM was very secretive about its positions and justly so. But the market began to learn about their positions and other firms started following them thereby reducing the pricing gap and shrinking profits. Having a 5 billion fund did not help either as LTCM was now fishing for fast evaporating opportunities thus ending up taking huge leveraged positions in assets that were illiquid. This did not leave an exit route and the moment markets turned against them, they were hard pressed for putting up more collateral as the positions dwindled.
- Without leverage LTCM may have been able to hold on to the positions but as soon as their problems leaked out traders at other firms who were closely following LTCM used this knowledge to hammer their positions further thus putting LTCM into a long slide from which it was difficult to recover as their capital started eroding fast.
- The models used by LTCM were backward looking. They assumed that past would repeat itself and future volatility will be same as past. But this is not true as the events that trigger a fall in the market are always surprises.
- LTCM also made the classic mistake of ‘Style Drift’. As the opportunities in their trade reduced, they ventured into unknown areas like equity arbitrage which is much more volatile and irrational as compared to bond arbitrage. LTCM took such big positions that their trade comprised significant chunk of the market and it became impossible for them to exit in a hurry without hurting themselves.
The fall of LTCM was a precursor to 2008. It showed how the intermediaries in the market have got intertwined with each other. Thus when in crisis as liquidity evaporates, it becomes a three legged race and in their flight towards safety everybody ends up tripping everybody else. This also highlighted government’s increasing role in checking excesses in the market, something that the governments across the world are still trying get the handle on. But there are some differences as well. The money was lost but it was lost honestly. The clients were not intentionally ripped off. LTCM fell victim to its own beliefs and the partners lost the most.
When Genius Failed is a well researched book. Not particularly witty and flashy as Michael Lewis’s Liar’s Poker, it is backed by solid research. Lowenstein is able to recount the events in detail narrating the thinking process of the partners who were secretive in their dealings. If you are interested in the world of derivatives and quant then this book is a definite read for you.
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