When Genius Failed

ROGER LOWENSTEIN

Reviewed by Todd

Throughout When Genius Failed, financial journalist Roger Lowenstein foreshadows the coming doom, and so there is no surprise in how the story of the Long-Term Capital Management fund ends. But what Lowenstein does best is show how blind arrogance brought down the company and almost the entire financial system. Building on the work of two Nobel laureates and the growing capabilities of computer technology, Long-Term Capital Management pushed academic theory further into real-world practice than had ever been done before, and it became a case study for how markets defy formulaic explanation. Lowenstein’s narrative, while set in the complicated financial market of today, tells an age-old story many will recognize.

The story begins with a Midwestern kid named John Meriwether, whose penchant for gambling and stocks eventually led him from teaching math in a high school classroom to trading bonds at Salomon Brothers. In the 1970s, the bond market was being revolutionized by the instant access to pricing that new computer technology brought, and Meriwether saw favorable odds everywhere. His earliest trading concentrated on spreads between various bond interest rates. These bonds were easy to value, and Meriwether found that the market often oversold the debt instruments in reaction to unfavorable news. As the spread widened, arbitrage opportunities were created, allowing him to place bets that spreads would contract after the emotion dissipated. His calculated gambles paid off handsomely for his employer, and he was quickly given more latitude in trading, but Meriwether believed he needed an edge in this new game.

His answer was to hire the best and brightest from academia. His growing Arbitrage Group was made up of students and professors with degrees from MIT, Harvard, and the London School of Economics. These data jockeys were quick to take to Wall Street. Their models suddenly meant something more than simply accolades in obscure journals; they were playing with real money now. Meriwether managed them, encouraged them, and protected them from the fraternity of Salomon’s trading floor. He also encouraged their interest in gambling, with internal wagering on everything from elections to frequent games of liar’s poker.

As his career at Salomon reached an apex, Meriwether was forced to leave after a trader under his watch was found to have committed several securities violations. Meriwether wanted to quickly regain his stature on Wall Street and formed a hedge fund under the name Long-Term Capital Management (LTCM). He sought to replicate the size and scope of the operation he had at Salomon. Meriwether easily recruited most of his intensely loyal team and added to the roster Robert Merton and Byron Scholes, superstars in academic finance and who, as the story of LTCM unfolds, both win the Nobel Prize in Economics for their overall work. And for his team he provided the means: one-and-a-quarter billion dollars to work with.

The traders picked up where they left off and started placing trades on bond interest spreads. Scholes had described the small amounts of money made on each trade to investors during the fund-raising as “vacuuming up nickels that others couldn’t see.” The only way to make large sums of money was through leverage, through taking on incredible amounts of debt to make the thousands of trades needed to earn substantial profits. This was both the genius and, as it turned out, the flaw of the strategy.

“‘You’re picking up nickels in front of bulldozers,’ a friendly money manager warned.”

The modeling that had been tested at Salomon and polished at the new company was working perfectly. Meriwether and his dream team had delivered a panacea: guaranteed results with little risk. In the first year, LTCM returned twenty-eight cents for every dollar their investors put in. The formulas told traders exactly what and when to buy. But as time went on, LTCM started to believe their modeling could work for other wagers. They were becoming victims of their own success: the money they were making needed someplace to go and opportunities in bonds were becoming harder to come by. It was relatively simple to predict a value of a bond; other instruments, like stocks, currencies, and interest rate swaps, carried higher risks, many of which required judgments on the part of the traders. This moved the firm dangerously further from the strategy of their success; regardless, in four years, LTCM quadrupled their capital and investors were ecstatic.

But in August 1998 everything came apart, and in a matter of five weeks, LTCM lost everything. Many of the bets they made were going the wrong way; rather than returning to historical norms, the bond spreads were widening. Meriwether’s traders watched in disbelief. The incredible amount of leverage that LTCM was using exacerbated the problem. Almost every firm on Wall Street was involved somehow, most having lent huge sums to LTCM. These firms had also built similar internal operations, making similar trades and competing with LTCM in many ways. In the end, the Federal Reserve pulled together a coalition of fourteen banks, which provided $3.65 billion to keep LTCM solvent. The bailout calmed markets, money was returned to investors two years later, and a chapter closed with real-world proof that markets are more than random movements.

We read narratives on history or industry for the lessons, and Lowenstein has many to share. He argues that the Fed’s intervention stopped the market from correcting itself, providing tinder for other financial recklessness. And while the fall of Enron was brought on by greed, the collapse of Long-Term Capital Management was a function of hubris: the traders believed they could predict the future. The book ends with a short note about Meriwether and his traders. They moved on two years after the collapse and formed JWM Partners with $250 million dollars of seed capital from the same people who helped start LTCM. With no consequences, was there ever a lesson learned? TS

When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House, Paperback 2001, ISBN 9780375758256

WHERE TO NEXT? Here for a book by Meriwether’s former trading colleague Here for another corporate failure that still reverberates Here for how to learn from failure | EVEN MORE: The Bonfire of the Vanities by Tom Wolfe; Liar’s Poker by Michael Lewis; Buffett by Roger Lowenstein