What happens when smart guys including some Nobel Prize winners borrow $125 billion to invest with huge leverage, gain further leverage from derivative contracts, and rely on markets remaining rational and investments remaining mostly uncorrelated to avoid blowing up? This is the story of the hedge fund Long-Term Capital Management (LTCM). Spoiler alert: they blew up.
Roger Lowenstein’s book When Genius Failed is an interesting account of LTCM’s seeming wild success starting in 1994 followed by its spectacular failure that threatened to take down the U.S. banking system in 1998. Apparently, “long term” is 4 years. Lowenstein does a good job of blending financial events with the personal interactions that were important to this story.
In its first four years, LTCM total returns were a staggering 311%! Even after deducting stiff management fees, investors were up 185%. Unfortunately, when trades started going against LTCM’s huge leveraged portfolio, it took only 5 months to erase all those gains and leave the fund’s total return at underwater at -67% before fees and -77% after fees.
“There wasn’t any risk—if the world had behaved as it did in the past.” At one point traders were shocked to see swap spreads surge as high as they did. Surges like this had “happened in 1987 and again in 1992,” but LTCM’s “models didn’t go back that far.”
You may wonder whether LTCM’s partners were evil geniuses who risked investor money and collected fat fees without risking their own money. This wasn’t the case. The partners believed so strongly in their methods that they left all their fees in the fund. They even found ways to add extra leverage to their personal stakes in the fund.
At one point not long before the blow-up, many outside investors were forced to take much of their money back. “The forced redemption of their money would come to seem a godsend.” The partners did this to increase their own stakes in the fund, a decision they came to regret.
One bad day showed the failure of LTCM’s models. LTCM, “which had calculated with such mathematical certainty that it was unlikely to lose more than $35 million on any single day, had just dropped $553 million” in one day.
George Soros had an opinion on LTCM’s methods: “The idea that you have a bell-shape curve is false. You have outlying phenomena that you can’t anticipate on the basis of previous experience.”
LTCM’s “employees, like most at Wall Street firms, had gotten most of their pay in the form of year-end bonus money. Most of those bonuses had been invested in the fund and went down the drain.” A bond trader said, “we ended up working for nothing.”
In the book’s epilogue, Lowenstein asks a good question. Regulators limit lending so that “loans do not exceed a certain ratio of capital. ... Why, then, does Greenspan endorse a system in which banks can rack up any amount of exposure they choose—as long as that exposure is in the form of derivatives?”
I found this book to be an interesting read, and it is instructive for anyone who doesn’t already have a healthy fear of leverage.