When Genius Failed: The Rise and Fall of Long-Term Capital Management
by Roger Lowenstein, published 2000
Following the success of his first foray into the financial markets with a biography of Warren Buffett (entitled "Buffett: The Making of an American Capitalist"), Roger Lowenstein strikes once again in 2000 with the publication of his second book on the financial markets entitled "When Genius Failed: The Rise and Fall of Long-Term Capital Management" - a short biography and chronology of the infamous hedge fund (Long-Term Capital Management) that nearly collapsed the world's financial system, along with its many founders and advisors, including John Meriwether, David Mullins (former Vice Chairman of the Federal Reserve), Robert Merton and Myron Scholes (two academic heavyweights in finance who would go on to win the Nobel price in economics in 1997).
Lowenstein's ability to come up with a concise, coherent story and his experience in financial journalism is strongly evident in this book. Not only can Lowenstein weave together and tell a great story (this author felt he was being led through the history of the fund and its characters by one of its inner partners while reading through this book), he also pays attention to details whenever it is needed - and he succeeds greatly by catching many important subtleties (such as in the beginning of Chapter one when he used one of those "subtleties" in Meriwether's early career to explain the basis of LTCM's core business model and the subtle, but gradual "style drift" that brought down the hedge fund afterwards) as well as making many interesting observations along the way (such as the fatal flaw LTCM committed when it started engaging in stocks arbitrage as opposed to sticking to bond arbitrage).
In a nutshell, "When Genius Failed." is a story about risk-management - and what can happen to even the best-intentioned and the most intelligent of us when it is found lacking. In the weeks leading up to its collapse, LTCM committed most if not all mistakes in the typical risk-management guide, such as:
Getting into huge, illiquid, leveraged trades with no exit strategy. That is, if pricing patterns and asset class relationships did not converge to historical means, then there is no way of getting out. Their core strategy generally did not allow them to take losses. Moreover - because these positions were too big and illiquid to sell - there would be no exit strategy even if they tried to develop one.
Assuming historical relationships between asset classes would hold. Such a belief is generally not a bad assumption, but can be very dangerous when it is followed to a tee. In LTCM's case, this belief (and overconfidence) led to many of the traders to average into losing positions - which is generally a sure way to losing even more money down the road.
"Style drift," also known as venturing in areas where you do not have a trading edge. Starting with 1997, many of the LTCM partners started lamenting of the lack of opportunities - and because of this, many of the traders started trading in asset classes which they have not traded before, such as equity arbitrage and selling volatility in the S&P 500 (as an aside, trading equities are much more risky than trading bonds since there are many more variables with equities than with bonds).
In a game of poker and other games involving cards, it is usually suicidal if most of your opposing players found out what kind of hand you are holding. Towards the fall of 1998, not only did most of Wall Street's traders know LTCM was in trouble, they also knew many of the positions that LTCM had in the financial markets. These traders would go on to use this information to exacerbate LTCM's losses; and in the process, make money for themselves and their companies. Unfortunately, the financial markets can deal a pretty harsh lesson to traders who are careless or desperate - and towards the fall of 1998, most of the traders of LTCM were being both.
Combined with Lowenstein's great story-telling abilities, it is no wonder that this book was a "must-read" on Enron's trading floor, right along with Edwin Lefevre's "Reminiscences of a Stock Operator." In a strange twist of irony, Enron would also ultimately collapse mainly due to its lack of financial and accounting controls - not to mention the hubris of its traders and its aura of invincibility. Enron did not learn its lesson before it was too late. Hopefully, none of our readers will have to learn the hard way!