FA truly defining moment in the saga of Long-Term Capital Management occurs early in Roger Lowenstein's compulsively readable account of the rise and fall of the fabled hedge fund, When Genius Failed.
Picture this: it's the fall of 1993 and the legendary academic Myron Scholes is making a pitch to the Indianapolis insurance company Conseco, claiming his soon-to-be-operational hedge fund will make boatloads of money in relatively efficient markets by deploying its super-secret proprietary models and strategies. Scholes, mind you, was the future Nobel Prize winner and co-inventor of the Black-Scholes options pricing model, which is to the derivatives world roughly what Microsoft Windows is to the computing world. Abruptly, a brash young Conseco trader scoffs at Scholes' pitch: "No way you can make that kind of money in Treasury markets.”
Scholes lets the kid have it with both barrels: "You're the reason. Because of fools like you we can.”
There you have it—the basic pitch for LTCM: We're smart, you're stupid, so give us your money. But this is Wall Street we're talking about, so the academic arrogance—the smug superiority—is a spectacularly successful marketing strategy. When LTCM chief John Meriwether (often reverentially referred to by his monogram, "J.M.”) and his team of brilliant quants migrated to Steamboat Road in Greenwich, Conn., and opened their doors for business in February 1994, they were flush with $1.25 billion in other people's money. The venture was nothing short of the most successful start-up in the history of finance.
| Lowenstein reserves some of his most scathing criticism for the banks and derivatives dealers that allowed LTCm to have most-favored-nation status. |
With When Genius Failed, Wall Street Journal reporter Lowenstein has written a concise and revealing chronicle of the rise and fall of LTCM that keeps the pages turning even though the reader knows the outcome. Lowenstein's narrative is laced with inside knowledge of events; it's clear he had the benefit of numerous unattributed sources who were keen to get the true story of LTCM into print. LTCM's principals refused to respond to Lowenstein's queries, and this is clearly an unauthorized account of the firm and its personalities.
Which is not to say it's imbalanced. Indeed, contrary to the title, nearly the entire first half of the book is devoted to when genius succeeded. One of its first trades, an arbitrage on the Italian fixed-for-floating bond, netted $600 million. Several hundred million dollars came pouring in when LTCM closed out an IO-PO mortgage-backed convergence play. A French-German inflation rate arbitrage brought a vast profit. In 1994—its first year of existence—LTCM racked up a 24 percent gain for its investors (before fees) when the fixed-income markets were getting killed. Right out of the box, LTCM was the 1927 New York Yankees of the financial world.
Its particular brand of financial alchemy was no fluke. The string of killer trades continued apace for the next three years: 59 percent in 1995; 57 percent in 1996; 25 percent in 1997. Every dollar an investor ponied up in 1994 was worth $4.11 by April 1998—a more-than-fourfold return in as many years. With about 100 employees, LTCM made more profits than McDonald's did selling hamburgers all over the planet. These guys were scary-smart, and everyone wanted to be in business with them. Everyone.
Indeed, 55 banks and derivatives dealers signed on to do business with LTCM on take-em-or-leave-em terms that, with the benefit of hindsight, were egregiously one-sided. Lowenstein notes that, from the outset, LTCM's counterparties were willing to lend $28 to the fund for every $1 it had in real capital. (This would balloon to an astounding 200-to-1 leverage factor during LTCM's September 1998 crisis.) Effectively, Lowenstein notes, this meant that LTCM was able to play the markets "without using a dime of its own capital.” The advantage of borrowing the balance sheet of Merrill Lynch, UBS and Goldman Sachs (to name a few) for free was undeniably an enormous advantage over all other Wall Street players and contributed extra octane to LTCM's amazing performance in its first four years.
Nevertheless, the advantages conferred on LTCM simply magnified the stellar returns of its all-star team. As Lowenstein notes, LTCM "had no black box” with the "benefit of superior, virtually fail-safe technology.” It was the brilliance of the team that powered LTCM—the team's collective and individual "bred-type” personalities ("intellectual, introverted, detached, controlled”).
LTCM was populated by some of the best minds in the business, the core group of which worked for J.M. in the domestic fixed-income arbitrage unit at Salomon Brothers in the early 1980s. Not only was this the genesis of Long-Term, but the Salomon experience embodied a truly watershed phenomenon in the history of American finance—when the geeks inherited the earth. Powerful computer workstations such as the Sun SPARC completely transformed the dynamics of market trading. Old-school Neanderthal traders who relied on their "gut” were being systematically replaced by "the cool discipline of scholars, with their rigorous and highly quantitative approach to markets.”
At Salomon, J.M. pioneered this trend, then accelerated it, by assembling a team of MIT-Harvard math and physics geniuses, including Harvard Business School professor Eric Rosenfeld, London School of Economics grad Victor Haghani, MIT Ph.D. recipient Greg Hawkins, and the brilliant Lawrence Hilibrand who had two degrees from MIT. The original circle of eggheads would continue to dominate the culture of Long-Term until its demise, much to the frustration of partners brought on in the next few years—luminaries such as Myron Scholes, former New York fed chief David Mullens, and Robert Merton (also a Nobel Prize winner in Economics, and an unnamed contributor to the Black-Scholes model).
For all the color Lowenstein gives us on the personalities of Long-Term, there remains a glaring hole. Just who the hell is J.M., anyway? Lowenstein tells us who he is not, convincingly deflating the popular myth of J.M. as the coldly calculating gambler-cowboy who outgunned Salomon CEO John Gutfreund in a $10 million hand of liar's poker in Michael Lewis' best-seller about Salomon Brothers, Liar's Poker. (Gutfreund strenuously denies the incident ever took place, claiming Lewis made it up; still, the legend persists—it's too juicy to fade away.)
Unfortunately, trying to discern the cult of personality of John Meriwether is an exercise in grabbing smoke. We know he is astoundingly successful at surrounding himself with bright people; we know he is passionate about golf and horses; we know he is fiercely competitive; we know that LTCM was his bid for redemption after his career at Salomon was blown up by the Paul Mozer Treasury-bond auction scandal (for which the Securities and Exchange Commission unfairly tagged him with a one-size-fits-all "failure to supervise” censure); we know he has an almost Howard Hughes-like obsession with privacy. Nevertheless, the pieces of J.M. never quite add up to a complete picture.
Yet the paradox is that J.M.'s inaccessibility lent LTCM an aura of secrecy, privilege and exclusivity that left the blue-chip names in high finance positively drooling to be in business with him and his team. In fact, investors never complained about having to pay 20 percent in management fees to LTCM—twice the industry standard.
Within a few years, J.M., Hilibrand, Haghani and Rosenfeld amassed astronomical personal wealth. Each member of the inner circle was on his way to becoming a billionaire. Not known for conspicuous consumption, the LTCM inner circle regarded money as "just a scorecard—proof of their superlative trading skills,” notes Lowenstein. Still, when a Merrill marketer smitten with the LTCM mystique asked Myron Scholes, "What do you have more of, Myron, money or brains?” Scholes laughed, "Brains, but it's getting closer.”
As 1997 came to a close, LTCM stood at the very pinnacle of the world of finance. In 1998, it plunged into the abyss.
The pace of When Genius Failed turns breakneck as Lowenstein describes how the wheels came off of the LTCM wealth-creation machine. The reader takes a sweaty-palmed ride through the five-week jag in August-September 1998 when LTCM loses a heart-stopping $4.5 billion (or 91 percent) of its investors' money, as virtually every one of the 7,600 positions the firm has taken around the globe turns ugly.
How could this have happened? First and foremost, Lowenstein posits, there was no equivalent of Salomon's John Gutfreund at LTCM to put the brakes on overly aggressive trades. J.M. never scotched a trading strategy, even when it skewed perilously away from LTCM's core strategy of "riskless” convergence arbitrage trading. When spreads began to dry up in LTCM's bread-and-butter arbitrage plays in 1998, the team began making ill-fated investments in equity volatility, merger arbitrage, Russian sovereign debt and Japanese bonds. Many of these were directional bets, meaning they were completely unhedged.
Finally, the quants possessed a near-religious blind faith in the utter infallibility of their models, which Lowenstein believes disregarded the "human spirit” factor. Indeed, LTCM's risk-aggregation model predicted that—worst-case—the fund was exposed to no more than $35 million in potential losses. In fact, on Friday, August 21, 1998, LTCM lost $553 million—in a single trading day. Ergo, genius failed.
Predictably (and rightly so), Lowenstein reserves some of his most scathing criticism for the banks and derivatives dealers that allowed LTCM to have most-favored-nation status in all of its dealings: "[T]hrough their carelessness, their reckless financing, their vain attempts to ingratiate themselves with a self-important client, the Wall Street banks had created this fiasco together.”
And so it was that "an awesome gathering” occurred at the offices of the New York Fed on September 23, 1998, in which the cream of Wall Street convened in a conference room to determine whether an alliance could be formed to avert a systemic meltdown of the world markets that could potentially occur if LTCM failed. Once again, Lowenstein's access to witnesses of these proceedings provides a previously unseen and rich mosaic of this historic, behind-closed-doors event. Merrill's David Komansky shouting at Bear's Jimmy Cayne for refusing to contribute capital to the bail-out; Chase's David Phlug telling Goldman's Jon Corzine to "f—- himself” over a disputed loan guarantee; the revelation of an eleventh-hour lowball bid by a secret "Mr. Big” (none other than J.M.'s long-term nemesis, Warren Buffett). In retrospect, it's astounding just how fragile this high-powered consortium truly was.
In the end, When Genius Failed actually tells a much bigger story than it set out to do. LTCM's story surfaces as the most prominent symbol of a spectacular era when hedge funds reigned supreme, one in which trading genius (real or perceived) was lavishly rewarded, only to end in spectacular nine-figure train wrecks engineered by some of the greatest financial stars of our time: Soros, Robertson, Druckenmiller, Steinhardt, Neiderhoffer, Askin and countless others.
With When Genius Failed, Roger Lowenstein has put together a cautionary tale that the global financial markets would do well to reflect upon—the potentially combustible combination of easy credit, weak derivatives oversight and the cult of personality.
Stephen Rhodes is the pseudonym of a Manhattan-based derivatives attorney and author of the financial thriller, The Velocity of Money (Avon Paperbacks, 2000). His last contribution to this magazine was "The Most Powerful Player on Wall Street,” a Derivatives Comix in the October 1997 issue.
