“When Genius Failed” – Roger Lowenstein – A Book Review

When Genius Failed

“Bet on a horse that craps just before the race.”John Meriwether

Roger Lowenstein is a financial journalist who often writes for the New York Times and this book, “When Genius Failed” is a fast paced account of one of the most spectacular blowups on Wall Street – that of the ironically named Long Term Capital Management. LTCM’s demise runs like a tense movie trailer for what we saw happen globally in 2008.

The cast of characters:

John Meriwether – A mild mannered mid-westerner and former Salomon Brothers bond trader in the 80s who rose to become vice chairman of the company in 1988. Solly sold the very first mortgage backed security and their bond traders were the “big swinging dicks” of the era. Meriwether was “the King of the Game” and acknowledged as the best bond trader on Wall Street. Just to give you an idea of the culture, they said that to do well on the trading floor at Sollys you had to come to work each morning “ready to bite the ass off a bear.”

Meriwether resigned when Salomon got nailed in a Treasury scandal under his watch and was fined $290 mn – the largest fine ever levied on a bank (up until that time). (“Liar’s Poker,” by Michael Lewis, a former Salomon bond salesman, describes that era and culture in a hilarious manner and I’ll have to get to reviewing it soon).  (I did and you can read the review here). Meriwether founded LTCM shortly after leaving Salomon.

Myron Scholes – A Canadian economist who was awarded the Nobel Prize in Economics in 1997 for his work with Fischer Black on pricing derivatives – the infamous “Black-Scholes” model. He co-founded LTCM with Meriwether in 1994.

Robert Merton – A financial economist who was lauded in academia for his innovative theories and who shared the Nobel Prize in Economics with Scholes.

While it is easy in hindsight to point fingers, one has to wonder how things could have ended any other way when you start off with a fearless bond trader and two financial academics who believe the world can be mathematically explained and placed in a neat little black box.  As Lowenstein puts it, “All of them were very smart. And they knew they were very smart.”

Roger Lowenstein
Myron Scholes – smart guy

Their clients believed that investing with such smart guys was a smart move and LTCM managed to rope in a huge number of investment banks and sovereign wealth funds as cornerstone clients. The firm launched in 1994 with $1.25 bn – the largest start up ever. LTCM enjoyed a few years of great success, racking up gains of up to 40% a year based on their infallible pricing models and solid belief in exploiting tiny credit spreads using massive leverage. It was failsafe, picking pennies up before a train. And everything went as the model predicted as long as markets were calm.

“It looks a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”

So wrote English essayist G.K. Chesterton and it was his view, and very much mine, that life can’t be predicted and measured and placed nicely in a box. Remember “chaos theory” in Jurassic Park? Jeff Goldblum plays the mathematician and chaos theorist Dr. Ian Malcom and says, “God help us; we’re in the hands of engineers.” And we all know how that ends.

John Hammond: All major theme parks have had delays. When they opened Disneyland in 1956, nothing worked!

Dr. Ian Malcom: But, John. If the Pirates of the Caribbean breaks down, the pirates don’t eat the tourists.

The Asian Crisis hit in 1997, sparked by Thailand’s devaluation. Eventually the IMF had to step in and bailout Thailand, Korea and Indonesia. Then things calmed for a while and credit spreads tightened.  The Dow continued to climb and it looked on the surface that the turmoil was behind us. As we know, this was the calm before the storm because the effects of the Asian Crisis continued to spread and hit Russia hard. Credit spreads widened dramatically and LTCM began to lose money. By the first half of 1998, LTCM was down 14% – it’s first losing streak. With prices down so much Meriwether the trader decided to double up and LTCM went long Russia. Big. Right before the explosion.

On August 17th, Russia defaulted. Markets collapsed. Investors worldwide piled into Treasurys, selling everything else. Spreads blew apart and LTCM lost money every day. They couldn’t sell their positions as there were no buyers. Liquidity evaporated. The market was behaving “irrationally” and “not according to the model.” OK, guys, you’re toast.

The partners at LTCM lost all their money. The Fed had to step in and coordinate a massive rescue of the fund and their derivative contracts. The view was if they didn’t, the contagion effect of those contracts not being honored would bring down counterparty banks. These smart guys with their neat pricing models, levered 25 times using derivatives, were half a step away from wreaking total financial armageddon. We saw something similar but on a grander scale with the Global Financial Crisis.

Models + Derivatives + Leverage = Hillbilly + Monster Truck + Jim Beam.

John Meriwether immediately went on to found another hedge fund which grew to $3 bn in size using the same strategies as LTCM. That blew up too in the crisis of 2008. He has since founded another fund but is reportedly having trouble raising money as it too, will use the same strategy as LTCM. Good grief. The horse keeps crapping but isn’t winning any races.

When Genius Failed” chronicles the high drama of the LTCM story; of making and losing billions of dollars while threatening the existence of the planet. It makes a very gripping read with lessons that ring true today. Highly recommended.

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2 Comments Add yours

  1. Hazel Vargas
    October 25, 2012
    10:42 pm #comment-1

    I am halfway through the book and I am appalled that this book has not been discussed more in the mainstream media. This is very relevant in the elections coming up in just two weeks. I like your review, but it assumes that your reader will know the terms: leverage, capital gains, derivatives, swaps, institutional investors, models, contagion, sovereign banks, investment banks, bailouts, Wall Street, disclosure, etc. I understand them (finally), but the 47% among us may not. How many people buy stocks or bonds or invest in these exotic financial products? Only the 1% — the rest are “noise makers” as labeled by the LTCM gang. These terms are not well understood even by educated people and people ignore news that speak in a “foreign” language.

    Our economy — and the world’s economy — is the way it is now, because of what went on in the era of LTCM in 1978-1980s , when its tentacles of doom spread throughout the financial world and engulfed even conservative institutional investors. Prudent government officials and private investors were ignored when they voiced their concerns. Greed won. The government policies that allowed this to happen is to blame, and which President/s or party allowed this to happen? While I am not saying that Democrats are blameless, Republicans have sinned more. It happened or began on their watch. And how long did it take for the real economic results to surface? Four years – oh, wait, eight years – the equivalent of two Presidential terms. Do the math.

    People don’t understand or realize the importance of changing the culture of Wall Street—an ordinary citizen does not have a personal connection to it. They do not see why the government needs to step in, in order to effect responsible regulations and disclosure obligations, and fair tax policies. That without this reform, history will repeat itself. Ordinary investors (the market “noise makers”) do no stand a chance against a select and exclusive group of big money investors, whose very capital is derived from borrowed money, and which borrowed money is derived from ordinary mortals like you and me, and which our own money in the end (the bailout money) saved us from complete ruin. People who bet large (meaning billions in capital “B”) of borrowed money on winners and losers in the Wall Street game as a business policy are not job creators. They are job wreckers. And it will take eight years for you and me to realize why you are feeling the pain.

    My suggestion: I wish someone would explain this complex economic scenario as a graphic illustration — e.g., a cobweb or an inverted pyramid or an atomic bomb mushroom cloud – showing the main players, the effects of their actions, the government policies that allowed those effects, and how it entangled the whole wide world. No statistical graphs – people don’t always understand them. Bring it down to lay language.

    • Derek
      October 26, 2012
      5:37 am #comment-2


      A great comment and sentiments that I wholeheartedly agree with.

      Enjoy the rest of the book.



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