Business Finance History

When Genius Failed: The Rise and Fall of Long-Term Capital Management (Summary)

by Roger Lowenstein

What happens when you give two Nobel Prize-winning economists and a team of Wall Street's most legendary traders the keys to a hedge fund? They create a 'money-printing machine' so certain of its own genius that it leverages itself over 100-to-1, places a trillion-dollar bet on the world's markets, and in a few short weeks, comes so close to collapsing that the Federal Reserve has to orchestrate a secret, multi-billion-dollar bailout to prevent a global economic meltdown.

The Smartest Guys in the Room Were Blind to Real-World Risk

LTCM's Nobel-winning partners believed their complex computer models had tamed market risk. But these models, built on historical data, failed to account for irrational human behavior and unforeseen 'black swan' events.

Their models assumed market spreads would always revert to their historical average. When Russia defaulted on its debt in 1998ā€”an event their models deemed virtually impossibleā€”investors worldwide panicked and fled to the safety of US Treasury bonds. This caused all of LTCM's supposedly uncorrelated bets to lose money simultaneously, vaporizing the fund.

Leverage Turns Small Errors into Catastrophic Failures

LTCM's strategy relied on making tiny profits on millions of trades. To generate meaningful returns, they used immense leverage, borrowing over $100 for every $1 of their own capital.

With a leverage ratio of over 100-to-1, even a minuscule 1% loss in their asset value would wipe out their entire capital base. When the market moved against them, their losses were magnified to an apocalyptic scale, forcing them to sell assets into a crashing market, which only accelerated their own demise.

Hubris Is the Most Dangerous Liability

The partners at LTCM were so convinced of their intellectual superiority that they ignored warnings, dismissed criticism, and refused to believe their models could be wrong, even as their fund was imploding.

As the fund was hemorrhaging hundreds of millions of dollars per day, founder John Meriwether and his partners remained stubbornly confident that the markets were being 'irrational' and would soon 'correct' in their favor. They even rejected an early buyout offer from Warren Buffett because they couldn't stomach admitting they had failed.

One Hedge Fund Can Threaten the Entire Global Economy

The sheer size of LTCM's positions meant its failure wasn't just its own problem. It threatened to trigger a chain reaction of defaults across Wall Street and around the world, creating a systemic crisis.

The New York Federal Reserve had to summon the heads of every major Wall Street bank and essentially force them to pony up $3.6 billion to bail out LTCM. It wasn't to save the fund's partners, but to prevent a systemic collapse, as LTCM's forced liquidation would have cratered markets and bankrupted many of its lenders.

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