It has been a busy year between work, play, family, and of course the recent elections. My work responsibilities contain a wide-ranging number of facets, but in addition to research, client meetings, conference calls, conferences, trading, and other activities, I also attempt to squeeze in some leisure reading as well. While it’s sad but true that I find pleasure in reading SEC documents (10Ks and 10Qs), press releases, transcripts, corporate presentations, financial periodicals, and blogs, I finally did manage to also scratch When Genius Failed by Roger Lowenstein from my financial reading bucket list.
When Genius Failed chronicles the rise and fall of what was considered the best and largest global hedge fund, Long Term Capital Management (LTCM). The irony behind the collapse makes the story especially intriguing. Despite melding the brightest minds in finance, including two Nobel Prize winners, Robert Merton and Myron Scholes, the Greenwich, Connecticut hedge fund that started with $1.3 billion in early 1994 managed to peak at around $140 billion before eventually crumbling to ruin.
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With the help of confidential internal memos, interviews with former partners and employees of LTCM, discussions with the Federal Reserve, and consultations with the six major banks involved in the rescue, Lowenstein provides the reader with a unique fly-on-the-wall perspective to this grand financial crisis.
There have certainly been plenty of well-written books recounting the 2008-2009 financial crisis (see my review on Too Big to Fail), but the sheer volume has burnt me out on the subject. With that in mind, I decided to go back in time to the period of 1993 – 1998, a point at the beginning of my professional career. Until LTCM’s walls began figuratively caving in and global markets declined by more than $1 trillion in value, LTCM was successful at maintaining a relatively low profile. The vast majority of Americans (99%) had never heard of the small group of bright individuals who started LTCM, until the fund’s ultimate collapse blanketed every newspaper headline and media outlet.
Meriwether: John W. Meriwether was a legendary trader at Salomon Brothers, where he started the Arbitrage Group in 1977 and built up a successful team during the 1980s. His illustrious career is profiled in Michael Lewis’s famed book, Liar’s Poker. Meriwether built his trading philosophy upon the idea that mispricings would eventually revert back to the mean or converge, and therefore shrewd opportunistic trading will result in gains, if patience is used. Another name for this strategy is called “arbitrage”. In sports terms, the traders of the LTCM fund were looking for inaccurate point spreads, which could then be exploited for profit opportunity. Prior to the launch of LTCM, in 1991 Meriwether was embroiled in the middle of a U.S. Treasury bid-rigging scheme when one of his traders Paul Mozer admitted to submitting false bids to gain unauthorized advantages in government-bond auctions. John Gutfreund, Salomon Brothers’ CEO was eventually forced to quit, and Salomon’s largest, famed shareholder Warren Buffett became interim CEO. Meriwether was slapped on the wrist with a suspension and fine, and although Buffett eventually took back Meriwether in a demoted role, ultimately the trader was viewed as tainted goods so he left to start LTCM in 1993.
LTCM Team: During 1993 Meriwether built his professional team at LTCM and he began this process by recruiting several key Salomon Brothers bond traders. Larry Hilibrand and Victor Haghani were two of the central players at the firm. Other important principals included Eric Rosenfeld, William Krasker, Greg Hawkins, Dick Leahy, Robert Shustak, James McEntee, and David W. Mullins Jr.
Nobel Prize Winners (Merton & Scholes): While Robert C. Merton was teaching at Harvard University and Myron S. Scholes at Stanford University, they decided to put their academic theory to the real-world test by instituting their financial equations with the other investing veterans at LTCM. Scholes and Merton were effectively godfathers of quantitative theory. If there ever were a Financial Engineering Hall of Fame, Merton and Scholes would be initial inductees. Author Lowenstein described the situation by saying, “Long-Term had the equivalent of Michael Jordan and Muhammad Ali on the same team.” Paradoxically, in 1997, right before the collapse of LTCM, Merton and Scholes would become Nobel Prize laureates in Economic Sciences for their work in developing the theory of how to price options.
Founded in 1993, Long-Term Management Capital was hailed as the most impressive hedge fund created in history. Near its peak, LTCM managed money for about 100 investors and employed 200 employees. LTCM’s primary strategy was to identify mispriced bonds and profit from a mean reversion strategy. In other words, as long as the overall security mispricings narrowed, rather than widened, then LTCM would stand to profit handsomely.
On an individual trade basis, profits from LTCM’s trades were relatively small, but the fund implemented thousands of trades and used vast amounts of leverage (borrowings) to expand the overall profits of the fund. Lowenstein ascribed the fund’s success to the following process:
“Leveraging its tiny margins like a high-volume grocer, sucking up nickel after nickel and multiplying the process a thousand times.”
Although LTCM implemented this strategy successfully in the early years of the fund, this premise finally collapsed like a house of falling cards in 1998. As is generally the case, hedge funds and other banking competitors came to understand and copy LTCM’s successful trading strategies. Towards the end of the fund’s life, Meriwether and the other fund partners were forced to experiment with less familiar strategies like merger arbitrage, pair trades, emerging markets, and equity investing. This diversification strategy was well intentioned, however by venturing into uncharted waters, the traders were taking on excessive risk (i.e., they were increasing the probability of permanent capital losses).
- 1994 (28% return, 20% after fees): After attempting to raise capital funding in 1993, LTCM opened its doors for business in February 1994 with $1.25 billion in equity. Financial markets were notably volatile during 1994 in part due to Federal Reserve Chairman Alan Greenspan leading the first interest rate hike in five years. The instability caused famed fund managers Michael Steinhardt and George Soros to lose -$800 million and $650 million, respectively, all within a timespan of less than a week. The so-called “Mexican Tequila Crisis” that occurred at the end of the year also resulted in a devaluation of the Mexican peso and crumbling of the Mexican stock market.
- 1995 (59% return, 43% after fees): By the end of 1995, the fund had tripled its equity capital and total assets had grown to $102 billion. Total leverage, or the ratio of debt to equity, stood around 28 to 1. LTCM’s derivative contract portfolio was like a powder keg, covering positions worth approximately $650 billion.
- 1996 (57% return, 41% after fees): By the spring of 1996, the fund was holding $140 billion in assets, making it two and a half times as big as Fidelity Magellan, the largest mutual fund on the planet. The fund also carried derivatives valued at more than $1 trillion, all financed off a relatively smaller $4 billion equity base. Investors were loving the returns and financial institutions were clamoring to gain some of LTCM’s business. During this period, as many as 55 banks were providing LTCM financing. The mega-returns earned in 1996 came in large part due to profitable leveraged spread trades on Japanese convertible bonds, Italian bonds, junk bonds, and interest rate swaps. Total profits for the year reached an extraordinary level of around $2.1 billion. To put that number in perspective, that figure was more money generated than the profits earned by McDonalds, Disney, American Express, Nike, Xerox, and many more Fortune 500 companies.
- 1997 (25% return, 17% after fees): The Asia Crisis came into full focus during October 1997. Thailand’s baht currency fell by -20% after the government decided to let the currency float freely. Currency weakness then spread to the Philippines, Malaysia, South Korea, and Singapore. As Russian bond spreads (prices) began to widen, massive trading losses for LTCM were beginning to compound. Returns remained positive for the year and the fund grew its equity capital to $5 billion. As the losses were mounting and the writing on the wall was revealing itself, professors Merton and Scholes were recognized with their Nobel Prize announcement. Ironically, LTCM was in the process of losing control. LTCM’s bloated number of 7,600 positions wasn’t making the fund any easier to manage. During 1997, the partners realized the fund’s foundation was shaky, so they returned $2.7 billion in capital to investors. Unfortunately, the risk profile of the fund worsened – not improved. More specifically, the fund’s leverage ratio skyrocketed from 18:1 to 28:1.
- 1998 (-92% return – loss): The Asian Crisis losses from the previous year began to bleed into added losses in 1998. In fact, losses during May and June alone ended up reducing LTCM’s capital by $461 million. As the losses racked up, LTCM was left in the unenviable position of unwinding a mid-boggling 60,000 individual positions. It goes almost without saying that selling is extraordinarily difficult during a panic. As Lowenstein put it, “Wall Street traders were running from Long-Term’s trades like rats from a sinking ship.” A few months later in September, LTCM’s capital shrunk to less than $1 billion, meaning about $100 billion in debt (leverage ratio greater than 100:1) was supporting the more than $100 billion in LTCM assets. It was just weeks later the fund collapsed abruptly. Russia defaulted on its ruble debt, and the collapsing currency contagion spread to global markets outside Russia, including Eastern Asia, and South America.
The End of LTCM
On September 23, 1998, after failed investment attempts by Warren Buffett and others to inject capital into LTCM, the heads of Bankers Trust, Bear Stearns, Chase Manhattan, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Brothers all gathered at the Federal Reserve Bank of New York in the heart of Wall Street. Presiding over this historical get-together was Fed President, William J. McDonough. International markets were grinding to a halt during this period and the Fed was running out of time before an all-out meltdown was potentially about to occur. Ultimately, McDonough was able to get 14 banks to wire $3.65 billion in bailout funds to LTCM. While all LTCM partners were financially wiped out completely, initial investors managed to recoup a small portion of their original investment (23 cents on the dollar after factoring in fees), even though the tally of total losses reached approximately $4.6 billion. Once the bailout was complete, it took a few years for the fund to liquidate its gargantuan number of positions and for the banks to get their multi-billion dollar bailout paid back in full.
- 1999 – 2009 (Epilogue): Meriwether didn’t waste much time moping around after the LTCM collapse, so he started a new hedge fund, JWM Partners, with $250 million in seed capital primarily from legacy LTCM investors. Regrettably, the fund was hit with significant losses during the 2008-2009 Financial Crisis and was subsequently forced to close its doors in July 2009.
- The Risks of Excessive Leverage: Although the fund grew to peak value of approximately $140 billion in assets, most of this growth was achieved with added debt. When all was said and done, LTCM borrowed more than 30 times the value of its equity. As Lowenstein put it, LTCM was “adding leverage to leverage, as if coating a flammable tinderbox with kerosene.” In home purchase terms, if LTCM wanted to buy a house using the same amount of debt as their fund, they would lose all of their investment, if the house value declined a mere 3-4%. The benefit of leverage is it multiplies gains. The downside to leverage is that it also multiplies losses. If you carry too much leverage in a declining market, the chance of bankruptcy rises…as the partners and investors of LTCM learned all too well. Adding fuel to the LTCM flames were the thousands of derivative contracts, valued at more than $1 trillion. Warren Buffett calls derivatives: “Weapons of Mass Destruction.”
- Past is Not Always Prologue for the Future: Just because a strategy works now or in the past, does not mean that same strategy will work in the future. As it relates to LTCM, Nobel Prize winning economist Merton Miller stated, “In a strict sense, there wasn’t any risk – if the world had behaved as it did in the past.” LTCM’s models worked for a while, then failed miserably. There is no Holy Grail investment strategy that works always. If an investment strategy sounds too good to be true, then it probably is too good to be true.
- Winning Strategies Eventually Get Competed Away: The spreads that LTCM looked to exploit became narrower over time. As the fund achieved significant excess returns, competitors copied the strategies. As spreads began to tighten even further, the only way LTCM could maintain their profits was by adding additional leverage (i.e., debt). High-frequency trading (HFT) is a modern example of this phenomenon, in which early players exploited a new technology-driven strategy, until copycats joined the fray to minimize the appeal by squeezing the pool of exploitable profits.
- Academics are Not Practitioners: Theory does not always translate into reality, and academics rarely perform as well as professional practitioners. Merton and Scholes figured this out the hard way. As Merton admitted after winning the Nobel Prize, “It’s a wrong perception to believe that you can eliminate risk just because you can measure it.”
- Size Matters: As new investors poured massive amounts of capital into the fund, the job of generating excess returns for LTCM managers became that much more difficult. I appreciate this lesson firsthand, given my professional experience in managing a $20 billion fund (see also Managing $20 Billion). Managing a massive fund is like maneuvering a supertanker – the larger a fund gets, the more difficult it becomes to react and anticipate market changes.
- Stick to Your Knitting: Because competitors caught onto their strategies, LTCM felt compelled to branch out. Meriwether and LTCM had an edge trading bonds but not in stocks. In the later innings of LTCM’s game, the firm became a big player in stocks. Not only did the firm place huge bets on announced mergers, but LTCM dabbled significantly in various long-short pair trades, including a $2.3 billion pair trade bet on Royal Dutch and Shell. Often the firm used derivative securities called equity swaps to make these trades without having to put up any significant capital. As LTCM experimented in the new world of equities, they firm was obviously playing in an area in which it had absolutely no expertise.
As philosopher George Santayana states, “Those who fail to learn from history are doomed to repeat it.” For those who take investing seriously, When Genius Failed is an important cautionary tale that provides many important lessons about financial markets and highlights the dangers of excessive leverage. You may not be a genius Nobel Prize winner in economics, but learning from Long-Term Capital Management’s failings will place you firmly on the path to becoming an investing genius.