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When Genius Failed
by Roger Lowenstein
March 3, 2008
About Author
First, let me comment a little on the author, Roger Lowenstein, also the author for the “Buffett: The Making of an American Capitalist.” He is a popular financial journalist reported for The Wall Street Journal. It seems his writings are well-researched, unbiased, and informative.
Intro
“When Genius Failed” is a book about the rise and the fall of the Long-term Capital Management, LTCM. The reason that LTCM is so well-know is mostly because of the people who were heading the advisors and the managements which consisted two noble-prized economists, and the LTCM was considered as the cream of the crops in the financials and packed with high IQ. However that did not prevent its eventual derail to its calamity. After raising about $1.25 Billion dollars at end of February of 1994, it had a run of success for four years reaching more than $4 Billions dollars before it crashed losing most to Swaps and Equity Volatility spreads. For four years, it was the envy of the Wall Street, generating more than 40% return annual and with no losing stretches, almost no volatility and risks, until one bad move.
The Partners
John Meriwether, coming out of Salmon’s in 1980’s, had one simple idea in creating his own fund: “Why not hire traders who were smarter?” So he hired an array of professors and economists, among them are Rosenfeld, a Harvard student used quantitative method to make investments; Victor Haghani with MS in finance from London School of Economics; Gregory Hawkins, a Ph.D. in financial economics from MIT; William Krasker another MIT Ph.D; Lawrence Hilibrand with two degrees from MIT; Robert C. Merton famous, a Nobel Prize winner for completed the Black-Scholes model who was considered the top of academia in finance; Myron Scholes of the original of the Black-Scholes, another Nobel Prize winner; and in 1994 David W. Mullins the vice chairman of the U.S. federal Reserve under Alan Greenspan. The Nobel Prize was awarded because the model put a price on risk, a first supposition on how market works.
The Model
LTCM first investment scheme is to build the “Bullet-Proof” computer model based on the Black-Scholoes to generate fixed-income trades on the Swap and Spreads. This derivative vehicle trade by betting one investment trend and hedge the other end, pocket the small differences in the volatility. Since the spread was small, LTCM needed large capital to generate the gains from this nominal delta. So LTCM borrowed from most institutes. Given their initial success, this was not a difficult task. Even as LTCM was charging one of the highest fees, the money poured in. LTCM was borrowing huge amount of money using “repo financing” risking billions worth of trades without using its own cash or putting up the collateral.
The Bet
LTCM “preferred to reap a sure nickel than to gamble on marking an uncertain dollar,” dubbed its safest bets on convergence trades. The arbitrage of spreads with similar underlying fundamentals is likely to converge. “LTCM typically wanted exposure to one or two risk factors – but no more.” To their theoretical model, volatility and returns was same thing. “Increase volatility meant increased returns.”
The Fall
The fall of LTCM started with its move to the equities in 1997. Previously, all LTCM spread models were used on fixed-incomes or bonds. But J.M. saw the largely uncharted equities with great opportunities. So LTCM transport its models to equities and mergers. “Although pricing a bond can largely be reduced to math, valuing a stock is far more subjective.” It contains one of the most risky factors, the human nature. “Scholes and Merton argued that merger arbitrage – particularly on such a scale – was excessively risky for the obvious reason that LTCM was playing in a field in which it had absolutely no expertise.”
Early in 1998, LTCM began to short large amounts of equity volatility. “According to the Black-Scholes formula, the key element in pricing an option is the expected volatility of the underlying asset. As the asset gets jumpier, the price of the option rises.” In essence, the LTCM’s returns were directly tied to the movement of the options. By the first half of 1998, the US market was suddenly volatile and option prices jumped, going against LTCM’s shorts of volatility. LTCM was down 14%, its first sustained losing streak. This is only the foretaste of the stampede that followed. Each month, the market spreads widen, and each month LTCM was losing millions and sometime billions. Other fund begins to sell the holding anticipating LTCM sell off, LTCM was immobilized by its sheer mass and become insolvent.
The Rescue
By this time, the LTCM was already hedging billions of assets through complicated vehicles using assets from most of major banks. In the event of bankrupt, it would trigger a possible meltdown of the entire financial network. The fiscal quickly caught the attention of Federal Reserve Chairman Alan Greenspan, who dispatched Peter Fisher to sort out the current situation. To protect the functioning of markets, Fisher formulated a plan to rescue the LTCM fund by raising substantial capitals from the banks anticipated in LTCM. At this time, this is a fund that was not even wanted by Warren Buffett unless at a substantial premium. In the end, the consortium of bankers finally agreed to stop profiting from the short squeezes and invested a total of $3.65 Billions with an agreement to the partners to liquid the fund and repaid the investors.
The Lessons
“Long-Term’s saga of riches to rags was replete with lessons for investors.” “No investment can be judged on basis of half a cycle alone.”
1. ”Long-Term put supreme trust in diversification – one of the shibboleths of modern investing, but an overrated one. As Keynes noted, one bet soundly considered is preferable to many poorly understood. The Long-Term episode proved that eggs in separate baskets can break simultaneously.”
2. “This is the true lesson of Long-Term’s demise. No matter what the model say, traders are not machines guided by silicon chips; they are impressionable and imitative; they run in flocks and retreat in hordes.”
Others
Maybe because the high concentration of IQs and high nerdyness in this group, this bunch were extremely secretive and inclusive. Meriwether nurtured his traders, holding intimate party, annual gathering, he had successfully shaped and build a protective fence around his people.
LTCM broke the firm on two trades: Swaps and Equity volatility with loss of $1.6 and $1.3 Billion respectively.
Other high-profile hedge fund managers: George Soros, Julian Robertson, and Michael Steinhardt.
Alfred Winslow Jones organized a partnership in 1949 was the first to run a balanced, or hedged portfolio. The Hedge Fund “neutralized the market factor by hedging – that is, by going both long and short.” The net return depend on the ability to single out the relative best and worst. This is considered a conservative approach, likely to gain less and loss less, with the steadiness and returns.
LTCM took in 2% annually off asset and 25% profit compare to the average of 1% and 20%.
LTCM, a Delaware partnership, 11 partners.
Like the way he managed his group, J.M. preferred his private life owning a $2.7 Million 68 acres of estate in north Salem with only neighbor, David Letterman.
The first swap was engineering in 1981 between a transaction between IBM and World Bank. IBM had bond denominated in Swiss francs and German marks and wanted to convert into dollars; World Banks had debt in variety of currencies, so the World bank swapped the debts for IBM. The notion was suggested by David Swensen, a Yale Ph.D worked at Salomon.
Nicholas Brady, former Treasury secretary on derivatives: “Every time there’s been a fire, these guys [derivative traders] have been around it.”
“A bit of liquidity greases the wheels of markets … Too much trading encourages speculation, and no market, no matter how liquid, can accommodate all potential sellers when the day of reckoning comes.”
“There is nothing like success to blind one to the possibility of failure.”