PDF Summary:When Genius Failed, by Roger Lowenstein

In When Genius Failed, financial journalist Roger Lowenstein explores the spectacular rise and catastrophic 1998 collapse of the hedge fund Long-Term Capital Management (LTCM). Lowenstein explains how LTCM, initially hailed as a financial genius, used complex mathematical models and sophisticated trading strategies to generate massive profits. The fund's founders and managers believed that they’d discovered a way to eliminate or at least greatly minimize market risk through their strategies. Their overconfidence in their models ultimately led them to make highly leveraged—that is, debt-financed—bets on various financial instruments.

In this guide, we’ll explore the history of LTCM, how its models operated, how it achieved such dizzying success, and how it suffered such a crushing and ignominious fall. Throughout the guide, we’ll supplement Lowenstein’s account with commentary from other financial experts and analysts, including commentators who wrote after the book’s initial publication in 2000—adding insights to the LTCM story in light of subsequent events.

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In Bad Blood, journalist John Carreyrou writes that medical startup Theranos (whose blood-testing technology was later revealed to be a fraud perpetrated by founder Elizabeth Holmes) lured investors and partners like Walgreens, taking advantage of that company’s short-sightedness. As Carreyrou writes, Walgreens couldn’t pull out of Theranos once it had already committed to its investment, despite mounting concerns about the startup.

As with the investors that Meriwether brought into LTCM, Theranos investors like Walgreens failed to perform due diligence. Walgreens’s concern was that if Theranos’s innovation had turned out to be real, Walgreens couldn’t risk competitor CVS taking it. Furthermore, in a classic “sunk-cost” fallacy, Walgreens had already shouldered the money of building out new clinics with Theranos’s technology, and once it got deep enough, pulling out would have been intensely embarrassing.

Another Theranos strategy was to land big-name investors—like former Secretaries of State George Shultz and Henry Kissinger, retired US Marine Corps General (and future Secretary of Defense) James Mattis, and former US Senator Sam Nunn. By reeling in these big fish, the company was able to boost its reputation and lure in overly enthusiastic investors who failed to investigate the validity and viability of the company's technology.

Leverage: Amplifying the Strategy

Lowenstein writes that what set LTCM’s approach apart was its use of substantial leverage, i.e., borrowed funds, to increase its volume of trades. Since price differences between the bonds they traded were marginal, the profits per trade were minimal. To generate substantial profits, LTCM needed to execute trades at high frequencies and volumes, which required a significant reserve of capital. And they could only acquire those reserves through borrowing. The strategy was an inherently “high risk-high reward” one for LTCM: If their model succeeded, profits could be magnified manifold times through leverage. However, if the model failed, losses would also be greatly amplified due to the debt incurred.

(Shortform note: LTCM’s high use of borrowed funds touches on an important concept in finance known as leverage ratio. A leverage ratio is a critical financial metric used to assess the capital adequacy and risk exposure of financial institutions, such as banks and investment firms like LTCM. The leverage ratio is calculated by dividing the institution's Tier 1 capital by its average total consolidated assets. Tier 1 capital is the core capital of the institution and includes common equity and retained earnings. Typically, regulatory authorities set minimum leverage ratio requirements for financial institutions. These requirements are in place to ensure that institutions maintain a minimum level of capital relative to their total assets.)

However, banks were willing to provide loans generously due to the perceived prestige of LTCM. Despite LTCM’s lack of transparency and secretive internal culture, the banks competed for the opportunity to lend to LTCM, seeing the new hedge fund as a potentially valuable client. Accordingly, the banks were willing to lend on highly favorable terms—even if they had a difficult time understanding exactly what LTCM was doing.

Information Asymmetry Leads to Poor Decisions

The banks’ failure to understand LTCM’s business model (despite investing heavily in it) demonstrates the point that people often make decisions with flawed or incomplete information. In Freakonomics, authors Stephen J. Dubner and Steven Levitt write about the phenomenon of information asymmetry—situations where information is unequally distributed between parties. Dubner and Levitt warn that experts can skillfully exploit information asymmetry when they leverage their superior knowledge to gain the upper hand over their counterpart in a transaction or negotiation.

Information asymmetry can have a systemwide impact, with the 2008 financial crisis as a prime example. In the run-up to the crisis, Wall Street financiers created products like derivatives (financial instruments whose value derives from an underlying asset) and collateralized debt obligations (complex financial products that bundle various debt assets, such as mortgages or bonds, into one security) whose larger implications many investors simply didn’t understand. When the housing market collapsed, those investors who bought these products were wiped out, while the sellers, who possessed a major information advantage, made a tidy profit.

Part 3: LTCM's Stunning Initial Success

With the foundation thus laid, it was time for LTCM to put its strategy into action. In this section, we’ll explore the extraordinary rise of LTCM and the growing risks posed by its high leverage—which ultimately set the stage for its downfall.

Implementing the Strategy

Lowenstein writes that LTCM boasted an astounding 28% return in its first year of operation in 1994, significantly outperforming the broader market. Their approach was grounded in quantitative and mathematical methods, giving an impression of rationality and scientific precision.

LTCM's success was predicated on its ability to find arbitrage opportunities and capitalize on mispricing across various financial assets, from mortgage-backed securities to international bonds.

Fundamental vs. Technical Analysis

LTCM’s approach of eschewing analysis of individual companies and stocks and instead looking at large data sets from a quantitative perspective speaks to the differences between two schools of investing thought: fundamental analysis and technical analysis. Fundamental analysis is the more traditional approach, which attempts to measure the intrinsic value of a stock. Adherents of this philosophy seek to answer why a particular stock goes up or down in value. They do this, as the name suggests, by delving into the “fundamentals” of the company behind the stock. They’ll look at sector-wide trends and the company’s earnings, expenses, assets, and liabilities to make predictions about what the stock will do.

Technical analysis, on the other hand, identifies trends and correlations—how a particular stock goes up or down in value. It’s much closer to what LTCM was doing. Technical analysts assume that the “fundamentals” are already factored into the stock price, so it’s a waste of time and effort to analyze them. Instead, they use mathematical analysis to identify patterns and trends within the market and across different types of financial instruments (like stocks, bonds, commodities, and currencies). These trends can then signal what a stock will do in the future and if its current pricing is rational or not.

A Mistaken Assumption of Predictability

According to Lowenstein, LTCM's model was built on the assumption that financial markets behave predictably. The crux of the problem, writes Lowenstein, lay in that core assumption of the world's rationality and predictability. In reality, the real world is complex, shaped by irrational human behavior, and events are often influenced by panic and fear, making human actions less predictable.

Lowenstein writes that research by Eugene Fama highlighted the higher risk of extreme or "tail" events in markets, contrary to LTCM's belief in constant predictability. Markets, in fact, exhibited more extreme price movements than would be expected from a normal distribution curve. The likelihood of an extreme financial event (say, a sudden, across-the-board collapse in asset prices) was far more likely than their models predicted. In a few short years, such outlier events would prove fatal to LTCM.

The Shortcomings of the Homo Economicus Model

LTCM’s operating theory about the fundamental rationality of economic actors is a well-established intellectual foundation of economics. In Doughnut Economics, economist Kate Raworth calls this the homo economicus model, which asserts that human beings are essentially rational, utility-maximizing entities, able to process, calculate, and have perfect access to information to make the optimal choice for themselves in all situations. It is a portrait of humankind rooted in self-interest, unconcerned with deeper moral imperatives like charity or altruism: Rational economic man cares only about increasing his material wealth and will always follow incentives to do so.

According to Raworth, the homo economicus model is a gross and inaccurate caricature of the nuances and complexities of the human condition. Rather than pure utility maximizers, we are highly social beings who prize intangibles like the respect, love, and admiration of our peers. Indeed, our lives abound with examples of reciprocity and altruism with no clear material benefit.

For instance, imagine a group of friends is planning to buy a gift for one of their friends who’s going through a tough time. According to the homo economicus model, each friend should contribute the minimum amount possible to the gift to maximize their own economic utility. However, in reality, the friends might choose to contribute more than the minimum required, driven by their desire to show support and express their love for their friend, even if there’s no immediate material benefit for them. This behavior exemplifies how humans often prioritize social and emotional connections over pure economic self-interest.

Continued Profits and Growth

Despite these philosophical flaws, writes Lowenstein, LTCM continued to amass impressive profits, earning 59% or $1.6 billion in 1995. Wall Street bankers were eager to lend more money to the fund, given its outstanding performance. LTCM had become the darling of Wall Street, outgrowing even the largest mutual funds. By 1996, the partners had collectively earned nine times their initial investment, a staggering return on investment. In that year alone, LTCM's profits exceeded $2 billion, surpassing those of major Fortune 500 companies and even Wall Street giants like Meriwether’s old firm, Salomon Brothers.

However, its rapid growth was precarious: For every $1 in assets, the fund had $28 in debts. LTCM kept banks in the dark about the fund's total degree of leverage, and they refused to disclose the assets on their balance sheet. Banks had to rely on LTCM's supposed genius and financial acumen, which masked the true riskiness of the investments they were unknowingly bankrolling.

(Shortform note: Lowenstein’s account that banks had little idea about the assets on LTCM’s balance sheet—and the fact that they, as LTCM investors, were also invested in those assets—can be seen as a harbinger of the systemwide calamity that befell the global financial system a mere decade after LTCM. Michael Lewis writes in The Big Short that major banks like Bear Stearns and HSBC had exposure to the collapsing subprime mortgage market. But because of the complexity of these bonds, very few people inside or outside these firms could tell exactly how much exposure they had to subprime mortgages. No one knew for sure how many of these toxic assets were littered across the balance sheets of the world’s leading financial institutions.)

Part 4: The Fall of LTCM

The year 1997 was the beginning of the end for LTCM, as it succumbed to the enormous risks it had taken on and the combined pressures of the 1997 Asian financial crisis and the 1998 Russian financial crisis. In this section, we’ll explore how unexpected volatility began to sink the fund.

1997: The Asian Financial Crisis Begins

In 1997, the currencies of several Asian countries—Indonesia, Malaysia, the Philippines, South Korea, and Thailand, the so-called “Asian tigers”—collapsed. In the years leading up to the crisis, investors had mistakenly believed that the economies of these nations were on sounder footing than they actually were. As a result, when these currencies collapsed, those investors found that their money was now tied up with these sharply devalued currencies. The crisis spread to the US as the American stock market suffered a 7% decline in a brutal selloff on October 27, 1997.

The crisis threatened to undermine LTCM’s whole strategy. In a turbulent market, asset prices tend to fall together: There aren’t price discrepancies, writes Lowenstein, because everything collapses at the same time. There wouldn’t be arbitrage opportunities to exploit: There would instead be a liquidity crisis where everyone was trying to sell their much-discounted assets at the same time, LTCM included. This had the potential to wipe out the fund.

(Shortform note: Experts suggest that during a liquidity crisis, businesses can take some key steps to protect themselves. The steps include understanding their current cash position, cash flows, and the impact of the crisis on their operations. Companies should focus on managing cash flows, which may involve accelerating cash collections, delaying payments, and closely monitoring working capital. Businesses should develop various financial scenarios to understand the potential impacts of the crisis on their liquidity. This helps in making informed decisions and contingency planning. Finally, companies should explore all available sources of capital, including bank credit lines, government relief programs, and negotiations with lenders and investors.)

Currency Pegs, Overvaluation, and the 1997 Asian Financial Crisis

To give a more complete understanding of the circumstances that led to LTCM’s collapse, it’s worth adding some historical context for the 1997 Asian financial crisis.

The crisis was triggered by the fixed exchange rate regimes or "currency pegs." By pegging their currency to a stronger foreign currency (like the US dollar), developing countries (like the Asian countries affected by the crisis) often hope to instill confidence in foreign investors and facilitate trade. By pegging their currency to a stronger one, these countries aim to provide stability and predictability for businesses and investors, making it more attractive for foreign capital to flow into their economies. However, when currencies are pegged to stronger ones, they can become overvalued, meaning their exchange rate doesn't accurately reflect economic fundamentals.

This is what happened in 1997. Due to the overvalued currencies, many businesses in these Asian countries borrowed in US dollars, at low interest rates. However, when their local currencies devalued, the real cost of servicing this debt in foreign currency soared, causing financial distress and corporate bankruptcies. As the crisis deepened, several Asian countries were forced to abandon their currency pegs and allow their currencies to devalue. While this helped restore export competitiveness, it significantly impacted foreign investors who had assumed the exchange rate was stable and suffered losses when the local currencies devalued.

The Russian Collapse and the Flight to Treasurys

The collapse of the Russian ruble in August and September 1998 exacerbated the impending liquidity crisis in global financial markets, intensifying the fund's difficulties. Russia defaulted on its financial obligations, sending shockwaves throughout global financial markets. This triggered widespread panic as investors sought refuge in US Treasury securities.

(Shortform note: Despite the calamity, some financial historians have written that the 1998 Russian crisis taught some valuable lessons. First, it demonstrated the interconnectedness of financial markets and how the default of even a relatively small emerging market like Russia could have a ripple effect on global markets. Secondly, it underscored the unique risks of investing in emerging markets and the need to evaluate political and economic stability, regulatory environments, and currency risks in emerging market investments. Finally, the Russian crisis showcased the importance of robust risk management strategies, diversification of portfolios, and the need to account for possible sharp market fluctuations.)

For LTCM, this situation led to a noticeable difference in prices between US Treasury bonds and other financial products. This difference influenced a broad array of assets, including common ones like stocks and foreign bonds, as well as more complicated financial tools like options, derivatives, and swaps. People rushed to invest in Treasurys, which are seen as safe because they’re backed by the US federal government. This surge in demand caused the prices of Treasurys to go up while the prices of everything else went down.

Does US Political Dysfunction Threaten the Security of Treasurys?

Lowenstein writes that investors flocked to US Treasury bills, notes, and bonds, because of their perceived safety. In The Deficit Myth, economist Stephanie Kelton notes that American national debt is created through the sale of these bonds. Because the federal government can never default on these bonds (because it has monetary sovereignty that enables it to always create the dollars it needs to make the interest payments), they are considered risk-free securities. However, some have argued that the growing political dysfunction of the United States could jeopardize that status.

The US federal government has a statutory limit on how much it is allowed to borrow to meet existing financial obligations (the “debt ceiling”). When the Treasury Department informs the president that the government is approaching this limit, Congress is supposed to pass new legislation that raises this figure and allows the government to pay its creditors. To not raise the debt ceiling, therefore, is to force the United States to default on its debt, even though, as Kelton argues, the US has unlimited power to create the dollars it needs to meet its debt obligations.

Unfortunately, the debt ceiling has become a political football in recent years, with Congressional Republicans threatening to withhold the votes to raise the debt ceiling to force spending cuts and other policy concessions from Democratic presidents—as happened in 2011 under Barack Obama and again in 2023 under President Joe Biden. Analysts warn that these brinksmanship exercises hurt confidence in the US dollar and US Treasury debt as safe assets—and could cause them to cede some reserve status to other currencies like the euro.

On the Wrong Side of the Trades

Compounding LTCM's woes was the fact that their existing positions were based on the expectation of the opposite scenario. Their entire strategy was built on the belief that markets overstated risk and that the price differences between risky assets and safe assets would eventually converge. Consequently, they often held the riskiest and most volatile assets in various markets. When universal panic gripped the market in 1998 following the Russian crisis, nobody had any interest in purchasing LTCM's holdings, and everyone was eager to rid themselves of these toxic assets. LTCM found itself in a dire predicament, with seemingly no way out.

With the value of their assets now reduced to a fraction of their former worth, their debts constituted an even larger portion of their balance sheet. By September, LTCM was operating with a highly leveraged position of $55 in leverage for every $1 in assets and the fund was hemorrhaging eight figures per day.

(Shortform note: For a true sense of the scale of LTCM’s leverage, financial experts write that a debt ratio (total debt divided by total assets) of greater than 100% is often considered risky for investors. But LTCM had a debt ratio of 5,500%, vastly greater than what most analysts would consider safe. However, it’s worth noting that the debt ratio, while useful for assessing a company's financial standing, doesn't provide information about the type of debt or its associated costs. Different debts may have varying terms and interest rates, impacting a company's financial stability differently. Additionally, the debt ratio relies on accounting information that can be manipulated for external reporting.)

The Panic Market Trumps the Rational Market

Lowenstein writes that the market was characterized by panic, representing a state of irrationality. Human emotions, including greed and fear, were driving economic decisions, highlighting the flawed and irrational nature of such decisions. The market deviated from a normal distribution pattern. LTCM's quantitative models were incapable of accounting for this irrationality, as they were built upon a framework assuming rational and utility-maximizing decisions.

(Shortform note: Some economists have written that economic models need to be updated to consider the influence of human psychology on economic decision-making. Behavioral economics recognizes that individuals don't always make rational choices and can be influenced by cognitive biases, emotions, and social factors. Furthermore, there is a push to incorporate the principles of complex system dynamics into economic modeling. Complex systems theory acknowledges that economic systems are interconnected and subject to feedback loops, making them inherently unpredictable and susceptible to sudden shifts and crises.)

An Orchestrated Bailout

As the house of cards that was LTCM collapsed, the New York Federal Reserve Bank stepped in to orchestrate a bailout. According to Lowenstein, the Fed played a pivotal role in assembling a consortium of Wall Street banks to stabilize and wind down the troubled LTCM. The final terms of the rescue package involved a consortium of over a dozen major banks collectively contributing more than $3.5 billion and acquiring 90% of whatever value remained in the fund. In a stark transformation, the original partners retained only a 10% stake as an incentive for their assistance in winding down the fund and ensuring creditors were made whole.

The partners found themselves effectively wiped out, and the banks were left to recoup whatever assets remained. The impact extended beyond the fund; it significantly affected the partners themselves, many of whom had substantial personal wealth tied up in the fund. The collapse pushed several of them into personal bankruptcy.

John Meriwether’s Post-LTCM Career

Although Meriwether avoided personal bankruptcy following LTCM’s collapse, his later career would be marked by unsuccessful fund ventures. Just a year after the demise of LTCM, Meriwether founded another company, JWM Partners. Its flagship fund, Relative Value Opportunity II, reached a net asset value of about $1.6 billion at its peak but declined by more than 44% following the 2007 financial crisis.

Perhaps unchastened by his experience at LTCM, the poor performance of Meriwether’s fund was exacerbated by its continued use of high leverage, with reports of up to 10 and 15 times leverage—a substantial amount of risk considering most hedge funds reduced their leverage to as little as two times or less after market volatility in 2007. The fund finally closed its doors in 2009, after suffering staggering 44% losses from 2007 to 2009.

A Tale of Hubris

Lowenstein writes that the LTCM episode served as a stark reminder that even the brightest minds in finance were not immune to failure. In a period of soaring returns on Wall Street during the 1990s, LTCM's renowned academics and financial wizards were among the few who managed to lose money. By the end of the crisis, the fund's assets were worth a mere 23% of their peak value.

The bailout of LTCM raised legitimate concerns about moral hazard, as it prompted questions about whether rescuing reckless speculators only encouraged future speculative behavior. It also led to a broader debate about whether preventive regulation to avert a financial crisis might be a superior approach to the post-crisis bailouts.

Overstating the Risk of Moral Hazard

Some critics have argued that the concept of moral hazard, often cited as a central issue in the financial industry, may be somewhat overrated. Moral hazard is the idea that people and institutions might take on excessive risks if they believe they won’t bear the full consequences of those risks. In the context of the 2008 financial crisis, it was a common belief that financial institutions might engage in reckless behavior because they anticipated government bailouts in the event of a crisis.

However, some contend that this traditional view of moral hazard is somewhat simplistic. It asserts that financial institutions, particularly after experiencing the full-blown impact of the crisis, were far more cautious and risk-averse than expected. They were aware that government bailouts could have severe consequences and didn’t want to rely on them. In the wake of the crisis, many financial institutions were either severely weakened or completely collapsed, further illustrating that their perceived safety nets might not be as reliable as previously assumed.

Moreover, according to this argument, the conventional understanding of moral hazard fails to account for the complexity and nuances in the financial industry. Financial institutions are subject to various regulatory and market pressures, and they operate in a dynamic and interconnected environment. This means they often have incentives to minimize risks rather than exploit perceived safety nets.