Book SummaryWhen Genius Failed, by Roger Lowenstein

1-Page Summary1-Page Book Summary of When Genius Failed

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 explores 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—i.e., debt-financed—bets on various financial instruments.

The fund engaged in a variety of strategies involving arbitrage (taking advantage of price differences for the same asset or security in different markets to make a profit with little to no risk), interest rate swaps, and other derivative instruments to exploit supposed market mispricings. However, when the market was beset by volatility following the Asian financial crisis of 1997, LTCM's positions rapidly deteriorated—leading to the fund’s demise and an orchestrated bailout by the Federal Reserve.

In this guide, we’ll explore...

When Genius Failed Summary Part 1: The Rise of John Meriwether and the Birth of Quantitative Trading

Lowenstein writes that hedge fund manager and arbitrage expert John Meriwether was pivotal in the conception and formation of LTCM. In this section, we’ll look at Meriwether’s early career as a trader at Merrill Lynch, where he discovered the power of arbitrage strategies and convergence theory, and his formation of the arbitrage group at the investment firm Salomon Brothers. These activities set the stage for what he’d later do to great effect at LTCM.

The Power of Arbitrage

Lowenstein writes that, at Salomon Brothers, Meriwether began his journey by learning the intricate art of arbitrage, a strategy that would become the linchpin of his success. Meriwether’s arbitrage strategy at Salomon Brothers enabled him to exploit price discrepancies, turning them into substantial profits.

At its core, notes Lowenstein, Meriwether's strategy was rooted in the concept of convergence. He believed that differences in price between nearly identical financial securities would eventually equalize. By structuring his trades to bet on these convergences, he consistently emerged richer at Salomon Brothers, far more often than he faced losses.

**Pure Arbitrage vs. Relative...

When Genius Failed Summary Part 2: The Birth of LTCM

Shortly after Meriwether left Salomon Brothers, he sought to create a new fund. In this section, we delve into the emergence of Long-Term Capital Management (LTCM); LTCM's unique convergence strategy; and the high-risk, high-reward nature of its approach.

Meriwether's Vision: Long-Term Capital Management (LTCM)

Lowenstein writes that John Meriwether envisioned striking out on his own by applying the convergence strategy that had brought him success at Salomon Brothers. This marked the intellectual underpinning of what became LTCM.

The core strategy was simple: Buy assets identified as underpriced by their model while simultaneously shorting similar assets deemed overpriced. The premise was that the prices of these assets would eventually converge. In essence, LTCM aimed to "buy low and sell high" at the same time they were "selling high and buying low.".

The Role of “Black Swans” in Finance

While convergence strategy may sound appealing in theory, Meriwether and his team may have overlooked its practical complexities and risks. As Lowenstein writes, the strategy relies on the concept that mispriced assets will inevitably correct themselves, leading...

When Genius Failed Summary 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...

When Genius Failed Summary 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:...

Shortform Exercise: Explore the Lessons and Consequences of LTCM

Use these questions to explore the lessons from When Genius Failed and the regulatory, legal, moral, and ethical concerns prompted by LTCM’s collapse.

Describe the lessons that can be learned from the LTCM crisis. In response to the LTCM fiasco, what types of strategies do you think firms should avoid and why?