In the late summer of 1998, the largest, most successful hedge fund in the history of the planet -- managed by the world’s smartest bond traders employing risk control models crafted by two Nobel laureates -- imploded.
All its equity capital gone, the fund’s $100 billion balance sheet, made up of hundreds if not thousands of underwater spreads and unmarketable derivatives, was held to constitute a global systemic risk. That is, were the fund permitted to fail, there seemed to be some real possibility that the entire global credit function might seize up.
The Federal Reserve found it necessary to convene the fund’s lenders and counterparties -- which included most of the major financial institutions in America -- and to engineer a massive bailout. (No taxpayer money was involved; that would come a decade later.)
So transpired the ignominious demise of Long-Term Capital Management. There was one bright spot in this denouement, however. LTCM’s hubristic partners, driven by insatiable greed, had forcibly cashed out the outside investors just months earlier, and levered up their personal investments in the fund. As a group, they ended up losing $1.9 billion.
The ultimate irony was that this putatively most perfectly hedged enterprise had in fact -- eyes wide shut -- become completely unhedged. It bet the ranch that global credit spreads were about to narrow significantly, as its models foretold that they must. The fund did this just in time for the Russian default and the second wave of the Asian Contagion, which drove spreads to widen as they rarely if ever had before, and then to just keep widening in a global financial panic.
This is the tale told in full by Roger Lowenstein in his book When Genius Failed: The Rise and Fall of Long-Term Capital Management. It is an indispensable classic in the literature of financial folly, and of the dark human impulses which spawn it. And literature it surely is, as Lowenstein’s research and reportage ultimately take flight, and become something even more rare and fine.
From time to time we plodding, slow-thinking retail advisors are badgered to get with some or another financial innovation -- to put our clients into an exotic new “sophisticated” vehicle, perfectly risk-controlled by super-smart people with great track records (or, at the very least, 100 percent successful backtesting).
If ever you feel the least bit enticed by such a siren song, lash yourself to the mast of Lowenstein, and keep reading until the feeling passes.
©2014 Nick Murray. All rights reserved. Reprinted by permission. Nick highlights new books, articles and research findings in the “Resources” feature of his monthly newsletter, Nick Murray Interactive. To download the most recent sample issue, visit www.nickmurray.com, and click on “Newsletter.”