Book of the Week: When Genius Failed

29 Oct 2015

when_genius_failed When I read the title, When Genius Failed: The Rise and Fall of Long-Term Capital Management, I thought long-term capital management was a concept and not a company. How little I know. They named the company that way for a reason. This book reminds of this XKCD comic: Engineer Syllogism. engineer_syllogism Long-Term Capital Management Cast

The Rise The central figure of the story is John Meriwether who started as bond trader at Salomon Brothers in the Arbitrage Group. All the trader’s loved to gamble and bet on things like elections, liar’s poker, the serial numbers on dollar bills, anything. The arbitrage group made a lot of money at Salomon, but some stuff went down and John took the fall and left. Some After John Meriwether left, he started Long Term Capital Management (LTCM) with some old buddies from Salomon and two Nobel Prize winners, Merton and Scholes. They were able to raise a lot of money and provided investors with great returns. LTCM tried to keep their positions secret by breaking up their pairs of trades with two different banks and using different banks for different types of trades. This cause the fates of the banks to be intertwined with LTCM. Wall Street bankers are like sheep. They didn’t want to get left behind while everyone else was doing business with LTCM even though it was a crappy deal that didn’t make the banks much money and exposed them to a lot of risks.

Since traders were not penalized for losses, they had a perverse incentive to bet as much as the company’s money as they could.

As LTCM started making so much money, they ran out of places to put it. They moved into areas out of their down expertise and started making unhedged bets. Eventually, they decided to give money back to the investors before the start of their downfall. The company was leveraged 31 to 1 as it started its decline. The Fall

Markets can remain irrational longer than you can remain solvent — John Maynard Keynes

When you have lots of buyers and sellers, there is a liquid market and prices are determined by supply and demand. When all the buyers disappear, the sellers are left holding things they want to get rid of, but can’t. LTCM had so many trades and contracts that it affected the market. They could not sell without crashing the prices. Reality is not normally distributed. What you think are rare events will occur and screw you over as described in The Black Swan. An event occurred outside the prediction of their mathematical models that caused a downward spiral of death that was eventually bailed out by the banks and the insistence of the government.

Ironically, only a very intelligent gang could have put Wall Street in such peril. Lesser men wouldn’t have gotten the financing or attracted the following that resulted in such a bubble.

When you have smart people fucking up, you get screwed real bad. You should never trust a smart person. Here is the loss tally. Russia and emerging markets | $430 million
—|—
Directional trades | $371 million
Equity pairs | $286 million
Yield-curve arbitrage | $215 million
S&P; 500 | $203 million
Junk bond arbitrage | $100 million
Merger arbitrage | break even
Swaps | $1.6 billion
Equity volatility | $1.3 billion
The two killers were swaps and equity volatility. Warren Buffett He’s rich, because he’s a hawk which swoops in and picks up assets for cheap. I think he’s like a loan shark or a pay day loan guy for rich people and big companies. When you’re desperate and need money, he’ll be there to lend you money for the right price. Purchase When Genius Failed on Amazon.com or check it out from your local library.