By LouAnn Lofton
Twenty years ago, a hedge fund in the high-class, big-money New York City suburb of Greenwich, Conn., opened for business. This, in and of itself, was not unusual. Greenwich had been home, and continues to be home, to Wall Street’s elite power brokers.
What made this particular fund, Long-Term Capital Management, stand out was its impressive roster of both brilliant academics and highly successful Wall Street traders. Indeed, with two Nobel Prize-winning economists on staff, it seemed a virtual certainty that Long-Term Capital would make its investors money and be around for, well, the long term.
For the first four years of its existence, all went according to plan. Long-Term Capital, which focused primarily on bond trading and arbitrage, returned investors more than 40 percent a year and seemed to have eliminated volatility and risk altogether. Driven by computer-trading systems and with full faith in their algorithms, Long-Term Capital was more than fulfilling on the implied promise that its illustrious staff brought to the table. Namely, that promise was that “genius” coupled with the power of computers could rule the financial markets, foresee any and all risks ahead, and generally outsmart anyone and everyone.
Alas, it was not to be. In the fall of 1998, Long-Term Capital was reeling. Big bets on Russian bonds went against them, and thanks to the use of derivatives, many of Wall Street’s biggest banks and investment houses were entangled in the mess, as well. By August of 1998, the fund had capital of $3.6 billion. Five short weeks later, it would all be gone.
Roger Lowenstein’s excellent book, When Genius Failed, details the story of Long-Term Capital from beginning to bitter end. Riveting and well written, he introduces us to the people and personalities behind Long-Term Capital. Perhaps the most famous (or infamous) of these is John Meriwether, who went from a humble childhood in a rough neighborhood in Chicago to heading up the bond arbitrage unit of Salmon Brothers in the 1980s to starting Long-Term Capital Management thereafter.
Lowenstein also walks us through the world of arbitrage and hedging. He paints a vivid picture of a culture infested with unbridled egos, absolute faith in financial modeling and equations, huge leverage, and a lack of respect for the unexpected. No one, especially them, thought these luminaries could get it wrong. And yet they did. The story of what happened, and Wall Street’s response to it, continues to be a fascinating cautionary tale.