When Genius Failed

"The Fed itself did not bail out LTCM, but it was worried enough to get a bunch of big banks into the room and say, “Would you care to chip in and save this thing?” Which they obligingly did – and then liquidated it. The Fed foresaw that the failure of a single big hedge fund could send shock waves through the entire financial system. The issue of systemic risk was highlighted. LTCM was a leading indicator in another way. Its principals didn’t believe they were speculating. They believed they had risk models that worked. As they saw it, they were arbitraging divergences between markets and instruments that were bound to come back in line, based on the historical data. And because they thought the risk was so controlled, the traders leveraged up enormously, placed huge bets, thanks to the magic of derivatives. What LTCM left out of its calculations was what we now called “fat tail” or “black swan” events. Those came with the crises in East Asia and in Russia in 1997-98. A lot of LTCM’s trades not only went wrong, but went wrong simultaneously across lots of different markets. The firm collapsed. Yet even as it was going down, John Meriwether – who appears in Michael Lewis’s Liar ’ s Poker as the man who took the liar’s poker bets – still believed that his bets were the right ones, if he only he had had more time and more money. He had a liquidity problem. But it was the markets that were wrong. Lowenstein explains in very elegant terms some pretty complicated concepts involving derivatives, Black-Scholes [financial model] and trading. He captures the characters. But it’s less a character book than a book about this thing that many people hadn’t heard of, bubbling up within the financial system. Before LTCM, nobody outside the elite of Wall Street had any idea of the importance of derivatives. But inside this elite, a whole class of traders was starting to think of financial markets in completely different terms. Meriwether is a stone-cold gambler. I think what he believed was that he’d found a way to twist the odds in the casino, using models that only a few brainiacs could understand. He got people on his side who knew more sophisticated ways to place bets on financial markets than even central banks did. So, as he thought, he had the intelligent money on his side, and the uninformed betting against him, and that made for pretty good odds. And indeed, he was right for a long time. It worked brilliantly for four years. And then it went bang. It’s a hazard of having high-powered economists as strategists. They always want to short volatility. They believe that the markets are going to come to their senses. It’s reverse speculation, if you like. The underlying idea is that other people panic, and that’s why markets go crazy. If you can think through all the noise, you can bet against them and win. The problem is, of course, that the markets can stay crazy a lot longer than you can stay solvent."