When Genius Failed tells the story of Long-Term Capital Management (LTCM), the world's largest hedge fund. Drawing from inside information and interviews with numerous players, Roger Lowenstein not only explains how LTCM makes and loses money, but also outlines the nature of LTCM's partners, the arrogance of the model. work. Thereby, the author also affirmed that the event of LTCM is not only a temporary tragedy but also a prospect for a market collapse, a wake-up call for Wall Street and the government.
Who should read this book?
- Those who want to work in investment banking;
- Those interested in risk management;
- Those who want to know more about hedge funds.
About the author
Roger Lowenstein is an American author and journalist. He is currently a contributor to The Wall Street Journal. In addition to his work as a journalist and book reviewer, he is the author of five best-selling books, including Warren Buffett - The Making of an American Capitalist, When Genius Fails .
What does this book have for me? Learn about a hedge fund that tried to outperform the market and failed.
Do you know the story of Icarus? Thanks to the wings his father made, Icarus was able to fly – an ability that humans never had. Complacent with proud wings, Icarus ignored his father's advice, tried to fly high, aspired to conquer the vast and vast sky. But the higher the flight, the greater the heat of the sun, causing the wax that binds the feathers of the wings to gradually melt. In an instant, the wings disintegrated into a hundred pieces. Icarus died, tragically.
This famous myth about the consequences of arrogance can be applied to the story of Long-Term Capital Management (LTCM), a giant hedge fund that once dominated the market. finance in the 90s. Like Icarus, they "climbed high", reached for achievements above the clouds only to suffer a painful "fall".
The following summary pages will interpret the author's message through the book: no "genius" can beat the market.
LTCM is a powerful hedge fund holding huge assets thanks to its arbitrage method.
If you have ever been in the investment field, you will probably know the name LTCM, a fund management company that has gone bankrupt. LTCM was a key factor in the 1997 Asian financial crisis, which once pushed the world financial system to the brink of collapse.
LTCM is a hedge fund or hedge fund founded in 1994 by bond trader John Meriwether. Hedge funds hold a huge amount of money from the richest group of investors. Contrary to its cousin mutual fund, which is a fund that raises funds from a wide range of investors, hedge funds are low in popularity and are not overly regulated, meaning there are no limits on the size of the fund. size of the fund as well as the place of investment.
Because of the loosening of the law, hedge funds become a hot but also dangerous and risky bait in the eyes of investors. Therefore, investors in hedge funds must be highly qualified, professional, with a thorough understanding of the market and trading.
Like other hedge funds, LTCM controls the investment system with an arbitrage trading strategy . Accordingly, hedge fund managers buy and sell financial products with the expectation or expectation that prices will change to their liking in the near future.
To better understand the strategy above, imagine a certain company sells shares on two markets. If both of these markets represent the same company, you would expect the stocks to be at the same price. However, sometimes the price of a stock in one market is slightly lower than the other. When that happens, you can seize the opportunity to buy the stock before the price returns to equilibrium again, and thereby profit from selling them.
In reality, market dynamics do not create such conspicuous and obvious scenarios. The arbitrage trading strategy largely depends on the swift elimination of deviations in the prices of financial products.
This gives LTCM an advantage. They use academic calculations and guesswork and state-of-the-art computer software to identify opportunities and capitalize on them quickly. Thanks to this strategy, LTCM became the largest hedge fund in the world ever. So what happened?
LTCM uses more and more leverage to maximize profits.
Hedge funds bet on even the smallest difference between the current and future prices of a financial product, meaning they need a huge investment to generate substantial returns.
And then they get huge amounts of money from wealthy investors, but that's not enough. To maximize returns, hedge funds need to be leveraged , meaning they use debt to generate profits.
LTCM also applies leverage, and borrows a lot, and encourages investors to make large investments. Many banks, notably Germany's Dresdner and Brazil's Banco Garantia, are excited to contribute a large amount of capital to the company because they believe that LTCM's strategy at least in theory contains very little potential risk. stock, profit will be guaranteed. They bet on financial anomalies – phenomena that are generally thought to be less affected by market fluctuations, such as interest rate changes. Even if the market suddenly drops sharply that no one can predict, profits will not be affected drastically. At least that's what they think.
Here's a small example of how much LTCM has contributed to leverage: with an initial capital of $1.25 billion, they can borrow enough to invest up to $20 billion.
And history has proven that banks raced to join funds like this because they simply didn't fully understand the risks.
LTCM's ability to control investment and borrowing is growing stronger – they can pour capital wherever they want.
Banks, on the other hand, have no control over how their money is used. At that time, this was not a big deal because LTCM was always the “expert”. Blinded by the potential profit, they fail to consider and evaluate the intrinsic advantages and disadvantages of hedge funds.
Due to the increasing number of banks joining the fund, the leverage ratio of the fund increased dramatically, putting the company at great risk if something unfortunate happened.
Above, you have just learned about the key tactics of LTCM. The next chapter will explain why their approach is successful.
LTCM applies academic knowledge to investing.
Not a few people believe that there is always a gap between superior academic insights and real-world situations.
This couldn't be more true in the field of finance, when it is recognized that there is a huge gap between professors and their theories and the fierce reality of the market.
However, LTCM believes that it will make a difference. Their plan is to apply expert knowledge and academic theories to the real world.
As a result, the company recruited prominent figures in the business world, notably two 1997 Nobel Prize winners, Myron S. Scholes and Robert C. Merton.
Run by bright and reputable names, the company has succeeded in attracting and attracting countless investors. Even many universities and research institutes are convinced to invest. Particularly the University of St. John (USA) contributed 10 million dollars. One of the reasons they're so interested in investing is because academia believes they've completely eliminated risk.
Usually, a dodgy salesperson will say reduce the risk in your investment. But LTCM is the opposite. In fact, they are very straightforward when it comes to potential negatives.
However, this action partly reveals LTCM's complacency: they believe that with a "genius" academic team, they can calculate risks so accurately that the risks are under control. or even completely eliminated.
That arrogance is "filled" with mathematical formulas - formulas that are elaborately built, surprisingly sophisticated. This “fuel” is carefully harnessed from historical analysis of market performance. By carefully studying the market's reaction to a past event, they hope to be able to predict future reactions. This system will help them recognize and avoid risks and crises before they happen. That's what LTCM thinks.
This compelling academic approach effectively lured investors and contributed to LTCM's resounding success.
Hedge funds grew in popularity in the 1990s, but LTCM still outperformed.
In the 1990s, investing in hedge funds became a trend. Hedge funds boomed in the US, growing from about 200 in 1968 to 3000. People found in hedge funds novelty, excitement and, above all, incredibly high returns.
But among the existing hedge funds, LTCM stands out in terms of size, reputation and loan amount. Operated by a team of stars with large capital, LTCM is a name that everyone wants to cooperate with. Many rich people as well as companies aspire to own a part of this cake.
At that time, the size of LTCM was 2.5 times larger than the second largest mutual fund in the world and 4 times larger than the rival hedge fund right behind it. They also control more assets than investment banks like Lehman Brothers or Morgan Stanley.
Banks compete to invest in LTCM for several reasons:
First of all, thanks to favorable market conditions for a long time, banks are holding a fairly large amount of available capital.
Besides, the bankers are eager to invest in this money-making machine. They even lend to LTCM without considering interest – the amount they usually ask for when making a loan. For example, for every $100 that the bank lends, the funds owed are only a few cents, and the fund has already borrowed much more than $100.
Imagine how much they borrowed – they still have to pay $100-$200 million a year in bank credit despite the special terms!
With all the favor that I receive, LTCM creates a healthier shell than it really is. Part of that is simple scams: although they do report assets and liabilities quarterly for banks and monthly for investors, the reporting is not always clear and simple. usually just for general summary information.
LTCM's success was not forever and the cracks began to show.
LTCM's model led them to make reckless decisions when the Asian financial crisis broke out in 1997.
Although the academic model that LTCM adopts is quite smooth, it still harbors a fatal flaw: human error.
This model assumes that the financial system is just a "rational" quantity, predictable and governed by predictable people. But not. Human nature is irrational, sensitive, and prone to panic. It is this contradiction that causes problems for LTCM.
These problems started with the Asian financial crisis in 1997, when Thailand, Indonesia, and South Korea suddenly dropped prices. This raises a question for LTCM as to whether they should set limits on the regions and products in which they can safely invest.
In such uncertain and uncertain times, people often choose to invest in bonds, which, although not providing high returns, are at least safer.
However, LTCM decided to take a different path. They increased their stakes in a riskier financial product: equity . According to the model, the crisis is a good opportunity to make money.
They started investing in paired shares – different shares of the same company. For example, they invest in Royal Dutch Petroleum and Shell Transport England – both of which are part of the international group Royal Dutch Shell. Although not very knowledgeable about these products, LTCM still invests aggressively because according to the model, everything will be fine.
They sell bonds with an open position , skipping the purchase of foreign currency forward contracts to hedge against exchange rate changes in the US market to buy in the Russian market.
When the crisis broke in the summer of 1997, LTCM noticed a slight drop in profits, but that still didn't stop them. They continue to follow the pattern and gradually push themselves closer to the edge of the abyss.
As you have seen, the fancy LTCM achieved unprecedented success. But "climbing high" means "falling painfully". The upcoming summary pages will help you discover the mistakes that inevitably lead to the failure of the genius of LTCM.
The model fails, the recession begins.
The model that LTCM's experts built and developed focuses on only one principle, that if a crash occurs, the market will always return to its natural state. Like a swing: you apply a thrust, it will go up and down repeatedly until it returns to its original equilibrium position. And according to the model of LTCM, the market is similar.
That is why the fund chose a reckless strategy during the Asian financial crisis. They see the market downturn as a small incident and the market will eventually stabilize, bringing them a huge fortune.
However, reality is far from the scenario. The market did not return to its normal state. Most people react sensitively, acting irrationally like pulling out all their stocks and investing entirely in bonds – a safer bet.
But LTCM's model told them not to follow the movement, to carry on despite the risks, and they did. This cost them dearly: after the Asian financial crisis, LTCM experienced several months of heavy losses for the first time in its life.
The size of LTCM really makes it difficult for them to profit from risky investments. As problems and losses began to mount, LTCM's ridiculously high leverage became an obstacle: they had to continue to follow the pattern and take risks in the hope of making enough money to spend. pay for expenses, debt is piling up. They are more confident in their ability to pay off promised by the model. Change is no longer an option. They have to stay engaged.
And in the end, the model failed completely.
The final sequence of LTCM autonomy is marked by an event, which, according to LTCM evaluation, is almost impossible.
According to the model of LTCM, the probability of losing nothing in just one year is only 1/10 24 , which means it is almost impossible.
However, on August 17, 1998, the impossible happened: the Russian government defaulted on its debt, and the rupee devalued. This caused a shock to the market. No one, not even the IMF, stepped in to help Russia.
Investors realize they don't always get relief. There will be times when bad things happen, they have to stand on their own two feet.
That awareness started an "migration" in the world market. People just look for the safest bonds and sell everything. This is bad news for LTCM.
According to their calculations, the most they lose in a day is just $35. In fact, the damage hit the threshold of $533 million.
Falling into a state of huge debt and serious lack of capital, LTCM needed to sell off quickly to settle all of its debt. But unfortunately no one wants what they provide. Some institutions and banks that used to love hedge funds were puzzled by this deal.
The fewer buyers in the market, the more the sellers lose. As of the end of August, LTCM lost 45% of its capital, trapped in $125 billion in unsold assets.
When the fund started to lose money, the banks just realized how risky the company was operating and they started to raid the fund to get back the money spent.
Ultimately, the fear that a financial crisis would erupt following the collapse of LTCM saved the fund.
As the LTCM empire began to shake, the banks - who were opposing the fund - realized: "If the fund goes bankrupt, we will lose all of our investments." And because so many banks rushed to invest in the fund, a crash would disrupt the market.
Many banks and investors began to look for ways to control and rescue LTCM. They fear that once LTCM loses control, all the money LTCM earns will be in jeopardy. But over time, their position only worsened, they had no other choice.
All attempts to raise capital have failed. LTCM sought help from Warren Buffett, George Soros and a few other banks. But who can buy such a huge fund? The size of LTCM makes no bank hope to save the company.
Immediately after the crisis in Russia, the default event of LTCM will trigger a new world financial crisis, the market will be completely destroyed. No one cared much about what would happen to the fund but was forced to find a way to protect their assets.
In mid-September 1998, understanding the spillover risks from this event, the Fed (US Federal Reserve) intervened to save the collapse of LTCM, as well as to save the stability of the financial system. world itself. The Fed establishes a chain of banks that can mobilize resources to rescue LTCM.
In the end, the Fed raised about 15 of the world's largest banks. Faced with the risk of bankruptcy, banks agreed to contribute $3.65 billion to buy 90% of LTCM's shares. This amount, plus the lost shareholders' equity and uncollectible debts, amounts to $110 billion. They hope this money will help reduce risk, bring capital back and turn things around.
The successful plan, the subsequent default and disintegration of LTCM did not harm the market as a whole. However, in the process of bailing out LTCM, they created many favorable conditions for the tycoons of LTCM.
For example, although the fund suffered catastrophic failure, one of the founders of LTCM, John Meriwether, managed to preserve personal assets (such as houses, cars, etc.) and avoid personal debts. core. Only a few years later, he returned to continue setting up a new hedge fund, but this fund still suffered the same fate as LTCM.
Prior to the collapse, LTCM had capital in excess of $5 billion, assets in excess of $100 billion, and financial products with nominal amounts in excess of $1 trillion. By 1998, within only 4 months, LTCM lost $4.6 billion in capital and had to receive aid from the government. The fund officially closed in 2000.
The main message of the book is:
Through the heyday and demise of one of the greatest hedge funds in American history, we've come to realize that even the most seemingly perfect models can't protect investors from bad luck. unpredictable behavior of fellows. A genius who does not understand and play by the rules of the market is also doomed to failure.