When Genius Failed: The Rise and Fall of Long-Term Capital Management

John Meriwether, a famously successful Wall Street trader, spent the 1980s as a partner at Salomon Brothers, establishing the best--and the brainiest--bond arbitrage group in the world. A mysterious and shy midwesterner, he knitted together a group of Ph.D.-certified arbitrageurs who rewarded him with filial devotion and fabulous profits. Then, in 1991, in the wake of a scandal involving one of his traders, Meriwether abruptly resigned. For two years, his fiercely loyal team--convinced that the chief had been unfairly victimized--plotted their boss''s return. Then, in 1993, Meriwether made a historic offer. He gathered together his former disciples and a handful of supereconomists from academia and proposed that they become partners in a new hedge fund different from any Wall Street had ever seen. And so Long-Term Capital Management was born.
        In a decade that had seen the longest and most rewarding bull market in history, hedge funds were the ne plus ultra of investments: discreet, private clubs limited to those rich enough to pony up millions. They promised that the investors'' money would be placed in a variety of trades simultaneously--a "hedging" strategy designed to minimize the possibility of loss. At Long-Term, Meriwether & Co. truly believed that their finely tuned computer models had tamed the genie of risk, and would allow them to bet on the future with near mathematical certainty. And thanks to their cast--which included a pair of future Nobel Prize winners--investors believed them.
        From the moment Long-Term opened their offices in posh Greenwich, Connecticut, miles from the pandemonium of Wall Street, it was clear that this would be a hedge fund apart from all others. Though they viewed the big Wall Street investment banks with disdain, so great was Long-Term''s aura that these very banks lined up to provide the firm with financing, and on the very sweetest of terms. So self-certain were Long-Term''s traders that they borrowed with little concern about the leverage. At first, Long-Term''s models stayed on script, and this new gold standard in hedge funds boasted such incredible returns that private investors and even central banks clamored to invest more money. It seemed the geniuses in Greenwich couldn''t lose.
        Four years later, when a default in Russia set off a global storm that Long-Term''s models hadn''t anticipated, its supposedly safe portfolios imploded. In five weeks, the professors went from mega-rich geniuses to discredited failures. With the firm about to go under, its staggering $100 billion balance sheet threatened to drag down markets around the world. At the eleventh hour, fearing that the financial system of the world was in peril, the Federal Reserve Bank hastily summoned Wall Street''s leading banks to underwrite a bailout.
        Roger Lowenstein, the bestselling author of Buffett, captures Long-Term''s roller-coaster ride in gripping detail. Drawing on confidential internal memos and interviews with dozens of key players, Lowenstein crafts a story that reads like a first-rate thriller from beginning to end. He explains not just how the fund made and lost its money, but what it was about the personalities of Long-Term''s partners, the arrogance of their mathematical certainties, and the late-nineties culture of Wall Street that made it all possible.
        When Genius Failed is the cautionary financial tale of our time, the gripping saga of what happened when an elite group of investors believed they could actually deconstruct risk and use virtually limitless leverage to create limitless wealth. In Roger Lowenstein''s hands, it is a brilliant tale peppered with fast money, vivid characters, and high drama.

Praise for Roger Lowenstein's national bestseller Buffett: The Making of an American Capitalist

"A delightful portrait . . . Mr. Lowenstein has done a masterly job."
-- The New York Times Book Review

"A significant contribution to the craft of biography as well as an illuminating and comforting story for investors everywhere."
-- Chicago Tribune

"The singular achievement of Lowenstein's excellent biography... is that it burnishes the Buffett myth while deconstructing it with heavy doses of reality."
-- Barron's

"Lively, smoothly written, and elaborately researched, Buffett is likely to stand as the definitive biography."
-- Business Week

"Thoroughly researched and perceptive . . . a highly readable account."
-- Financial Times

"Lowenstein has accomplished something remarkable."
-- Los Angeles Times


From the Hardcover edition.

Roger Lowenstein, author of the bestselling Buffett: The Making of an American Capitalist, reported for The Wall Street Journal for more than a decade, and wrote the Journal''s stock market column "Heard on the Street" from 1989 to 1991 and the "Intrinsic Value" column from 1995 to 1997. He now writes a column in Smart Money magazine, and has written for The New York Times and The New Republic, among other publications. He has three children and lives in Westfield, New Jersey.

Q: Do you know if anyone from Long Term Capital Management has read WHEN GENIUS FAILED? Have you heard from any of them?

A: Yes. Some of Meriwether's former partners, who are partners with him now in a new venture, asked me to make changes because they thought sections of the book would be harmful to their future fund-raising efforts. We, of course,
carefully reviewed and re-reviewed the accuracy of everything in the book but followed a "let-the chips fall where they would" policy with regard to what the reverberations would be.

Q: Was there any way to predict the demise of LTCM by looking at their investment style in the 1990s? Was anyone paying attention?

A: No - they had been a big success in the [19]90s. That was part of the problem. Their models looked backward and, based on that prior success, they invested as though they thought they couldn't lose.

Q: Could LTCM have done more effective damage control to save the fund or did events spiral too quickly?

A: No - that was also part of the problem. Being so self-confident they also got way too big in positions, meaning that once the trouble hit it was impossible to get out without rocking the market even more. They were trapped.

Q: John Meriwether's September 1998 letter to investors (informing them of their incredible losses) was surprisingly optimistic. Do you think he was being disingenuous at the time?

A: No. He believed his trades were good trades- that's why he had gotten into them. As it turned out, they weren't nearly so good as he thought - many have yet to recover. But that aside, he forgot that even good trades can go the
other way. This is what the book calls "the human factor." When people panic, markets don't resemble what's in a computer model. They go where the most nervous trader takes them.

Q: Why do you think the government has filed this incident away and refuses to address it in terms of regulation or legislation while Alan Greenspan simultaneously calls for less regulation?

A: We live in a time of unprecedented prosperity and bullishness. Regulations change (as during the New Deal) when times are bad. When times are good, nobody cares.

Q: The hubris you describe in WHEN GENIUS FAILED is more than most of us can imagine. Should the public treat Meriwether's recent contrition (during interviews) as sincere?

A: You know, I wasn't in the room. It's certainly notable that he said nothing for two years and then issued a mea culpa two weeks before the book came out. But then, he has always been a private man. Perhaps he was being sincere but also self-interested - as are most of us most of the time.

Q: What is the lesson in WHEN GENIUS FAILED for the average American and investor?

Don't believe the future will look like the past. History rhymes, as Twain said, it doesn't repeat. Moreover, don't think that more "sophisticated" investors possess some magic formula or key. They don't, nor do all their computers and their "models." And finally, whenever someone is so confident that they run huge amounts of leverage-more than 30 times debt to equity in this case - run the other way. The one feature that does repeat, although in different forms, throughout financial history is that the people who get into trouble are the people who run up too much debt to survive a rainy day.

Q: Somehow it makes sense that LTCM was based in the secret, monied playground of Greenwich, Connecticut. Maybe a bunch of guys from Jersey would have handled this better.

A: Well I have a strong bias for Jersey guys, as you know. But I think what was important wasn't the Greenwich locale per se but the partners' distance from Wall Street. Seclusion fed the partners' already inflated sense of superiority. If they had been rubbing elbows a little more with guys downtown, who knows?