When Genius Failed

Myron Scholes was on top of the world in 1997, having won the Nobel Prize in economics that year for his work in financial economics, work that he had applied in the real world in a wildly successful hedge fund, Long Term Capital Management. But just one year later, LTCM was saved from collapse only by a last-minute bailout that wiped out his equity (along with that of the other partners of the fund) and cast doubt on the value of his academic work.

Roger Lowenstein told the story of LTCM in his 2001 book “When Genius Failed“. I finally got around to reading this classic of the genre this year, and I’d say it is still well worth picking up. The story is well-told, and the lessons are timeless-

Beware hubris
Beware leverage
Bigger positions are harder to get out of (especially once everyone knows you are in trouble)
In a crisis, all correlations go to one
Past results don’t necessarily predict future performance
Sometimes things happen that are very different from anything that happened in your backtest window.

The book came out in 2001 but it presages the 07 financial crisis well- not about mortgage derivatives specifically, but the dangers of derivatives, leverage, using derivatives to avoid regulations restricting leverage, and over-relying on mathematical models of risk based on past behavior. If Fed had let LTCM fail, could we have avoided the next crisis? Perhaps so, as their counterparties (most major Wall Street banks) who got burned would have been more careful about the leverage and derivatives used by themselves and their counterparties, and regulators may have taken stronger stances on the same issues.

Perhaps some more recent well-contained blowups foreshadow the next big crisis in the same way, like FTX or SVB?

Some more specific highlights about LTCM:

The partners were smart traders, but their true genius was their ability to raise money, and especially to borrow money:

Long-Term in 1995 returned an astounding 59 percent before fees and 43 percent after… at the end of 1995 it was leveraged 28 to 1. Of course, its return on total assets– both those that it owned and those it had borrowed- was far, far less than the gaudy return cited above. This return on total capital was approximately 2.45%. This minuscule figure is what long-term would have earned had it invested only its own money. But even this figure is too high…. taking its derivative trades into account, its cash-on-cash return was probably less than 1 percent.

They convinced many banks to give them special terms, the ability to borrow while taking no haircut on their collateral. The partners appear insanely risk-loving, both through the fund itself (thinking their realized vol was too low and therefore they needed to push it higher to match the vol of the stock market), as well as with their personal accounts (always pushing to borrow more money or use options to get even more exposure to LTCM’s returns). No cynicism about just collecting fees- they were true believers who were pushing out the outside investors by 1997 to make more room for themselves.

Chase’s hedge fund director Pflug sums up the book well with his take on options “You can’t over-intellectualize these greek letters… One greek word that ought to be in there is hubris”