Rise and Fall of LTCM

["Ulhas Joglekar" <ulhasj@xxxxxxxxxxxxxxxxxxxx>]

Business Standard

Last updated 1600 Hrs IST, Friday, November 17, 2000

OFF THE SHELF
Wall Street, rocket scientists and hubris
When Genius Failed: The Rise and Fall of Long-Term Capital Managemnet
Roger Lowenstein
Random House
$ 26.95/ 264 pages
Manas Chakravarty
The failure of Long-Term Capital Management wasn't just a case of one more
hedge fund biting the dust. LTCM was no ordinary fund. It had delivered
excellent returns to its investors, its chief John Meriwether was a legend
on Wall Street, and, most importantly, it was staffed by rocket scientists,
with two Nobel Prize winners on its roster.
LTCM's fall wasn't just the fall of an investment firm, it was the fall of
an idea, of the Black-Scholes model - it was the ultimate blow to efficient
markets theory. The ignominious failure not only pricked the egos of the
smug geeks who thought that they were far smarter than ordinary traders, it
also destroyed the notion that the markets could be defined by mathematics
alone.
Roger Lowenstein tells the story of the rise and fall of LTCM in all its
drama and colour. He takes the reader into the personalities of the men who
built up the hedge fund, men like Meriwether, Nobel laureates Merton and
Scholes, and the eggheads from Salomon's Arbitrage group, who later formed
the heart of LTCM.
What distinguished LTCM from other firms was its belief in market
rationality. Its team of professors turned traders believed in the efficient
markets hypothesis as an article of faith. Their mission was to sift reams
of data looking for securities out of line with their historical trend
price, and then exploit that opportunity to make profits.
When spreads widened more than usual, as in times of uncertainty, panicked
investors wanted to get out of the market, without bothering to check
whether the securities they held were actually underpriced. LTCM bet big
money that spreads would sooner or later move back to the norm, and used
this insight to make what they called a play on "convergence".
That was the name that LTCM gave its safest bets, because it rested on the
mathematical certainty that, because instruments matured on a certain date,
convergence appeared to be a sure thing. Others were known as relative value
trades, where convergence was expected, but not certain. The geniuses at
LTCM believed that they were playing the market by adopting a scientific
attitude to risk.
Usually, the extent of mispricing was miniscule, but LTCM's genius lay in
the fact that they were able to mesmerise the Wall Street banks to give them
almost unlimited credit. That way, even a small gain could be leveraged
umpteen times into a billion-dollar profit. And LTCM's leverage at times was
as high as 28 to one.
In the first few years of its existence, nothing could go wrong for the
firm.
So good were the returns that the partners even returned money to protesting
outside investors, because they wanted all the profits for themselves.
Unfortunately, there were soon to be no profits at all. The Asian crisis
struck first, and then the Russian default. LTCM had bet that spreads on
bonds would reduce, but the recurring crises only increased the spreads,
leading to continuing losses.
And as usually happens when tested strategies are not working, LTCM made
bigger and bigger bets to try and recover some of the money, and in the end
it all unravelled. With over a trillion dollars in derivative exposure, LTCM
's counterparties and bankers would have faced almost certain extinction had
the Fed not cobbled together a rescue package.
So what went wrong at LTCM? The professors' hubris lay in believing that the
abstract world of their models would work in the hurly-burly of real life
markets. People are irrational - they do not behave as the textbooks would
like them to. The upshot: the fund with the highest IQ had lost 77 per cent
of its capital over a period when the ordinary investor more than doubled
his money.
But that doesn't mean Wall Street's honeymoon with computers and nerds is
over. Far from it - in December last year, fifteen months after he lost $4.5
billion, Meriwether raised $250 million, much of it from former investors in
LTCM, and was up and running again with his "Relative Value Opportunity Fund
2."
There's market rationality for you.

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