In 1994, bond arbitrage guru John Meriwether, late of Salomon Brothers, launched a hedge fund. Its partners included two soon-to-be Nobel laureates and an ex-vice chairman of the Federal Reserve. The fund was to exploit highly quantitative techniques to bet on (primarily) bond spreads throughout the world, using large amounts of leverage to magnify small returns from supposedly low-risk positions. By early 1998, each dollar invested in the fund had grown to $4.11. By early fall 1998, that $4.11 was down to 33 cents. The fund's potential bankruptcy so threatened the world economy that the U.S. Federal Reserve had to step in to broker a rescue.The tale of the rise and fall of Long-Term capital was coming to its end as I was putting to press my own book on option-based trading strategies and their effects on market volatility (Capital Ideas and Market Realities). The whole adventure constituted a perfect capstone to my story, which goes back to the crash of 1929, showing how strategies that purport to eliminate the risk of investing can end up exploding in the face of their followers and investors generally.
Now Roger Lowenstein, formerly a journalist at the Wall Street Journal and author of a biography on Warren Buffett, has devoted a whole book to LTC. Drawing largely on contemporaneous reporting and on his own personal interviews with many of the principal and supporting players (although not, alas, Meriwether himself), Lowenstein manages to create a real page-turner out of the unfolding events, even for readers who already know the ultimate outcome.
Part of the tension, it seems to this reader, stems from the unresolved (and probably unresolvable) ambiguity about the real nature of the story.
...
On the one hand, it seems to play out as a classic tragedy: Its larger-than-life protagonists hubristically pit themselves against the gods of the marketplace and fall hard. Certainly, for many of the players involved, it was a tragedy. Meriwether not only lost his money but his reputation. Nobel laureates Robert Merton and Myron Scholes found their lives' works on modern finance theory rocked to the core. Many of those instrumental in engineering LTC's rescue (including Goldman Sachs' Jon Corzine) ended up subsequently losing their own jobs. LTC's employees, who had been encouraged to invest their bonuses from the firm's fat years back into the firm itself, lost it all when the firm collapsed; nor did they get the $500,000 bonuses secured by the LTC partners as part of the bailout package.On the other hand, one can also view the whole affair as great comedy (especially if one is on the outside looking in). After all, a scene with 140 lawyers in one room is worthy of the Marx brothers. Then you have the Fed descending, at the eleventh hour, like some deus ex machina, to restore order and stability; not to mention Wall Street's viciously competitive masters of the universe gathered on folding metal chairs around the New York Fed's boardroom table, trying to rescue the world from themselves. Even LTC's partners bounce back. Meriwether (J.M. to friends, and throughout the book) starts a new hedge fund, bringing in several old LTC colleagues. Merton and Scholes are still teaching and consulting. A week after LTC was bailed out, many of the principals gather at the Pierre Hotel in New York to celebrate Scholes' remarriage; a wedding, of course, is the classic comedic emblem of reconciliation and renewal.
The vibrancy of any play, whether comedy or tragedy, often rests on the quality of its villains. Lowenstein singles out a few individuals for special opprobrium. These include Victor Haghani and Lawrence Hilibrand, who basically ran LTC's trades and pushed the firm into ever larger, more highly leveraged positions, and into areas such as merger arbitrage in which the firm had no demonstrated expertise. Hilibrand comes across in a particularly bad light, especially when he shows up at the bailout negotiations with his own private lawyer and threatens to derail the whole process because "there was nothing in it for him."
The person one might expect to hold the center of the story, J.M. himself, plays a strangely muted role. Lowenstein describes him as "an unlikely star, too bashful for the limelight." Even his contributions in furtherance of LTC's eventual downfall seem to be more sins of omission than sins of commission. That is, he failed to rein in his uber traders, Haghani and Hilibrand, and he failed to heed the warnings of his more temperate (and, as it turned out, more realistic) colleagues. Of course, J.M. did set the tone for the firm-the air of infallibility that was to prove its downfall.
The book emphasizes how LTC's greed, arrogance and even foolhardiness made it susceptible to a market crisis. But was this crisis purely a result of exogenous events, such as the turmoil in Asia and Russia, as Lowenstein suggests? If so, how did these troubles overwhelm markets in fundamentally sound Western economies?
In my opinion, the book lets LTC off the hook in failing to explain how the very strategies it followed helped to create the perfect storm that ended up swamping the firm. The argument in my book, based on decades of debate with options experts in the industry and in academia, is that LTC provides yet another illustration of the market's susceptibility to certain large-scale trading strategies. These strategies tend to attract a lot of capital because they appear to offer a haven from the vicissitudes of market risk; given leverage and derivatives, they can command hundreds of billions (even trillions) of dollars of assets. Under adverse market conditions, however, the "rules" of these strategies call for dumping all these assets on the market-all at once. We saw this in the crash of 1987, and again in the turbulence of 1989, 1991,1994 and 1997.
All in all, however, When Genius Failed is a classic tale of greed and fear on Wall Street. Lowenstein tells it well, especially in the later chapters, which give readers a blow-by-blow account of the bailout negotiations. What's more, he brings out the story's particular pertinence for today's investors: Even with all the brains and all the computers in the world, investors can't control, let alone predict, human nature.
Bruce I. Jacobs (cimr@jlem.com), Principal, Jacobs Levy Equity Management, and author of Capital Ideas and Market Realities (Blackwell, 1999)
