Book Report: When Genius Failed

Well, I guess it’s time to review some of the books I read while in Korea. A few of the SFU students I’ve met have been asking what to read and I’d like to let people know which are the good reads out there. Incidently, I spoke for a while with one SFU finance student who had read some of the same books and I noticed a curious thing: we both spoke the same language. Others in the group had little idea of the people and events we were talking about but we were very into the conversation. Thus, for those of you who aspire to get into the investment business here is my advice: read as much as you can about the past—especially the big events like Mike Milken and Baring’s collapse and the various bull and bear markets. When you get in the business you will meet people who actually lived through these things and met these people (or know of them) and then you can take in what they are saying a lot easier. Everyone seems to frame reality and the present based on their past—and this is a good way to have a shared past.

When Genius Failed was a great book. Roger Lowenstein is a very concise and eloquent writer with an eye for not only the details of the events but also the nuances that percolated through the markets at the time. The story was about how John Meriweather and his analytical team (who started in Salomon Brothers) started a hedge fund in Stamford Connecticut called Long Term Capital Markets (or LTCM). It really was setup to arbitrage between pricing discrepancies in the markets—discrepancies that might take a while to converge or go their way (which might be where the ‘long term’ aspect came in).

Hedge fund is a bit of a misnomer. The fund was set up with the high minimums traditionally used with hedge funds (in this case $10 million) but the trading was done via many primebrokers (most hedge funds have just one primebroker--—hence the term ‘prime’). As well, the trades were broken up between brokers, so, for example, Bear Sterns might get the buy side and Goldman Sachs might get the sell. On the consolidated books the fund would be hedged (more or less, in some cases, as there is rarely a perfect hedge) but each party to the transaction (except LTCM would not know exactly what they were up to—thus, they could not piggyback the strategy and make copy-cat trades that might ruin the precarious formula.

As with other hedge funds they also required investors to tie up their capital for an extended period (I believe it was 3 or 5 years—, this might be the other basic for the LT in LTCM). They also expected profits to be quite robust with little risk (or standard deviation, as we call it in statistics). For those who questioned them (Warren Buffett was one) arrogance and hubris reigned from time to time. It’s said that Myron Scholes (of Black-Scholes fame) said, “As long as there are people like you (who think there is no free ride/lunch) we’ll make money.”

Indeed, the fund did make a lot of money. 40% or so a year for a few years (you’ll have to read the book to get the actual stats) and the risk (standard deviation) was quite low. Their sophisticated computer modeling programs could not find fault with their trades. For the most part, they were playing the “on-the-run, off-the-run” game where they’d buy the long government bond issued over 6 months ago and sell the one that was just issued. Since institutions tend to trade them for a short while and then lock them into inventory, the liquidity premium in the newly issued bond lead to a slightly higher price then the older one—. This discrepancy would alleviate itself in a short while (a few months or years) and the profits were virtually guaranteed—--but they were very, very small: so they had to lever up the portfolio and throw millions (or billions) at it in order to make it profitable.

A few other arbitrage strategies were used, but, in time, the managers found that they were getting too big even for these highly liquid markets. There was also the risk that they might be found out and other traders would ruin their little game. So they branched out into emerging market debt arbitrage: buying, say, Argentinean bonds, and selling U.S. treasuries as a hedge to interest rates. They could also use swaps and credit default derivatives and other instruments to tailor their exposure (and profits) to their models.

When these markets started to get a little boring they even started doing merger arbitrage (also called risk arbitrage) whereby they’d go long and short the stocks of target and acquiring firms in announced deals (and even unannounced deals--—very risky!).

Over the years LTCM, as noted, racked up impressive gains and really didn’t take into account that a Perfect Storm was brewing. (This is, of course, looking back, so you’ll have to forgive my holier-than-thou attitude.) The principals of the fund decided to lever up their personal investments. They already had a good deal of their own wealth in the fund (as is typical with hedge funds) but they thought that all these minority investors should be bought out and replaced with their money. Of course they didn’'t necessarily have enough to do so. They approached UBS on the idea of writing an option on the fund (the principals would pay UBS an up front premium and be able to get, in essence, a levered play on their fund—the higher it went the more they’d make and because their original investment would be lower than buying it outright their levered returns would be astronomical). Of course, UBS was a little hesitant at this. It would have to buy the fund itself to ensure that it hedged its position. This was not all that palatable so it balked at the deal. Swiss Bank Corporation (SBC) did bite and, in effect, the other original (non-principal) investors were bought out at an incredible gain (much to their chagrin—at least in the short term). (Later SBC was bought by UBS and UBS got the option albatross regardless—--haha!)

As alluded, the Perfect Storm did occur with Russia defaulting on its bonds in the Summer of 1998. Many other emerging markets became ‘submerging’ markets and LTCM’s investments in them dropped like a stone. With the flight to quality their short on the U.S. Treasuries was less of a hedge and more of a source of losses--—while many of the other strategies ended up tanking as well. Their capital reserved wanes and the primebrokers (hoping that LTCM has hedged their positions effectively, but later finding out the ugly truth) got worried—Bear Sterns being the most vocal (they were also the one large investment bank that did not invest in the fund. Goldman Sachs was approaching its IPO when the crap hit the fan and it was found that LTCM’s $1 billion in assets was levered up to control $125 billion and, through swaps, the total was even higher (about $1 trillion if I remember correctly). It all came crashing down even moreso as investment bankers who combed through the newly-opened books of the fund were reportedly calling their firms’ trading desks and alerting their staff to the major problems--—problems that traders would exacerbate with great glee not only for the profit motive but to help bring down LTCM’s tower of hubris.

In the end about $350 million was pledged by many of the big U.S. banks (Bear Sterns notably absent from the bailout group) to take on the positions and work on an orderly liquidation. Apparently Warren Buffett entered the fray as well, —as his Berkshire Hathaway was one of the few firms in the world with the capital and corporate structure to take on the task single-handedly—--but he seemed to have low-balled his offer and the Fed, who had stick-handled the deal, decided to go with the consortium.

Basically, if you want to know what can go wrong (even with Nobel laureates on staff) this book is a great read.