Finance
by Roger Lowenstein
How do geniuses go broke?
In 1994 John Meriwether, Salomon Brothers' star bond trader, launched Long-Term Capital Management, with two future Nobel prizewinners among his partners. Four years later it had lost almost all its capital, and the New York Fed was summoning Wall Street's banks. Roger Lowenstein tells how.
Hear a sample · read by Laura
LTCM hunted tiny price gaps between near-identical bonds, like a new thirty-year US Treasury and one issued months earlier. It bought the cheap one, sold the dear one and waited for the gap to close. Each trade paid very little, so the fund borrowed heavily to make the pennies count.
At the start of 1998 LTCM had under $5 billion of its own capital and had borrowed well over $100 billion. On top of that sat derivatives contracts with a face value above $1 trillion. At that scale, a small move against it could erase much of its capital.
The partners' models used years of price history to judge how far markets could move and how their trades moved together. Lowenstein's objection is that markets are people, not dice. In a panic, everyone rushes for the same exit, and prices go further than any history suggested.
The stars
Long-Term Capital was run by star traders and two Nobel winners, and everyone wanted in.
Borrowed money
Long-Term Capital made tiny price gaps pay by borrowing heavily, at times about thirty dollars for every one it had.
Models
The fund's models assumed the future would look like the past, so wild swings seemed nearly impossible.
1998
When Russia defaulted in 1998, markets did what the models said couldn't happen.
Crowded trades
Other firms had copied its bets, so everyone rushed for the same exit at once.
A story from the book
Russia devalued the rouble and stopped paying some of its debts. Investors everywhere fled to the safest, easiest-to-sell bonds. Nearly every gap LTCM had bet would narrow grew wider, all at once. On one Friday that month, the fund lost over half a billion dollars.
Hot take · true or myth?
Two of LTCM's partners won the Nobel Prize in economics.
True. Robert Merton and Myron Scholes shared the 1997 prize for their work on pricing options, while partners at the fund. It collapsed the following year.
One thing to try
Write down what you owe and what you could sell within a month if you had to. Then imagine two bad things landing together, like losing your job in the month house prices fall. LTCM treated its risks as if they would rarely strike together. Plan as if yours might.
Knotd has the key ideas from 250+ non-fiction books, each in a few minutes, in plain words. When Genius Failed comes with a Hot Take round and a Spot the Trap case to make it stick.
Get the whole book on KnotdOpen in the appHow do geniuses go broke? In 1994 John Meriwether, Salomon Brothers' star bond trader, launched Long-Term Capital Management, with two future Nobel prizewinners among his partners. Four years later it had lost almost all its capital, and the New York Fed was summoning Wall Street's banks. Roger Lowenstein tells how.
Betting on gaps closing; Leverage; Trusting the past.
Write down what you owe and what you could sell within a month if you had to. Then imagine two bad things landing together, like losing your job in the month house prices fall. LTCM treated its risks as if they would rarely strike together. Plan as if yours might.
Yes. Knotd has the key ideas from When Genius Failed in a few minutes, in plain words, plus a Hot Take round and a Spot the Trap case to test them. It's one of 250+ non-fiction books in the app.
