When Genius Failed

Roger Lowenstein, a former Wall Street Journal reporter who wrote its Heard on the Street column and the author of a biography of Warren Buffett, tells how a team of brilliant traders and academics at Long-Term Capital Management nearly broke the financial system. The partners included John Meriwether, who had built Salomon Brothers' bond arbitrage group, along with Robert Merton and Myron Scholes.

The fund's trades bet that small price gaps between related securities would close. They were safe individually but enormous in aggregate, with leverage of more than 25 to 1, and when spreads widened everywhere at once in 1998, its capital vanished in weeks.

Lowenstein drew on the partners' confidential memos and interviews with many of the players. Kirkus praised the lucid, often funny explanations of arbitrage, and The Economist called it storytelling journalism at its best. He is unsparing about the partners' arrogance, so readers wanting their defense should look elsewhere.

Anyone who uses leverage, value-at-risk models or relative-value trades should read it. The story anticipated much of 2008.

1. Leverage turns small errors into ruin. Trades that each looked low-risk became lethal at more than 25 to 1 leverage, because there was no room to wait for prices to converge.
2. Correlations go to one in a crisis. LTCM's diversification across markets assumed independent positions. When liquidity vanished, everything moved together.
3. Models describe the past, not the tails. The fund's risk models treated the losses of August 1998 as nearly impossible. Fat tails and regime changes are where the money is lost.
4. Crowded trades exit through a narrow door. Banks and other funds held copies of LTCM's positions and sold them at the same time, which deepened the losses.
5. Too interconnected to fail. The Fed's role in organizing a private rescue showed how a single fund's counterparties could threaten the system, a pattern repeated in 2008.

After an introduction set at the Federal Reserve Bank of New York in September 1998, the book is told in two halves that follow the fund's rise and its fall.

1. Meriwether's group. Lowenstein traces the arbitrage team at Salomon Brothers, the academics it recruited and Meriwether's exit after the 1991 Treasury auction scandal.
2. Building the hedge fund. In 1993 and 1994 Meriwether raises money on unusually demanding terms, recruits Merton and Scholes, and wins financing terms from banks that no other client could get.
3. The good years. Through on-the-run bond trades, swap spreads and equity pairs such as Royal Dutch and Shell, the fund compounds rapidly. Its letters to investors and the 1997 Nobel Prize add to its aura, and at the end of 1997 it returns $2.7 billion to outside investors while keeping its positions, raising its leverage.
4. The fall. In 1998 the fund sells large amounts of equity volatility, acting almost as a bank of volatility. After Russia's default in August, losses mount daily as markets move against all its positions at once.
5. The rescue and after. The Fed gathers LTCM's creditors, the banks bicker and agree on a recapitalization, and the epilogue follows the partners as Meriwether starts again under a new name.

Roger Lowenstein captures the gripping roller-coaster ride of Long-Term Capital Management. Drawing on confidential internal memos and interviews with dozens of key players, Lowenstein explains not just how the fund made and lost its money but also how the personalities of Long-Term’s partners, the arrogance of their mathematical certainties, and the culture of Wall Street itself contributed to both their rise and their fall. When it was founded in 1993, Long-Term was hailed as the most impressive hedge fund in history. But after four years in which the firm dazzled Wall Street as a $100 billion moneymaking juggernaut, it suddenly suffered catastrophic losses that jeopardized not only the biggest banks on Wall Street but the stability of the financial system itself. The dramatic story of Long-Term’s fall is now a chilling harbinger of the crisis that would strike all of Wall Street, from Lehman Brothers to AIG, a decade later. In his new Afterword, Lowenstein shows that LTCM’s implosion should be seen not as a one-off drama but as a template for market meltdowns in an age of instability—and as a wake-up call that Wall Street and government alike tragically ignored.