In the early 1990s, Wall Street was recovering from a giant treasury bond scandal at Solomon Brothers. John Meriwether, a former Solomon trader, set out to create one of the largest and most exclusive hedge funds the world had ever seen. Using mathematical arbitrage strategies, he had developed over the years, Meriwether became one of the most successful bond traders on Wall Street.
The Genius Assembly
In setting up his fund – dubbed Long Term Capital Management – Meriwether recruited colleagues from his days at Solomon. Many held prestigious PHDs, and Meriwether even recruited professors from MIT’s most advanced programs. The fund’s thesis was simple. With the use of complex mathematical models, Long-Term could take advantage of thousands of daily price discrepancies and beat the market by miles.
The group’s reputation for being analytical geniuses allowed them to raise money from Wall Street’s largest banks and some of the world’s wealthiest individuals in what was the biggest hedge fund startup of all time. Within their first year Long-Term had raised $1.25 billion from the Bank of Taiwan, the Bank of Italy, and even private investors such as Phil Knight, the founder of Nike.
The fund’s first years of operation did not disappoint. In 1994, the fund appreciated by 28%, and in 1995 they produced an even more impressive 59% gain, far exceeding the returns of any other fund at the time. The primary factor in the fund’s performance was not so much the mathematical models used by the fund but rather their excessive use of leverage.
Because the arbitrage strategies involved taking advantage of small discrepancies in bond spreads the fund had to use an increasing amount of leverage to earn such high returns. By 1996, two years after the start of the fund, Long-Term was leveraged over 30 to 1.
Nonetheless, the fund consistently outperformed form 1994-1997 leading the members of the fund to be convinced they were invincible. The increasing capital and the continuous outperformance pushed the traders beyond the boundaries of bond arbitrage that had served them so well in the past and soon began trading in junk bond and equity arbitrage through the use of complex derivatives.
Because of SEC regulations, a hedge fund can only have so much leverage when trading in equities. To get around this rule, the fund would use leverage to purchase derivatives directly tied to the value of a stock without actually owning any stock certificates (a practice that many funds continue to use today).
As happens too often, the unending success of Long-Terms traders made them blind to the hubris that was starting to take over their fund.
In 1998, the fund began to make increasingly risky bets such as buying put options on tech companies such as Microsoft and Dell, as well as bets on Russian bonds. One of Long-Term’s traders, Larry Hilibrand, even shorted Berkshire Hathaway thinking it was over-valued. The year proceeded with a series of unpredictable events causing panic throughout the financial markets.
Rumors of Russia defaulting, compounded with an announcement from President Clinton about his affair with Monica Lewinsky, caused investors to pile into treasury bonds and abandon their positions in Russian debt, driving markets down severely.
The combination of all these events caused Long-Term’s capital to fall dramatically in the latter part of 1998, and by late August the fund was down 84% from the beginning of the year.
The fall in the fund’s capital caused panic to spread throughout the fund’s members, who in turn attempted to withdraw their money. Additionally, Wall Street banks, to whom Long-Term still owed billions, were calling for payments which the fund could barely make.
In order to meet capital calls, Long-Term began reaching out to outside investors asking for funding. After numerous rejections, they resorted to calling George Soros and even Warren Buffett asking if they were interested in investing.
Deal after deal fell through until the day came when only one institution in the world would bail them out: The Fed. Because so many banks on Wall Street were tied to Long-Term through either leverage or derivative contracts, the Fed felt that they had no other choice but to bail out the fund.
The Cost of Greed
By the end of 1998 almost all the investors of Long-Term Capital Management had their investments wiped out and the fund’s employees were all out of a job. The easy money that comes too often on Wall Street caused the fund to get overwhelmed by their success and push themselves into positions that over time could only lead to downfall.
Time and again speculative behavior on Wall Street has brought down some of the world’s largest institutions. From the fall of Long-Term Capital Management in 1998 to the bankruptcy of Lehman Brothers 10 years later, the greed of speculators repeats itself. Interestingly, both of these firms turned to Warren Buffett’s Berkshire Hathaway during the wake of their downfall.
Perhaps the greatest lesson to learn is that the value investing approach is immune to speculation and overtime speculators will always be turning to true investors to save them. The virtues of patience and rationality that are central to successful investing continue to be proven true with every Wall Street collapse.
Roger Lowenstein has time and again proven his superior ability to recount Wall Street’s most tumultuous events. When Genius Failedshows us the hubris and greed that overtook some of the world’s most intelligent people, which included MIT PHDs and Nobel Prize winners.
We see first-hand through Lowenstein’s writing how these hyper intellects went from running one of the world largest investment funds to scrambling for jobs and trying to avoid bankruptcy. When Genius Failed teaches us one of the most important laws of investing: no amount of intelligence can protect oneself from the emotions and greed frequently found on Wall Street.