When Genius Failed: The Rise and Fall of Long Term Capital Management

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But among the existing hedge funds, LTCM stands out in terms of size, reputation and loan amount. Operated by a team of stars with large capital, LTCM is a name that everyone wants to cooperate with. Many rich people as well as companies aspire to own a part of this cake.

LTCM is said to have leveraged its equity even up to 1:55 levels using direct leverage at one point of time with 1:30 to 1:40 being the norm. It means that it put USD 1 of its own money and raised USD 55 by debt and invested USD 56 in its own name (at USD 4.6 billion of own equity, this asset size amounts to USD 253 billion, which is 4.6*55). If the value of the investment increased by USD 1 i.e. from USD 56 to USD 57 (a return of 1.7% on total assets), then after deducting debt of USD 55, its equity increased to USD 2, which is 100% return on its own equity. It is not necessary to understand markets to make money; but it is necessary to understand oneself." The account of the LTCM debacle is a vivid illustration of how hubris can lead to disaster in finance."Roger] Lowenstein has written a squalid and fascinating tale of world-class greed and, above all, hubris.” —BusinessWeek Some people at Wall Street tried to raise some red flags, but LTCM saw pink: they believed they were smarter than everybody and that they were the first ones to break the system . Apparently, There Is No Such Thing as a Midas Formula With all the favor that I receive, LTCM creates a healthier shell than it really is. Part of that is simple scams: although they do report assets and liabilities quarterly for banks and monthly for investors, the reporting is not always clear and simple. usually just for general summary information. America’s impending pension problem is brutally simple: private companies and governments have pledged to provide retirement income and health care for workers, but have not set aside the Continue reading » At that time, the size of LTCM was 2.5 times larger than the second largest mutual fund in the world and 4 times larger than the rival hedge fund right behind it. They also control more assets than investment banks like Lehman Brothers or Morgan Stanley.

Above, you have just learned about the key tactics of LTCM. The next chapter will explain why their approach is successful. LTCM applies academic knowledge to investing. When the crisis broke in the summer of 1997, LTCM noticed a slight drop in profits, but that still didn't stop them. They continue to follow the pattern and gradually push themselves closer to the edge of the abyss. Bookstaber, Richard (2007). A Demon Of Our Own Design. USA: John Wiley & Sons. pp. 97–124. ISBN 978-0-470-39375-8. Lowenstein describes all the events in great detail - he has clearly done a tremendous amount of research. My only gripe is that I often did not feel immersed in the situation. Michael Lewis in his Liar's Poker creates a vivid image of each character and really makes you feel like you're there in the story. This book is more factual and less immersive in a way. But don't get me wrong, that's a minor issue, more of a personal preference. a b Niall Ferguson (2008). The Ascent of Money: A Financial History of the World. London: Allen Lane. ISBN 978-1-84614-106-5.The size of LTCM really makes it difficult for them to profit from risky investments. As problems and losses began to mount, LTCM's ridiculously high leverage became an obstacle: they had to continue to follow the pattern and take risks in the hope of making enough money to spend. pay for expenses, debt is piling up. They are more confident in their ability to pay off promised by the model. Change is no longer an option. They have to stay engaged.

This model assumes that the financial system is just a "rational" quantity, predictable and governed by predictable people. But not. Human nature is irrational, sensitive, and prone to panic. It is this contradiction that causes problems for LTCM. As per the managers, they had all the normal patterns mapped out for all the situations and traded only when the markets moved away from normal. They took the bet that markets would return to normal, as their models showed that it always did in the past. To be safe, LTCM always seemed to diversify their bets. It is said that they simultaneously held almost 60-70 different kind of trades spread across assets and geographies, to safeguard their portfolio from any catastrophic event.

LTCM uses more and more leverage to maximize profits.

Q: Was there any way to predict the demise of LTCM by looking at their investment style in the 1990s? Was anyone paying attention? LTCM’s investments though mainly classified under arbitrage, varied from interest rate arbitrage, M&A risk arbitrage, geographical arbitrage, currency pairs, derivatives and what not. LTCM’s management team consisted of mathematicians, economists & professors who turned into traders to apply their theories to real life markets. They had the best of the computers at their disposal. All the known data of financial markets for as many years available, was put into the software and analysed to find out recurrent/normal patterns. The genius fund managers then set out to exploit the aberrations in the markets across the world in any asset class. Even though Merton disparaged the idea that investors could turn collectively irrational at some point, it seems that Mr. Market had the last laugh. LTCM is a hedge fund or hedge fund founded in 1994 by bond trader John Meriwether. Hedge funds hold a huge amount of money from the richest group of investors. Contrary to its cousin mutual fund, which is a fund that raises funds from a wide range of investors, hedge funds are low in popularity and are not overly regulated, meaning there are no limits on the size of the fund. size of the fund as well as the place of investment.