When Genius Failed: The Rise and Fall of Long Term Capital Management (Anglais) Broché – 6 octobre 2001
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The Federal Reserve Bank of New York is perched in a gray, sandstone slab in the heart of Wall Street. Though a city landmark building constructed in 1924, the bank is a muted, almost unseen presence among its lively, entrepreneurial neighbors. The area is dotted with discount stores and luncheonettes-and, almost everywhere, brokerage firms and banks. The Fed's immediate neighbors include a shoe repair stand and a teriyaki house, and also Chase Manhattan Bank; J. P. Morgan is a few blocks away. A bit further, to the west, Merrill Lynch, the people's brokerage, gazes at the Hudson River, across which lie the rest of America and most of Merrill's customers. The bank skyscrapers project an open, accommodative air, but the Fed building, a Florentine Renaissance showpiece, is distinctly forbidding. Its arched windows are encased in metal grille, and its main entrance, on Liberty Street, is guarded by a row of black cast-iron sentries.
The New York Fed is only a spoke, though the most important spoke, in the U.S. Federal Reserve System, America's central bank. Because of the New York Fed's proximity to Wall Street, it acts as the eyes and ears into markets for the bank's governing board, in Washington, which is run by the oracular Alan Greenspan. William McDonough, the beefy president of the New York Fed, talks to bankers and traders often. McDonough especially wants to hear about anything that might upset markets or, in the extreme, the financial system. But McDonough tries to stay in the background. The Fed has always been a controversial regulator-a servant of the people that is elbow to elbow with Wall Street, a cloistered agency amid the democratic chaos of markets. For McDonough to intervene, even in a small way, would take a crisis, perhaps a war. And in the first days of the autumn of 1998, McDonough did intervene-and not in a small way.
The source of the trouble seemed so small, so laughably remote, as to be insignificant. But isn't it always that way? A load of tea is dumped into a harbor, an archduke is shot, and suddenly a tinderbox is lit, a crisis erupts, and the world is different. In this case, the shot was Long-Term Capital Management, a private investment partnership with its headquarters in Greenwich, Connecticut a posh suburb some forty miles from Wall Street. LTCM managed money for only one hundred investors, it employed not quite two hundred people, and surely not one American in a hundred had ever heard of it. Indeed, five years earlier, LTCM had not even existed.
But on the Wednesday afternoon of September 2-3, 1998, Long-Term did not seem small. On account of a crisis at LTCM, McDonough had summoned-- invited," in the Fed's restrained idiom-the heads of every major Wall Street bank. For the first time, the chiefs of Bankers Trust, Bear Stearns, Chase Manhattan, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Smith Barney gathered under the oil portraits in the Fed's tenth-floor boardroom-not to bail out a Latin American nation but to consider a rescue of one of their own. The chairman of the New York Stock Exchange joined them, as did representatives from major European banks. Unaccustomed to hosting such a large gathering, the Fed did not have enough leather-backed chairs to go around, so the chief executives had to squeeze into folding metal seats.
Although McDonough was a public official, the meeting was secret. As far as the public knew, America was in the salad days of one of history's great bull markets, although recently, as in many previous autumns, it had seen some backsliding. Since mid-August, when Russia had defaulted on its ruble debt, the global bond markets in particular had been highly unsettled. But that wasn't why McDonough had called the bankers.
Long-Term, a bond-trading firm, was on the brink of failing. The fund was run by, John W. Meriwether, formerly a well-known trader at Salomon Brothers. Meriwether, a congenial though cautious midwesterner, had been popular among the bankers. It was because of him, mainly, that the bankers had agreed to give financing to Long Term-and had agreed on highly generous terms. But Meriwether was only the public face of Long-Term. The heart of the fund was a group of brainy, Ph.D.-certified arbitrageurs. Many of them had been professors. Two had won the Nobel Prize. All of them were very smart. And they knew they were very smart.
For four years, Long-Term had been the envy of Wall Street. The fund had racked up returns of more than 40 percent a year, with no losing stretches, no volatility, seemingly no risk at all. Its intellectual supermen had apparently been able to reduce an uncertain world to rigorous, cold-blooded odds-they were the very best that modern finance had to offer.
Incredibly, this obscure arbitrage fund had amassed an amazing $100 billion in assets, all of it borrowed-borrowed, that is, from the bankers at McDonough's table. As monstrous as this leverage was, It was by no means the worst of Long-Term's problems. The fund had entered into thousands of derivative contracts, which had endlessly intertwined it with every bank on Wall Street. These contracts, essentially side bets on market prices, covered an astronomical sum-more than $1 trillion worth of exposure.
If Long-Term defaulted, all of the banks in the room would be left holding one side of a contract for which the other side no longer existed. In other words, they would be exposed to tremendous-and untenable-risks. Undoubtedly, there would be a frenzy as every bank rushed to escape its now one-sided obligations and tried to sell its collateral from Long-Term.
Panics are as old as markets, but derivatives were relatively new. Regulators had worried about the potential risks of these inventive new securities, which linked the country's financial institutions in a complex chain of reciprocal obligations. Officials had wondered what would happen if one big link in the chain should fall. McDonough feared that the markets would stop working, that trading would cease; that the system itself would come crashing down.
James Cayne, the cigar-chomping chief executive of Bear Stearns, had been vowing that he would stop clearing Long-Term's trades which would put it out of business-if the fund's available assets fell below $500 million. At the start of the year, that would have seemed remote, for Long-Term's capital had been $4.7 billion. But during the past five weeks, or since Russia's default, Long-Term had suffered numbing losses-day after day after day. Its capital was down to the minimum. Cayne didn't think it would survive another day.
The fund had already gone to Warren Buffett for money. It had gone to George Soros. It had gone to Merrill Lynch. One by one, it had asked every bank it could think of. Now it had no place left to go. That was why, like a godfather summoning rival and potentially warring- families, McDonough had invited the bankers. If each one moved to unload bonds individually, the result could be a worldwide panic. If they acted in concert, perhaps a catastrophe could be avoided. Although McDonough didn't say so, he wanted the banks to invest $4 billion and rescue the fund. He wanted them to do it right then-tomorrow would be too late.
But the bankers felt that Long-Term had already caused them more than enough trouble. Long-Term's secretive, close-knit mathematicians had treated everyone else on Wall Street with utter disdain. Merrill Lynch, the firm that had brought Long-Term into being, had long tried to establish a profitable, mutually rewarding relationship with the fund. So had many other banks. But Long-Term had spurned them. The professors had been willing to trade on their terms and only on theirs-not to meet the banks halfway. The bankers did not like it that now Long-Term was pleading for their help.
And the bankers themselves were hurting from the turmoil that Long-Term had helped to unleash. Goldman Sach's CEO, Jon Corzine, was facing a revolt by his partners, who were horrified by Goldman's recent trading losses and who, unlike Corzine, did not want to use their diminishing capital to help a competitor. Sanford I. Weill, chairman of TravelersSalomon Smith Barney, had suffered big losses, too. Weill was worried that the losses would jeopardize his company's pending merger with Citicorp, which Weill saw as the crowning gem to his lustrous career. He had recently shuttered his own arbitrage unit-which, years earlier, had been the launching pad for Meriwether's career-and did not want to bail out another one.
As McDonough looked around the table, every one of his guests was in greater or lesser trouble, many of them directly on account of Long-Term. The value of the bankers' stocks had fallen precipitously. The bankers were afraid, as was McDonough, that the global storm that had begun so innocently with devaluations in Asia, and had spread to Russia, Brazil, and now to Long-Term Capital, would envelop all of Wall Street.
Richard Fuld, chairman of Lehman Brothers, was fighting off rumors that his company was on the verge of failing due to its supposed overexposure to Long-Term. David Solo, who represented the giant Swiss bank Union Bank of Switzerland (UBS), thought his bank was already in far too deeply, it had foolishly invested in Long-Term and had suffered titanic losses. Thomas Labrecque's Chase Manhattan had sponsored a loan to the hedge fund of $500 million; before Labrecque thought about investing more, he wanted that loan repaid.
David Komansky, the portly Merrill chairman, was worried most of all. In a matter of two months, the value of Merrill's stock had fallen by half-$19 billion of its market value had simply melted away. Merrill had suffered shocking bond-trading losses, too. Now its own credit rating was at risk.
Komansky, who personally had invested almost $1 million in the fund, was terrified of the chaos that would result if Long-Term collapsed. But he knew how much antipathy there was in the room toward Long-Term. He thought the odds of getting the bankers to agree were a long shot at best.
Komansky recognized that Cayne, the maverick Bear Stearns chairman, would be a pivotal player. Bear, which cleared Long-Term's trades, knew the guts of the hedge fund better than any other firm. As the other bankers nervously shifted in their seats, Herbert Allison, Komansky's number two, asked Cayne where he stood.
Cayne stated his position clearly: Bear Stearns would not invest a nickel in Long-Term Capital.
For a moment the bankers, the cream of Wall Street, were silent. And then the room exploded.
From the Hardcover edition. --Ce texte fait référence à l'édition Broché .
Revue de presse
“[Roger] Lowenstein has written a squalid and fascinating tale of world-class greed and, above all, hubris.”—Business Week
“Compelling . . . The fund was long cloaked in secrecy, making the story of its rise . . . and its ultimate destruction that much more fascinating.”—The Washington Post
“Story-telling journalism at its best.”—The Economist --Ce texte fait référence à l'édition Broché .
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Le livre décrit l'ascension et la chute du hedge fund LTCM qui comptait parmi ses partners les meilleurs professionnels de Wall Street ainsi que deux prix Nobels et non des moindres: R. Merton et le fameux M. Scholes, l'inventeur de la célébrissime formule de Black et Scholes qu'on apprend dans tous les cours de finance. LTCM c'est donc un peu un cas d'école.
Face à un sujet aussi aride, notre auteur s'en sort plutôt bien. Il parvient à retracer le fil des événements de manière précise. Les explications techniques sont claires mais minimales. Mieux vaut disposer de quelques rudiments de finance. Quant au contenu, la seule chose qu'on puisse dire est qu'il est édifiant. Sensation de vertige (et de nausée) assurée.
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LCTM began operating in 1994, set up by John Meriwether formally head of the bond-arbitrage group at Solomon Brothers. He put together a star-studded cast that included three (1997) Nobel prize winners in economics. Their basic strategy was something called convergence arbitrage. In essence this strategy says buy two bonds that you think will track one another. Go long on the cheap one and short on the other; you make money if the spread narrows. In theory you are protected from changing prices as long as the two vary in the same way. To make the big bucks LCTM was after they took a gigantic number of highly leveraged arbitrage positions all over the world. To get high leverage you borrow for the position, like buying a stock on margin. LCTM got really high leverage by avoiding something called the "haircut," which is an extra margin of collateral banks usually demand, but forgave LCTM. Why would banks they do such a thing? Because they were blinded by the glitter of the cast, and in some cases the banks themselves were investors in LCTM. By 1997 convergence arbitrage opportunities in bonds began to dry up, everyone was doing it. So LCTM applied their strategy to stocks. Find two stocks that will track on another and go long and short with borrowed money. This is not easy. Stocks are less amenable to mathematical analysis than bonds, and after all these were the bond guys from Solomon, they were out of their depth. You might ask how can you borrow most of your stock position when the Federal Reserve requires 50% margin (Regulation T). Answer: don't really buy the stocks, instead buy derivative contracts that simulate stocks, an end run around Regulation T. Even with all this leverage LCTM would claim that the fund was no more risky than the stock market, meaning a stock index. In 1998 the markets went against LCTM, with the "flight to quality" (US government bonds) as investors panicked. The fund suffered from what reliability engineers call "common mode error." Spreads got wider not narrower across the board, and LCTM's capital base began to shrink as their positions lost money. At a certain point they would have to start liquidating positions, and the market impact of such large scale selling would cascade across their portfolio. The fund would "blow up."
The above gives a flavor of the material Lowenstein provides, only in much greater detail. If that's what you want, buy the book. Is this a tale of human folly or just plain bad luck? Answering that question is not easy, one needs to grasp a large amount of technical finance theory, and understand what happened in the particular case of LCTM. This book will help.
Dunbar - a physicist by trade - is more interested in the theoretical economics that went into the risk arbitrage fund in the first place and how this came unstuck. He gives a long description of the Black-Scholes model, what it says, and how it was used to pull off the risk "free" trades which made Long Term so much money for three or four years.
Lowenstein, by contrast, barely mentions either the Black-Scholes model (he barely touches on option pricing at all, as a matter of fact) or the Italian convergence trades which eventually blew the gaffe on the fund, but instead tells the human story, exposes the inevitable egos, and indulges in more than a little smuggery (this book is long on wisdom after the fact) in dissecting the naivety of the LTCM hedging and trading strategy and the people who ran it.
As long as he sticks to the egos and the posturing, When Genius Failed is a dandy read: the negotiations amongst the Wall Street top brass as the fund is going under rate with anything served up in Barbarians at the Gate, and as this is a large part of the book, it rips along quite nicely.
But the schadenfreude grates: One of the lessons of the whole fiasco was that the smart money is with the guy who can predict the future: any old mug can be a genius with hindsight. Lowenstein spends a lot of his time wisely pointing out what the traders should have done.
Additionally, Lowenstein employs some metaphors which indicate he might not have much of a grip on his subject: for one, he states "a bit of liquidity greases the wheels of markets; what Greenspan overlooked is that with too much liquidity, the market is apt to skid off the tracks." It's a poor metaphor, because it isn't excess liquidity which causes markets to skid, rather, it's the sudden disappearance of it. As this is the fundamental lesson of the Long Term story, it's a bad mistake to make for the sake of a smart-alec aphorism.
Similarly, in the epilogue states, with regard to the putative diversification in the fund "the Long-Term episode proved that eggs in separate baskets *can* break simultaneously". Again, this conclusion is not supported by the text, which observes several times that in a market crash, liquidity drains and the correlation risk of instruments in the market goes to one: that is to say, it turns out all your eggs are in the same basket after all. Diversity wasn't the problem; the problem was you wrongly thought you had it.
For these reasons I prefer Dunbar's more academic work: it may not be such a sizzling read, but nor does it misguidedly kick a fund when it's down.
The tale of the rise and fall of Long-Term capital was coming to its end as I was putting to press my own book on option-based trading strategies and their effects on market volatility (Capital Ideas and Market Realities). The whole adventure constituted a perfect capstone to my story, which goes back to the crash of 1929, showing how strategies that purport to eliminate the risk of investing can end up exploding in the face of their followers and investors generally.
Now Roger Lowenstein, formerly a journalist at the Wall Street Journal and author of a biography on Warren Buffett, has devoted a whole book to LTC. Drawing largely on contemporaneous reporting and on his own personal interviews with many of the principal and supporting players (although not, alas, Meriwether himself), Lowenstein manages to create a real page-turner out of the unfolding events, even for readers who already know the ultimate outcome.
Part of the tension, it seems to this reader, stems from the unresolved (and probably unresolvable) ambiguity about the real nature of the story. On the one hand, it seems to play out as a classic tragedy: Its larger-than-life protagonists hubristically pit themselves against the gods of the marketplace and fall hard. Certainly, for many of the players involved, it was a tragedy. Meriwether not only lost his money but his reputation. Nobel laureates Robert Merton and Myron Scholes found their lives' works on modern finance theory rocked to the core. Many of those instrumental in engineering LTC's rescue (including Goldman Sachs' Jon Corzine) ended up subsequently losing their own jobs. LTC's employees, who had been encouraged to invest their bonuses from the firm's fat years back into the firm itself, lost it all when the firm collapsed; nor did they get the $500,000 bonuses secured by the LTC partners as part of the bailout package.
On the other hand, one can also view the whole affair as great comedy (especially if one is on the outside looking in). After all, a scene with 140 lawyers in one room is worthy of the Marx brothers. Then you have the Fed descending, at the eleventh hour, like some deus ex machina, to restore order and stability; not to mention Wall Street's viciously competitive masters of the universe gathered on folding metal chairs around the New York Fed's boardroom table, trying to rescue the world from themselves. Even LTC's partners bounce back. Meriwether (J.M. to friends, and throughout the book) starts a new hedge fund, bringing in several old LTC colleagues. Merton and Scholes are still teaching and consulting. A week after LTC was bailed out, many of the principals gather at the Pierre Hotel in New York to celebrate Scholes' remarriage; a wedding, of course, is the classic comedic emblem of reconciliation and renewal.
The vibrancy of any play, whether comedy or tragedy, often rests on the quality of its villains. Lowenstein singles out a few individuals for special opprobrium. These include Victor Haghani and Lawrence Hilibrand, who basically ran LTC's trades and pushed the firm into ever larger, more highly leveraged positions, and into areas such as merger arbitrage in which the firm had no demonstrated expertise. Hilibrand comes across in a particularly bad light, especially when he shows up at the bailout negotiations with his own private lawyer and threatens to derail the whole process because "there was nothing in it for him."
The person one might expect to hold the center of the story, J.M. himself, plays a strangely muted role. Lowenstein describes him as "an unlikely star, too bashful for the limelight." Even his contributions in furtherance of LTC's eventual downfall seem to be more sins of omission than sins of commission. That is, he failed to rein in his uber traders, Haghani and Hilibrand, and he failed to heed the warnings of his more temperate (and, as it turned out, more realistic) colleagues. Of course, J.M. did set the tone for the firm-the air of infallibility that was to prove its downfall.
The book emphasizes how LTC's greed, arrogance and even foolhardiness made it susceptible to a market crisis. But was this crisis purely a result of exogenous events, such as the turmoil in Asia and Russia, as Lowenstein suggests? If so, how did these troubles overwhelm markets in fundamentally sound Western economies?
In my opinion, the book lets LTC off the hook in failing to explain how the very strategies it followed helped to create the perfect storm that ended up swamping the firm. The argument in my book, based on decades of debate with options experts in the industry and in academia, is that LTC provides yet another illustration of the market's susceptibility to certain large-scale trading strategies. These strategies tend to attract a lot of capital because they appear to offer a haven from the vicissitudes of market risk; given leverage and derivatives, they can command hundreds of billions (even trillions) of dollars of assets. Under adverse market conditions, however, the "rules" of these strategies call for dumping all these assets on the market-all at once. We saw this in the crash of 1987, and again in the turbulence of 1989, 1991,1994 and 1997.
All in all, however, When Genius Failed is a classic tale of greed and fear on Wall Street. Lowenstein tells it well, especially in the later chapters, which give readers a blow-by-blow account of the bailout negotiations. What's more, he brings out the story's particular pertinence for today's investors: Even with all the brains and all the computers in the world, investors can't control, let alone predict, human nature.
Bruce I. Jacobs (email@example.com), Principal, Jacobs Levy Equity Management, and author of Capital Ideas and Market Realities (Blackwell, 1999)
Merriweather and his gang go on to do quite well (all the while we hear the Jaws-like music playing in the background), in fact they do a little too well. At one point they forcibly return money to investors - it is, of course, after this that things start to go tragically wrong. There are wonderful descriptions and backgrounds of the key characters involved along the way, which adds to the reader's desire to know just how things wind up. The fund continues to lose all of its holdings, and as things start to go bad, they continue to get worse and worse. Now it is no longer just the markets conspiring against LTCM, but also the growing number of bankers who learn of LTCM's positions, and knowing that due to their size LTCM's exit of those positions would ruin markets. Everything that could go wrong does, and eventually we are left with the aftermath, the fund being bailed out through the behind the scenes maneuvering of the New York Fed.
The book does lack a couple of items, (i) there is little to no in depth discussion of the trading techniques used by LTCM, (ii) there isn't really any 'insiders' view of the behind the scenes maneuvering going on at the fund through the fall, and finally (iii) there isn't a real sense of finality at the end of the book.
All in all this is a well written book about an interesting point in the financial history of the US, as there are few other major incidents that don't involve some kind of criminal misdeeds. Rather, what we see here is the sheer error of man's hubris and seeming belief that a resounding knowledge of the past would allow LTCM to be victorious no matter what the future lay before it. I believe that this book will grow more interesting with every revision and addition to the epilogue. I recommend the text, but I do look forward to reading "Inventing Money" by Dunbar, which supposedly is a bit more detailed when reviewing the actual trading techniques that LTCM was was built on.
On the other hand, this book does have its limitations. For people who are not familiar with the modern financial derivatives and "risk management" techniques, Lowenstein gave a comprehensible, but rather incomplete explanation. This won't hurt the book's readability, but readers certainly won't understand any better about options and swaps after reading this book, either. The "leverage" used by LTCM, central to both its success and downfall, is mainly due to the use these derivatives than simply saving the "haircut" as described in the book. There are also some incorrect statements, though relatively minor, such as Merton's insistence of "continuous time" model without any sudden price jumps. Just for the record, it was exactly Merton himself who first proposed a "jump" model for pricing financial assets in 1976. You can find this in most derivatives textbooks.
Derivatives regularly get a bad rap for causing financial disasters, and LTCM is just the latest in a string of headline news over the years. This is quite unfortunate. Americans probably don't realize that many, many mutual funds and pensions funds use derivatives to "reduce" their investment risks. Lowenstein's book shows that it's really the human factor lying at the root of these fiascos. If only it could give the public a better understanding of the true nature of these modern financial instruments......