When Genius Failed | Roger Lowenstein

Summary of: When Genius Failed: The Rise and Fall of Long-Term Capital Management
By: Roger Lowenstein


Embark on the intriguing journey of Long-Term Capital Management (LTCM), a hedge fund company that was once the world’s largest, only to spiral into failure. With our summary of ‘When Genius Failed: The Rise and Fall of Long-Term Capital Management’ by Roger Lowenstein, learn about LTCM’s strategies that relied on arbitrage, complex market predictions, and massive leveraging that thrust the company into unprecedented growth. Discover how LTCM brought together some of the brightest minds in finance, only to be undone by human error, market anomalies, and an unwavering adherence to flawed models. Get ready to glean crucial lessons on the perils of overconfidence and the importance of understanding the risks, as well as gaining an appreciation for the unpredictable nature of financial markets.

The Rise and Fall of LTCM

LTCM, a hedge fund founded in 1994 by trader John Meriwether, became the largest hedge fund ever by managing their investments with a strategy called arbitrage. They used academic calculations and predictions as well as the latest computer software to recognize opportunities and exploit them quickly. However, LTCM played an important role in both the 1997 Asian financial crisis and the 1998 Russian default, bringing the financial world to the brink of collapse. This lack of regulation makes hedge funds a ripe environment for investment in riskier financial products, such as derivatives.

Leveraging for Profit

The story of how LTCM borrowed heavily to invest in financial product anomalies that banks thought were low-risk. However, their leverage rate eventually reached 30 times the amount owned by the fund, leaving the company at risk if things went wrong.

LTCM was a hedge fund that utilized a strategy of betting on tiny discrepancies between present and future prices of financial products. For this strategy to yield significant profits, they needed large investments, which prompted them to leverage heavily. The fund borrowed money and urged investors to make sizable investments to maximize potential returns. Banks loaned huge amounts to LTCM because they believed that the strategy involved minimal risk, betting on financial inconsistencies that were thought to be little affected by market fluctuations. Dresdener Bank in Germany and Banco Garantia in Brazil were among institutions that lent vast sums to LTCM. With an investment capital of just $1.25 billion, LTCM could borrow enough to invest around $20 billion.

Banks were enticed by the profits the fund promised, but they did not understand the risks involved. The hedge fund had total control over where they invested borrowed money, leaving banks with no say over where their money went. As more banks lent the fund money, LTCM’s leverage rate surged, eventually reaching 30 times the amount owned by the fund. This left the fund highly susceptible to risks if things didn’t go according to plan.

Ultimately, the fund was not able to survive the financial turmoil that happened in the late 1990s. However, the story of how LTCM employed leveraging to make huge profits and how it ultimately became their downfall remains a valuable lesson for the finance world.

The Academic vs. Trading World

LTCM was a hedge fund that wanted to bridge the gap between academia and the real world of trading. They recruited Nobel Prize winners and other experts to prove that their complex mathematical formulas could eliminate risks. They were upfront about the potential downsides and their arrogance was fuelled by their ability to predict market trends based on historical analysis. Investors were lured by their academic approach and universities invested millions. The policy worked, and the fund was successful until it fell apart in the late 1990s. This book focuses on the people behind the fund and how their obsession with financial risk management contributed to their downfall.

The Rise and Fall of LTCM

In the 1990s, LTCM was the most popular and profitable hedge fund. It controlled more assets than investment banks and borrowed significant amounts from banks at low-interest rates. However, their reports were not transparent, and they were relying on a deceptive strategy. The signs of failure began to show, and their success could not last forever.

The Fatal Flaw of LTCM

LTCM became popular due to its academic models, which assumed the financial system was directed by rational people. However, humans are irrational and panic easily, causing problems during the 1997 Asian crisis. While bonds are secure, LTCM decided to increase their share of equities, a riskier financial product, when the crisis began. Despite knowing very little about these products, they invested heavily based on their models’ predictions. This ultimately led them off a cliff, as they continued to follow their models even though profits were dipping. LTCM enjoyed a period of success, but their downfall resulted from their reliance on academic models and underestimation of human error.

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