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

Roger Lowenstein · 10 HN comments
HN Books has aggregated all Hacker News stories and comments that mention "When Genius Failed: The Rise and Fall of Long-Term Capital Management" by Roger Lowenstein.
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Amazon Summary
“A riveting account that reaches beyond the market landscape to say something universal about risk and triumph, about hubris and failure.”— The New York Times NAMED ONE OF THE BEST BOOKS OF THE YEAR BY BUSINESSWEEK In this business classic—now with a new Afterword in which the author draws parallels to the recent financial crisis—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. Praise for When Genius Failed “[Roger] Lowenstein has written a squalid and fascinating tale of world-class greed and, above all, hubris.” —BusinessWeek “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
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Hacker News Stories and Comments

All the comments and stories posted to Hacker News that reference this book.
That sounds too much like this:

https://www.amazon.com/When-Genius-Failed-Long-Term-Manageme...

As I remember, beaucoup back testing, hilarity ensues anyway.

simtel20
The issue with LTCM wasn't just that they didn't test sufficiently - the problem is that traders could take positions without supervision and any accountability. My understanding is that any firms that survived that period (and I believe they were all pulling the same shenanigans as LTCM, just maybe to a lesser degree) now have risk management because unlike Lehman/Bear they can't just foist that risk off onto the public market. No one at the head of a multi-billion dollar hedge fund wants to stop being there if all they have to do to endure is pay for risk management.

*edit: I'm not a serious student of this aspect, but I recall that none of the top independent hedge funds took a bath in the 2007+ collapse (that is, those that weren't in-house funds from a major wall st. company). They all had their risk management in order and all did pretty well in buying distressed assets. Some like Bridgewater really managed to grow non-stop right through that.

PorterDuff
As I remember the book, they back tested quite a lot. It's just that whenever they went live with trading reality changed on 'em. Go figure.
tim333
One thing backtesting misses is the other market participants may see what you are up to in live trading and try to take advantage. That was a big factor with LTCM.
simtel20
They were exposed to a margin call. Trading reality changing or no, if you can get taken out by your prime broker at the end of the day, you need to account for that too and they didn't.
Based on your listings, you may also enjoy When Genius Failed, which is based on LTCM and their downfall.

Link: https://www.amazon.com/dp/0375758259/ref=cm_sw_r_cp_api_i_j0...

linuxlizard
Did read _When Genius Failed_. Is indeed a great read.
https://www.amazon.com/When-Genius-Failed-Long-Term-Manageme...

https://en.wikipedia.org/wiki/Long-Term_Capital_Management

> Initially successful with annualized return of over 21% (after fees) in its first year, 43% in the second year and 41% in the third year, in 1998 it lost $4.6 billion in less than four months following the 1997 Asian financial crisis and 1998 Russian financial crisis requiring financial intervention by the Federal Reserve, with the fund liquidating and dissolving in early 2000.

dpc59
That's the thing with high-risk high-reward financial gambling. When you're always all-in at one point you're going to lose it all.
lintiness
they were more than "all-in"; they were levered 25*.
This article seems like it was "borrowed" very heavily from this book:

http://www.amazon.com/Inventing-Money-Long-Term-Capital-Mana...

Most people read this book but I think the above book is much better.

http://www.amazon.com/When-Genius-Failed-Long-Term-Managemen...

I'd recommend reading both if this sort of thing interests you, in the order that they are listed.

Since this article is mostly about LTCM, its kindof interesting to look at their downfall and realize that in the end they were right, their trades ended up being profitable, they were just so leveraged that when the markets started to diverge they couldn't make their margin calls.

Interestingly the reason things went south so fast was that LTCM and the banks had different risk models.

To LTCM they would do spread trades, where you take 2 very similar instruments, the article mentions 29.5 and 30 year bonds. You short the one you think is expensive and buy the one you think is cheap and hold them until the prices converge.

This has a nice risk management feature that the risk on both cancel each other out almost as if the markets move up, your long leg covers the loss on your short leg and visa versa if markets move down.

Unfortunately, partially due to secrecy(trying to hide what they were doing) and partially due to just who had the bond inventory to short from, they often ended up having the long leg and the sort leg at two different banks.

So to LTCM they were perfectly hedged, while to the bank with the short positions, if the market went up they needed LTCM to send them more margin. So LTCM, which was already heavily leveraged was required to send their prime brokers margin that they never figured they'd need to.

Couple that with markets that started move in an unprecedented manner caused too many of their spreads to diverge beyond what they could cover.

The firm ends up getting a margin call it can't afford, liquidates everything to its prime brokers and other investment banks and those banks end up making money off their trades in a time frame from 6 months (for Goldman) to 3 years for the longer term bonds.

Even when your models are right the market can still rip you to shreds:(

EDIT As to book recommendations below is a picture of my work bookshelf. Id' recommend most of the books on the shelf: https://imgur.com/OdzB4aW

https://imgur.com/zdLSEek

henrik_w
Thanks for the book recommendations! As a SW dev who recently (a year and a half ago) moved into finance (from telecom), I’ve been trying to educate myself as much as possible in the domain - I find it quite fascinating. Below is a list of books I’ve read and MOOCs I’ve taken, but it would be great to hear what your top recommendations are for books to read (I’ve noticed that your high-quality comments here on HN). Thanks.

Books:

Liar’s Poker, The Quants, Flash Boys, Against the Gods, The Complete Guide to Capital Markets for Quantitative Professionals

MOOC courses: Financial Markets (Coursera), Computational Investing (Coursera), Mathematical Methods for Quantitative, Option Pricing (EdEx - got too difficult at the end)

EDIT: Thanks for the pics, really great! Lots of good CS books there too! Sidenode: I just finished "Ghost in the Wires" a week ago - great read.

My bookshelf is shown here: http://henrikwarne.com/2015/04/16/lessons-learned-in-softwar...

Cshelton
Ah, I moved from finance into software, although I write financial software. Great books, some embellish the truth a bit though, take it as entertainment value. They all provide great insight though! I've been re-reading the big short by Michael Lewis for the movie coming out this month. I recommend that for insight into the 07-08 collapse. It's a really good book
osullivj
Frank Partnoy's FIASCO, Das' Traders, Guns & Money. Also Victor Niederhoffer's Education of a Speculator.
nissimk
That's because most of the risk models aren't modeling the most important and real risk in financial business: the risk of receiving margin calls in excess of your capital, or in other words, the risk of ruin. Models generate valuation under various conditions and sometimes these valuations are compared to available capital, but that is not enough. Especially when your securities are held at banks that determine their valuations based on factors not included in your model. If actual trdes are posting in similar securities at values that are very far from the model due to a liquidity or some other event then the margin calls will come in. This is how almost all spectacular failures have happened. If you don't use excessive leverage (> 2:1) it's not important, but for highly leveraged portfolios the most important risks are market moves that are unrelated to fancy models.
I think that you are referring to LTCM ( https://en.wikipedia.org/wiki/Long-Term_Capital_Management ) which blew up in the late 90s. For others interested, I would strongly recommend the book "When Genius Failed" ( http://www.amazon.com/dp/0375758259 )
>, and cashing in _when_ the price crashes and rebounds.

[my emphasis on "when"]

I think the "when" is a huge part of the puzzle. How can an algorithm know the difference between a flash crash that will get remedied within 24 hours vs a longer period of irrational pricing that takes months to sort out?

For example, at the time of the famous LTCM downfall[1], it held several arbitrage positions that were eventually proven right... but they didn't have sufficient capital reserves to survive the short term irrational spreads (Russian default, flight to US Treasuries, etc). I'm not saying that LTCM didn't have many other flaws of risk analysis that would have also caused their downfall but in that one case, it was an illustration of "the markets can remain irrational longer than you can remain solvent."

[1]http://www.amazon.com/When-Genius-Failed-Long-Term-Managemen...

None
None
rlucas
GP is talking about a long-only flash-crash arb strategy -- so assuming you're not buying on margin you don't have the need to have capital reserves to "survive" until the recovery.

Of course, especially these days in the markets, whatever can be leveraged, will be leveraged...

For anyone interested in this topic, be sure to read "When Genius Failed". I finally read it last year and it's excellent.

http://www.amazon.com/When-Genius-Failed-Long-Term-Managemen...

Liar's Poker - Michael Lewis http://www.amazon.com/Liars-Poker-Rising-Through-Wreckage/dp...

In Defense of Food - Michael Pollan http://www.amazon.com/Defense-Food-Eaters-Manifesto/dp/01431...

When Genius Failed: The Rise and Fall of Long-Term Capital Management - Roger Lowenstein http://www.amazon.com/When-Genius-Failed-Long-Term-Managemen...

An excellent book on LTCM is 'When Genius Failed' (not an affil link):

http://www.amazon.com/When-Genius-Failed-Long-Term-Managemen...

Yes, I am. They are not synonymous in this context. Don't take it personally.

Projected to be less tomorrow? Says who? I would think that JP Morgan would not accept even a $2/share buy out if they thought it would be worth less tomorrow. They would only make such an offer if they thought it was a good deal to them with a potential upside. Thus they are willing to buy a "illiquid" asset and provide "liquidity" for "value" to themselves. It's how the world goes 'round. Illiquid and crappy may be the same thing now, yes, but investment is, by definition, making decisions for future profit. This is why, in terms of net present value, crappy and illiquid are not the same thing. JP Morgan is thinking "This is a great opportunity".

In terms to my reference to LTCM as being hardly reassuring: get over it. We are in a credit crunch. We were in '98, we are now. It's bad, yes. This is probably worse than LTCM. I never said this was good, I said that 'illiquid' and 'crappy' are not by definition the same thing. That's all I said.

I'm not even going to address your Buick analogy. Read this book - http://www.amazon.com/When-Genius-Failed-Long-Term-Managemen... - it will give you a good idea how credit markets operate and how they can act irrationally.

Right now the major issue is that no one knows how to value themselves because no one else knows how to value themselves because no one can value their portfolios. And in that uncertainty no one can judge who is right and wrong, who is getting a good deal and getting a bad deal. This is exactly why this situation is so screwed up. And this is exactly why the Fed is offering to provide liquidity for the rest of the market: because no one else is liquid enough to. Yes, it is a moral hazard, it sucks, but it is how it is.

Look, this isn't a zero sum game. For all we know, inaction by the Fed could lead us down a more damaging path. There are smart people working there, with far more education and experience than both of us and then some. Let us not be so quick to judge.

giardini
"I am right and you are wrong." -book by Edward de Bono

[In deference to de Bono I must add that I am using the phrase with it's original meaning.]

Indeed I am right and you are wrong. The foreign markets are punishing the Fed's moves.

1. Yes, BS was "projected to be worth less tomorrow". Until the Fed stepped in, JPM wouldn't touch BS without the Fed first taking the bad parts.

2. J.P. Morgan is buying only the "liquid" assets of BS; the Fed is getting the illiquid assets. Of course that's a sweet deal for JPM. It's a very bad deal for the Fed and the U.S. taxpayer. And part of the deal is a 6-month guaranteed bailout for hedge funds for the rich that have been posting returns from 20%-80% annually. Moral hazard never reached such scales before.

3. Drop the straw-man "this isn't a zero-sum game" statement: everybody knows that. The Fed's move is a redistribution of wealth regardless: wealthy investors are now wealthier than before the Fed stepped in and the value of the dollar is plunging further.

4. "There are smart people working there." How smart? I don't see the smarts oozing out today as the foreign markets punish the choices the Fed makes. Wait until the stock-buying public gets into this brouhaha. I would be the last to oppose the existence of the Fed, but today there I see only people who have their own and their mostly wealthy friends' interests in mind.

5. Sometimes inaction is best. Inaction would resolve the quandary more quickly by allowing the liquidation of BS assets on the open market and punishing wealthy investors for taking high-risk investments in hedge funds. All worthy goals. And that would happen without adding inflationary fire to the economy.

6. I don't relish "punishing investors" for it's own sake. But protecting high-risk investors against risk is foolish and, in the end, inflationary. "Caveat emptor" should apply to any investment.

This is indeed "Socialism for the Rich".

Tuna-Fish
The upside for JP is the office building. It's worth over a billion on it's own. Since there were no other bidders and the price was just 200m, it's really clear that the real value of all the securities that Bear held is negative. The only question is how much negative.
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