everyonerich
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quote from book :
Markets can stay irrational longer than you can stay solvent - John Maynard Keynes
In 1993 John W. Meriwether, a well-known trader on Wall Street, approached Merrill Lynch with a plan. He wanted to replicate the successful Arbitrage Group he ran at Salomon Brothers, but this time on his own. He had taken the fall at Salomon for a bond-rigging scandal and he wanted to clear his name and prove his undoubted worth. Meriwether was an excellent trader and his reputation, though tarnished, remained intact. He persuaded Merrill Lynch to come up with a strategy to raise cash, while he, Meriwether, would put a team together and devise trading strategies. Long Term Capital Management (LTCM), an investment company that for the next 5 years would dominate the financial landscape, was born. And what a team it was.
The lure of big money, the scope of the project, Meriwether's reputation and his engaging personality pulled in the top traders (many of them his old buddies from Salomon) whiz kid mathematicians and two Nobel Prize winners in Economics. It was indeed a dream team and they were going to bust the bank. They very nearly did, but not in the way they had imagined. Their strategy was essentially simple. They would take advantage of small mispricings in the market and bet that these mispricings would be corrected based on their belief in the theory of the efficient market. Using excessively high gearing they traded these discrepancies watching them converge time and time again. The money rolled in. They were racking up returns of more than 40 percent a year, year after year.
Wall Street was amazed and envious. They also disliked many of the LTCM traders who had not endeared themselves to their erstwhile colleagues by being secretive, aloof, and arrogant. They were clever, and they knew it. But the results were indisputable and everyone wanted a piece of the action. Investment banks, central banks, the who's-who of the financial world, impressed by the team and its credentials, invested. Sumitomo Bank, German Dresdner Bank, and Italy's Central bank were only some of the high rollers. There were pension funds, high-worth individuals and the LTCM partners themselves. Everyone was clamouring to get in. LTCM's trading system had been developed by some of the finest minds in the business. Perhaps they had finally cracked the secret of the market some awed analysts whispered.
In less than two years the firm's equity capital had grown to $3.6 billion. Their assets had grown to the sum of $102 billion meaning they were leveraged at 28 to 1. By 1998 they had $4.5 billion under management. Geared, their exposure was astronomical. In May of 1998 rumours started spreading that all was not well at LTCM. The markets were not acting as they had expected * they were not being efficient. LTCM was bleeding but they backed their system and kept on trading. But the interest rates gaps, instead of converging, widened. What were the chances of this happening? They fed their computers with info and calculated the probabilities as infinitesimally small that spreads would continue to widen. They kept trading. Rumours were starting to circulate in the market that Russia may default on its debt. They fed the computers with more statistics. What they got back was reassuring. A one-in-a-million-year event was required for them to go under. They kept on trading, their gearing frighteningly high. In disbelief they watched as day by day they lost millions. The market wasn't doing what it was supposed to do. It stayed irrational. "Stuck in their glass walled palace far from New York's teeming trading floors, they had forgotten that traders [markets] are not random molecules, or even mechanical logicians...but people moved by greed and fear, capable of the extreme behaviour and swings of mood so often observed in crowds."
And other traders, banks, everybody who had wanted in when the going was good saw that LTCM was floundering and they closed in for the kill, taking advantage of their predicament by giving the bleeding company unattractive quotes, making margin calls, and keeping the liquidity out of the market. LTCM was mystified. Why didn't the market have an appetite, why couldn't they offset their trades? By September LTCM was dead, having lost a staggering $4 billion in four months. In two days in August and September they lost more than $500 million on each day. Reputations were ruined, fortunes lost, and the New York Federal Reserve had to intervene in order to prevent a global financial crisis. What had happened?
Roger Lowenstein, When Genius Failed
In an interview with Brett Fromson in TheStreet.com, Roger Lowenstein, author of the book When Genius Failed, a story about the rise and fall of LTCM, said the following:
"There are two morals in it. One is the tale about the limitations of human intelligence bordering on genius and .... the risks of extreme intelligence when not tempered by judgment. Others who might have a different perspective than the three or four or 12 geniuses themselves. And as it relates to the financial markets specifically, I think it's a cautionary tale about inherent limits of models, of historical lookbacks."
In short, LTCM had made two mistakes. They had not adequately accommodated the occurrence of exceptional real time events into their trading strategy and secondly, they had over-geared their positions. Russia defaulting on its debt was an exceptional event with an unforeseen knock-on effect in Asian and Latin markets causing in turn even more unforeseen and unexpected events. If the brains behind LTCM could have stood back and forgotten their systems and models just for a second, it is possible they would have gotten a clearer picture. But instead of using their judgement and discretion, they chose to back their system. To be fair, perhaps they were already in too deep, and there was little that could have salvaged the situation but reading Lowenstein's gripping account of the crisis leaves one without doubt that at some point brains, experience and discretion had taken a back seat to faith in a model based upon inductive reasoning: it had always worked in the past, it would continue to work in the future. But the model was clearly not coping with an exceptional situation. What to do with the black swan?
Even though they knew their model was at best a representation of reality and the traders knew that it did not work mechanically, and that the traders were not simply robots, at some point, because of a combination of past successes, hubris and zeal, and despite being aware of the "fat tail" theory * the idea that unexpected disasters should be expected * they lost their judgment and their heads.
LEARN FROM HISTORY As LTCM was haemorrhaging Meriwether realised they needed money fast to stay afloat. He approached George Soros to ask whether he would invest. The billionaire speculator had made his name when he shorted the Sterling in September 1992 because he thought it was overvalued, netting $1bn dollars in the process. Soros said yes, he'd put in $500m if Meriwether could raise another $500m to match it. What is interesting is their contrasting views of the market.
"Long-Term envisioned markets as stable systems in which prices moved about a central point of rational equilibrium. I had a different view," Soros noted. The speculator saw markets as organic and unpredictable. He felt they interacted with, and were reflective of, ongoing events. They were not sterile or abstract systems. As he explained it, "The idea that you have a bell-shaped curve is false. You have outlying phenomena that you can't anticipate on the basis of previous experience." Soros believed in real time events.
