There's an old saying to the effect that every army prepares to fight the last war, rather than the next one. In financial circles, the equivalent is to create models that optimize decisions in light of the history of financial markets. That is great, as long as the future is like the past. As soon as the future becomes different, this 'rear-view mirror' vision of the future can create terrible crashes. That's what happened with Long Term Capital Management (LTCM). The cost was almost a meltdown in the financial markets around the world. This cautionary tale should stand as a warning to regulators, investors, academicians, and traders about avoiding the same mistakes in the future. One particular reason to be so concerned is that John Meriwether and his crew of geniuses were back in business as of 1999, as reported by the book (apparently with some of the same investors as in LTCM).
You may recall that Mr. Meriwether appeared in the book, Liar's Poker, by challenging John Gutfreund, CEO of Salomon Brothers, to one hand of liar's poker for ten million dollars. Mr. Gutfreund correctly declined, but lost face. Mr. Meriwether later had to leave Salomon Brothers after the firm was found to have failed to notify the Federal Reserve promptly after discovering that it had been violating rules on bidding for government securities.
In this book, you will learn more about Mr. Meriwether and his love of brilliant people, betting on everything in sight, and taking outside bets when the odds seemed to be in his favor. This approach can work well when the odds can be known, but that is not the case in the financial markets. Mr. Meriwether did not make himself available to the author.
Roger Lowenstein is our most talented financial writer (you may remember him from his days at The Wall Street Journal and for his wonderful biography on Warren Buffett), and he has produced an outstanding work that will be a cautionary tale for future generations about the financial myopia of the 1990s.
Long Term Capital Management was built around consensus in the financial markets. The firm attracted the thinkers in the financial markets with the greatest reputations (including future Nobel Prize laureates, Robert Merton and Myron Scholes -- of Black-Scholes option pricing fame, and the top talent from the arbitrage area at Salomon Brothers), a top regulator (the vice-chairman of the Federal Reserve Board), famous investors from the top investment banks and consulting firms, and lines of credit from every major financial institution in these markets.
The firm planned to invest by finding small mispricings of one security versus another (such as the interest rate on one bond maturity versus another compared to history, an option versus the underlying stock for the time remaining on the option, a bond yield in a foreign currency versus the currency futures, and the price of a stock versus a hostile takeover bid price for the company). Here, it hoped to proverbally make lots of nickels by borrowing lots of money to make these trades.
Although other firms took similar risks (and many also took enormous losses in 1998), LTCM stood out for two things: It had no independent evaluation of its risk to control what it was doing (the traders monitored themselves -- a little like letting the fox guard the hen house) and it took on vastly more debt than others did compared to its equity base. At the firm's peak, it had borrowed over $100 billion against a base of $4 billion in equity and had derivative (option) positions for an exposure of another $1 trillion. This enormous finanical leverage magnified the size of any gains or losses it took. Part of what had been deceptive is that the firm had been regularly and spectacularly profitably for most of its initial four years.
What the firm had neglected was to consider what might happen to historical price differentials in a market crisis (particularly a 'stress-loss liquidation'). In 1998, an unprecedented financial crisis occurred following the Asian meltdown and Russia's refusal to pay its debt. In the panic that followed, there were many sellers and few buyers. Tens of billions evaporated quickly in these abritrage trades. LTCM moved slowly to unwind the trades, believing that things would come back to normal. Soon, it was too late, and the New York Federal Reserve supported a shotgun wedding of the firms that would lose the most if LTCM died to put another $4 billion in the firm until it could be wound down. The aftermath was not much fun for anyone.
Mr. Lowenstein does an excellent job of describing what occurred at the level of a college-level course in finance. If you have a higher level of knowledge than that about trading, you can skip most the explanation of what happened and why.
The crash exposed several major weaknesses in the financial system. One, the lenders were too lax. Two, the risk review of the firm was essentially nonexistent, although it reported risk levels monthly (apparently based on incorrect assumptions). Three, the Federal Reserve doesn't know what goes on with hedge funds, until they are about to blow up the financial markets. Four, Wall Street goes along with reputations more than due diligence. Five, excess risk compared to current market conditions creates excess losses. Six, modeling historical trends is a dangerous way to make money unless you use small amounts of leverage to hedge against the risk of unexpected market volatility.
After reading this interesting book, I hope you will also ask yourself if you know what the risk level is with your financial investments for the current market. If you don't know, I hope you will quickly find out. And have your testing done against the potential risk of something extreme happening, not just with history. Certainly, the 80-90 percent losses that many Internet stocks have suffered in the last years should be an indication of how much risk can occur even in a successful industry.
Good luck with avoiding large losses in pursuing financial gains!