The story of the collapse of the hedge fund Long Term Capital Management (LTCM) is recounted in Roger Lowenstein's compelling book.
The fund was run by geniuses with Nobel prizes in economics and PhDs from Harvard. One of them, Myron Scholes, gave his name to the formula for valuing options. Another LTCM trader had two degrees from MIT. They were scholars who thought they had invented computer models that were so clever they could predict the future. But they were wrong. Their genius failed.
It was the Northern Rock of its age.
LTCM was formed in Greenwich, Connecticut in 1994. At its peak, the fund had amassed over £120 billion in assets, while its derivative positions amounted to over £1 trillion. But in 1998, it was on the brink of collapsing into nothing.
LTCM was founded by John Meriwether, former Head of Bond Trading at Salomon Brothers and coincidentally star of another marvelous finance book that I am sure will soon be reviewed in The Gateway - "Liars Poker" by Michael Lewis.
LTCM's strategy was based around fixed income arbitrage. This took the view that over the long term, the prices of long-dated bonds, issued a short time apart, would become identical. On issue, there was generally a small spread between their prices. LTCM sought to profit as this spread converged. So they bought one bond (went "long") and simultaneously sold the other one (went "short") in gigantic quantities - mostly with borrowed money. If the bond prices behaved as they hoped, the profit on one bond was always greater than the loss on the other. Even though the profits on each single trade were tiny, the huge leverage meant they were multiplied a million times.
In the first three years of its operations, LTCM averaged returns of 40% per annum and the fund's managers became heroes.
When times were good for LTCM, all the investment banks wanted a piece of the action. They pushed to lend the fund more capital with which to trade. They competed to earn commissions from clearing LTCM's trades. But in the end, they were asked to step in and save it from destabilising the entire financial system, just as the UK Government was forced to intervene to prevent the collapse of Northern Rock doing the same.
Like all hedge funds, LTCM aimed to make money in all market weathers. However, in 1998, the global economy became stormy after the Russian government defaulted on its loan repayments. Investors panicked and sought the safety of buying US treasury bonds in huge quantities. This threw out LTCM's trading models as bond prices diverged. LTCM lost nearly £2 billion of its equity capital.
The LTCM debacle was an example of quantitative trading strategies going wrong. The Nobel prize winners and PhDs designed computer models that were thought to be able to predict the future with absolute surety and safety. But it was similar "black box" hedge funds that blew up last year after the credit crisis.
The LTCM story is important today as the inter-twining of LTCM's derivatives contracts and susceptibility to shocks from the global economy, mirror the effect of home-loans being packaged and re-packaged into collaterised debt obligations - derivatives debt parcels - by investment banks and then re-sold to hedge funds.
Just as the defaults of sub-prime mortgages in the US has triggered a global financial crisis since August last year, so the demise of LTCM was triggered by events in Moscow - a long way from its head-quarters in Connecticut.
The book charts a chronological course through the history of LTCM, from its start-up, through its ascendancy, to its fall and implosion.
It explains in simple terms the complex relationships between bond prices, interest rates and credit risk. It also explains the principles of arbitrage and hedging that LTCM adopted as strategies and are still used today.