When Genius Failed - Roger Lowenstein (Random House, 2000)

The story of the rise and painful fall of Long-Term Capital Management.  The hedge fund boasted of its ties to Nobel prize-winning economists as a new approach to efficient markets.  The denouement almost brought down several major Wall Street houses.  [332.6]

It is very human to enjoy a tale of hubris and arrogant certainty when the end of the story comes to ruin; such stories have entertained us since the Greeks gave a word for it 2,500 years ago.  The collapse of the Long-Term Capital Management hedge fund fills that same role.   

Because it is a drama of pride and its hazards, the narrative must invest a large share of its print on the individuals involved and their personalities: the traders, the academics, and the bankers.  In this regard, it is much like the work of writers such as Michael Lewis.  The risk in such writing is that the author will become so focused on the personalities that the book flirts with biography rather than with documenting for understanding the events themselves.  It is assumed that the reader will understand the nature of the trades being undertaken, although a brief explanation is given in many cases. 

In the case of LTCM, however, the basic trade was quite simple.  It was a true hedge fund when its trades involved taking two positions on one security to exploit small differences in actual price from theoretical prices.  An example might be selling the instrument short while buying the future of the same instrument when there is a difference that allows arbitrage of these two.  The key problem was that the differences could be so small that the only way to make money on the trades was through massive leverage.  Money would eventually be borrowed from several large banks and those loans would become the problem for the financial markets.  (I find it ironic that economists of the stature of Merton or Scholes could argue for the efficiency of the market - and that same efficiency would force prices to converge eventually - while not recognizing that the momentary inefficiencies might argue  that the entire theory may be imperfect.)  That became the problem.  After the collapse of the Russian ruble in 1997, prices were not converging fast enough.  Every bank which had lent LTCM money was in danger of taking large losses that could destabilize the system.  Wall Street had to find a way out, but it was a close call.

This book is highly recommended.