When the Genius Failed-The Rise &Fall of Long Term Capital Management (LTCM) provides in depth insight into the world of hedge funds (Lowenstein, 2001). It outlines useful lessons to investors by illustrating the way capital markets can be severe on individuals and entities that have reduced capital markets to precise mathematical and scientific analysis. The text explores who the leading characters are, how they grew, marketed and managed the long term funds, and the factors that led to their collapse. Ideally, the author attempts to make complex financial concepts and structures easy to understand. The book provides examples suggesting that models, strategies, and some trades used by LTCM were commonplace before LTCM came into being. The phenomenon forestalled trouble for LTCM because it implies that imitations and new entries were capable of eroding its profits.
LTCM was a form of hedge fund created by a group of former bond traders and high-profile financial academics and a former central banker (Lowenstein, 2001). They were hotshots in the capital market world with all the greed and arrogance that one can imagine. They convinced themselves that they were the best in the business after they grew $1 billion to $ 4.5 billion. However, it turned out they were not as invincible as they thought because they later lost it all within a span of a few months. Their reckless activities nearly brought down the financial sector.
Corporate greed and arrogance are some of the issues discussed in the book. At one point LTCM was trading at 30: 1 leverage and even higher when the hedge funds started collapsing. It implies that they had control over about $120 billion in assets when the fund had about $4billion in equity (excluding the risks they experienced in more complex derivatives). It is difficult to establish their level of exposure to risks associated with the complicated derivatives.
Overreliance on scientific and mathematical models is another theme discussed in the text. For example, the models are based on Black-Scholes’ pricing options .The models stem from a hypothesis of an efficient capital market. The theories were based on the notion that current market prices are a reflection of everything known and that price’s future movements are distributed in a random manner according to bell curve. The things that went wrong with LTCM include the models and the ideas that used were not new in the field of finance (Lowenstein, 2001). Long-Term demonstrated that stakeholders in the capital markets should take new ideas seriously. A number of academic economists started arbitrage activities at various finance houses. The competition diminished the competitive edge that Long term had and drove returns downwards.
The reaction of Long-Term to the competition among the major finance houses was strange. they were accustomed to receiving over 50 percent returns so when the margins started shrinking , Long-Term decided to increase the leverage with an aim of getting back to the high returns. Towards its final days Long-Term was leveraged about 100:1. After losing sight of arbitrageur’s discipline, Long-Term began engaging in blatant speculative activities. While the speculations were small when considered in the light of Long-Term’s overall position, they were small when one compares them to the actual assess that Long-Term was managing at the time. The crises in Russia, Asia, and Brazil negatively affected the position of Long-Term and market liquidity. Long-Term found itself in an awkward position in illiquid markets.
Problems in the financial markets and new technologies are not the only factors that contributed to LTCM problems. Long-Term had easy access to capital but faced increasing competition. It also faced changing markets that it did not understand and resorted to strategy that left it exposed to adverse price moves. It would have been a financial surprise if LTCM did not collapse eventually. LTCM partners knew that future projections might not be a reflection of the past, losses that are not incurred frequently could be larger than what is projected by standard modeling assumptions. The partners understood that they were acquiring illiquid assets that are susceptible to losing significant value if they are sold quickly. The partners of LTCM must have been aware of such concerns. LTCM had faith in its ways of predicting future when compared to alternative forecasts. Conclusion:
Greed, sheer hubris, reliance on defective technologies and plain foolishness of Long-Term that dealt in businesses that were not fitting its model as well as areas where it had no real competitive advantage and no expertise are some of the problems that resulted in the crisis experienced by LTCM. When everything was falling apart, the Feds coordinated a consortium of banks that bought out LTCM. The Federal Reserve painstakingly persuaded the banks to be involved in the buyout because they also lost their own arbitrage units. However, the fear of the potential impact of LCTM crisis on the larger capital markets brought the banks together. One of the main lessons to be learnt from the LTCM crisis is that without effective barriers, profits above normal levels will attract imitations and entrants, which will ultimately drive down returns.
References
Bookstaber, B. A Demon of Our Own Design: Markets, Hedge Funds, and Perils of Financial Innovations .New Jersey: Pearson Press.
Brown, A. (2011). Fischer Black and the Revolutionary Idea of Finance. Stanford: Stanford University Press.
Lowenstein, R. (2001).When Genius Failed: The Rise and Fall of Long-Term Capital Management. New York: Random House Press.
Meng H. (2001). Bet Those (long-term Capital Management: The Rise and Fall of LTCM). Oxford: Oxford University Press.
