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It’s one of the popular finance books that Gong Rui introduced to me. Before it I read Monkey Business, where two ex-I-bankers tell the tales of the life of associates in an I-bank. And then I only read a few pages of Liar’s Poker because the style is too similar to Monkey Business, and I was too busy reading Paris tourbooks.

The book is about the rise and fall of Long Term Capital Management. I like it because it’s a lot like a technical report: straightforward and in a matter-of-fact tone. I first heard of LTCM from Zhang Zhiwei, who must have read the same book because the way he told the story was exactly the same as the book’s opening chapter, and back then I thought wow this guy knows a lot about Wall Street. It’s quite an amazing story, that how a group of math/finance/economics wiz, together with Scholes and Merton (who got their Nobel Prize while there) and Fed’s No. 2 David Mullins as partners, growing their asset to more than $100 billion (yes 100, mostly borrowed) from $1.25 billion in 4 years, only to crash spetacularly when Russia defaulted, almost bringing down the whole financial system with them.

LTCM’s main strategy is convergence arbitrage, which is to bet on bond spread to decrease, but it also did other crazy stuff like risk arb (bet on M&A to go/fall thru) and equity spread (pair of stocks). It uses very big leverage (more than 20, as much as 100) with huge position (hundred mils to bil). It believes blindly in market efficiency and predictability and constant volatility (which is one basic assumption of Black-Scholes). The Russian default isn’t the direct cause of its demise, rather the global risk-aversion sell off triggered by the default, which increased bond spread and market vol to “unreasonable” heights for “unreasonable” long time.

It’s fascinating to learn how LTCM strongarmed so many banks to give them credit at zero or almost zero margin, and how derivatives like swaps weave a tighter and tighter web encompassing the whole financial industry around the world, so perturbation in one market segment can easily wripple through the world, magnifying by chain reactions and copycat traders.

The second half of the book is like a top rate thriller, for which I could hardly put down the book (also it’s overdue). Within a few months, mostly in August and September of 1998, LTCM’s capitol went down from more than $4 bil to only a few hundred mil, hanging on the brink of bankruptcy. The Fed is afraid of a “systemic risk” that brings down the whole system, so it calls all Wall Street banks together for a bail out. After a week of crazy negotiation, 14 banks together provided almost $4 bil credit and saved the day.

The only thing I don’t like the book is the self-fulfilling prophecy tone. Sure LTCM was overboard arrogant and confident to fully believe in the power of their models, but who wouldn’t? The author made it seem like they’re doomed from the very first day, which is somewhat true, but they failed only after earning billions of profit in the first 4 years. They failed mostly for not hedging enough and keeping positions too long. Of course the real lesson learned is the same everywhere: there’s no silver bullet. You’re dealing with people, community, societies, and countries. All are inherently messy and illogic. You have to expect the unexpected.

I remember reading a Time magazine issue in 1999 where the cover showed Greenspan, then Treasury Secretary Robert Rubin (former Goldman chairman), and then Deputy Treasury Secretary Larry Summers, titled “The Committee to Save the World”. Lowerstein probably sneered at the cover a lot since he thinks Greenspan was oblivious to the perils of heavy derivatives trading (instead he lauded and fostered it to provide more “liquidity”), and Rubin’s bailing out of Mexico gave people a false sense of safety that some white knight would always arrive at the last moment to save the day, which was indeed the case with LTCM.

On a side note, it’s interesting to see then Goldman CEO Jon Corzine in the LTCM bailout (he almost arranged a buyout by Warren Buffet, Goldman, and AIG), who was just elected governor of our beloved New Jersey after being kiced out of Goldman by a boardroom coup, only to herald a state budget impasse that resulted in a week of state government shutdown, even forcing the Atlantic City casinos to close. And let’s see what Hank Paulson, Corzine’s Goldman successor, can do as the new Treasury Secretary, working with the new Fed chairman Bernankee. Mullins might have become Greenspan’s successor instead if not for LTCM. Are we better off?


UPDATE I was adding cover image to all the books I’ve mentioned, and when searching for “When Genius Failed Roger Lowerstein” I was astounded to see my blog as the VERY FIRST result. I hesitated for a long time whether I should correct it…

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