Long Term Capital Management

A response to:

When Genius Failed: The Rise and Fall of Long Term Capital Management by Roger Lowenstein.

Reading the book in the summer of 2009, the book seems as pertinent as ever. It deals extensively with financial theories that had a role in the crises in mortgage and credit markets, and eventually the broader economy. The parallel continues, as the Fed decided to intervene then as it has now. As a case study, LTCM offers a window into the worlds of arbitrage, academia, and financial markets generally.

There seem to be a few key points to LTCM's strategy and composition:

First, it made heady use of software models. Two partners in particular played huge parts in the development of quantitative finance: Myron Scholes and Robert Merton. Scholes was one half of the Black-Scholes formula, Merton developed that formula even further and also contributed to the Efficient Market school of thought.

Second, it relied on massive capital. Their strategy was to make massive bets with very small pay-offs, "sucking up dimes" as the firm put it. That relied on a huge investor base ($1.25 billion at its inception) and even more colossal amounts of borrowing. In 1995 the firm pulled in a 56% return before fees (43% after). By that time, their capital had grown to $3.6 billion. Their assets under management, meaning capital plus borrowed cash? $102 billion, 28:1 leverage. If they had invested at 1:1 leverage, their return would have been approximately 2.45% (in fact, that doesn't take account of derivatives transactions, which were held off balance sheet - if derivatives were included, the return might have been as low as 1%). Sucking up dimes indeed. Relying on that degree of leverage begs the question of whether the LTCM was really all that good at investing, or if they just had a lot of cash to throw around. So long as you can wait out losses, thanks to a huge amount of capital you can draw on and use to avoid forced sales, you can weather out storms that knock out smaller players. Keynes had a poignant insight on that idea: "markets can remain irrational longer than you can remain solvent." Lowenstein points to an early lesson learned by the LTCM's founder, John Meriwhether, when he was a trader at Salomon Brothers. A bond trader had made what he believed to be a good bet that the spread between bond futures and the actual bonds would narrow, so he bought futures and shorted bonds. But the spread only widened further, until eventually the trader had taken on so much loss he was being forced to sell. Salomon, and Meriwhether, looked at the trade and decided it was in fact a good bet. The little guy simply didn't have the capital to wait it out. So they bought him out, and sure enough, a little while later the spread narrowed and Salmon made a killing. The lesson? Have enough capital to wait out the storm. And eventually, in running LTCM, that's exactly what Meriwhether did - took in massive investment and then massively leveraged it, to the point where he was controlling a hundred billion dollars.