Most of us are all too familiar with the word bailout since the financial crisis, when governments around the world fought to save their biggest banks from going under.
However, go back another decade and there is an equally shocking tale to be uncovered, involving mind-boggling numbers.
That tale is the story of Long-Term Capital Management, a supersized hedge fund led by some of the brightest minds in finance and economics.
Former New York Times reporter Roger Lowenstein’s book, When Genius Failed, tells that story in fascinating detail and looks at the human element behind a fund that nearly brought the global economy to its knees through a series of errors.
The founder of LTCM, John Meriwether, was the senior figure at Salomon Brothers when that investment bank ruled Wall Street.
As a result of his time at Salomon, his status amongst the financial elite was almost God-like when he sought investors for his new venture in the early 1990s.
What made LTCM look even more of a ‘sure thing’ was that Meriwether recruited bond traders from his old employer (and Salomon’s bond trading division was known to be the biggest and baddest in town) as well as Nobel-prize winning economists Myron S. Scholes and Robert C. Merton, who created the first real options pricing model.
As Lowenstein recounts, the trading strategy employed by the fund – known as fixed income arbitrage – profited when the prices of two securities or currencies converged. By betting on one price rising the other price will go down. The fund was executing what is known as a ‘convergence trade’.
To achieve the kind of scale that generates the returns Wall Street expects, the fund leveraged itself to the hilt. At one stage, the hedge fund was borrowing $25 for every $1 it held in assets.
Lowenstein’s retelling carries a relentlessly foreboding tone, even as readers are told about the golden years between 1994 and 1997, when the fund generated returns of up to 43 per cent annually and grew from $1bn in assets to $7bn (controlling some $125bn in securities and a further $1.25trn in leveraged derivative trades).
But even though the figures were impressive, eventually it all came crashing down.
On 21 August 1998 came the announcement that Russia was essentially defaulting on its debt, resulting in a single-day loss for LTCM of $550m on its two main bets, long interest rate swap spreads and short stock market volatility.
As a result of all the intertwined bets LTCM had placed on various markets, including tricky off-balance sheet derivative trades, clearing the mess was virtually impossible and allowing the fund to collapse was not a risk that Federal Reserve of New York chairman William McDonough was prepared to take, asserts Lowenstein.
On September 23, McDonough organised a bailout of LTCM, encouraging 14 banks to invest $3.6 billion in return for a 90 per cent stake in the firm. It is impossible to miss the parallels between LTCM and Lehman Brothers, which was allowed to fail in 2008.
Whether it is a morbid reminder that the financial world fails to learn from its mistakes, or simply a fascinating read about hubris in a world of astronomical sums of money, When Genius Failed is a genuine page-turner and a worthwhile read for all.