When Genius Failed.
Imagine a bright Monday morning accompanied by some cool breeze and a delightful breakfast post-golf session, with a computer making decisions on your behalf and earning 40+% every year. Sounds unrealistic, right? Well, this dream pipe has been a reality for some time. Remember these names: Mayron Scholes, Robert Merton, and John Meriwether. I bet you've heard at least one of these names before. If not, then let me make you all familiar with who these three financial polymaths were and the empire they created, which was successful in drilling a giant hole in the American financial system in the late 1990s. The organisation was Long Term Capital Management (LTCM).
Starting with Mayron Scholes, a Canadian economist who is famous for his options valuation formula, the Black Scoles formula, for which he received a Noble Prize. He was the principal and limited partner at LTCM L.P. Also, he was a millionaire. The second person on the list is Robert Merton, another millionaire economist who received a Noble Prize in Economic Sciences and is the founder of the Black Scholes Merton model. Another option's pricing formula. He was the co-founder of LTCM L.P. Lastly, John Meriwether, the former vice chairman of Solomon Brothers (bankrupt today but the biggest investment bank in the 1990s), and the founder of LTCM. These three insanely intelligent human beings came together and started a hedge fund called LTCM in 1994.
All in all, there were 4 mathematicians, 2 noble price winners, and 1 successful investor running LTCM. The combined IQ of these seven people was unquestionably higher than that of a few hundred people sitting in a stadium. When you had such geniuses running a fund, you didn't expect the fund to go bankrupt, didn't you?
By the end of 1998, the fund went bankrupt, leaving a $1 trillion hole in the American economy. What was the story? Let's find out.
Scholes, Merton, and Meriwether were mathematicians. They believed that the markets were inherently random and that the only way to be successful in them was to understand the science of randomness, i.e., probability. Based on this belief, one of their founders created the Black Scholes formula. As mentioned earlier, Scholes bagged a Noble price for the model. However, Scholes further partnered with Merton and Miller and created a financial model that could make risk irrelevant. This would be done by something called "dynamic hedging". This meant that if an open position created a risk, this risk could be offset by creating a position that had an opposite risk, thereby nullifying the effect. Basically, buying spinach as a backup meant that even if the potatoes you bought were ripped, it didn't matter. The founders of LTCM had developed algorithms that would help them identify such securities within nanoseconds across global markets. It sounds scarily brilliant.
The founders of LTCM were already big names in academic circles relating to finance and economics. Decision-makers in various banks had virtually studied under them or followed their opinions via their books. Hence, when it came to light that Scholes, Miller, and Merton wanted to raise funds, Wall Street queued up outside their offices. The reputation of the founders was so stellar that Wall Street banks and investors had to compete with each other for an opportunity to invest in this fund. Even central banks like the Central Bank of Italy have invested money in this fund! Within no time, the founders had a huge kitty of $3 billion to invest in the marketplace, and the operations of LTCM were soon underway.
For the first few years, LTCM was a remarkable success. The founders had lived up to their reputation. The first year saw a return of 23%, whereas the latter years saw returns that were consistently in excess of 40%, a remarkable feat in the stock markets! All this was happening by itself, as the founders of the fund were often seen playing golf or attending conferences during office hours. A passively managed fund generating those kinds of returns was virtually unheard of, and Scholes, Merton, and Miller came to be hailed as geniuses!
The spectacular success and invincible business model of LTCM faced failure when the markets started behaving irrationally. All the assumptions in the model are based on how participants in the market would behave under normal circumstances. However, the Asian crisis sparked an epidemic of abnormalities in the market. A crisis that began in Thailand started spreading across Asia into developed countries like Japan and Korea, and mayhem ensued in the marketplace. However, the founders of LTCM were supremely confident in their model. Hence, they continued to trade even as the rest of the world closed shop. In fact, LTCM saw this as a massive opportunity and borrowed $100 billion against $3 billion of equity. You don't need to be a financial genius to comprehend this situation. Borrowing $100 billion when you only have $3 billion creates a debt-equity ratio of 33.3. Surprisingly, the Americans were barking when the Adani group had a debt-equity ratio of mere 3.45. I believe the British developed the word "hypocrisy", but I believe they were looking at the Americans at the time they developed this word.
Talking about LTCM, the unthinkable happened: Russia, the erstwhile economic superpower, defaulted on its debts. This made LTCM lose a lot of money. They were losing close to $500 million every single day in mark-to-market losses on their derivative positions (mark-to-market losses happen in the futures market. You have to pay a certain percentage of margin before entering the contract, and if, because of market volatility, your contract value falls below the initial margin you paid, you get a mark-to-market loss and will have to deposit additional margin in proportion to the loss amount). Before they knew it, their $3 billion equity was wiped off and LTCM was bankrupt, leaving other Wall Street firms with over a trillion dollars in counterparty risk and no means to cover it. In retrospect, the founders admitted that the market knew something that they did not, and their attempts to outsmart the market every time had led to their downfall.
As always, the FED jumped in and used taxpayers' money to bail out the creditors of LTCM. This saved the markets in the short term. However, the FED came under enormous opposition because it had used public money to bail out billionaires who were toying with risk.
A shocking fact: all the founders of LTCM had parked their personal money in the fund as well. It takes guts to make irrational bets when you are playing with your own money. Forget outside investors.
Charlie: I don't know about good decisions, but I know about bad decisions, and I avoid them. Inverting the problem is the key.
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