Aaron's Reviews > When Genius Failed: The Rise and Fall of Long-Term Capital Management

When Genius Failed by Roger Lowenstein
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's review
Jan 09, 11

bookshelves: business
Read from January 02 to 08, 2011

I've had this book for a few years and after reading The Big Short I wanted to circle back to this book, because I suspected that part of the situation with irresponsible leveraging found in the recent financial crisis could be tied to the Fed-organized bailout of Long-Term Capital Management. After reading this book, I think I'm right.

From page 231: "If the Long-Term episode proved anything, it is that the system of disclosure that has worked so well with regard to traditional securities has not been able to do the job with respect to derivative contracts. To put it plainly, investors have a pretty good idea about balance-sheet risks; they are completely befuddled with regard to derivative risks. Some of the reporting standards are being changed (over the opposition of both Greenspan and the banks), but gaping holes remain. As the use of derivatives grows, this deficiency will return to haunt us." (bold mine)

In fact, the entire last part of the Epilogue is basically a warning that Wall Street will have learned nothing from the failure of LTCM except that the Fed will bail them out if they lose too much money. I guess they learned that lesson well, eh?

For those of you with no idea what Long-Term Capital Management was, it was a 'hedge fund' founded by the folks who invented the idea of bond arbitrage. They hired in guys who went on to win the Nobel Prize in economics, and everyone thought they were brilliant and could do no wrong. Including, unfortunately for them, themselves. With the hubris of people who believe themselves perfect, they wrote derivatives contracts in excess of one trillion US dollars on all sorts of things. For a few years they made a lot of money. As soon as the markets turned, though, they lost pretty much all of their money in about a month and a half. The Federal Reserve organized a bail-out of the fund by over a dozen different banks in order to allow a rational unwinding of their positions rather than letting them go bankrupt.

Overall, the book is great if you want to understand how the Fund was set up and managed, including what brought it down. As someone who was taking graduate-level Finance classes during the period when LTCM was making money hand over fist and could seemingly do no wrong, I heard multiple finance professors gush about the brilliance of the partners at the fund and the Black-Scholes options pricing model that they used as their magic bullet. Now I understand why that gushing praise was offered, and how that bullet ended up killing its users.

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01/02/2011 page 22

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