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(More customer reviews)A somewhat didactic narrative history of the hedge fund Long Term Capital Management. Nicholas Dunbar covers the same subject in his book "Inventing Money." Both books present a blizzard of details about who did what and when. Too much detail. The general reader would better served by a medium sized article. Nevertheless if you're a finance buff interested in the nitty-gritty then read both books. Dunbar has a physics background and his book is more technical, while Lowenstein comes from journalism and his narrative flows better.
LCTM began operating in 1994, set up by John Meriwether formally head of the bond-arbitrage group at Solomon Brothers. He put together a star-studded cast that included three (1997) Nobel prize winners in economics. Their basic strategy was something called convergence arbitrage. In essence this strategy says buy two bonds that you think will track one another. Go long on the cheap one and short on the other; you make money if the spread narrows. In theory you are protected from changing prices as long as the two vary in the same way. To make the big bucks LCTM was after they took a gigantic number of highly leveraged arbitrage positions all over the world. To get high leverage you borrow for the position, like buying a stock on margin. LCTM got really high leverage by avoiding something called the "haircut," which is an extra margin of collateral banks usually demand, but forgave LCTM. Why would banks they do such a thing? Because they were blinded by the glitter of the cast, and in some cases the banks themselves were investors in LCTM. By 1997 convergence arbitrage opportunities in bonds began to dry up, everyone was doing it. So LCTM applied their strategy to stocks. Find two stocks that will track on another and go long and short with borrowed money. This is not easy. Stocks are less amenable to mathematical analysis than bonds, and after all these were the bond guys from Solomon, they were out of their depth. You might ask how can you borrow most of your stock position when the Federal Reserve requires 50% margin (Regulation T). Answer: don't really buy the stocks, instead buy derivative contracts that simulate stocks, an end run around Regulation T. Even with all this leverage LCTM would claim that the fund was no more risky than the stock market, meaning a stock index. In 1998 the markets went against LCTM, with the "flight to quality" (US government bonds) as investors panicked. The fund suffered from what reliability engineers call "common mode error." Spreads got wider not narrower across the board, and LCTM's capital base began to shrink as their positions lost money. At a certain point they would have to start liquidating positions, and the market impact of such large scale selling would cascade across their portfolio. The fund would "blow up."
The above gives a flavor of the material Lowenstein provides, only in much greater detail. If that's what you want, buy the book. Is this a tale of human folly or just plain bad luck? Answering that question is not easy, one needs to grasp a large amount of technical finance theory, and understand what happened in the particular case of LCTM. This book will help.
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When Genius Failed: The Rise and Fall of Long-Term Capital Management
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