The key ideas

When Genius Failed: The Rise and Fall of Long-Term Capital Management

Roger Lowenstein, 2000

How did a fund with two Nobel laureates on its team lose almost everything in a few weeks? Roger Lowenstein rebuilds the story of Long-Term Capital Management from internal documents and interviews: from the brilliant years to a rescue the Federal Reserve had to arrange. It is a book about leverage, about models that only see the past, and about why brains and reputation are no protection against risk.

Who it is for

For anyone who invests, borrows, or simply wants to understand why crises catch even the smartest people off guard. And for anyone used to trusting calculations more than doubts.

A man who drives at thirty miles an hour can blame the road if his car skids on the ice. A man who races at a hundred miles an hour cannot.

Bankers at the Fed rescue someone else's fund

On September 23, 1998, the heads of the biggest banks on Wall Street gathered at the Federal Reserve Bank of New York. They had not been called in over a war or a stock market crash. The meeting was about one private fund from Greenwich, a quiet suburb of New York. The fund was called Long-Term Capital Management, and in a few weeks it had lost almost all its money. The trouble was that it owed these very banks so much that its fall could drag the whole market down with it.

Roger Lowenstein, a financial journalist and the author of a biography of Warren Buffett, who wrote for the Wall Street Journal for many years, rebuilt this story from the fund's internal documents and dozens of interviews. The book came out in 2000, two years after the collapse, and ever since it has been read as one of the great stories about risk on Wall Street.

The book's central question sounds almost rude. How could the people considered the smartest in finance, with two Nobel laureates on the team, get it so wrong? Lowenstein looks for the answer not only in the formulas. In his view, what sank the fund was the partners' character, their faith in their own mathematics, and a Wall Street culture that was only too happy to lend them money.

You'll learn how they made money on nearly identical bonds, why a small mistake becomes fatal when the debt is huge, and what the models could not see in a living market. It is a story about big money, but its lesson applies to anyone who has ever taken a risk.

Professors at the trading desk

In the 1980s John Meriwether ran the bond arbitrage group at the investment bank Salomon Brothers. A bond is an IOU: a government or a company borrows money and promises to pay it back with interest. Arbitrage is a game played on small price mismatches. You buy what costs a little less than it should, sell what costs a little more, and wait for the gap to disappear.

Meriwether made an unusual bet. Instead of loud traders who lived on instinct, he hired young academics with doctorates, people who knew how to build mathematical models. They looked at the market as a problem to solve: if two securities are essentially the same, their prices must come together. Find the gap, calculate it, and the money will follow.

The group made huge profits for the bank, and its members earned bonuses the rest of Salomon envied. Lowenstein describes how much this irritated everyone else: the academics kept to themselves and shared very little. A caste sure of its own superiority grew up inside the bank.

Meriwether himself was a quiet, reserved man who disliked the press but had a gift for inspiring loyalty. His team would follow him anywhere. That loyalty became the future fund's greatest asset. But you can see it another way too: in a team that close, there was hardly anyone left to say stop.

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About the author

Roger Lowenstein is an American financial journalist who wrote for The Wall Street Journal for many years. He is the author of a biography of Warren Buffett and several books about crises on Wall Street.

All books by this author: Roger Lowenstein

Terms from the book

  • Buffett
  • Hedge fund
  • Default
  • Wall Street
  • Arbitrage
  • Long-Term Capital Management
  • Meriwether
  • Merton
  • Scholes
  • Liquidity
  • Leverage
  • option
  • AIG
  • Salomon Brothers
  • Wall Street Journal
  • Fed
  • Black
  • Goldman Sachs
  • Greenwich: A town in Connecticut, not far from New York, where many hedge funds have their offices.
  • Bond: A debt security: whoever issues it promises to pay the money back on a set date and to pay interest along the way.
  • Mozer: Paul Mozer, a Salomon Brothers trader who reported to Meriwether. In 1991 he submitted false bids at US Treasury bond auctions.
  • Treasury: The US Department of the Treasury. It issues government bonds, which are considered among the safest in the world.
  • Mullins: David Mullins, former vice chairman of the Fed and a partner in Long-Term Capital Management.
  • Convergence: Here: a trade betting that the prices of two similar securities will come together. You buy the cheap one, sell the expensive one and wait for the gap to disappear.
  • Derivatives: Financial contracts whose price depends on another asset: an interest rate, a bond, a stock or an index.
  • Peter Fisher: A senior official of the Federal Reserve Bank of New York, in charge of its market operations. In September 1998 he went to the fund and saw the full picture of its positions.
  • McDonough: William McDonough, president of the Federal Reserve Bank of New York from 1993 to 2003. He brought the banks together to rescue the fund.
  • Bear Stearns: An American investment bank that cleared the fund's trades. It refused to take part in the 1998 rescue.
  • Moral hazard: When a person or a company takes bigger risks because someone else will pay for the consequences.

All terms

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