The rise and fall of long-term capital management



Roger Lowenstein write the book “When Genius Failed” about the risk management of funds which collapsed the world's financial market system along with his founders and PhD genius intelligence.

Summary of the content

The story of long-term business of bond trade started in 1979 when well-known trader at Solomon's brothers whose name was Meriwether introduced it. The young and talented Meriwether after his graduation from the University of Chicago joins Solomon's in 1970, s. In 1970,s, the bond market was more active as compared to 1960,s and more people were interested in bond trades, which made them to earn high returns. In addition, one of the main reasons behind the active bond market was the invention of new computers, which had over taken the classic image of trader who shouts for selling and buying the orders at the trading floor, the computer network help and made their accesses to all buying and selling price very easy and effective. The formation of arbitrage group in 1977 was the one main reason of Solomon's evolution. Meriwether was making high profits from the bond trades because his trade had high risk taking abilities, which increased its value in long-term business. Due to Meriwether, the banks were ready to give him financing for long term at suitable terms because he was the famous figure at that time among bankers. Meriwether was consider the only known public figure behind the long term capital management but the heart of the funds were the PhD computer genius who were computers freaks to whom Meriwether hired. They developed the models, which could quantify the bonds and tell when the market would be efficient to invest. Meriwether was very happy with his people work and their models; he was confident that he hired smartest people and develop incredible close relationship with them to get most out of them but the 1987 crash in which Solomon had lost $120 million in one day which was great shock to every one and here the story of long term losses start. The Mozer scandal in which one member of arbitrage use unfair deals in getting

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unfair profits while ignoring the good will of Meriwether and its firm, and Meriwether failed to supervise the MOOZAR activities. After settling this scandal by court Solomon's appointed Hilibrand and Rosenfiels as a heads of arbitrage and govt desk.

At the same time J.M, introduces hedge funds as a business in 1990.Americans were very excited at hedge funds and this raises the stock prices in market, high return increases the investment activities in the bond market. And set the new records at that time. Many Americans became millionaire and were interested in re investing their money. Hedge funds were the private investment pools for rich and wealthy people. So it was easy for SEC to monitor. Due to high returns in 1990,s investors start considering the safest and less risky bond trades. Meriwether wanted to give bond trade a high relative value in market. Early in 1993, Merrill agreed to raise capital for long term on the request of Meriwether, soon at that time. J.Morgan, s old arbitrage group left the Solomon one by one. And J.M hired the Melton a good consultant to Solomon's to justify his investors about the bond plan. He joined the long term with the intension of showing his theories and models that long term is not a capital but it is a finical intermediary which provide the liquidity to the market. At the end of 1993, Merrill made a partnership with foreign banks in long term because investors were not satisfied with J.M investment strategies. After its partnership Merrill start raising funds by feeder system which was a piece of paper or a earning statement issued by Solomon's to spread the long term portfolio around the world with the help of good marketing strategies. Long term gained the unparallel access to international banks for their private funds. A long term with this raised the funds by net amount of $1.25 billion in 1994, which was a good start ever.

Long-term trade was not easy trade and required the investment banks to lend money for longer period with safest terms. Due to attraction of long term, high profits investment banks itself involved in long term business and became the competitors of long term, so J.M revise its marketing strategies and made only specific deals with investment banks to get maximum return from the market than any one else could get. At that time on Wall Street, the long-term traders and operators were doing their best in earning high profits by their good collaborations and high skills and better knowledge of market and their models.

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As a result, their profits were much higher than their expectations. After bond market, crash in 1994 long term used the mortgage securities for the purpose of refinancing and generated capital of $ 2 billion. Long term also enters in Italian market for hedging the funds and they successfully capture the market and boost their returns.

It was very important for investors to learn about the nature of long term because if they were making profits at one time they also could make looses at some other time. It was responsibility of traders to make their investors aware about the nature and trends of long term. It was difficult to quantify the risk of funds but history of funds helped to assess their bonds market risk. According to Black-Scholes formula, the nature of bond prices in the market was random and this could help the investors to understand the prices and sudden swing in the market. Different assumptions gave by traders to investors that how they could make their money more in efficient market. In addition, if market is efficient than there will be less volatility, less risk and investors could get benefits from that situation. In 1987, portfolio insurance was given to investors to minimize their looses.Many long term had low risk but none of them had no risk. The main problem with long term was its inherited uncertainty, nobody knew how the long term will react in future and stocks return was simply considered as random distributed that means that if long term was loosing money at one time their would be time that it could make profits as well and this all depend on market efficiency. In 1995, long term made profits of $ 1.66 billion and Italy contributed a lot in that profit. The derivative trade had the same risk of gaining and losing but the long term returns were high more than ones expectations and long term had high returns because it had high leverage power. As the financial risk involves in long-term trade so no body at that time could say that they will make this profits forever because the future was uncertain and every investors should kept them selves ready to face any kind of uncertainty in future.

Long-term balance was 30% more than its capital and this mutual fund was the largest fund at that time on Wall Street. According to the J.M, the long term shows its result over the long periods and required not only the time but also the patience of investors for high returns. Due to the J.M, good strategies for long term it became the model of wisdom and caution in 1995.

By the late 1990,s every investment bank involved in long term business due to its lure. Different stock traders developed partnership and formed the merger deals. Arbitrage business was making high returns in capital market. Long term business attracted the banks , individual investors towards itself who were making their money from millions to billions and finding them selves the smartest people because they were involve in the riskiest and highly lucrative trade of that time. Merton's and Scholes won the noble prizes for their economics models and formulas, which could quantify the market risk and help to gain high returns. They decide to join LTCM to earn money.

The fall of long term

The failure of long term was the volatility of banks which short the huge sum  of equity volatility. Equity volatility was considered the major trade of long term but its funds also destroyed. It was assumed that the equity volatility will remain consistent based on Scholes model but it did not happened in the case of equity volatility. Because of less liquidity the long term short and at this trouble situation there were no buyer who was willing to invest in long term. As storm hits the markets the swaps spread and long term losses its billion of amounts in Russia, Japan, Germany and USA. Meriwether wanted to raise the money but looses were high than leverages and bond market was simply vanished. After increasing risk of long term looses in various countries J.M asked his traders to keep close eye on every proceedings and required up to date reports on arbitrage, equities and swaps but there was fall in demand as no buyer was there and banks also strict their credit policies towards long terms because of fear of looses. Due to continuous poor performance of bonds long term capital management had not enough cash for there payment to banks and declared as insolvent. At that time long term liquidate its trade and wanted to retain its existing investors and wanted to attract new ones but they were unable to raise money as no one was ready to finance long term because of high risk of loosing money in future.

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The august was the worst month which destroyed the financial market of long term and was the month when there was no buyer, Merton's model was no more their, bond yield, swap spreads and equity all shrink and looses money and was the reason of close of bond market. The main reason of the tremendous looses of long term was the problem which was with the cash flow of long-term capital management after revealing this confidential information to investors they tried to get out of all this. It was suspected that if long term by any of its trade would not able to raise money than it could loose its repo line and would not survive in market..

The main flaws of long-term strategies were

* Totally relying on the market models which were developed on the believe that the market fluctuation in past could help to determine the prices ,risks and returns of the securities in future without taking this concept under consideration that the future is highly uncertain no one can predict the future. Therefore, it was wrong to design the future models on past performances of the market.

* Market are not always perfectly efficient, if securities are making money in good time there could be time when it face looses

* There was no exit strategy for highly illiquid leverage trade of long-term capital management.

* Shifting of long-term partners from bond market where they had skills, knowledge and experience, to equity market, which was new to them, was one reason of failure of long-term capital.


This story is about the failure of long-term capital management due to its care less and greedy traders. Moreover, the investors were not aware of the nature and strategies of long term and its total indebtedness. Banks gave funds to long term due to its brand name, which it had established with its famous partners. In conclusion and after combining all facts together this is a good professional and interesting book which tell us that for trade we need experience and trading is not about the risk management. It is also important to understand the dynamics of market.