When Genius Failed - Then and Now

One review of a good Roger Lowenstein book deserves another? Perhaps good things come in pairs.

I decided to review When Genius Failed, because reading While America Aged for last week's review reminded me of how much I liked Lowenstein’s writing style, simplifying matters for the average reader.

I was an investment actuary when LTCM was founded, and watched out of the corner of my eye, as I saw articles about their success. Being a risk manager, I was a little skeptical over the leverage employed, but I knew of other firms that had records almost as good, employing esoteric strategies of Residential MBS. That was the era of build a better prepayment model, and the returns will flow. (Perhaps today that would apply to default models…)

When LTCM imploded, I had just joined my first investment department. In the panic that ensued, Treasury yields fell, and my boss asked his new mortgage bond manager, me, why prepayments weren’t accelerating. I suggested that the banks could not borrow at Treasury rates, better to look at single-A bank and financial yields, which were considerably higher. (Surprisingly, I got that one right.) A number of the clever prepayment modelers got their heads handed to them during this era.

The implosion affected all fixed income markets, and it was a lesson to me that markets ordinarily recover from crises starting with short maturities, and moving to longer maturities, and with high quality, and moving to lower quality. We had cash flow, and and provided liquidity at a price.

Um, oh yeah, book review. LTCM suffered from a number of troubles:

• They were systemically short liquidity.
• They did not consider the effect of others mimicking their trades.
• They were internally disorganized; leadership was weak.
• They intensified their leverage at the wrong time.

The liquidity aspect is significant. Illiquid assets that are similar to a liquid asset usually yield more, because the cost of trading is much higher, and the possibility of being trapped is higher also. LTCM bought the higher-yielding illiquid assets, and hedged them with more-liquid liabilities. This set the stage for the run-on-the-fund. Almost all run-on-the-bank scenarios occur from institutions where the ability of depositors to demand cash is greater than the ability to raise cash in the short run.

In the same way, many on Wall Street mimicked the trades of LTCM, but they had risk control desks that forced them to kick out the trades when they went awry, which further intensified the pressure on LTCM, because it forced the asset prices of LTCM lower.

The lack of discipline inside LTCM was a eye-opener for me, and I would not have appreciated it, were it not for Lowenstein’s book. Financial businesses that last require tight controls on risk taking.

Another thing captured by Lowenstein was the hubris involved as they cashed out some investors in order to “favor” internal investors and close friends. They levered up at the wrong time. The cashed-out investors were offended, but they were the ones who did the best of any; they got the good years, and missed the bad year.

Now, beyond that, Lowenstein delivers the attitudes of LTCM and Wall Street, with all of the fear and greed. It is entertaining reading, and the book is still timely. Even though there is no dominant investment firm that threatens the financial markets, we have the investment banks as a group taking a great deal of risk in their trading and investment banking. The assets are illiquid, the liabilities are more liquid. Their balance sheets are opaque. Many of them are in the same risk posture. Many of them are more leveraged than they would like to be. Bear has already fallen, will Lehman fall next?

Just because investors are smart does not mean that they are infallible. Any investor playing at a high enough level of leverage can be ruined. This book inoculates investors against perverse risk-taking, and makes them more skeptical about the claims of hot investors. Not losing money is a big help in making money, and skepticism in investing is usually a plus.

Full disclosure: If you enter Amazon through a link in this post and buy something, I get a small commission, and your costs don’t increase. This is my version of the “tip jar.” Thanks to all who support me.

Comments

[razorfangius:]

I think the difference is that the LTCM guys actually thought they were doing a good job, whereas the the recent crisis has more of a 'control fraud' feel to it.

The guys at the top of the food chain in a lot of these companies that have blown up knew it was going to happen and cashed out along the way, knowing they'd be set for life and there probably wouldn't be any prison terms in their future ...

2008 Jun 07 03:01 PM

[rainman:]

Fischer did predict that, wonder what he would have comment on the Fed if only he were alive..

2008 Jun 08 02:00 AM

[rainman:]

My star is that Rick from CHI of CNBC, others are just noises.
Read Fischer Legacy...

2008 Jun 08 02:01 AM

[Richard Yong:]

That's the best full disclosure ever.

Genius is failing at the moment everywhere.

Rainman, your star should be your own analysis... please for the love of god don't rely on CNBC...

I'm trying to find an article from the Sydney Morning Herald, but ther e is a great piece there on how sudden wealth, CNBC and trash magazines has brought up a generation of stupid investors, who unfortunately don't know they are stupid.

It gives a great example of how people are so concerned with P/E ratios today, they forget what the company does, and don't even know where the E comes from.

Obviously we know from the last 6 months that where the E comes from is still pretty important.

2008 Jun 08 03:22 AM

[Richard Yong:]

Here we go, I found the link, it's an article by Marcus Padley

business.smh.com.au/th...

I'll give you guys the short quote though, as the article isn't that relevant.

'...foolish stock market practices?'

'Like investing in a portfolio of 20 stocks for long term returns, when you could just buy an index. Like thinking declarations of interest make research independent again. Lik eusing PEs without knowing where the E came from. Like not taking tax into consideration. Thinking there's science in short-term trading. Thinking private placements are above board. Thinking fund managers don't deserve their fees'

There is another great one I think on this site about how the markets have been pumped by investor's who aren't that well informed, or think they know, but don't.

In any case, I'm in Australia. In Australia we're buying your stocks.

2008 Jun 08 03:38 AM

[Edward Janeck:]

When Genius failed is one of the great book on market history. I think most people would think problems are must worse now. We have a recession, credit crunch, declining dolar and housing bubble. I write about it at @theinvestingspeculator...

2008 Jun 08 10:15 AM

[Reinko:]

To: The author David Merkel.

Since you are in the risk department I would like to place at your feet my so called 'derivate crash thesis'.

The (local USA) thesis says that when the stock markets get below a certain threshold, suddenly all those multi trillion derivative positions will come crashing down.

I think this is the case because for a long time we had all that OTC (over the counter) stuff and that was not regulated. Therefore there was no 'risk guard' at flowing too far from the put to call ratio from the number one.

Lately I observed some info that indeed in the CBoE there was info that supported my view that for years on a row the put to call ratio was far from one.

Lehman and Citi Group have taken up absurd positions in derivatives, but are they flying elephants?

They have taken about or over six time the US GDP and we all know what happens to big leverages when (borrowed) assets decline just a little bit.

2008 Jun 08 06:34 PM