On why “greed” is a cheap, and dangerous, answer
Long, long ago*, in a world before the GFC and the dot com crash, Long Term Capital Management made its mark on financial history with a dive so epic it came perilously close to taking financial markets down with it. The hedge fund lost $4.5b in value in a matter of months when Russian debt default triggered a financial market panic, and LTCM’s highly leveraged position left it vulnerable to a liquidity crisis.
Roger Lowenstein’s 2001 book, When Genius Failed: The Rise and Fall of Long Term Capital Management, tells the short history of this shooting star in compelling style. John Meriweather was the firm’s founder and CEO, and in a reboot of a concept he first ran at Saloman Brothers, built his risk arbitrage team of PhDs with future Nobel Prize winners Myron Scholes and Robert C. Merton in advisory roles. The firm’s point of difference was the complex modelling of risk, at the other end of the spectrum from the instinct driven trading of most of Wall Street. For a few years they were a hot investment for banks across the world, and their capital raising strategy had a distinctive FOMO flavour several years before the phrase was first coined. At its peak, the fund held a staggering $129b in assets, with a debt to equity ration of 29:1; its off balance sheet derivatives positions were nominally worth over a trillion dollars.
Lowenstein has written a compelling book and I confess I was riveted in the same way I get watching the closing stages of Hamlet or Romeo and Juliet- “maybe this time they’ve changed the ending and it won’t be so bad….”. As you’d expect with an enterprise as complex as this with that kind of leverage, there were a lot of players with skin in the game. When things started to go pear shaped, the ripple effect across financial markets was significant and the effort to stop the entire financial system grinding to a halt would itself be complex and tense. Oddly, as I read the closing chapters, songs from musicals started popping into my brain. I had the strange thought that this story, with its ludicrous scale and sensitive exploration of the frailty, self delusion and determination of humans would make a really great Broadway musical. The Derivatives song would be a quintessential musical tongue twister comic set piece. **
This book is a classic of business, economics and finance, and well it should be. The lessons here are important and layered. Most obviously this is a tale about the dangers of hubris, and it genuinely seems that it never occurred to John Meriweather and crew that their scheme could fail. I’ve done a little modelling myself (computer, not catwalk) and it’s pretty seductive being able to generate scenarios and test lots of options without ever really risking a cent. If you then play for real based on your model, and win big for a while, I can see how you could reject reality and substitute your own without ever realising it.
Robert C.Merton later said It’s a wrong perception to believe that you can eliminate risk just because you can measure it, and this is another layer of the lesson here. In the world of finance, risk is synonymous with volatility, ie how much the returns of a stock or derivative vary around its long term average. But when you are placing a bet on volatility - or in LTCM’s case, a bet on volatility reverting to the mean, you are also placing a bet on how quickly volatility will return to normal, and how far it will stray before it does so. As John Maynard Keynes (might have) put it, “The market can stay irrational longer than you can stay solvent.”
At the risk of cliche, lyrics from Kenny Roger’s classic, The Gambler spring to mind, and you might ask, were they just greedy? During an Investments class discussion on the GFC, someone offered the explanation of “greed” for the behaviour of the financial sector. The lecturer’s not unkind response was that greed is a cheap answer, and that we should dig a little more. I was reading the book concurrently with this class, and the idea applies equally here. If I were merely to say they were greedy, and look disgusted, it would be easy for me to dismiss this experience as happening to other people- greedy people that aren’t me. Reading this book, I felt that the truth is more complex than that.
When Genius failed is a very human tale, where the actors are not merely an evolving dramatis personae list, but people with histories, hopes and fears. From Lowenstein’s thoughtful opening introduction of the ill-fated protagonists, to his careful selection of quotes from cameo players in the bailout process, a highly personal picture builds of the cast involved in this drama. It is essential that it be so: for this to be a true cautionary tale, we must be able to identify with at least some the players, otherwise it’s to easy to say that this would never happen to me…and miss the point. Instead of writing this episode off as greed, this book invites you to understand how rationalising your actions and surrounding yourself only with like minds can lead you very, very astray.
- * it was 1998- not quite 20 years ago.
- **I’m only about 60% facetious when I say When Genius Failed would make a great musical. If there are any composers out there interested in a collaboration, drop me a line. #nextHamiltonTheMusical.
