Welcome back to the Deep Dive. Today, we are
not just talking about money. We are talking
about what might be the single most expensive
private education in the history of Wall Street.
That's a great way to put it. We're going to
unpack a story that involves, and I don't use
this term lightly, the absolute smartest people
on the planet. Truly. I mean, certified geniuses.
And these certified geniuses managed to effectively
set a pile of $4 .5 billion on fire. And not
over a decade, but in a matter of, what, less
than four months. It's the ultimate Icarus story.
You know, it has absolutely everything, hubris,
genius, what seemed like unlimited capital and
just a catastrophic ending that almost, and this
is not an exaggeration, almost took down the
entire global economy. We are talking, of course,
about long term capital management or LTCM, as
everyone came to know it. And before we really
get into the weeds here, I just want to frame
the stakes for everyone listening. This is important.
This isn't just a story about some hedge fund
that had a bad quarter. This is a story about
a fund that became so big, so leveraged and so
interconnected that when it started to crack
in 1998, the Federal Reserve, we're talking the
Central Bank of the United States, had to step
in, had to orchestrate a bailout. They were genuinely
terrified that if LTCM fell, it would cause a
complete systemic freeze. And that's not hyperbole.
I mean, the real fear, the thing that kept the
Fed chairman up at night was that the actual
plumbing of the global financial system would
just stop working. So if this one fund in Greenwich,
Connecticut, went under, ATMs might stop dispensing
cash. Corporate payrolls might bounce. I mean,
that was the level of panic we're talking about.
A true meltdown. Okay. So our mission today is
to reverse engineer this disaster. We're going
to look at the dream team they assembled. We'll
get into the... the specific trading strategies
that made them billions in the first place. And
then the fatal flaw, the mathematical blind spot
in their risk models that they just couldn't
see. And then, yeah, the minute by minute panic
of the bailout. We've got a massive stack of
sources here. Biographies, Fed transcripts, trading
logs, academic autopsies of the crash. I mean,
this is one of the most studied financial events
in history. It is. And I think, you know, if
there's one big theme to look out for today,
it's the difference between intelligence and
wisdom. Oh, that's good. You're going to hear
about Nobel Prize winners. You're going to hear
about guys who literally invented the math that.
you know, Wall Street still uses today. They
were so incredibly intelligent. Beyond intelligent.
But as we'll see, they lacked a certain kind
of street smarts, a survival instinct. They mistook
the map for the territory. I love that. The map
is not the territory. Let's start at the very
beginning then, the assembly of this team. Because
like you said, this wasn't just some guys in
a garage with a Bloomberg terminal. This was
the 1927 Yankees of finance. I really was. And
it all starts with one man, John Merriweather.
Who is this guy? John Merriweather is or was
a legend. Before LTCM, he was at Salomon Brothers
in the 1980s. Now, if you've ever read Michael
Lewis's book, Liar's Poker. Oh, a classic. You
know the culture of Salomon at that time. It
was aggressive. It was loud. It was full of,
to use their terminology, big swinging dicks.
Right. A pure alpha male environment. Absolutely.
But Merriweather was. He was different. He was
the exception to the rule. How so? He was quiet.
He was cerebral, you know. He wasn't the guy
screaming across the trading floor, throwing
phones. He was the guy staring at the numbers,
seeing these tiny patterns that nobody else saw.
And he ran the bond arbitrage desk, right? He
did. Yeah. And to give you a sense of just how
important he was to that firm, in the late 80s
and early 90s, Merriweather's specific group,
just his desk, was reportedly responsible for
something like 80 to 100 % of Salomon Brothers'
total global earnings. Wait, wait, say that again?
80 to 100 %? Of the entire bank's profits. That
is just, that's wild. One desk was basically
carrying a global investment bank on its back?
Exactly. He was the golden deuce. Which is why
it was such a big deal when he left in 1991.
There was a trading scandal involving treasury
auctions. Now, it wasn't something he did personally,
mind you, but it happened on his watch. So he
took the fall for it? He took responsibility,
yes. And he resigned. But his reputation was
so pristine, so legendary, that when he decided
to start his own shop a couple of years later
in 93, people were practically throwing money
at him. They were lining up. But he didn't just
bring his old traders with him, did he? This
is where the story gets really interesting. He
went out and recruited the academic heavyweights.
This was his brilliant move. He decided to bridge
the gap between the ivory tower of academia and
the dirty fingernails world of the trading floor.
He recruited the intellectual giants of finance.
Specifically, Myron Scholes and Robert C. Merton.
Yep. Now, for anyone who hasn't suffered through
a university finance degree, those names are,
well, they're effectively gods. These are the
Scholes and Merton you read about in the textbooks.
Precisely. They, along with a third academic
named Fisher Black, created the Black -Scholes
model. This is the formula, the math, that allows
you to accurately price stock options. Before
them, Pricing a derivative was. It was a guessing
game. It was all intuition and gut feeling. They
turned it into a science. They turned finance
into physics. That's the key. They gave it the
veneer of scientific certainty. And just to underscore
how big a deal this was, these two guys, Scholes
and Merton, they won the Nobel Prize in economics
in 1997. While they were working at LTCM. Right.
So imagine your potential investor. You're sitting
in a meeting and the pitch is, we have the greatest
bond trader of his generation, John Merriweather.
And on our board, we have the guys who literally
wrote the laws of physics for the market. Oh,
and by the way, they just won the Nobel Prize.
It created this aura of infallibility. availability,
didn't it? It wasn't gambling anymore. It was
science. They weren't betting on gut instinct.
They were harvesting what they saw as mathematical
certainties. And the structure of the fund itself,
it sort of reflected that exclusivity, that arrogance
almost. They weren't on Wall Street. No. They
set up in Greenwich, Connecticut. They wanted
to be physically removed from the noise and the
emotion, the panic of New York City. It was designed
to be very academic, very quiet, just supercomputers
and silence. And very unregulated. Oh, absolutely.
They used an exemption in the Investment Company
Act of 1940. Basically, if you only take money
from highly sophisticated, very wealthy investors,
you don't have to tell the SEC, the regulator,
much of anything. Which means they could be secretive.
Extremely. They told their investors absolutely
nothing about what they were actually trading.
It was a total black box. The deal was, you give
us the money, we give you incredible returns,
and you do not ask how the sausage is made. And
people lined up for that deal. They couldn't
get the money in fast enough. By the time they
launched in February 1994, they had amassed just
over $1 .01 billion in capital. For a hedge fund
launch at that time, that was a massive, massive
number. Okay, so the dream team is assembled.
They have the capital. They have the Nobel Prize
winning brains. Now we need to understand the
machine. How did they actually make those billions?
Because the phrase bond arbitrage sounds incredibly
boring. It does, doesn't it? But clearly it was
incredibly lucrative. It's lucrative if you do
it at their scale. The core strategy was something
called convergence trading. All right, lay it
on me. Simple terms. What is that? The fundamental
belief of LTCM was that markets are efficient
eventually, but in the short term, they can be
inefficient. So things get out of whack for a
little while. Exactly. Sometimes two things that
are essentially the same that should have the
same price, they trade at slightly different
prices. Yeah. Maybe due to a temporary supply
and demand quirk or a liquidity issue in the
market. A convergence trade is a bet that eventually
those prices will converge. They'll snap back
together. OK, can we use the old versus new bond
trade? I saw that in the notes and it seems like
it was their bread and butter. It absolutely
was. It's the perfect example. So think about
U .S. Treasury bonds. The U .S. government issues
30 year bonds all the time. When a brand new
30 -year bond is issued, it's called the on -the
-run bond. It's a shiny new thing. It's the shiny
new thing. It's incredibly liquid. Everybody
wants it. Pension funds, foreign governments,
other banks, they all want the newest, most actively
traded issue. It's like the new iPhone. Everyone
pays a little premium for the new iPhone, even
if last year's model is basically the same. That's
a perfect analogy. Because it's the new iPhone,
people are willing to pay a tiny, tiny premium
for it. Now, you look at a bond that was issued,
say, three months ago. Right. It's now technically
a 29 and three quarter year bond. Right. The
cash flows from these two bonds, I mean, they're
almost identical. The credit risk is identical.
It's the U .S. government. They're going to pay
you back. So it's basically the same product.
It is. But that older bond, it's harder to trade.
It's less liquid. It's called off the run. And
because of that, it trades just a little bit
cheaper. So you have two things that are worth
almost exactly the same, but one is expensive
and one is cheap just because of liquidity. Correct.
So LTCM's computer models would scan the market
and spot this tiny discrepancy and they'd make
a trade. They would short the expensive new bond
betting. Its price would go down relative to
the other. And they would simultaneously buy
the cheap old bond, betting its price would go
up. And the key is... They didn't care if the
overall market went up or down. Didn't matter
at all. Interest rates could go to the moon or
to zero. All they needed was for the gap, the
spread between those two bonds to close. They
just needed the prices to converge. Because eventually
the new bond becomes an old bond. Exactly. The
moment the Treasury holds its next auction and
issues an even newer bond, the on the run becomes
off the run. The premium evaporates. The spread
closes. It's a mathematical certainty, or so
they thought. OK, but here's the catch, right?
The difference in price between those two bonds,
the spread, it can't be very big. We're talking
pennies, aren't we? Or like fractions of pennies.
We call them basis points. And yes, it is tiny.
You are literally picking up nickels. If you
or I did this with $1 ,000, we might make enough
money to buy a stick of gum. It's very low risk.
but it's also very, very low return. That's the
problem with pure arbitrage. So how on earth
do you generate 40 % annual returns from a stick
-of -gum strategy? One word. Leverage. Massive,
mind -boggling leverage. This is the scary part
of the story. This is the fuel that they poured
on the fire. Since the spreads were so small,
like you said, like picking up nickels, they
figured they had to use a bulldozer to pick up
enough of them to make it worthwhile. And a bulldozer
means borrowed money. Lots and lots of borrowed
money. They borrowed from every bank on Wall
Street to amplify their bets. I'm looking at
the numbers here for the start of 1998. They
had about $4 .7 billion in their own equity,
their own capital, which is a lot of money. A
huge amount. But they had borrowed over $124
.5 billion. It's just an insane number. That
is a debt -to -equity ratio of over 25 to 1.
For every single dollar of their own money in
the fund, they were playing with $25 of someone
else's money. And that's just the stuff on the
balance sheet, right? That's what they reported.
What about the derivatives? Yeah, that's the
shadow exposure. The really scary part off the
balance sheet, they had positions, mostly things
like interest rate swaps with a notional value
of one point to five trillion dollars. Trillion
with a T. I mean, it's hard to even wrap your
head around a number that big. It is. To put
it in perspective, they took an equity base of
less than. $5 billion and turned it into a market
footprint that rivaled the GDP of a country like
Spain or Canada. It was immense. And for a while,
it worked beautifully. Until it didn't. Until
it didn't. Because leverage cuts both ways. If
you're leveraged 25 to 1, a tiny 4 % drop in
the value of your assets wipes out 100 % of your
equity. You're at zero. Gone. And that's where
that famous analogy comes from, isn't it? The
strategy was compared to picking up nickels in
front of a bulldozer. Yes. You make small, reliable
gains day after day after day. But there is a
very small, non -zero chance that one day the
bulldozer will move and you'll get completely
flattened. But for the first three years, from
94 to 97, that bulldozer was parked in the garage.
They were just crushing it. They were the kings
of the world. I mean, look at the early returns.
Year one. 21 % after fees. Year two, 43%. Year
three, 41%. Unbelievable numbers. They were the
envy of all of Wall Street. They felt completely
untouchable. So what changed? We get to 1997
and the seeds of destruction start to get planted.
Things start to look a little different. Well,
the first problem was, ironically, their own
success. Arbitrage opportunities are basically
market inefficiencies. Once a smart person finds
an inefficiency and exploits it, it tends to,
well... disappear. Because other people copped
to you. Exactly. LTCM was so successful, so famous,
that copycats started showing up. Other firms,
other banks, they all said, hey, we can do that
on the run, off the run bond trade too. So suddenly
there were too many people trying to pick up
the same nickels. That's exactly. And when that
happens, the spreads get tighter and tighter.
The opportunities get smaller. And you can see
it in their numbers. In 1997, their returns dropped
to 17 percent. Which for you or me, 17 percent
is a fantastic year. We'd be thrilled. We'd be
retiring. But for the geniuses in Greenwich charging
these massive fees. It was an embarrassment.
It was a failure. It barely beat the S &P 500
stock market index that year. They were under.
immense pressure, a lot of it internal, to keep
the magic alive, to keep posting those 40 % numbers.
And this leads to something called style drift.
I love this term because it sounds so harmless,
so academic, but it's actually incredibly dangerous.
It's a beginning of the end for so many great
investors. Style drift is what happens when you
move away from your core competency, your area
of expertise, because the returns just aren't
there anymore. You start betting on things you
don't understand quite as well. LTCM was the
king of fixed income arbitrage. They knew U .S.
bonds, European bonds, Japanese bonds, inside
and out. But suddenly they're looking at other
stuff. That's right. They started moving into
equity volatility, merger arbitrage, and... this
is the crucial part, emerging market debt. They
were buying Russian bonds, Brazilian bonds, pie
bonds. And this was a source of internal debate.
Myron Scholes himself, the Nobel winner, actually
warned the other partners about this. He said,
and this is a quote, that they had no informational
advantage in trading things like the Norwegian
krona. But they did it anyway. They did. They
needed the yield. They felt their models, their
mathematical approach could be applied to anything.
If the math works for U .S. treasuries, why wouldn't
it work for a currency in Norway? It shows a
certain level of hubris, a belief that math trumps
local knowledge. It's pure hubris. And there's
another story from this period, this UBS tax
scheme, that I think really shows their mindset.
It's a clear sign that they were getting too
cute for their own good. What was that about?
It was financial engineering at its absolute
peak. The partners wanted to treat their income
as long term capital gains to pay a lower tax
rate, about 20 percent versus almost 40 percent
for ordinary income. So they set up this incredibly
complex call option structure with the Swiss
Bank UBS. I'm not even going to pretend to understand
the details. The details are a nightmare. But
the takeaway is that they were using their immense
brainpower not to find value in the market, but
to game the tax code. It just showed a belief
that they could outsmart any system, whether
it was the market. Or the IRS. And it was a distraction.
A huge one. And it brought UBS way too close
to them, which would come back to haunt the bank
later. Before we get to the final crash, we have
to talk about one specific trade that went wrong.
The Royal Dutch Shell trade. This one feels like
the perfect microcosm of their entire model failing.
It is the classic example. So Royal Dutch and
Shell were at the time a dual listed company.
Basically two different stocks, but for the same
underlying company. The economic value of the
whole enterprise was split 60 -40 between them.
So theoretically, the two stocks should move
in perfect lockstep. They should, right. If the
company makes more money, both stocks should
go up by roughly the same percentage. But for
historical reasons, they didn't. They traded
at different prices. Royal Dutch consistently
traded at a premium to show. And LTCM looked
at this and their model screamed inefficiency.
Their model screamed, this is wrong. Matt says
these prices should converge. So they put on
a massive trade. They bet $2 .3 billion that
the spread would close. They shorted the expensive
Royal Dutch stock and went long the cheaper shell
stock. A classic convergence trade. What happened?
The market decided it didn't care about their
math. The premium didn't shrink. It widened.
Dramatically. It went from about 8 or 10 percent
to over 22 percent. So the trade went completely
against them. Completely. And they lost hundreds
of millions of dollars on that one trade alone.
It was a brutal lesson. It really is the old
John Maynard Keynes saying, isn't it? The market
can remain irrational longer than you can remain
solvent. Precisely. Their model said, this must
happen. And reality said, yeah, maybe, but not
today. And not before you go broke. Which brings
us to the really big question, the blind spot.
We talked about the geniuses, the Nobel winners,
the supercomputers. How did they miss this? How
are their models so fundamentally wrong? It really
comes down to one thing, data, or more specifically,
a lack of it. Their primary risk model was something
called value at risk or VAR. VAR? I've heard
of this. Most banks use some version of it. It's
a model that tries to calculate the maximum amount
of money you might lose on any given day based
on historical patterns. Okay, based on historical
patterns, that sounds reasonable. It is reasonable
if, and this is a very big if if you use enough
history, the fatal flaw, the blind spot for LTCM,
was that their models were largely built on data
from the previous five years. Five years, that's
it, from what, 93 to 98? Basically, yes. And
what was happening in the early to mid -90s,
it was a generally calm, steadily rising bull
market period. Right. Not a lot of volatility.
Very little. By using only five years of data.
They completely, totally excluded the 1987 stock
market crash. They excluded the bond market crisis
of 94. They excluded the 1917 Russian default,
which might have been a useful thing to have
in their models. So their models basically assumed
that a major global crash was impossible because
it hadn't happened recently. Their models assumed
it was a statistical impossibility. The historian
Neil Ferguson had this absolutely brutal quote
about it. He said, the Nobel Prize winners had
known plenty of mathematics. but not enough history.
Ouch. That's a perfect summary. It is. Their
models predicted that the kind of daily loss
they eventually suffered in August 98 was what's
called a 10 -sigma event. It was an event that
should happen only once in the entire life of
the universe. And yet it happened on a Tuesday.
Exactly. Because in the real world, financial
markets don't follow a perfect bell curve. Real
life has fat tails. Okay, fat tails. Explain
that. So think of a normal bell curve. In a normal
distribution, the tails... The extreme events
way out on the left and right are very, very
thin. They almost never happen. In financial
markets, the tails are fat. Crashes, panics,
defaults, pandemics. These extreme universe -ending
events happen way more often than a standard
statistical model predicts. And LTCM bet their
entire firm and $120 billion of borrowed money
that the tails were thin. They bet the farm on
it. And then in August 1998, they found out just
how fat those tails could be. The perfect storm
arrived. And it started in Russia. It started
in Russia. On August 17th, 1998, the Russian
government defaults on its domestic debt. Now,
hold on. Why was this such a massive surprise?
I mean, governments go broke sometimes, right?
They do. But they usually default on debt issued
in a foreign currency, like U .S. dollars. The
conventional wisdom at the time was that a sovereign
nation would never default on debt issued in
its own currency. Because they can just print
more money to pay it off. Right. It would cause
hyperinflation, sure, but they wouldn't technically
default. Russia proved that entire school of
thought wrong. They just said, nope. We aren't
paying. And that one event sent shockwaves through
the entire global system. It triggered a global
panic. I mean, a real visceral panic. Investors
everywhere woke up and collectively realized
the world was a much more dangerous place than
they thought. And when investors get scared,
they all do the exact same thing. Flight to quality.
Flight to quality. They sell anything that looks
even remotely risky. Emerging market bonds, junk
bonds, corporate bonds. Anything with hair on
it. They sold it all. And they poured all of
that money into the safest, most liquid asset
on planet Earth. Brand new. On the run U .S.
Treasury bonds. Wait a minute. That sounds familiar.
That's the exact asset LTCM was shorting as the
expensive side of their trade. You nailed it.
LTCM was fundamentally betting that the spread
between the risky stuff and the safe stuff would
shrink. Instead, because of this global panic,
that spread blew out to historic widths. The
safe bonds they were short got massively, insanely
expensive because everyone in the world wanted
them. And the illiquid risky bonds they owned
got dirt cheap because no one wanted to touch
them. So every single one of their core convergence
trades went the wrong way at the exact same time.
Every single one. The fundamental assumption
of their models was that all these different
trades were uncorrelated. But in a crisis, that's
not true. In a crisis, the only thing that rises
is correlation. Everything you own goes down
and everything you're short goes up. And to make
matters worse, Salomon Brothers, Merriweather's
old firm, had just decided to exit the arbitrage
business right before this in July 98. That was
just the worst possible luck. It was the nail
in the coffin. Salomon had a portfolio that looked
almost exactly like LTCM's. When Salomon started
to liquidate their positions, they were selling
all the same things LTCM owned, which pushed
the prices down even further. faster it was like
a run on the bank but the bank was the entire
global bond market it was there was no liquidity
no bids they were trapped so let's look at the
damage the numbers are just breathtaking august
of 1998 their losses were 1 .85 billion dollars
in one month and it gets worse September starts
and the equity in the fund just evaporates. It
drops from $2 .3 billion at the start of the
month to just $400 million by the third week.
And remember the leverage. As their equity base
shrank to almost nothing, their leverage ratio
just skyrocketed. It went from 25 to 1 to over
250 to 1. 250 to 1. That's not investing. That's
not even gambling. That is just pure, desperate
prayer. And by this point, the sharks were circling.
The rest of Wall Street could smell blood in
the water. Other traders knew LTCM was in deep
trouble. They knew LTCM had to sell their positions
to meet margin calls. So what do you do? You
front run them. You sell the same things before
they do, driving the prices down even more, forcing
them to take even bigger losses when they finally
have to sell. It's a brutal, vicious death spiral.
Yeah. And they were caught right in the middle
of it. So this is it. The fund is collapsing.
And now we get to the bailout. And this is the
part of the story that really highlights how
dangerous this whole situation had become. It
wasn't just that some rich guys in Connecticut
were losing money. The Federal Reserve got involved.
Why? Systemic risk. That's the phrase you'll
hear over and over. LTCM was so deeply interconnected
with every major investment bank on Wall Street.
They had those trillions of dollars in derivative
contracts. If LTCM just collapsed overnight and
defaulted on all those contracts, they would
have left massive. gaping holes in the balance
sheets of Merrill Lynch, Goldman Sachs, UBS,
JP Morgan, everyone. It would have been a domino
effect. One falls, they all fall. The Fed was
terrified it would freeze the global financial
system. That credit would just stop flowing between
banks, that markets would crash. It was a genuine
fear of a 1929 style event. So on September 23rd,
1998, the New York Fed calls a meeting. And it
wasn't just a meeting, it was a summons. They
basically locked the heads of all the major banks
in a conference room at the Federal Reserve Bank
of New York and said, we have a problem. But
before that final meeting, there was this incredible
moment where Warren Buffett almost bought the
whole thing, right? Yes. This is one of the great
what -ifs in financial history. Warren Buffett,
along with Goldman Sachs and AIG, made an offer
to buy out the partners and take over the fund.
They offered $250 million for the partners' stake.
$250 million? They had started the year with
nearly $2 billion of their own money in there.
It was pennies on the dollar. It was a total
humiliation. But it was also the only offer on
the table. And Buffett, being Buffett, put a
very specific condition on it. He gave them less
than one hour to decide. One hour. to decide
the fate of their entire firm. He didn't want
to get into a negotiation. He faxed them the
offer and said, you have until this time to say
yes or no. But apparently the structure of the
offer was complicated, or Merriweather couldn't
get the legal sign off in time. Whatever the
reason, the hour lapsed. The deal died. So they
were left with the Fed, with the government.
Well, with the Fed playing chaperone. This is
an important distinction. The Fed didn't want
to use public money. This wasn't a taxpayer bailout
like we saw in 2008. The Fed's role was to act
as an organizer or maybe an enforcer. They basically
told the banks, you guys created this monster
by lending him all this money. You enabled them.
So you guys need to fix it. If you don't all
chip in to save this fund, you are all going
down with it. That is some serious arm twisting
from the central bank. It worked. 14 banks agreed
to inject $3 .6 to $5 billion of new capital
into the fund to keep it afloat. In exchange,
they effectively took 90 % ownership of LTCM.
But not everyone played ball, did they? There
was a famous holdout. Bear Stearns. Bear Stearns
declined to participate. They did. They were
the clearing agent for LTCM, which meant they
had a lot of exposure already. They refused to
put any new money into the pot. They essentially
said, we've got enough risk, thanks. Wow. That
is just rich with irony, considering what happened
to Bear Stearns almost exactly 10 years later
in 2008. It is. A lot of people on Wall Street
remembered that moment when Bear Stearns came
asking for help in 2008. Let's just say they
didn't have a lot of friends left in the room.
So the banks put the money in. They stabilized
the fund. What happened to the partners? The
dream team. Meriwether, Scholes, Merton. They
were completely wiped out. They had $1 .9 billion
of their own personal money invested in the fund.
All gone. All gone. They were left with a tiny
sliver of equity that was basically worthless,
consumed by the debt. They lost their personal
fortunes. They lost their reputations. It was
a total and complete financial ruin for them.
But the banks, the ones who put up the bailout
money, they eventually got paid back. They did.
And then some. Once the immediate panic subsided
and that flight to quality reversed, those convergence
trades actually started to work again. The spreads
started to close. The liquidation of the fund
was orderly. By early 2000, the fund was completely
dissolved and the banks got all their money back,
plus a small profit. So in the end, disaster
averted. The system was saved. In the short term,
yes, the immediate fire was put out. But in the
long term, no. Maybe not. The solution might
have planted the seeds for an even bigger crisis
down the road. Okay, this brings us to the analysis,
the aftermath. What did we learn from this? Or
maybe, what did we fail to learn? I think the
single biggest concept that comes out of this
is moral hazard. Explain that for us. Moral hazard
is the idea that if you protect people from the
consequences of their risks, they will naturally
take even bigger and crazier risks in the future.
By orchestrating this private sector rescue,
The Fed, and specifically the chairman at the
time, Alan Greenspan, signaled to the market
that if a financial firm is too big to fail,
the Fed will always step in and organize a lifeboat.
This is the famous Greenspan put, right? Exactly.
It's the belief that there's a safety net underneath
the market provided by the central bank. And
it arguably set the stage for the massive excessive
risk -taking we saw in the housing market that
led to the 2008 crisis. Banks thought we can
lend a risky hedge funds. We could load up on
subprime mortgages because if it all blows up,
the Fed will save us. So the rescue itself created
a bigger problem. Many people argue it did. And
what about the players? Surely Merriweather and
the Nobel winners retired to a quiet life of
teaching and writing their memoirs. You would
absolutely think so. You would think after a
humiliation of that magnitude, you'd never show
your face on Wall Street again. But no, John
Merriweather launched a new fund. JWM Partners
in 1999. You are kidding me. Less than a year
after the collapse. Not even a year. And guess
what strategy he used in his new fund? Please
don't tell me it was the same one. It was the
exact same strategy. Fixed income arbitrage,
just with slightly less leverage. And how did
that one go? It actually worked pretty well for
a while. Yeah. Until the 2008 financial crisis
hit. And then JWM Partners. lost 44 % of its
value and had to shut down. It's unbelievable.
It's like they were so convinced their model
was right that 98 was just a fluke, a one -time
thing. It suggests a real addiction to the model,
a core belief that this time is different or
we've fixed the bug. They just couldn't let it
go. And what about the banks involved? UBS took
a huge hit, right, from that tax scheme. They
did. The chairman of UBS was forced to resign.
The bank lost nearly $800 million, mostly related
to those clever tax schemes and the put options
they'd written for LTCM. It was a career ender
for a lot of very senior people. Let's just tally
the final bill on the fund itself. The total
loss was $4 .6 billion. How did that break down?
The sources show about $1 .6 billion was lost
in swaps, $1 .3 billion in equity volatility
trades. You know, what's really interesting is
that only 430 million was actually lost in Russia
directly. Wow. So the trigger event, the Russian
default, was actually a pretty small part of
the total loss. A tiny part. It wasn't the default
that killed them. It was the ripple effect. The
global panic, the flight to quality, and most
importantly, the liquidity drying up. That's
what killed them. You know, there's a saying
that liquidity is like oxygen. That's perfect.
You don't notice it at all when it's there. You
take it for granted. But the second it's gone,
it's the only thing in the world that matters.
And LTCM suffocated. So we've unpacked the rise,
the strategy, the spectacular crash, and the
controversial bailout. When you step back and
look at the whole story, what is the big takeaway
for you? If you had to summarize the lesson of
LTCM in just one thought. For me, it comes back
to what I said at the start. It's the profound
difference between intelligence and wisdom. These
men were, without question, some of the most
intelligent people ever to work in finance. They
could calculate the price of a complex derivative
to the tenth decimal place in their heads. But
they lacked the wisdom to understand that the
real world doesn't always follow the clean, elegant
rules of mathematics. They mistook their map
for the actual territory. I love that phrase.
The map is not the territory. Just because your
model, your map says a 10 -sigma crash is impossible
doesn't mean the market can't crash. And more
specifically, I think it's the ultimate cautionary
tale about the danger of leverage. Leverage doesn't
make you a better investor. It just magnifies
your outcome. If you're right, you win big. If
you're wrong, you get wiped out. They were smart
enough to be right 99 % of the time. But leverage
meant that the 1 % of the time they were wrong,
it was fatal. And history. You have to look at
more than just the last five years of data. Always.
Yeah. History is a long, messy, complicated book.
And if you only read the last chapter, you are
absolutely going to be surprised by the plot
twist. So before we wrap this up, I want to leave
our listeners with one final provocative thought
to chew on. We mentioned that Meriwether started
a second fund that failed in 2008. But the source
material notes that he launched a third fund
in 2010. JM Advisors Management. Yeah. Unbelievable.
Like using the same basic strategy all over again.
He just can't quit it. It raises a really fascinating
question, I think. Is the allure of this kind
of easy, mathematical, scientific money so powerful
that even a $4 .6 billion failure, a global public
humiliation, can't break the addiction? And then
you have to think about today's market. Right.
It is completely dominated by algorithmic trading,
high frequency trading, AI models making decisions.
We have faster computers and way more data than
they ever did. You do. But do we have more wisdom
or have we just built a bigger, faster, more
powerful bulldozer? If LTCM could almost break
the world in 1998 with, you know, Excel spreadsheets
and telephones, what happens when the algorithms
that run our entire market today all decide to
rush for the same exit at the exact same millisecond?
That is a terrifying thought. The fat tail might
be even fatter next time. On that cheery note,
thank you for joining us on this deep dive into
the rise and spectacular fall of long term capital
management. It's a story of genius, ruin and
the razor thin line that separates the two. Thanks
for having me. It was great to talk through.
We'll see you on the next deep dive.