The Rise and Fall of Long-Term Capital Management: Insight from Roger Lowenstein - Essay Sample

Introduction

"When Genius Failed: The Rise and Fall of Long-Term Capital Management" by Roger Lowenstein is a book that details the rise and fall of a fund that was at its time, the largest; Long-Term Capital Management. According to the Book, important personalities and Wall Street played a significant role in the rising and falling of the fund. The author of the book is an American financial journalist and writer aged 66 years with extensive experience having been reporting for the Wall Street Journal for over a decade. Roger Lowenstein has also been a frequent contributor to the New York Times and New Republic media houses.

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Summary of Key Concepts The first chapter of the book focuses on the origin of Long-Term Capital Management, Hedge fund and major stakeholders whose contributions were vital for the success of the fund. John Meriwether, a Solomon Brothers former trader, founded the fund. The author explores the arbitrage-trading concept and its application by Merewether at Solomon Brothers. The concept entails the identification and exploitation of the spread between futures and the underlying bonds. They hoped that then spreads would eventually converge to the maturity of the bond. Lowenstein also explores, in chapter one, the role that academia had on trading. Meriwether started the Bond-Arbitrage Group, which consisted of smart academia like Black Scholes the inventor of option pricing model.

The second chapter of the book explores the key features of hedge funds that are responsible for its popularity during the formation of LTCM. They were largely considered private and unregulated because they did not require registration with the Securities Exchange Commission (SEC) and had no restrictions on amounts they were allowed to borrow. According to the author, an increasing number of Americans owned investments during this period. The period also experienced rising stock prices and growth in the number of wealthy people (Lowenstein, 2002, p. 35). The high number of wealthy people meant that they wanted where to invest their funds and the hedge funds provided them with a solution.

The concepts of financial models are highlighted in the book together with their application in investment decisions. The application of models such as value-at-risk, Black Scholes, and others in the determination of pricing of securities and identification of models was a critical part of arbitrage trading and the Long-Term Capital Markets. It seemed that the models had positive outcomes for the LTCM during the first four years. This is because appropriate bonds and securities bore higher returns. Lowenstein (2002) notes that LTCM had positive returns of 28% and 59% in its first and second years of operation correspondingly.

In chapter 7 of the book, which marks the beginning of its second part, Lowenstein provides accounts of the limitations of the financial models used in trading. The crumbling of the LTCM began in 1998 at a time when it made the decision to short significantly large amounts of equity (Lowenstein, 2002, p. 130). The Black-Scholes model was used to derive the prices of equity vol. The model indicated that they were mispriced. The Long-Term Capital Market equally relied on the Mortenian perspective, which indicated that markets are efficient while prices adhere to normal distribution. According to the author, it is the decision to trade in 'equity vol' that for the LTCM in a disastrous road. The models did not indicate that it was almost impossible to lose everything within a year. they indicated that the most that an investor could lose in a day was $35. According to Lowenstein (2002, p. 154), LTCM lost a whopping $533 million, which was equivalent to 15% of its capital in one day.

Reading the book gives a perception of irrational behavior of human beings and a view that contrary to the proposal by the finance theory, markets are not efficient. The assumptions, according to the models, were that markets are efficient and that day always reverts to a natural position through rational investors' reactions. The Assumption informed LTCM's 1997 decision to invest in equity vol at the time of the Asian crisis. It believed in the morning that indicated it was the right time for investing in large amounts of equities. Disappointingly, the market did not return to normalcy, which made LTCM to suffer losses for a number of months. It was the first time the fund had suffered losses since its formation. According to the author, John Keynes' argument that "markets can stay irrational longer than you can remain solvent" held in the situation (Lowenstein, 2002).

Lowenstein emphasizes the concept of investment being purely scientific as well as an art. Therefore, an investor must be rational and not rely solely on science as per the models but must also use common sense together with science to make a reasonable investment decision. The fund relied solely on mathematical models. For instance, at the time of the Asian crisis, the fund made a decision to short large amounts of equities despite the fact that common sense would dictate that, at a time of a crisis, investors are supposed to sell the equities and invest in bonds, which are safer.

In conclusion, the role of the Federal Government and other regulatory bodies in the financial system is explored in the book. In particular, Lowenstein holds the Federal Government label of being reactionary and focusing on intervention measures rather than prevention measures. According to the author, the Fed waited until the fund was on the brink of collapsing before it brought in banks together to save it. He argues that more effort should be put on prevention rather than an active intervention. Lowenstein disagrees with the bailout of LTCM in chapter 10 of the book. He notes errors and reckless risk-taking by the fund who are responsible for the near collapse of the hedge fund. According to him, LTCM should not have been bailed out since that would have sent a message to investors and institutions about the high prices they would pay for making imprudent risk-taking decisions. Lowenstein advocates for increased regulation of hedge funds to ensure that there is enhanced disclosure of derivative products to limit their exposure.

Analysis

Arbitrage Trading

The purchasing and selling of assets for the purposes of benefiting from the differences in the price of the assets between markets is referred to as arbitrage. Arbitrage is one of the concepts that appears prominently in the book, "The Rise and Fall of Long-Term Capital Markets". The Foundation of LTCM was on arbitrage trading. Several authors have explored the concept. For instance, Shleifer, and Vishny (1997) notes that a significant amount of capital and high leverage commitment is required to start fixed-income arbitrage trading. Opportunities from arbitrage trading arise from asymmetry of information in the financial markets. When more stakeholders in the financial markets are more informed on the pricing policies and arbitrage trading strategies the profits from arbitrage trading tend to diminish. It was the case with LTCM when the market got flooded with investment Banks seeking opportunities in arbitrage bond trading (Lowenstein, 2002, p. 104). Arbitrage can become in ineffective in extreme circumstances where prices may move far away from values that are considered fundamental.

Bailing out of Collapsing Financial Institutions by the Government

The role of government in enhancing stability of the financial system has been addressed in the book. According to Lowenstein (2002), the government should undertake measures that prevent financial crisis instead of intervening when such crises arise. Regulations need to be put in place to ensure enhanced stability of the financial system. Lowenstein (2002) refutes the claim that financial systems have the ability to self-regulate and terms it unrealistic. The role of the central Banks as last resort lender during financial crises cannot be understated Herr (2014). Nevertheless, the Fed still has a great responsibility in correcting fundamentals of financial systems. The government and the central banks can do more than bailing out struggling firms in order to prevent financial crises.

Lowenstein could not understand the reasons for bailing out institutions that had engaged in imprudent and reckless risk-taking. Studies have indicated an association between bailouts and moral hazard. According to Rosenblum et al. (2008), bailouts that have been done previously by the Fed who are part of a tradeoff solving choosing between collapse of an entire financial system and a moral hazard. Arguments against bailing out of collapsing institutions as a result of their reckless decisions are reasonable since it will deter such institutions from making such imprudent risk-taking decisions. The near collapse experience of LTCM was a result of imprudent risk management and as such, it was wrong for the Fed to facilitate its bailout.

Regulation of Hedge Funds

The fact that hedge funds were unregulated and they were allowed to borrow as much as they wanted and they could invest in whichever security they wanted. According to Lowenstein (2002), there is a need to regulate hedge funds and investment banks. Lack of regulation leads to toxic investments in securities. The author notes there were limited disclosure requirements on hedge funds. At the same time, banks had no restrictions on actual exposures. The Federal Government and other regulatory bodies seem to have double standards for banks. Regulation of hedge funds helps in improving disclosures on derivatives and other securities. Banks also need regulation to keep their exposure within acceptable limits. Therefore, the Fed was right to impose regulations on LTCM and other hedge funds.

Investment Trading

Lowenstein has talked about the application of financial models and their limitations in his book. He notes that the crumbling of LTCM can be traced to the failure of financial models. The models help with valuation, pricing, and risk determination. However, the models are not intended to replace the decision maker. According to Le Bellac and Viricel (2016) it implies that, as much as the scientific elements of their models are important, the input of decision-makers, which considers common Sense and reasonableness, have to be incorporated. Modelling data alone has limitations and as such, total reliance can be hazardous to an institution.

References

Lowenstein, R. (2002). When Genius Failed: The Rise and Fall of Long-Term Capital Management. New York: Random House Inc.

Shleifer, A. and Vishny, R. (1997). The Limits of Arbitrage. Journal of Finance, 52(1).

Herr, H. (2014). The European central bank and the US Federal Reserve as lender of last resort. Panoeconomicus, 61(1), pp.59-78.

Le Bellac, M. and Viricel, A. (2016). Deep Dive into Financial Models: Modeling Risk and Uncertainty. World Scientific Publishing Company.

Rosenblum, H., DiMartino, D., Renier, J. and Alm, R. (2008). Fed Intervention: Managing Moral Hazard in Financial Crises. FRBSF, 3(10).