Book Review: When Genius Failed ; the Rise and Fall of Long Term Capital Management

It isn’t like this hasn’t happened before. In 1907 US I banks went bankrupt, Wall Street was cleaned up and subsequently the US became the 20th Century King of the Jungle. In 1966 almost all the financial companies went bankrupt in Japan, the Japanese then cleaned up the system and Japan became the world’s best growth economy for the next 20 years! In 1990s the Japanese propped up banks and, they did not let their banks fail, this led to the creation of zombie banks and major problems for Japan which still haunts it. The same happened in the 1970’s in the US and this was a lost decade for the US with high inflation rates and troubles galore. Even, the dot com burst, all this happened but the world did not end! When capitalism goes awry you can’t bring in socialism all of a sudden, bankruptcies teach the capitalists to respect the markets and accept their failures with humility. So, this current performance is just desperation as the US doesn’t have any bullets left after shooting in the dark.

Mr. Brown readily admitted that he was not at ease discussing the most recent approaches to risk reduction or hedging. He had received his MBA from Harvard in the 1960s and had spent most of his career working for a company that had little international exposure. Moreover, he was not familiar with derivatives such as currency options, which until recently were not widely traded. However, Mr. Brown had recently hired an assistant, Mr. Dan Pross, who had some knowledge of hedging and derivatives. As a student at UCLA, Mr. Pross had traded various types of derivatives for his own portfolio and was familiar with how they were traded. Although Mr. Pross did not have a finance background, he was, in Mr. Brown’s opinion, extremely intelligent and highly capable. Mr. Brown suggested that Mr. Pross make a presentation to the senior management on the use of derivatives to reduce risk.

The significant finding from this article is that the world of finance is a very strange world. This world can offer opportunities to many, and at the same time, it can prove to be a mess for the others. Many people are not corrupt in their person, but by being negligent or by being careless, they fail at doing their duty successfully at some points in time. However, what the article talks about is the complete picture. Steven A Cohen faced a problem. He got entangled in an enormous financial mess.

Little regulation in the banking industry allowed for risky investments and banks to grow out of proportion ultimately causing the Great Recession. The Great Recession of 2008 had many parallels with the Great Depression of 1929 and when compared it can be concluded that history repeats itself when the necessary precautions are not put into place. The Great Depression and the Great Recession each followed periods of exceptional business investment, productivity growth and economic gain. Interestingly preceding both these events too much leveraging was taking place leading to both of the collapses. Although leverage can be a good financial strategy, in the cases of the Great

“The single greatest contributor to financial crises is the Federal Reserve manipulating interest rates in ways that distort the true price of capital.” (Kibbe, 2011) The distortion of numbers created a false sense of overinvesting when in actuality they are responding to false economic signals. Just like the Great Depression, the stock market was not the only thing that was effected, unemployment doubled and debt rose from 66% to 103%. The housing market also took a hit falling 30%.

They’re either really volatile or not so much volatile. What is also presented is a way to fix how financial institutions are regulated. Paccagnella states “A common element to several alternative solutions to command & control approach is the partial re-allocation of regulatory power from Central State to other subjects…defined as auto-regulation and co-regulation.” Further into the book Paccagnella discusses how making institutions regulate themselves and have a greater regulation oversee, could potentially attract these large financial institutions and begin to take up some forms of more

Lewis focuses the book from the perspectives of leaders from three investment firms that saw the future of the financial market and its inevitable collapse in the early 2000’s. Though given the opportunity, these men were not heroes. Instead of spreading the news and rebelling against Wall Street for infecting the market, they were more interested in making a profit. Michael Burry was focused on his company Scion Capital and buying credit default swaps to make both him and his investors’ money. Charlie Ledley and Jamie Mai focused on betting against Wall Street and ultimately in the end made fortunes.

| Attempt made to analyse a financial issue incorporating discipline knowledge and theory, but only minimal understanding of the issue is evident; Analysis addresses some aspects of the issue, but key elements are not

Mr. John Meriwether who had established fame as a pioneer of fixed- income arbitrage at Salomon Brothers in the early 1980s, and for having built Salomon’s profitable Fixed-Income Arbitrage group headed LTCM. Before leaving in 1991, John Meriwether had been Vice Chairman of Salomon Brothers in charge of the firm’s worldwide Fixed Income Trading, Fixed-Income Arbitrage and Foreign Exchange businesses. Several of LTCM’s founding principals had, years earlier, been recruited to Salomon’s Fixed-Income Arbitrage group by Meriwether, and had held senior positions at Salomon. In 1994, Salomon Inc. disclosed that its proprietary trading activities had generated more

LTCM’s board of directors included many geniuses in from the financial world, who collectively created complex models allowed them to calculate risk of securities much more accurately than others. LTCM’s trading strategy was featured by the divergence in price between long-term U.S. Treasury bonds. It shorted the more expensive “on-the-run” bond and purchased the “off-the-run” security at the same time to exploit the price divergence. In order

“Too Big to fail” was first known in a 1984 Congressional hearing where Congressman Stewart McKinney discussed the Federal Deposit Insurance Corporation’s intervention with Continental IIIinois. The idea interprates that certain financial institutions are so large, if any of them fails, it will bring an unexpected disastrous effect to the economy. As we all known, the 2008 financial crisis had arose the “too big to fail” problem to the peak controversial point. Banks, insurance companies, auto companies are part of the big company industry. They make profit by creating and selling complicated derivatives and trading loans, commodities and stocks. When the big economic environment is prosperous, those big companies make a competitive

Established in January 1999, Pine Street Capital (PSC) was a market-neutral hedge fund that specialized in the technology field, facing market risk and trying to decide whether and which way to use in order to hedge equity market risk. They choose technology sector because the partners of PSC felt that they have enough ability to evaluate this sector and specially be good at picking out-performing stock. Short-selling of NASDAQ and options hedging strategy are the two major hedging choices for PSC. Either strategy has its own advantages in different economic periods and conditions. The fund has just through one of the most volatile periods in NASDAQ 's history, and it was trying to decide whether it should continue its risk management

A large financial firm presents systemic risks due to its “interconnectedness, leverage, and its tendency to finance long-term assets with short-term debt.” The systemic risk associated with Money Market Mutual Funds, became glaringly obvious when Reserve Primary Fund, a MMMF, had “broken the buck”. This drop in value of shares from $1.00 to $0.97 spread panic to other MMMFs and created the systemic risk that “the failure of a single entity…can cause a cascading failure” of the entire financial system. Another systemic risk posed by MMMF is that associated with the withdrawals by investors from MMMFs that would lead to a freezing of the markets. This was especially prominent in the short-term investment markets. When $200 billion were withdrawn from “prime MMMFs”, the short-term interest rates immediately spiked. This spike in short-term interest rates posed another systemic risk in that these interest rates affect the entire market and not just one industry or entity. Another systemic risk issue that arises from MMMFs stems from the very essence of these instruments. MMMFs attract risk-adverse

The important implication of this is that investors cannot consistently outperform the market, and if they do it is purely through luck. With competition for information reaching new heights, professional managers face greater difficulties in attempting to outperform each other. If these professionals are unable to consistently beat the market, there remains little hope for the average investor.

Economic derivatives could be so unsafe that they could even a great cause of financial disasters. This is because many investors turn to financial derivatives market to direct them into future funding, rather than of observing at the genuine market. This can lead to market distortions and hence can be extended to other parties of the market connected in the market and thus financial position of a country can be obstructed badly. Derivative instruments were created after 1970s as a way to manage risk and create insurance downside. They were created in response to the frequent oil market shocks, inflation and drops in the stock markets. Hence the initial intend was to defend against the risk and protect against the downside. However, the derivatives became speculative tools often used to take more risk in order to maximize profits and returns. Derivatives do ensure against the risk when used properly, but when the packaged instruments became too complicated that neither the borrowers nor the rating agencies understood them or their risk and hence the initial premise just failed. Not only did investors, like pension fund, got stuck holding securities that in reality turned out to be equally as risky as holding the underlying loans, bank got stuck as well. Banks held many of these instruments on their books as a source of fixed income requirements and hence using these derivatives instruments as a collateral. However, later it was found out that they had less