• “Long-Term, a bond-trading firm, was on the brink of failing. The fund was run by John W. Meriwether, formerly a well-known trader at Salomon Brothers. Meriwether, a congenial though cautious mid-westerner, had been popular among the bankers. It was because of him, mainly, that the bankers had agreed to give financing to Long-Term - and had agreed on highly generous terms. But Meriwether was only the public face of Long-Term. The heart of the fund was a group of brainy, Ph.D.-certified arbitrageurs. Many of them had been professors. Two had won the Nobel Prize. All of them were very smart. And they knew they were very smart. For four years, Long-Term had been the envy of Wall Street. The fund had racked up returns of more than 40 percent a year, with no losing stretches, no volatility, seemingly no risk at all. Its intellectual supermen had apparently been able to reduce an uncertain world to rigorous, cold-blooded odds - on form, they were the very best that modern finance had to offer. This one obscure arbitrage fund had amassed an amazing $100 billion in assets, virtually all of it borrowed… As monstrous as this indebtedness was, it was by no means the worst of Long-Term's problems. The fund had entered into thousands of derivative contracts, which had endlessly intertwined it with every bank on Wall Street. These contracts, essentially side bets on market prices, covered an astronomical sum - more than $1 trillion worth of exposure. If Long-Term defaulted, all of the banks in the room would be left holding one side of a contract for which the other side no longer existed. In other words, they would be exposed to tremendous - and untenable - risks.” - intro
• $1 invested in long-term capital management 4xed within 4 years, but 6 months later crashed and burned - interesting lessons about tail risks, leverage, and overconfidence in their rise & fall!

An Edge of PhD “Geniuses”

• “Pressed by his young traders, who simply wouldn't give up, in 1989 Meriwether persuaded Gutfreund to adopt a formula under which his arbitrageurs would get paid a fixed, 15 percent share of the group's profits.” - upset the rest of Salomon Brothers, especially trader Paul Mozer who used to be in arbitrage… “In 1991, a year after the storm over Hilibrand's pay, Mozer went to Meriwether and made a startling confession: he had submitted a false bid to the U.S. Treasury to gain an unauthorized share of a government-bond auction… Meriwether took the matter to Gutfreund. The pair, along with two other top executives, agreed that the matter was serious, but they somehow did nothing about it… A few months later, in August, Salomon discovered that Mozer's confession to Meriwether had itself been a lie, for he had committed numerous other infractions, too. Though now Salomon did report the matter, the Treasury and Fed were furious. The scandal set off an uproar seemingly out of proportion to the modest wrongdoing that had inspired it. No matter; one simply did not - could not - deceive the U.S. Treasury. Gutfreund, a lion of Wall Street, was forced to quit.” (Buffett had to take over as interim CEO and Meriwether had to walk away, now ready to start Long Term Capital Management unrestrained)
• “What Meriwether lacked, he must have sensed, was an edge… His solution was deceptively simple: Why not hire traders who were smarter? Traders who would treat markets as an intellectual discipline as opposed to the folkloric, unscientific Neanderthals who traded from their bellies?… Most Wall Street executives were mystified by the academic world, but Meriwether, a math teacher with an M.B.A. from Chicago, was comfortable with it. That would be his edge.” → he went out and recruited PhDs from MIT and Harvard to carry out this new strategy
• “Meriwether had taken it upon himself to set up a sort of underground railroad that ran from the finest graduate finance and math programs directly onto the Salomon trading floor. Robert Merton, the economist who himself would later become a consultant to Salomon Brothers and, later still, a partner at Long-Term Capital, complained that Meriwether was stealing an entire generation of academic talent.” - how the eggheads cracked - “At the end of 1994, Hans left Salomon to become a partner in Long-Term Capital's London office. It gives you an idea just how desirable it was to work for John Meriwether that to do so people quit jobs at the finest Wall Street firms, which paid them bonuses of $28 million.”

Long-Term Capital Management - Betting on Convergence & Efficient Markets

• “Essentially, two factors dictate a bond's price. One can be gleaned from the coupon on the bond itself. If you can lend money at 10 percent today, you would pay a premium for a bond that yielded 12 percent. How much of a premium?” - and two… “The other factor is the risk of default… The riskier the bond, the wider the spread - that is, the greater the difference between the yield on it and the yield on (virtually risk-free) Treasurys. Generally, though not always, the spread also increases with time - that is, investors demand a slightly higher yield on a two-year note than on a thirty-day bill because the uncertainty is greater.” - “he often bet that a spread-say, between a futures contract and the underlying bond, or between two bonds - would converge… if he had the capital to stay the course, he'd be rewarded in the long run, or so his experience seemed to prove. Eventually, spreads always came in”
• A main bet of theirs was that efficient markets would win out: “They believed, spreads between riskier and less risky bonds would tend to narrow. This followed logically because spreads reflect, in part, the uncertainty that is attached to chancier assets. Over time, if markets did become more efficient, such riskier bonds would be less volatile and therefore more certain-seeming, and so the premium demanded by investors would tend to shrink.” - dangerous way of thinking - “Backed by their models, they felt more certain than others did - almost invincible. Given enough time, given enough capital, the young geniuses from academia felt they could do no wrong, and Meriwether, who regularly journeyed to academic conferences to recruit such talent, began to believe that the geniuses were right.”
• Leverage & tail risk is a bad combo - “But there was a different lesson, equally valuable, that Meriwether might have drawn from the Eckstein business, had his success not come so fast: while a losing trade may well turn around eventually (assuming, of course, that it was properly conceived to begin with), the turn could arrive too late to do the trader any good-meaning, of course, that he might go broke in the interim.” (Keynes markets can remain irrational longer than you can remain solvent)

Leverage Their Capital 20 to 30 Times

• “Meriwether planned from the very start that Long-Term would leverage its capital twenty to thirty times or even more. This was a necessary part of Long-Term's strategy, because the gaps between the bonds it intended to buy and those it intended to sell were, most often, minuscule. To make a decent profit on such tiny spreads, Long-Term would have to multiply its bet many, many times by borrowing.” - how many times have we seen extreme leverage in these downfall stories?!
• “If you aren't in debt, you can't go broke and can't be made to sell, in which case "liquidity" is irrelevant. But a leveraged firm may be forced to sell, lest fast-accumulating losses put it out of business. Leverage always gives rise to this same brutal dynamic, and its dangers cannot be stressed too often.” → We’ve seen this as an issue in real estate with Zeckendorf and Macklowe, and it’s especially pronounced in the stock market where volatility & liquidity can lead to much faster losses as herd behavior accelerates in selling - Galbraith Great Depression (optimize for survival)

Little Understanding of How Meriwether’s Gang Actually Operated

• He wanted to raise an ambitious $2.5B fund and take 2 and 25% fees! - recruited Myron Scholes of the black scholes option pricing model to offer some legitimacy to their bond pricing strategy
• “The fact was, they had made a ton of money at Salomon, and investors warmed to the idea that they could do it again. In the face of such intellectual brilliance, investors - having little understanding of how Meriwether's gang actually operated - gradually forgot that they were taking a leap of faith.” → We see this again and again with bubbles, where the first crop of investors know an asset well but the final groups are more driven by FOMO and don’t feel the need to understand the business - Thorp: “Be aware that information flows down a food chain, with those who get it first eat and those who get it late being eaten”