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Because Of Fools Like You!

Since Nassim Taleb trashes Nobel prize winning economists Robert Merton and Myron Scholes so often in his books, I decided to look deeper into the disdain he harbors for these two men by reading Roger Lowenstein’s “When Genius Failed: The Rise And Fall Of Long Term Capital Management“.

In case you didn’t know, LTCM was a high-falutin’ hedge fund that racked up huge investment gains for four years in 1998 before exploding with a bang that almost shook the financial system to its core. As the following graph shows, if you were privileged enough to have invested $1 in LTCM in March 1994, you would have quadrupled your money by March 1998. Four hundred percent in four years. W00t!

LTCM upside

But wait! Looky at how LTCM’s vaunted fund performed between March and October 1998. From $4 to $.25 in eight months. D’oh!


Mssrs. Merton and Scholes were a pair of highly regarded academicians hired by LTCM as the brains behind the mathematically elegant economic models that eventually drove the firm into the gutter. In addition to this dynamic duo, LTCM’s head honcho, John Meriwether, hired several MIT PhDs and a former federal reserve banker to round out his superstar roster. Even before LTCM’s performance began its mercurial ascent, all the big Wall St. banks were tripping over themselves to loan money to, and do business with, the wizards at LTCM.

As you might think, the LTCM partnership thought quite highly of themselves. Thus, they treated everyone else like shit – because they could. They were loaned money at rock bottom prices while charging astronomical fees for their money management “expertise“. Even though LTCM kept their numerous, obscure, huge, derivative-laden trade positions and their precious models secret, the greed of their investors and lenders allowed the elites to do as they pleased.

“There is no way you can make that kind of money in Treasury markets.” Scholes angled forward in his leather-backed chair and said, “You’re the reason—because of fools like you we can.” – Lowenstein, Roger (2001-01-18). When Genius Failed: The Rise and Fall of Long-Term Capital Management (Kindle Locations 693-694). Random House Publishing Group. Kindle Edition.

The LTCM success story began to unravel when Russia defaulted on their national debt in 1998. Since it was “unthinkable” that a nuclear power could ever default on its obligations, the panic quickly spread to other “supposedly uncorrelated” markets around the globe. Of course, the rational Merton/Scholes equations didn’t account for this irrational event. Because of their mammoth size, LTCM couldn’t dump any of their assets like the hysterical herd was doing. Everyone was selling and no one was buying – the market for LTCM’s holdings simply disappeared. LTCM stood by helplessly as their equity tanked faster than you can say WTF! Their fund lost an unprecedented $500M in one day- and they did that twice. Now THAT, takes genius.

Since LTCM was so intertwined with virtually every big player on Wall St., the US Federal Reserve feared that if LTCM went bankrupt the financial system itself could collapse. Thus, the public Fed ended up orchestrating  a 3.6 BILLION dollar bailout of the private LTCM by a consortium of Wall St. banks (better them than us taxpayers; but we would come to the rescue in the next panic, 10 years later in 2008). The same people whom LTCM treated like inferior beings had begrudgingly come to the rescue. Even though the LTCM partners were (thankfully) wiped out, the bailers ended up recouping their $3.6B over the next few years. But don’t think of them as heroes.  They only signed up for the bailout because they were terrified of sinking too; and their brazen disregard for how LTCM spent their money helped precipitate the meltdown in the first place.


Incredibly, after the bailout, the LTCM fatheads, who were superficially contrite in public, claimed that the panic was a fluke “10 sigma” event. They were (and perhaps still are?) convinced they could mathematically model the human race as a rational-thinking aggregate mass of matter whose “parameters” are dictated by the Gaussian probability density function. A subset of LTCM partners, spearheaded yet again by perpetual loser John Meriwether, started another hedge fund with more complicated models accounting for “fat tail” rare events, but, incredulously, still anchored on the utterly wrong Gaussian distribution. Somehow, they raised $250M from a fresh set of rich idiots.

People caught in such financial cataclysms typically feel singularly unlucky, but financial history is replete with examples of “fat tails”— unusual and extreme price swings that, based on a reading of previous prices , would have seemed implausible. -Lowenstein, Roger (2001-01-18). When Genius Failed: The Rise and Fall of Long-Term Capital Management (Kindle Locations 4176-4178). Random House Publishing Group. Kindle Edition.

As of today, both LTCM and the eggheads’ later fund, JWM Partners, don’t exist – poof!

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