phik

The week before last I read a short book, something of a lighter and fluffier complement to the backbreaking tome about the Federal Reserve. This one was about the rise and fall of a hedge fund called Long-Term Capital Management, which after a celebrated four-year run up — during which they gave investors a more than 300% return — lost $4.5 billion in about five weeks. Their stunning collapse threatened to bring down more than one of America’s largest banks, who had foolished allowed them to leverage their capital more than 30 to 1, with no oversight into their trading activities.

Why would they do such a thing? Because LTCM had two Nobel prize-winning economists on board, and a team of celebrated arbitrage traders. Everyone, including themselves, believed that they had solved the puzzle, and devised a foolproof strategy for trading in bonds — particularly new and not-widely-understood derivatives. They had complicated models by which they supposedly predicted to the nth decimal place the likelihood that any given trade will fail. Eventually, other arbitrage desks caught on to how these new markets worked, so their yields became steadily smaller. Instead of backing away to safer ground — or closing the fund and returning the money to their investors — LTCM leveraged even more, and the fund collapsed spectacularly. A representative quote:

“You take Monica Lewinsky, who walks into Clinton’s office with a pizza. You have no idea where that’s going to go,” Conseco’s Max Bublitz, who had declined to invest in Long-Term, noted. “Yet if you apply math to it, you come up with a thirty-eight percent chance she’s going to go down on him. It looks great, but it’s all a guess.”

I found it thoroughly fascinating, but it’s not for everyone. When I started talking about the book, Deb looked at me like I had a live hamster in my mouth.