When Genius Failed summary

Hedge funds bet on tiny discrepancies between the present and future price of financial products, which means that they need large investments to make any significant profits.

Despite the huge funds they had received from their wealthy investors, it wasn’t enough. To earn the greatest profits, hedge funds need to leverage, i.e., they need to borrow in order to maximize their potential returns.

Many people believe that there is a gap between the knowledge and opinions of high-minded academics and the conditions of the “real world.”

This is no less true in finance. There is assumed to be a massive chasm between the professors and their theories and the real, dog-eat-dog world of trading.

In the 1990s it was hip to invest in hedge funds. People saw them as new, exciting, and above all incredibly profitable financial products. Many wealthy individuals and companies wanted desperately to get a piece of the pie.

Yet even in this love affair with hedge funds in general, LTCM stood out, both in terms of popularity and borrowing.

Despite the popularity of the academic models used by LTCM, they had one fatal flaw: human error.

The models assumed that the financial system was a rational, predictable entity directed by rational, predictable people. But it’s not. By our nature, humans are irrational and panic easily, a fact which caused enormous problems for LTCM.

The models that the academics and experts at LTCM developed were centered around the axiom that, if disrupted, markets will always revert to their natural position.

Think about it like a swing: you can push a swing and it will rise and fall until it eventually returns to its natural resting position. The same thing was supposed to happen with markets, according to the models.

According to LTCM’s models, the probability of losing everything in a single year was only one in a septillion (or ten to the power of 24). In other words, it was virtually impossible.

And yet, on 17 August 1998 the impossible happened: the Russian government defaulted on its debts and devalued its currency.

As LTCM started to topple, the banks, many of whom had recently acted against it, had a realization: “If this fund goes bankrupt, we lose our investments.” And because so many of them had invested in the fund, a collapse would wreck the market.

Many banks and investors began looking into ways of taking control of LTCM and rescuing it. LTCM wasn’t eager to let banks into the fund. They feared that if LTCM lost control, all its earnings were in danger. But as time passed, their position only worsened, and they were left with no other choice.