We Study Billionaires - The Investor’s Podcast Network - TIP707: The Collapse of Long-Term Capital Management w/ Clay Finck

Starting point is 00:00:00 You're listening to TIP. Charlie Munger once said that smart men go broke in three ways. Liquor, ladies, and leverage. The story of long-term capital management is a case study in the third. In this episode, we're diving into the book When Genius Failed by Roger Lowenstein, which tells the incredible rise and catastrophic fall of one of the most famous hedge funds in history. Founded by Wall Street's brightest minds, including Nobel Prize-winning economists, long-term capital management seemed invincible, until it wasn't. Using complex mathematical models,

Starting point is 00:00:36 they placed massive, highly leveraged bets, convinced the market would always behave predictably. For four years, they raked in astronomical profits with almost no volatility, attracting capital from the biggest banks and investors in the world. But in 1998, a financial crisis exposed the flaws in their assumptions, triggering a collapse so catastrophic, that the Federal Reserve had to step in to prevent a broader financial meltdown. During this episode, we'll also explore the dangers of overconfidence, the illusion of diversification, and why excessive leverage can be a ticking time bomb. Markets don't always behave rationally, and as John Maynard Keynes warned, they can remain irrational longer than you can stay solvent.

Starting point is 00:01:22 During the last few minutes of the episode, I'll also be sharing details on a brand new, exclusive event that TIP will be hosting in the mountains of Big Sky, Montana, in September of 2025. So if small in-person gatherings are adventurous to you, then be sure to stick around until the end to learn more. With that, let's dive right in. Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Playfink. From 1994 to 1998, long-term capital management had been the envy of Wall Street, putting up eye-popping returns of more than 40% per year,

Starting point is 00:02:19 with no losing stretches, minimal volatility, and seemingly no risk at all. It was run by a number of geniuses with PhDs who would arbitrage the market and had decades of experience doing so. The fund amassed $100 billion in assets, with virtually all of it borrowed from bankers. Worse yet, they entered into thousands of derivative contracts, which made the firm endlessly intertwined with every bank on Wall Street. Since derivatives are another form of leverage, this gave the firm, and thus, the banks as well, more than $1 trillion worth of exposure. And if LTCM were to somehow fail, all of the banks would be left holding one side of a contract,

Starting point is 00:03:01 for which the other side no longer existed, leaving them open to untenable risks. Financial crises are as old as markets, but derivatives were relatively new, which helped lead to this House of Cards to stack up as high as it did. So how did prominent banks like Goldman Sachs, Lehman Brothers, and Merrill Lynch over-exposed themselves to this rather secretive firm? Why do they seem to think that 40% returns using leverage and derivatives were sustainable? This story was well covered in the book when Genius failed by Roger Lowenstein. Now, the face of long-term capital management was John Meriwether.

Starting point is 00:03:38 Meriwether was born in 1947 and was raised in a tight-knit community on the south side of Chicago. He was a great student, especially in mathematics, which was an indispensable subject if you're going to become a leading bond trader. He was also drawn to gambling, but only when he felt the odds were sufficiently shifted in his favor to give him an edge. He also got into investing early on as he and his brother made money in the stock market. Meriwether attended Northwestern University for his undergrad, then got his business degree at the University of Chicago and graduated in 1973. Then at the age of 27, he was hired on at Solomon Brothers.

Starting point is 00:04:16 In the mid-1960s, bond trading was really a dull sport. For the most part, investors would buy bonds and simply hold on to them until maturity while getting a steady income along the way. At this time, managing a bond portfolio or even trading bonds was a foreign concept. This all changed in 1971 when the United States announced that the dollar would be depegged from gold, ushering in a period of currency debasement and inflation, wrecking havoc on bond investors who were accustomed to stability. By the late 1970s, Solomon Brothers were slicing and dicing bonds in ways that would have been unimaginable just 10 years earlier.

Starting point is 00:04:55 The other big change was the rise of computers, making it easier to quickly price bonds accurately. Meriwether learned the art of arbitrage at Solomon Brothers in the late 1970s. The premise was simple. Let's say you have a U.S. Treasury bill that was trading at a slight discount to the futures price that wasn't that far into the future. The securities dealer, such as Solomon, was simply buy the treasury, short the future, and simply wait for the two prices to converge, as it was reasonable to assume that they ultimately would. Solomon really didn't care whether the price of the U.S. Treasury would go up or go down,

Starting point is 00:05:32 because it didn't matter. All that mattered was that eventually the relative prices between the spot and the future would ultimately converge, and that was the basic idea of arbitrage. Maryweather would set up his own bond arbitrage group within Solomon in 1977, which would have the model that long-term would use in the 1990s. They would often bet that the spread would close between the spot and the future price and bet that those two prices would eventually converge. By the early 1980s, Meriwether would become one of Solomon's sharpest traders, and in fact, one of his best skills was his ability to hire traders who were smarter than he was. That was his major edge. This applied both at Solomon and then later at long-term capital management. While most Wall Street execs were

Starting point is 00:06:19 mystified by the academic world, Maryweather used it to his advantage. He called Eric Rosenfeld and asked him to recommend students at Harvard Business School that he could look into hiring. Rosenfeld originally wasn't really interested in working with Maryweather, but just 10 days later, he was eventually hired on at Solomon Brothers. Maryweather would hire a number of others from the academic world, including Lawrence Hillibrand, which was probably the smartest of the bunch and had two degrees from MIT. They downloaded all the data they could find on bond prices, and they looked for inefficiencies in that market.

Starting point is 00:06:55 Since this was a smart and really logical group, and there were many inefficiencies in the market, they ended up making a ton of money for Solomon. And there was this interesting dynamic where because the Arbitrage group had just so much capital behind them, and these guys that Meriwether hired were just so smart, they just really didn't fit in with the rest of Wall Street. Maryweather served as the head of the group and sort of shielded them from the rest of the company, almost making everything they did entirely secretive. Despite their amazing ability to find inefficiencies in the market, some of them could barely hold a normal conversation. The secretive dynamic of the Arbitrage Group fueled resentment

Starting point is 00:07:37 from other departments as they couldn't learn more about what the group was up to. As the Arbitrage Group made more and more money, Solomon opened the reins for them to invest more capital, and Meriwether gained command over all bond trading, including government bonds, mortgages, high-yield corporate bonds, and more. Soon enough, the Arbitrage Group was making up a greater and greater share of Solomon's business as other departments struggled. In 1987, Solomon was the target for a hostile takeover, and Solomon fined off the hostile bidder by selling control of the firm to a distinctly friendly investor named a Warren Buffett, and Buffett would also join the board of Solomon Brothers.

Starting point is 00:08:19 That year was also the year of the 1987 Flash Crash, which led to Arbitrage's portfolio dropping by $120 million in just one day, and others at Solomon weren't quite sure what they were up to, but they trusted Meriwether, so they thought that it would just work itself out, as I always had before. In 1989, the Arbitrage Group negotiated that they would get a 15% cut of the group, profits, and they put up a record year as they brought in $23 million for the firm. One trader at Solomon had become furious with the inside deal that they had previously worked with the group, and he confessed to Meriwether that he had submitted a false bid to the U.S.

Starting point is 00:08:59 Treasury to gain an unauthorized share of a government bond auction. This trader was Paul Moser. He was a volatile trader who repeatedly and recklessly broke the rules at Solomon and jeopardized the reputation of Mary Weather and the entire firm. The Treasury and the Fed then got involved in this debacle, and this sparked a scandal within Solomon, and John Goopfriend, who was the CEO was forced to quit, and Warren Buffett became the interim CEO. Maryweather, on the other hand, was known throughout the company as being the firm's top moneymaker and also as impeccably ethical. So Buffett wanted him to stick around, even though he was near the center of the scandal and being

Starting point is 00:09:39 blamed for much of the wrongdoings, since he didn't properly supervise Moser. Lawrence Hillibrand filled in for Meriwether temporarily, and he made a near catastrophic bet in mortgages, and he was down $400 million for the firm. He believed that the market was getting the trade wrong, so he just held onto it, and it did eventually come back. The Arbitrage Group had Buffett and Munger uneasy with the risks that they were taking taking on, and the Mosier scandal led Meriwether at the age of 45 to set his sights on starting his own firm to implement the tactics that he had used at the Arbitrage Group within

Starting point is 00:10:15 Solomon. Now, by this time, we're in the early 90s, and if there was any time to launch a hedge fund, this would have been the time. More Americans owned investments than ever before. Stocks were hitting new all-time highs, and stock screens started to enter the limelight at the gym, at the airports, and in the offices. Hedge funds at the time didn't need to register with the SEC, so for the most part, what was in their portfolios was really up to them and it sort of could be hidden.

Starting point is 00:10:44 They could also borrow as much money as they wanted and could buy all sorts of different types of assets that suited their desires. But they couldn't partner with more than 99 investors, and each investor had to be worth at least $1 million. And since hedge funds were fairly new at the time, they had this allure due to their exclusivity and high investment minimums. Lowenstein writes, for people of means,

Starting point is 00:11:08 for people who summered in the Hamptons, and decorated their homes with warhols, for patrons of the arts and charity dinners, investing in a hedge fund denoted a certain status, an inclusion among Wall Street's smartest and savviest. Hedge funds became a symbol of the richest and the best. Paradoxically, the pricey fees that hedge fund managers charged enhanced their allure.

Starting point is 00:11:33 for who could get away with such goddy fees except the exceptionally talented." At the time, there were around 3,000 hedge funds with $300 billion in AUM, and with strong investor demand, Meriwether was just the person to deliver the fund that could deliver returns that were both bold and safe. From the beginning, Maryweather planned to leverage its capital 20 to 30 times to one, or even potentially more. This was a necessary part of his strategy because little was to be made on minuscule spreads closing unless leverage was used. The allure of this strategy is that it increases the upside substantially, but the obvious drawback is that if the trade goes south,

Starting point is 00:12:17 the losses are magnified just as quickly. To help alleviate this concern, he insisted that investors commit to at least three years, which was an unheard-of lock-up period. This would help prevent investors from calling capital at the worst possible time, hence the name, long-term capital. He's set to raise $2.5 billion, while most other funds likely would have been happy with just 1% of that. They would charge much higher fees than others. They would charge 25% of profits in addition to 2% of assets, while the typical fund was charging 20% of profits and 1% of assets. And they required a minimum investment of $10 million. Then Meriwether looked to put together an elite team. He hired Robert Merton, who was a leading scholar in finance at Harvard,

Starting point is 00:13:03 and had trained many Wall Street traders and knew the Arbitrage Group quite well. Merton also contributed to the creation of the infamous Black Shoals Options pricing model, which helped give long-term capital management some instant credibility. Then Meriwether recruited Myron Scholes, who was the second academic star and, of course, was also involved in the creation of the Black Shoals model. Lowenstein writes here, with two of the most brilliant minds in finance, each said to be on the short list of Nobel candidates, long-term had the equivalent of Michael Jordan and Muhammad Ali on the same team, end quote. And then once Maryweather was able to point back to his track record at Solomon, he believed that the hedge fund would really just start to sell itself because the concept was proven. Solomon had broken out their earning statement, which showed that Maryweather's team was responsible

Starting point is 00:13:53 for most of Solomon's previous profits, topping more than $500 million a year during the last five years of the firm. This led to a ton of investor interests who were told that 30% returns in net of fees would not be out of reach, but that wouldn't come without risk, which is why long-term would diversify and spread out their bets so no one bet could pull down the entire fund. To help with marketing, David Mollins, the vice president of the U.S. Federal Reserve, gave Meriwether access to international banks and joined long-term himself. Mollens was also a former student of Robert Merton at Harvard.

Starting point is 00:14:30 And the connection with him led to commitments from the government of Singapore, the Bank of Taiwan, the Bank of Bangkok, and the Kuwait state-run pension fund. They even earned a $100 million commitment from the Foreign Exchange Office of Italy's central bank. Lowenstein explained that such entities simply did not invest in hedge funds, but the Italian agency thought of long-term not as a hedge fund per se, but an elite investing organization with a quote-unquote solid reputation. Long-term also secured commitments from a diverse group of celebrities and institutions in the U.S., including Phil Knight from Nike, the consulting firm McKenzie and Company, the CEO of Bear Stearns, among a number of universities, pension funds,

Starting point is 00:15:14 and insurance companies. Many were reassured by Meriwether and his partners putting up $146 million of their own money as well. In long-term capital management opened up for business at the end of February 1994, led by Meriwether, Rosenfeld, Hawkins, and Leahy, and purchased $10 million worth of workstations from Sun Microsystems to get started deploying their $1.25 billion in AUM. Just as the fund launched in In 1994, Alan Greenspan, who was the chairman of the Federal Reserve, since the economy was overheated. So he raised interest rates, which led to declining bond prices, which was great for long-term. They did better when markets were moving rather than stable, and the opportunities were

Starting point is 00:15:59 more abundant. Bond funds were losing hundreds of millions of dollars, leading to forced liquidations in widening spreads for long-term to take advantage of. To some extent, long-term was doing a service to the market as a whole because, you know, they would help provide liquidity to four sellers who were receiving margin calls. One trade they made was simply shorting the 30-year U.S. Treasury that was yielding 7.24% and going long the 29-5-year Treasury yielding 7.36%, capturing that spread and levering it up over 20 times to earn a satisfactory return that they were looking for. Part of the beauty in their eyes of this

Starting point is 00:16:37 transaction was that they could pull off this $2 billion trade without putting up any of its own cash balance because the cash raised from going short could be used to finance the purchase to go long. Most firms would need to pay what's referred to as a haircut, which was to put up some collateral to implement the trade, but Merriweather always looked to eliminate the haircut if possible or substantially reduce it. They would argue with banks that they were the exception to the rule of needing to post additional collateral simply because of who they were. Merrill Lynch agreed to waive its usual haircut requirement and go along. and so did Goldman Sachs, J.P. Morgan, Morgan Stanley, and just about everyone else.

Starting point is 00:17:18 It was sort of this prisoner's dilemma. Since the other banks were waiving their haircut requirements, you'd be a fool to require it. Otherwise, long-term simply wouldn't do business with you. Meriwether's marketing strategy served him well because he had the banks believing that they were at the mercy of him, when in fact it was the opposite. Long-term strategy of pushing for outsized profits and returns relied on their ability to get favorable financing terms that they wouldn't think to give to anyone else. The only reason the banks agreed to such terms is because they believed that they were lending to a new-age financial intermediary that benefited from superior and virtually fail-safe brains

Starting point is 00:17:59 and technology. The banks also fell prey to the liking bias, as they generally liked Meriwether as a person and wanted to be associated with his excellent reputation. Since many of these banks did similar arbitrage trades themselves, Maryweather operated in this secretive manner and spread out his bets across many banks so none of them could really peer in and see what was happening underneath the surface, as Maryweather didn't want them closely replicating their strategy. Maryweather never talked about his personal life, even with his close friends.

Starting point is 00:18:32 After setting up long term, he and his wife moved outside of Manhattan to a very much of a $2.7 million $68-acre estate in Westchester County. This allowed him to live even more privately and help shelter himself from the unwanted volatility that you would find in the city. Long term was headquartered in Greenwich, Connecticut, which was located northeast of Manhattan. They had a whole team in the office. There were the partners, some junior and senior traders, as well as the analysts, legal, and accounting professionals. The top employees made anywhere from $1 to $2 million per year, and there was a bit of pressure for the staff to invest their bonuses into the fund, which most of them were just eager to do anyways. And this was actually considered one of the perks of working at the firm, so most people confidently reinvested most of their pay.

Starting point is 00:19:18 They liked to bet on sure thanks. And in their first year, just about every trade long-term touched had turned to gold, which were mostly with these convergence trades. These were attractive because there was a maturity date, while the relative value trades offered the potential for convergence, but without a limited timeline. There was one hotly debated trade that wasn't so much a sure thing. One of the partners, Victor Hagani, made a bold bet on Italian sovereign bonds, betting that the country wouldn't default on its debt in light of their economic crisis. Had Italy defaulted, long-term would have lost their shirt on the trade, and they didn't disclose that default risk to their investors, of course, or really tell them anything about how or where

Starting point is 00:20:03 any of their money was invested. The book shares that Seth Clarmman had received an offer to invest in long term, and he was skeptical of their cavalier approach to debt, so he declined the offer. Clarman, who's very much a deep value investor, would be one that shuns the excessive use of debt, like long term, would certainly use in his view. Clarmine had wondered how investors could be so certain that markets would always be liquid, allowing them to get out when they needed to exit their positions, or perhaps when they're forced to sell due to margin calls. Lowenstein writes here, he feared that investors were turning a blind eye to the consequences of outlier events, such as sudden disturbances and occasional crashes that historically

Starting point is 00:20:45 have always upset the best laid plans of investors. In general, Claremont warned successful investors have positioned themselves to avoid the 100-year flood, end quote. Let's take a quick break and hear from today's sponsors. All right. I want you guys do a math. Imagine spending three days in Oslo at the height of the summer. You got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year, bringing

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Starting point is 00:25:00 That's Shopify.com slash WSB. All right. Back to the show. So, Clarman recognized that just a single serious mistake could lead to major impairment of capital for their investors. Two major errors at the same time would likely be catastrophic. In the meantime, long term managed to put up 20% returns for investors in 1994. net of fees and 28% returns before fees, while the average investor in bonds lost money.

Starting point is 00:25:31 Oddly enough, Meriwether wrote in his letters that investors shouldn't expect such a gain each year. In roughly 12% of years, they would lose at least 5% of their money and went on to share the odds of losing, say, 10%, 15%, 20%, as if they could forecast the future so precisely, but they didn't highlight any of their trades or investments, nor did they have to. All investments pose a risk and uncertainty. If we buy shares of Amazon today, there's the risk that the share price will fall over time, and there's the uncertainty of how likely it's going to fall. While Meriwether was acknowledging the risk of the loss of capital,

Starting point is 00:26:11 he was disregarding the uncertainty of the world and how us as humans simply can't place probabilities on the future with such certainty. To long term, investing was more of a science than an art as they operated very mathematically. They used academic concepts such as market prices follow a random walk, from day to day they would fluctuate in an unpredictable manner, and the price changes followed a normal distribution with some volatility around a statistical mean. And they assumed that volatility or risk of an asset was constant over time, just as it had been assumed in the Blackshould's formula. Additionally, likely to a fault, they assumed that markets would trade in a continuous manner,

Starting point is 00:26:55 without any jumps. So if shares of IBM dropped sharply from, say, 80 to 60, they assumed that it was more of a step-like function where it would go from 80 to 79 and 3 quarters to 79 and a half, with the options market repricing continuously each step along the way. In calm and liquid markets, this might make sense. But in outlier events like the 1987 flash crash, it could be argued that markets were largely discontinuous. At one moment, you could buy shares of IBM at $80, and in the next moment, it traded for

Starting point is 00:27:29 60, with very few, if any, trades in between. But long-term based their models on the assumption that markets were efficient and continuous, and it had served them very well to that date. Lohenstein writes here, Merton's theories were seductive not because they were mostly wrong, because they were so nearly often right. As the essayist, G.K. Cherston wrote, life is a trap for logicians because it is almost reasonable, but not quite. It is usually sensible, but occasionally otherwise, end quote. And then he shares a quote from Cherston. It looks just a little more mathematical and regular than it is. Its exactitude is obvious, but its inexactitude is hidden. Its wildness lies in

Starting point is 00:28:13 wait, end quote. In a deck of cards, say, Blackjack players could calculate the odds of hitting 21 if they know all of the cards that were played up to that point. The data set is known and it's fixed. I used to work in the world of insurance as an actuary, and actuaries are well known for meticulously analyzing data and determining insurance premiums based on that data. Although the approach isn't perfect and the world is always changing, this works well for insurance companies because the data set is so large and mortality rates change slow enough for insurance companies to adapt to new trends. The stock market is really a whole different beast.

Starting point is 00:28:53 Sometimes markets change entirely, making past datasets not as useful. For example, the Great Depression would have changed everyone's models or the inflationary 1970s or the 1987 Black Monday crash. If we're just looking at IBM, they are operating in an ever-changing market, perpetually, perpetually confronting new problems, new competition, and ever-changing consumer trends. Unlike the deck of cards, what the future could look like for IBM or any ticker is never fully known. In other words, there could be a card in the deck that you didn't even know existed. Interestingly, Eugene Fama did some research in the 1960s on stock price movements of the Dow Jones Industrial Average

Starting point is 00:29:34 and found that for every stock, there were many more days of extreme price movements than would occur in a normal day. distribution. In a normal distribution, an observation of five standard deviations from the mean or more would happen once every 7,000 years. But in reality, these observations occurred in the stock market once every three or four years. The Black Monday crash is a perfect example. In that one day, the market plunged by 23% on no apparent news. Based on the market's historical volatility, this type of move was statistically impossible, and yet it still happened It's a good reminder that simply looking at the past can't prepare us for what can potentially happen in the future.

Starting point is 00:30:20 Markets that were discontinuous and had these fat tails on the bell curve certainly made investing more risky for long-term than they initially realized. The human aspect also can't be ignored. Sometimes trends will continue simply because people expect them to. In the efficient market hypothesis does not consider that sometimes humans get too far ahead in themselves and take on leverage. and eventually become four sellers at the worst possible moment. After you've had three bad coin flips in the market, the probability of fourth bad coin flip

Starting point is 00:30:51 might be much greater than 50%. Jumping to 1995, long-term had another great year, earning investors a 43% return after fees. In the first two years, they had earned $1.6 billion overall, $600 million of which came as profits to the firm and they've rest as gains to investors. This was the most impressive start for any fund ever. In fact, the partners thought they weren't generating the returns they had the potential to get.

Starting point is 00:31:20 In only one month, did they have a return worse than minus 1%. So they thought that they could take on more risk to achieve higher returns over time. Meriwether had no issue raising another billion dollars in capital from investors, tripling their AUM to 3.6 billion. Now, their equity capital was $3.6 billion, but their total assets were a whopping $102 billion, meaning that they were levered $28 to 1. So despite the returns being so high for the investors, the return on total assets was just 2.4%. And that's the return that the firm would have earned had they not taken on any leverage.

Starting point is 00:32:01 And Lowenstein makes the additional point that this asset figure did not include the exposure to derivatives, which likely would have brought their returns on assets below 1%. The exact figure isn't important, but the point is that the big driver of their returns to date was simply a function of the high amount of leverage they had. Had they taken on much less leverage than their returns would have been substantially lower. Now, if we were to put ourselves in the shoes of the investors in long term at the time, you look like a genius for investing in what looks like the best hedge fund out there run by the smartest investors on the planet. And if you had the chance, you probably would have given them more money. And these guys are telling you that they're likely

Starting point is 00:32:44 not taking enough risk, given that they've only had one month of losses more than 1%. As time went on, long-term strategies became more diverse. They became more comfortable taking bigger positions believing that the positions would be uncorrelated, and one position's total loss would likely be offset by the gains in another position. In long-term success continued. They were not only phenomenally profitable, but eerily consistent. I think if anyone were to see a hedge fund today continually putting up 30% plus returns with minimal drawdowns, they would assume that it was a fraud or a Ponzi scheme.

Starting point is 00:33:20 By the spring of 1996, leverage expanded and their asset base reached $140 billion. The fund was two and a half times as big as the Magellan Fund at Fidelity. It was their largest mutual fund and they controlled more assets than Lehman Brothers and Morgan Stanley. And again, they hadn't actually raised that much capital from investors. The vast majority of it was simply a function of leverage and money they borrowed from banks. In 1996, long-term had begun to worry about their reliance on Bear Stearns. While most banks bent the knee for long-term's contractual demands and favorable terms, Bear Stearns wasn't so kind.

Starting point is 00:34:00 They refused to clear long-term's trades on the usual no-haircut basis, and Long-Term was well aware that without Bear Stearns to serve as the clearing broker, they were in trouble. Back in 1994, a hedge fund named Askin Capital had suffered extraordinary losses in the mortgage market, and they collapsed after receiving margin calls from Bear Stearns. Ever since, Longterm was worried about the possibility of this somehow happening to them. Long term clearly needed Bear Stearns much more than the other way around, but Meriwether and his crew were working to change that by budding up with their managers and working to lock in more

Starting point is 00:34:37 favorable terms in writing. At this point, Longterm had grown to well over 100 employees and the partner's profits were reinvested back into the fund. Their stake in the fund was worth $1.4 billion, nine times their initial investment of $150 million. That's quite a fortune made from bond spreads. There were so many stories in the book that just highlight the level of greed that humans can have and how easily we can overlook taking on risks when things are going well. UBS is a bank based out of Switzerland, and they initially declined to invest in long term.

Starting point is 00:35:13 A couple of years in, they had dropped their conservative measure of not getting involved in leverage hedge funds and wanted to push for more growth as they were just overtaken by a nearby competitor. Overnight, long term would become their biggest account. The head of fixed income at UBS had stated that not investing in long term initially was the biggest mistake they had ever made. In the meantime, long term had then closed to new investors and UBS was buying out old investors at a 10% premium. Long-term continued to march along in 1996, earning a 41% return net of fees thanks to leverage spreads on Japanese convertibles, junk bonds, interest rate swaps, and again, Italian bonds. Their total profits in 96 were $2.1 billion.

Starting point is 00:35:59 Lowenstein writes, to put this into perspective, this small band of traders, analysts, and researchers, unknown to the general public, and employed in the most arcane and esoteric businesses earned more in one year than McDonald's did selling hamburgers all over the world, more than Merrill Lynch, Disney, Xerox, American Express, Sears, Nike, Lucent, or Gillette, among the best-run companies and best-known brands in American business. And they had done this with stunningly little volatility, end quote. Although the results were extraordinary, Maryweather was aware of the impact of luck and chance, and had stated that they would need at least six years of results to get a better idea

Starting point is 00:36:40 if their formula was really working or not. Additionally, he noticed that the arbitrage business was getting more crowded at rival banks and competitor funds as they forced spreads tighter and tighter, which would make achieving the same results going forward much more difficult without taking on or leverage, of course. As free market capitalism would have it, excess profits tend to get withered away and long term wasn't doing something that others weren't capable of doing themselves. In search of new places to deploy capital, they started to sift through the equity markets, which present its own set of challenges, since valuing inequity tends to be slightly less mathematical and more qualitative than valuing

Starting point is 00:37:22 a bond, for example. They did decide to experiment with pair trades on similar public listings that traded under different tickers. So one example that listeners might be familiar with is Alphabet. They have multiple share classes. The only differences between the A share and the C share of alphabet is simply the voting rights. So the shares that have more voting rights tend to trade at a slight premium to the other share class. So for example, if the spread tends to be, say, 1%, and all of a sudden that spread between the two share classes widens to 5%, then an arbitrager like long term, they'll come in, short the overvalued shares,

Starting point is 00:37:59 buy the undervalued shares, and wait for that gap to close. But given that long term was betting billions of dollars on these trades, they were taking enormous risk because these trades were illiquid relative to the size of their positions, which was a sign that the firm's hubris was starting to get the best of them. They were beginning to play games that they were by no means experts in, simply because they had capital they needed to get deployed. In most institutions, wouldn't have been able to legally buy stocks on 20 to 1 leverage, But long-term worked around this regulation since they entered into derivatives contracts that

Starting point is 00:38:35 essentially mimicked the behavior of the underlying shares. By 1997, Fed regulators had met with several large New York banks to discuss their relationships with hedge funds as they were concerned about the credit that banks were extending to hedge funds. Every time there was a shock to financial markets, some firms would manage to blow up due to derivatives exposure, so regulators wanted to ensure that no firm going under, would significantly impact the entire financial system overall. I know there are a lot of people out there who believe that you should just let the free market play things out,

Starting point is 00:39:09 but I think Wall Street has proven that some level of oversight and regulation is needed. If someone like Long Term is managing to hold their cards close to their chest and they aren't disclosing the positions that they hold, then they may be taking on too much leverage and putting these other counterparties at a significant risk as a result. In the early 90s, Alan Greenspan loosened regulations, backed by the belief that increased liquidity in the markets was a good thing. But Lowenstein makes a great point here. He writes, A bit of liquidity greases the wheels of markets. What Greenspan overlooked is that with too much liquidity, the market is apt to skit off the tracks.

Starting point is 00:39:46 Too much trading encourages speculation, and no market, no matter how liquid, can accommodate all potential sellers when the day of reckoning comes. But Greenspan was hardly the first to be seduced by the notion that if only we had a little more liquidity, we could prevent collapses forever, end quote. So with the system awashed with liquidity, Longterm was in a good position to get insane credit lines from all these banks. And a lot of these banks, they assumed that they were the biggest lender to long term. But some of them might have been, you know, number of 10 on the list, not realizing just how much risk and exposure and leverage that long term was getting. During 1997, they were beginning to find fewer opportunities to deploy capital. The firm's leverage ratio, not including derivatives, declined from 30 to 1 to 20 to 1 as a result

Starting point is 00:40:35 of finding less opportunities, and in the first half of 97, they only earned 13% before fees. July of 1997 was the beginning of what was known as the Asian financial crisis. A wave of defaults swept through Thailand, which led to their currency falling by 20%, and And this cascaded to other currencies throughout the region. Tens of billions of dollars had flowed into Asia in 96, and now that capital was rapidly fleeing. Meanwhile, one of long-term's merger arbitrage investments did not go as expected. The MCI merger was renegotiated at a lower price, so MCI's stock price collapsed and long-term lost $150 million overnight, which was offset by $300 million in gains that

Starting point is 00:41:19 they earned in Japan. for their investors, they started to return part of their investors' money simply because they couldn't find opportunities to deploy it, which they absolutely hated, given that they were just making so much money at that point. The partners weren't interested in taking their money off the table, though, and to the best of my knowledge, most of them had most, if not all, of their net worth riding in this fund. They even took on a pyramid of debt, so not only was the fund itself leveraged, but the management company that owned the fund was also a pyramid. leverage. And the partners used their stake in long term to take on even personal debt as well

Starting point is 00:41:57 to invest more. It almost hurts for me to read this and share it with our listeners today. In October of 97, Merton and Scholes won the Nobel Memorial Prize in Economic Science. Academics praised the two for their contributions to finance, and one economist called the Black Shoals model, one of the most elegant and precise models that any of them had ever seen. While these two were being praised for their ability to price risk, Asian currencies and stock markets continued to implode. One day, the epicenter was Thailand, the next it was Malaysia, and then Indonesia. Long term seemed to have managed to dodge a bullet as the fund broke even in October and November, and given the volatility of markets in Asia, they were going searching for opportunities in the area.

Starting point is 00:42:45 Throughout the book, Loenstein touches on a number of the partners and how they sort of viewed long-term. Some partners were all in. Others were hedging their bets and saw potential flaws in the strategy. Scholes, for example, has a deep academic background, and he recognized that long-term was going a bit outside of their wheelhouse of expertise, so he didn't view the strategy as bulletproof like some of the others did. Merton did not like the top-heavy compensation structure for two of the other partners, which created moral hazard and incentivized them to shoot for the moon with the bets that they were making.

Starting point is 00:43:21 Brandy Hiller, who had been a part of the group at Solomon, he believed that long-term was an accident waiting to happen. But for the most part, the hunger to make as much money as possible was alive and well, even as they scaled up to astronomical heights, and the partners were financially independent many times over. They returned $2.7 billion to investors at the end of 97 and earned a 17% return net of fees, which was, again, a remarkable achievement given the market conditions. To put this into perspective, the original investors from 94 had gotten back $1.82 for every dollar they put in, and they still had their original dollar still in the fund. Hillo brand was estimated to be worth half a billion dollars, and Meriwether was worth a couple hundred

Starting point is 00:44:05 million dollars. This brings us to the section of the book on The Downfall. Lonestein opens this section with a quote from John Maynard Keynes. Markets can remain irrational longer than you can remain solvent. Early in 1998, long term began to short a large amount of equity volatility, which led the fund on a road to disaster. The stock market tends to vary around 15 to 20 percent per year. Sometimes the market is more volatile, but eventually that volatility has historically always reverted back to its historical norm. For those of you who are familiar with the Black Shoals pricing model, which is a method of pricing options, you'd know that volatility is a key assumption in the model. The more volatile a stock is, the more that option is worth.

Starting point is 00:44:52 So for example, if we're looking at a call option on Tesla stock, it's going to be more expensive than a call option on, say, AT&T, all else equal, because with higher volatility, there's higher probability of a big payout on the Tesla call relative to AT&T. So the investor would have to pay a higher price to compensate for that higher reward. In order to determine the implied volatility that is priced in the market, Quants could simply look at the options market and how it's priced and then back their way into what level of volatility investors expect going forward. Since the implied volatility was 20%, and the historical volatility was 15%, long-term bet the firm that volatility would revert back to the mean as it historically had done.

Starting point is 00:45:40 In my view, making a short-term forecast on something like volatility, especially doing it with leverage is just a fool's errand, but I know that these guys are likely way, way smarter than I am. To make matters worse, since long-dated options weren't traded on exchanges, long-term had put together private options contracts sold by the big banks, which required them to settle up their position every day. So if one day no one was selling the options they were short, the prices might get bid up, and long term would be on the hook to put up a substantial amount of additional capital. So they weren't just betting on the ultimate realized volatility.

Starting point is 00:46:16 They were also betting on the day-to-day inferred volatility. According to the firm's models, the chance of them losing a significant amount of their money, say 40% of their capital in a month, was unthinkably low. So far, the worst month they've had was minus 2.9%. So very impressive. In 1998, some of Wall Street had concluded that the market's appetite for risk had gone too far and that it was time to take some risk off the table.

Starting point is 00:46:43 John Succo, who ran the Equity Derivatives Desk at Lehman Brothers, had publicly stated that Wall Street was playing with fire with the level of unseen leverage that was being used in the form of derivatives. Shortly after, Succo was forced to resign from Lehman. And Travelers' insurance had discovered that their fixed-income arbitrages within their newly acquired subsidiary, Solomon Brothers, were pulling in year-end bonuses of 10 million or more. Additionally, they weren't penalized for the losses they incurred, which encouraged them to bet as much of the company's money as they could.

Starting point is 00:47:17 This brought to question, were the arbitrators simply partaking in a dressed-up form of gambling? In May of 98, arbitrage spreads began to widen, which set off a hard-to-break-stressers, cycle of selling as firms encountered forced liquidations, which led to long-term having their worst month ever at a minus 6.7 percent return. In June, spreads continued to widen, and to make matters worse, they were widening in every single market long-term was active in, which reflected the market's overall trend of credit contracting and investors taking risk off the table. As markets were in chaos in Asia, investors globally were fleeing to U.S. treasuries

Starting point is 00:47:56 for safety, and about the only firm that was going short U.S. Treasuries at the time was long-term, leading them to lose 10% on the month. Solomon had become increasingly wary of their arbitrage division, and they ultimately decided to close it down. That meant that they would be liquidating many of the positions that directly aligned with long-term, which, as Lowenstein writes, would arguably trigger the fund's downhill spiral. In July, word had gotten out that Solomon was exiting the office. arbitrage business in a memo that was leaked to the Wall Street Journal stated,

Starting point is 00:48:30 Opportunity for Arbitrash profits has lessened over time, while the risks and volatility have grown. At the time, Solomon was the second largest player in the industry. Naturally, other traders started to unload their Arbidage trades to prevent being on the wrong end of a potential leverage unwind. Yet, Meriwether and his crew were unfazed, despite all of their positions going against them in the most recent month. Furthermore, they looked forward to adding to their positions that were now more favorably priced. They were confident that the future would look like the past.

Starting point is 00:49:04 It was the natural thing to do, given that that approach was so successful for so many years. In addition to the crisis happening in Asia, there was also a currency crisis happening in Russia as well. Short-term yields in Russia had skyrocketed to more than 120%. The IMF was working through the situation in Russia, and they encouraged Solomon to be back Moscow, but executives at Travelers, the parent company of Solomon, didn't trust Russia and the potential risks they presented. Long term, on the other hand, believed that Russia simply wouldn't let their currency fail.

Starting point is 00:49:37 Again, long term was playing with fire, trying to model what was happening in Russia, given the corruption that was taking place. Russia at the time was less than a decade removed from communism and struggling to become a democratic society. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform.

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Starting point is 00:52:56 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income funds prospectus at fundrise.com slash income. This is a paid advertisement. All right. Back to the show. During the second week of August in 98, Russia's markets snapped. Dollars were fleeing the country, reserves were dwindling, its budget was overtapped, and the price of oil, its chief commodity, was down 33% while the government imposed controls on the ruble.

Starting point is 00:53:29 Russia's stock market was down 75% on the year, and short-term interest rates skyrocketed to 200%. Investors continued to flock to U.S. treasuries, and 30-year yields in the U.S. reached a new low of 5.5%. Longterm was now experiencing their third losing month in the last four months. To help stop the pain, Longterm offered to buy Solomon's entire arbitrage position they were undewinding, which was worth $2 billion. When times were good, long term set the rules and was able to secure favorable terms. And in August of 1998, Solomon, J.P. Morgan, Bear Stearns, and Lehman, they sensed that long-term was in trouble, as they reached out to Lehman to raise more capital.

Starting point is 00:54:13 But long-term certainly didn't anticipate what lied ahead in the very near future. At this point, the fund managed $3.6 billion, $1.4 billion of which was the partner's capital, and it would take just five weeks for them to lose it all. On August 17th, Russia announced a debt moratorium. They decided that they would rather use their rubles to pay Russian workers than Western bondholders. This moratorium applied to $13 billion of ruble debt, denominated in rubles, which was rapidly being devalued. This sent a shock to markets globally.

Starting point is 00:54:49 Investors like those at long term assume that a country like Russia would never default. If anything, the IMF would bail them out to ensure that they were able to make good on their debt. Firms like Barclays decided that they wanted to offload any risk exposure, regardless of the current prices. And investors continued to cascade into the same. safest assets. Minute by minute, long-term capital was losing millions of dollars. Meanwhile, many of long-term's partners were on vacation. Their office was largely deserted. Victor was in Italy, Eric was in Idaho, and Meriwether was in China of all places. One of the partners named Bill Krasker

Starting point is 00:55:26 couldn't believe his eyes looking at credit spreads continuing to widen week after week. In fact, they were exploding. From long-term's point of view, this was totally unpubes. But these types of spreads were also seen in the 1987 flash crash as well. According to long-term models, they were very unlikely to lose more than $35 million in one day. And on Friday, August 21st, their fund lost $553 million, 15% of its capital. On Sunday, August 21st, the partners assembled in a conference room and they brought in Jim Rickards to advise the group. Rickards held the role as General Counsel of Long-Term Capital Management.

Starting point is 00:56:09 He's a lawyer with degrees from Penn, John Hopkins, and New York University. And Rickards is also a New York Times bestselling author, and it's been a guest on our show many times in the past, such as on episode 514 and 233. Now, long-term was in an extremely precarious situation. For one, if their positions continued to move against them, then they were simply going to go bust. There was no way around that. And since their positions were so massive, they wouldn't be able to offload them without drastically

Starting point is 00:56:39 moving the market. There simply wasn't buyers for the positions that they held because of this sudden flight to safety. Now, Mary Weather's entire career was built on the premise that spreads always normalize. So his initial reaction was just raise more capital to give them a cushion to weather through the storm. That night, Eric Rosenfeld called Warren Buffett to see if he would be willing to purchase long-term merger arbitrage portfolio. Now, the credit spreads was long-term's bread and butter

Starting point is 00:57:09 for generating returns. This is separate than the merger arbitrage portfolio. And the merger arbitrage was just another field they ventured into, and they had a portfolio with them. And Buffett really wasn't up to speed on merger arbitrage at the time, so he just wasn't interested. The next day, Rosenfeld met with George Soros and Stan Drucken Miller. Soros agreed to invest $500 million at the end of the month, given that they could raise another $500 million from other investors, but markets continued to go against them, and due to the high levels of leverage, they were losing money faster than they could raise it.

Starting point is 00:57:44 Long term knew that they needed to reduce their positions, but they simply couldn't, as there was zero liquidity in the markets. And there never is when everyone wants out at the same time. These types of situations destroy the academic idea of efficient markets, bell curves, random walks, and continuous price movements. When liquidity dries up, prices can become quite irrational, causing leveraged investors to be forced to sell their position at the worst possible time. This causes prices to get to extreme levels that would typically be deemed impossible

Starting point is 00:58:18 if you're looking at it through the lens of a bell curve or normal distribution. Loenstein shares the example of yields on news corporation bonds. They had recently traded 110 basis points above U.S. Treasuries, and they soared to 180 basis points over, even though the company's prospects had not changed at all. In the long run, such spreads might seem absurd, but long-term thinking is a luxury not always available to the highly leveraged, as they may not be able to survive that long. Hillibrand arranged another meeting with Buffett as they were desperate to raise more money. That week, the Wall Street Journal referred to what was happening as the global margin call.

Starting point is 00:58:56 as markets were plummeting and commodity prices had hit a 20-year low. Hillebrand was calm with Buffett and transparent about the losses on their books. He pitched Buffett on the high prospective returns going forward and even offered to charge him half of the fees they charged the other investors. And Buffett, of course, thought the fees in the first place were already far too high and even after they cut the fees are far too high. So he had little interest in investing in the fund. That day, the fund lost another 277 million and their asset base was down to the cost.

Starting point is 00:59:26 to $2.2 billion. Meanwhile, the fund's holding company owed a total of $165 million to a group of banks, money that they certainly didn't have. Part of the problem was that their pair trades were oftentimes with different banks. So more margin was required than necessary relative to them simply having the same pair trade at the same bank. So they tried to consolidate all these pair trades with the appropriate bank, which sounds simple, but it was actually quite overwhelming as they had a mind-boggling 60,000 positions. The partners were now deeply regretting their decision to return the $2.7 billion back to investors that they did in the previous years, which could have served as a lifeline when disaster struck.

Starting point is 01:00:09 Hillibrand was at one point worth $500 million, and in a matter of weeks, he was having to use his wife's checking account for expenses related to his extravagant new mansion. Near the end of August, Maryweather called an old friend, Vinnie Matone, who had been the Fund's first contact at Bear Stearns, unlike Mary Weather's partners, Matone saw markets as exquisitely human institutions, inherently volatile, ever fallible. I wanted to read this interaction directly from the book here. I quote, where are you? Matone asked bluntly. We're down by half, Maryweather said. You're finished, Matone replied as if this conclusion needed zero explanation. For the first time, Mary Weather sounded worried. What are you talking about? We still have two billion

Starting point is 01:00:53 We have half and we have Soros. Matone smiled sadly. When you're down by half, people figure you can go down all the way. They're going to push the market against you. They're not going to roll or refinance your trades. You're finished. Not long after Matone's visit, Merriweather and Mack and Tea went for a drink at a local inn favored by Meriwether

Starting point is 01:01:14 and other transplanted Wall Streeters. Sipping his trademark gin and tonic, Maryweather looked at his pal and said in a voice that was completely flat. You were right. I should have listened to you." End quote. The partners were working tirelessly to try and keep the fund alive, but it of course just wasn't enough. They weren't able to raise the additional $500 million that Soros required. And one thing that was unique about this time period was that there was no depression happening on Main Street. For the most part, the panic was just on Wall Street, where there

Starting point is 01:01:45 was too much optimism and leverage that had suddenly become undone. In August, long term would lose a whopping 45% of its capital. And if their bets on spreads continue to go against them, their equity base of $2.2 billion would be gone in a blink of an eye. The partners found themselves in uncharted territory. And markets were behaving in a way that they weren't prepared to handle. According to their models, losing 45% in one month wouldn't happen even one time over the entire life of the universe. But it ended up happening within just four years of their existence. After Meriwether's letter to investors for August got out to Wall Street, more selling pressure came to the positions that long-term held as they assumed that an avalanche of selling

Starting point is 01:02:29 was going to take place as a result of them being forced liquidated. Long-term felt that they just couldn't catch a break as day after day in September, they saw all their positions go against them. Long-term had met with Solomon Brothers and other banks and part of their last-ditch efforts to raise more capital. And out of desperation, they were willing to show all of their books to help make it happen, which was quite contrary to how they acted in the years prior. Solomon was shocked to learn that in just the last five trading days, Long-term lost $530 million.

Starting point is 01:03:02 Goldman Sachs had told them that very few would be able to provide the amount of capital they needed, perhaps Warren Buffett, George Soros being two candidates, but long-term had already asked them. John Corzine from Goldman Sachs thought that the federal, Reserve should be brought into the loop to prevent the collapse of long-term severely impacting the broader market. The Federal Reserve was initially created to help regulate banks, not necessarily bail them out for making poor capital allocation decisions. Richard Fisher from the Fed was just as surprised as everyone else when he uncovered what was happening in the portfolio.

Starting point is 01:03:36 An outsider would have believed that long-term was well diversified, but once he looked under the hood, he realized that their trades were correlated from the start. They had spread trades all over the world. Gary Gensler had remarked that in a crisis, the correlations always go to one. Fisher estimated that if long-term were to suddenly go under and they needed to liquidate their positions, then its 17 biggest counterparties would stand to lose anywhere from $3 to $5 billion, depending on how much they could get for the collateral that long-term had.

Starting point is 01:04:08 And that was if they could find buyers for what they were selling. Fisher came to the realization that he probably had three days or so to come up with the solution to this mess, and the banks were ensuring him that long-term wasn't going to be bailed out privately, as he probably would have hoped. Corzine brought more than a dozen banks together to quickly formulate a solution to this mess. After many long, drawn-out discussions and debates, Merriweather received a call from none other than Warren Buffett. Buffett worked with Goldman Sachs to put in a last-minute bid for the portfolio hours before the

Starting point is 01:04:41 value of the equity had gone to zero. The offer that long-term received shared that Berkshire Hathaway AIG and Goldman Sachs would be willing to buy the fund for $250 million, and if they accepted, they would immediately invest $3.75 billion more dollars to stabilize the operation. In other words, Buffett was proposing to pay $250 million for a fund that had been worth over $4 billion at the start of the year, essentially a 95% discount to its previous value. To ensure that Maryweather wouldn't shop around for another, offer, Buffett gave him just 50 minutes to make his decision.

Starting point is 01:05:17 Maryweather was shocked, to say the least, to receive such a low-ball offer. When he looked at Rickards and asked what to do, as they contemplated their decision, the offer got withdrawn, as it was rumored that an investment banker let Buffett in on the risk that Berkshire would be taking by purchasing exposure to such complex derivatives. And he would just own the portfolio's assets, and not necessarily the portfolio company That was a separate entity. Orsene then convinced 14 banks to pitch into the bailout, raising $3.65 billion to acquire 90% of long term. The existing investors would retain the other 10%, while the partner shares would be liquidated

Starting point is 01:05:58 to cover their debts. The partners once had $1.9 billion invested, and in just five weeks, their stakes would be worth zero. This was, of course, a tragedy for the partners, as they now worked on a salary for the fund in order to make good on the damage that they've done. And from the public's perspective, they had been branded as just purely irresponsible speculators, and their reputation had, of course, been ruined in the eyes of Wall Street. Meriwether was well known as the face of long term, and he never spoke publicly about the

Starting point is 01:06:29 downfall of the firm. And after the bailout from the banks, the credit spreads continued to widen and long term continued to lose money. So not only did the value of the firm continue to implode, but they were bringing all of Wall Street down with them. And then by mid-October, the Federal Reserve cut interest rates twice after the bailout, and it signaled to the market that new liquidity was coming for investors, and finally, the storm had passed. Most of long-term investors actually came out ahead because they invested early on and had that capital return at the end of 97. And the fund's employees

Starting point is 01:07:03 received most of their pay in the form of year-end bonuses, and most of those bonuses were invested in the fund, which just went down the drain. So many of the employees at long term essentially worked for nothing over that time period. The partners continued to manage the fund on a more moderate salary and they were under the whims of the big banks that bought them out. The bank's only interest was to simply just get their money back. Over time, the partners in long term would step away one by one with the bank's permission, of course, and move on with their lives and their careers. Many of the partners also strongly believed that they had done nothing wrong and had blamed to the irrationality of other traders portraying themselves as victims of outside events.

Starting point is 01:07:45 Ironically, credit spreads in 99 the year after the bailout, it ballooned to even wider levels. So according to the partners, an event that was practically impossible had now happened two years in a row. After earning a modest return post-bailout, the fund was liquidated in early 2000. So what is there to learn from the downfall of long-term capital management? I would say the first lesson is to avoid the use of excessive leverage in investing and ensure you have a very solid financial foundation. Buffett and Amonger have stated that their investment returns would have been higher had they

Starting point is 01:08:17 used more leverage, but ensuring you have a strong financial position and aren't over levered ensures that you aren't going to be short cash when it's hardest to get. Buffett has a quote that cash is to a business as oxygen is to an individual. Never thought about when it's present, the only thing in mind when it's absent. Using leverage looks smart in a bull market when it seems that only good things can happen, but using leverage can also prove to be disastrous when things turn against you, especially when the leverage can be margin called. It's one thing to have a mortgage on your home at a low interest rate

Starting point is 01:08:51 that just can't be margin called as long as you're making your monthly payments. And it's another thing to have your portfolio liquidated if your portfolio or stock happens to fall by 50%. Since cash can just be so valuable in these rare instances when markets are crashing and the economies in disarray, I can see the case for holding a good amount of cash and emergency fund. Perhaps it can be used for emergencies, such as if you temporarily lose your job, or if you decide during a crisis that you're going to tap into that a little bit to buy discounted assets, I can see that case as well. The second lesson is to avoid overconfidence.

Starting point is 01:09:27 Related to this is another Buffett quote, never risk what you have in need for what you don't have and don't need. The partners that long term were already financially independent many times over, and they were overconfident that their models accurately aligned with reality. No matter how smart you think you are, when it comes to investing, we should also account for the unthinkable happening. That card in the deck that you just don't simply know about. In Michael Batonet's book, Big Mistakes, he added, the lesson us mere mortals can learn from

Starting point is 01:09:57 this seminal blowup is obvious. Combined with overconfidence is a dangerous recipe when it comes to markets." One way to help guard yourself against overconfidence is by putting limits on the amount that you will invest in any one stock, industry, or asset class. This ensures that if you end up being wrong, then you limit your potential downside. It's also important to remember that we humans are emotional creatures and are prone to becoming overconfident and have blind spots. Warren Buffett, for example, referred to the management team at Dexter Shoe as one of the best managed

Starting point is 01:10:30 companies he and Charlie had ever seen. Berkshire purchased Dexter Shoe in 1993 and ended up losing all of their money on that investment. If the greatest investor in the world can make the mistake of being overconfident, I have no reason to believe that I won't be in a similar position at some point in my investing lifetime. The third lesson I'd like to share is just around the reflexivity of markets. Long-term models did not account for the fact that markets aren't 100% rational 100% of the time. As humans are what make markets. Investor George Soros believes that financial markets always provide a distorted view of reality and never reflect all available knowledge. So he's essentially saying that market prices are always wrong. Sometimes the divergence

Starting point is 01:11:14 is minuscule and other times the divergence is massive. From my personal experience, I learned about reflexivity after the market crash in March 2020. As I checked the markets hour by hour, sometimes a minute by minute, the week of March 9th and March 16th, I believe that markets were simply pricing in the reality that the entire economy was shutting down, and thus corporate profits would fall off a cliff. What I didn't necessarily realize or fully appreciate was that since the market was falling so swiftly, this can lead to massive margin calls by leveraged institutions. So it becomes a self-reinforcing cycle where, because, because the market's falling, these firms are forced to sell their positions, which causes the market

Starting point is 01:11:54 to fall even lower. Had I understood the reflexivity of markets at the time, I feel that I would have been more excited to buy discounted assets at the time instead of simply holding my positions out of fear of what lied ahead. Reflexivity can also apply to the upside. With a company like Tesla, for example, they have a cult-like following and shareholder base that promotes the stock in the company, and they hold large amounts in their portfolio. This leads to many believing that the stock is far overvalued, and since shares of Tesla have been richly priced historically, this has actually helped them issue new shares to fund future growth. Had the stock been priced lower, they may not have been able to execute on their strategy near as successfully as they have, and actually, it might be

Starting point is 01:12:39 fairly likely that they would have gone bankrupt at some point in their history. So reflexivity can work both ways, both on the upside and the downside, and we should keep that in mind whenever we believe something is drastically undervalued or overvalued. The fourth lesson I'd like to share is related to diversification. Conventional wisdom suggests that the more diversified you are across your investments, the less risk you're taking. On the contrary, John Maynard Keynes stated that one bet soundly considered is preferable to many poorly understood.

Starting point is 01:13:10 The fall of long term showed that eggs in different baskets can all break simultaneously. They fooled themselves into thinking that they had diversified in substance when in fact, they had only done so in form. All of their bets were essentially correlated. So for stock investors, we might own different stocks in different countries or industries, for example, but we shouldn't just use that logic alone as a way to say that we're adequately diversified. And then the final lesson I would share is just related to some risk management.

Starting point is 01:13:40 So it sounds good when you say that you're chasing the highest possible of returns, but we must keep in mind the level of risk we're taking as well. Oftentimes, chasing the highest returns out of any investor also means that you're likely taking too much risk, and that strategy can work well until it doesn't. Not only is achieving adequate investment returns important, but managing risk appropriately is also just as important. The collapse of long-term capital management serves as a cautionary tale that all of us can learn as investors. Even the smartest minds can ignore basic principles of risk management, leverage, and the inherent unpredictability of markets. I guess to piggyback on that idea, I think we should

Starting point is 01:14:23 also be wary of looking at a model and telling ourselves that closely reflects reality. Reality does not care about your Excel spreadsheet, no matter how fancy it is or how reliable it's been in the past. Towards the end of the epilogue, Lowenstein writes, if Wall Street is to learn just one lesson from the long-term debacle, it should be the next time a Merton proposes an elegant model to manage risk and foretell odds, investors should run and quickly run the other way. I hope you enjoyed today's discussion on the book when Genius Failed by Roger Lowenstein. I'll have the book linked in the show notes for those interested in checking it out themselves. And as promised, I wanted to take a minute to share some details on a new event that TIP will be hosting from September 24th through September 28th,

Starting point is 01:15:08 25 in Big Sky, Montana. The event is called The Investors Podcast Summit. We'll be gathering around 25 listeners of the show to bring together like-minded people and enjoy great company with a beautiful mountain view. I'm sure that many of you have been to an investment conference in some form or fashion in the past. And while this could technically be considered an investment conference, it's likely much different than most investment conferences you've ever been to. My favorite part of these various conferences is meeting people and seeing people that I rarely get to meet with in person. So I'm fine with skipping the formalities and dressing up to sit through a day through of speakers

Starting point is 01:15:47 and presentations. So we're looking to bring together listeners of the show who are passionate about value investing and are interested in building meaningful connections and relationships with like-minded people. Many of our attendees will likely be entrepreneurs, private investors, portfolio managers, or just passionate value investors who work in all sorts of industries. We'll have an itinerary plan to do various things, such as hiking, go to the lake, go out for dinner and whatnot, but there will be plenty of time to just relax and really get to know other people.

Starting point is 01:16:17 TIP has already booked the houses we'll be staying at, and there's a few photos of it on our website to get a sense of the environment. The houses also have plenty of rooms to do various things. Go to the pool, hot tub, workout room, theater room, a large kitchen. there's a large patio and then there's a trail out back and just much more. We're thrilled to be hosting this special event for our listeners and can't wait to hopefully see you there. On our website, we have the pricing, frequently asked questions, and the link to apply to join us.

Starting point is 01:16:45 So if this sounds interesting to you, you can go to theinvestorspodcast.com slash summit. That's the investorspodcast.com slash summit. We only have room for around 25 members of our audience, so be sure to apply soon if you'd like to join us. With that, thank you for your time and attention today, and I hope you enjoyed today's episode. Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional.

Starting point is 01:17:26 This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP707: The Collapse of Long-Term Capital Management w/ Clay Finck

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