story of Long Term
By Nicholas Dunbar
(John Wiley pounds 17.99)
THE ONE occasion on which I visited the London offices of Long Term Capital Management, the hedge fund that crashed to earth so spectacularly last year, it did not take long to see that this was no ordinary fund management business. There were no piles of analysts' reports lying around the floor, no endless chattering down the phone, and little sense of urgency.
Only the sound of quietly humming computers let you know anything much was happening. Those who did speak spoke mostly in jargon that was next to impossible to follow for any layman without a training in computer programming or advanced mathematical finance.
John Meriwether, the founder of LTCM, may have made his name, and acquired folk-hero status, from his bravura exploits as the streetwise head of bond trading at Salomon Brothers in the glory days so brilliantly chronicled in Michael Lewis's bestseller, Liar's Poker. Yet there was no clue to the man's style, or his volatile temperament, in the quiet and donnish atmosphere in which his hedge fund chose to go about its business.
Behind the veneer, as we now know, the fear and greed that have always driven financial markets were very much in evidence. What LTCM stood for was a heady combination of exceptional human brainpower, the awesome data processing muscle of the computer and the overweening ambition of Meriwether and his co-founders.
The business that LTCM was about was arbitrage - buying and selling similar financial instruments simultaneously, in the hope of exploiting tiny mispricing errors for profit. LTCM set out to be the biggest and the best. It had the highest fees, the smartest ideas and (fatally, as it proved) the greatest level of gearing.
We know now that what actually did for the fund was a combination of its overgearing and an unprecedented set of market conditions that, briefly, sent the whole world's financial system into a blind funk. The hedge fund's trading positions of well over $200bn were underpinned by equity of just $4.7bn, a level of gearing that spoke volumes about the confidence Meriwether and his colleagues had in their abilities.
In hindsight, it is easy to see where LTCM went wrong. As Nicholas Dunbar makes clear in this readable account of the saga, the fund was arrogant as well as overgeared. It was not just too clever by half, but too clever by about nine-tenths.
Both its money-making strategies and its risk management system proved fragile when tested to the limit by the freak market conditions. The fatal flaw of its computer-driven arbitrage strategies, as with all financial models, was that they depended on past data and the assumption that relationships which had held in the past would in time revert to their traditional parameters.
There is no doubt LTCM knew the risks. But their computer model failed to allow for the freakish set of circumstances in 1998, when all the things that could go wrong did go wrong at the same time. Was this plain bad luck - a once in a million event, as Meriwether and co now claim - or simply a disaster waiting to happen? The answer: a bit of both.
Inventing Money is a brave and ambitious book. The trouble is that there is more than one strand to the LTCM story, each of which in some way deserves a book in its own right. One is the story of John Meriwether. A second is the story of the two Nobel professors he enrolled, Myron Scholes and Robert Merton, and how they, with other academics at American universities, made the theoretical breakthroughs, including options pricing, which underpin the way modern financial markets work. And yet a third story is the narrative of the crisis of 1998 and the last-minute rescue of the fund by a consortium of banks.
Weaving three stories together is no easy task. Dunbar at times struggles to keep a balance between the need to explain the mysteries of modern financial economics with the need to keep the human drama of the story rolling forward.
I spotted at least one simple mathematical error in the early sections, and found the chapter on how the Italian central bank came to be an investor in LTCM unsatisfying (Dunbar hints at scandal, but both the facts and the argument are too obscure to be entirely convincing).
The book clearly suffers in places from the fact that several key participants have not yet given their versions of events. But there are plenty of good things in it too. Those who are a little hazy about exactly how arbitrage and the derivatives business work will find many of the answers here. Even those who have followed the LTCM affair quite closely will find some of the new details fascinating (for example, about LTCM's position in the UK gilts market).
This is not the definitive account of the rise and fall of LTCM, but it is a highly readable account of a financial drama of the highest kind.
Jonathan Davis is a columnist on The Independent and chairman of Investor Publishing