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July 31, 2000

Disaster at Long-Term Capital Management

By Gregory Bresiger

Also in this article

  • Disaster at Long-Term Capital Management

Inventing Money

The Story of Long-Term Capital Management and the Legends behind it.

by Nicholas Dunbar

(John Wiley & Sons, New York, $29.95, 245 pages)

by Gregory Bresiger

They were a group of mathematicalgeniuses. They couldn't miss.

John Meriwether, Robert Merton and Myron Scholes all but invented modern finance by using complex scientific trading techniques. They had seemed to create a new way of minting money. Between 1994 and 1998 this trio ran up the LTCM portfolio to $100 billion with positions commanding a notional value of $1.25 trillion.

In 1998, Long Term Capital Management, a heretofore incredibly successful hedge fund, suddenly lost 90 percent of the value of the portfolio. An earthquake shook the trading world. LTCM had to be rescued by the Federal Reserve Bank of New York and 14 other banks because it was believed letting the hedge fund go down the tubes would have adversely affected the entire market.

Nicholas Dunbar has written a very interesting book. But, as some hostile reviewers have implied, it doesn't answer all the questions raised by this financial and trading debacle. Which financial institutions are too big to fail and which ones should be allowed to fail because the nature of capitalism is supposed to punish those firms that consistently misread the market? And are hedge funds too secretive? Should they have tougher regulation? And should investors in these funds have more warnings? And should offshore operations be under more scrutiny? Traders Magazine caught up with Dunbar to discuss some of these issues. (Dunbar is technical editor at Risk Magazine in London).

TM: Henry Kaufman, in his book "On Money and Markets," has predicted that an "even bigger debacle" than the LTCM crisis will happen again. Do you agree?

Dunbar: Yes. But I think it will be in a different form. It won't be precisely like LTCM. But it will be in a form that no one can now foresee because that's the way these things usually work.

TM: After the LTCM mess, is there a clear policy that central banks can adopt in deciding when and when not to rescue a firm?

Dunbar: It is something that Alan Greenspan has been trying to talk down ever since the LTCM problem. There's now a belief in the U.S. trading community that nothing too bad can ever happen to the market; that the Fed will always step in to solve problems; that it will always cut interest rates very fast. You've heard Greenspan say that there is no too big to fail policy, but there is, in fact, an agreement that the federal government will step in.

TM: But there was no federal bailout for LTCM. No direct bailout.

Dunbar: Right. But there were drastic cuts in interest rates, which clearly was the U.S. government making life easier for the banking system. So you could argue that by cutting rates, there was an element on governmental/financial aid to the market.

TM: Like the 1987 crash?

Dunbar: Right, there is today so much pressure on the regulators that the pressure to intervene is tremendous.

TM: Back to hedge funds. Does the way they're run in the United States, with little regulation, make them inherently dangerous?