TIP707: The Collapse of Long-Term Capital Management w/ Clay Finck
01:20:54 Share

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 and

including Nobel Prize-winning economists, long-term capital management seemed invincible. Until it wasn't. Using complex mathematical models, 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. John Maynard Keynes

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 of interest 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, Playthink.

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 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 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 overexpose 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 Merriweather. Merriweather 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 Salomon Brothers. In the mid-1960s, bond trading was really a dull sport. For the most part, investors would buy bonds and simply hold onto 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 de-pegged 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, Salomon brothers were slicing and dicing bonds in ways that would have been unimaginable just 10 years earlier. The other big change was the rise of computers, making it easier to quickly price bonds accurately.

Meriwether learned the art of arbitrage at Salomon Brothers in the late 1970s. The premise was simple. Let's say you have a US 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 Salomon, would 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 US Treasury would go up or go down 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. Meriwether 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 futures price and bet that those two prices would eventually converge. By the early 1980s, Merriweather 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 mystified by the academic world,

Meriwether 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 Meriwether, but just 10 days later, he was eventually hired on at Salomon Brothers. Meriwether would hire a number of others from the academic world, including Lawrence Hillebrand, which was probably the smartest of the bunch and at two degrees from MIT. They downloaded all the data they could find on bond prices, and they looked for inefficiencies in that market. Robert Leonard :

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. 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. Meriwether served as the head of the group and 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 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 fended off the hostile bidder,

by selling control of the firm to a distinctly friendly investor named Warren Buffett, and Buffett would also join the board of Salomon Brothers. 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 Salomon weren't quite sure what they were up to, but they trusted Merriweather, so they thought that it would just work itself out as it always had before.

In 1989, the Arbitrage Group negotiated that they would get a 15% cut of the group's profits, and they put up a record year as they brought in $23 million for the firm. One trader at Salomon had become furious with the inside deal that they had previously worked with the group, and he confessed to Merriweather that he had submitted a false bid to the US 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 Salomon and jeopardized the reputation of Merriweather and the entire firm. The Treasury and the Fed then got involved in this debacle, and this sparked a scandal within Salomon. John Goopfriend, who was the CEO at the time, was forced to quit, and Warren Buffett became the interim CEO.

Mary Weather, 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 blamed for much of the wrongdoings since he didn't properly supervise Moser. Lawrence Hillibrand filled in for Mary Weather 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 we 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 on, and the Mosher 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 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. 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. 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, 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. For who could get away with such gaudy fees except the exceptionally talented?" End quote. At the time, there were around 3,000 hedge funds with $300 billion in AUM. And with strong investor demand, Merriweather was just the person to deliver the fund

that could deliver returns that were both bold and safe. From the beginning, Merriweather 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,

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 lockup period. This would help prevent investors from calling capital at the worst possible time, hence the name long-term capital. He said 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 that

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 and had trained many Wall Street traders and knew the arbitrage group quite well. Merton also contributed to the creation of the infamous Black-Scholes option.

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-Scholes 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 Meriwether was able to point back to his track record at Salomon, he believed that the hedge fund would really just start to sell itself because the concept was proven. Salomon had broken out their earnings statement, which showed that Meriwether's team was responsible for most of Salomon's previous profits, topping more than $500 million a year during the last five years of the firm. Robert Leonard :

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. Robert Leonard :

To help with marketing, David Mullins, the Vice President of the US Federal Reserve, gave Meriwether access to international banks and joined long-term himself. Mullins was also a former student of Robert Merton at Harvard, 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 "solid reputation." Long Term also secured commitments from a diverse group of celebrities and institutions in the US, including Phil Knight from Nike, the consulting firm McKinsey & Company, the CEO of Bear Stearns, among a number of universities,

pension funds, and insurance companies. Many were reassured by Meriwether and his partners putting up $146 million of their own money as well. And 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 1994, Alan Greenspan, who was a chairman of the Federal Reserve, sensed that 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 more abundant.

Bond funds were losing hundreds of millions of dollars, leading to forced liquidations and 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 they would help provide liquidity to forced sellers who were receiving margin calls. One trade they made was simply shorting the 30-year US Treasury that was yielding 7.24% and going long the 29 and a half 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 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, JP Morgan, Morgan Stanley, and just about everyone else. 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. Maryweather'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

is because they believed that they were lending to a new age financial intermediary that benefited from superior and virtually fail-safe brains and technology. The banks also fell prey to the liking bias as they generally liked Merriweather as a person and wanted to be associated with his excellent reputation. Since many of these banks did similar arbitrage trades themselves, Merriweather operated in this secretive manner and spread out his bets across many banks so

so none of them could really peer in and see what was happening underneath the surface as Meriwether didn't want them closely replicating their strategy. Meriwether never talked about his personal life, even with his close friends. After setting up long-term, he and his wife moved outside of Manhattan to a $2.7 million, 68-acre estate in Westchester County. This allowed him to live even more privately and help shelter himself from

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. They like to bet on sure things. 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 Higani, 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 any of their money was invested. The book shares that Seth Klarman had received an offer to invest in long-term,

and he was skeptical of their cavalier approach to debt, so he declined the offer. Clarkman, 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. Clarkman 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, "The

He feared that investors were turning a blind eye to the consequences of outlier events, such as sudden disturbances and occasional crashes that historically have always upset the best laid plans of investors. In general, Klarman 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.

Robert Leonard : Holding Bitcoin is the best way to protect your family from the threat of fiat currency collapse. And few people understand this better than Tony Yazbeck, cybersecurity expert and founder of The Bitcoin Way. Tony was in Lebanon when the currency imploded. He's seen the chaos that erupts when the ATM stop working and the bank accounts get frozen. He knows what it's like to lose everything.

But with his cybersecurity expertise and by fully adopting Bitcoin, Tony was able to engineer his escape. And now Tony and the Bitcoin Way team work to make sure this never happens to you. With over 25 years of experience, their expert training empowers you to self-custody your family's Bitcoin the right way, secure your devices and protect your privacy, develop robust inheritance plans, and secure for plan B citizenship.

The Bitcoin Way can transform you into a sovereign individual. You just need to take the first step. Schedule a free consultation today at thebitcoinway.com slash TIP.

As Bitcoin's role in global financial landscape evolves, understanding its potential impact on your wealth becomes increasingly crucial. Whether we see gradual adoption or accelerated hyper-Bitcoinization, being prepared for various scenarios can make the difference between merely participating and truly optimizing your position. This is why Unchain developed the Bitcoin Calculator, a sophisticated modeling tool that helps you visualize and prepare for multiple Bitcoin futures.

Beyond traditional retirement planning, it offers deep insight into how different adoption scenarios could transform your wealth trajectory.

What sets this tool apart is its integration with the Unchained IRA, the only solution that combines the tax advantages of a retirement account with the security of self-custody. In any future state, maintaining direct control of your keys remains fundamental to your Bitcoin strategy. So explore your potential futures at unchained.com slash fundamentals. That's unchained.com slash fundamentals.

When it comes to business, great ideas are a dime a dozen. But actually implementing those ideas and converting prospects to buyers is a whole different ballgame. Nobody helps me convert customers better than Shopify, home of the number one checkout on the planet.

Shopify made me realize that starting and scaling a business is so much easier than it used to be. It's like having a business partner that works for you around the clock and only gets better with time. My business would be nowhere without Shopify and brands like Allbirds, Gymshark, and Allo, who all use Shopify, would probably agree with me. Businesses that want to grow, grow with Shopify. Sign up for your $1 per month trial period at shopify.com slash WSB.

That's all lowercase. Go to shopify.com/wsb to upgrade your selling today. Shopify.com/wsb.

All right, back to the show. So Klarman 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. 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, 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 Black-Scholes formula. Additionally, likely to a fault, they assumed that markets would trade in a continuous manner 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 three 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 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. Lowenstein writes here, "Merton's theories were seductive not because they were mostly wrong, but 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." 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 weight." 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 dataset 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. 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 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 and found that for every stock, there were many more days of extreme price movements than would occur in a normal 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 anyway. It's a good reminder that simply looking at the past,

can't prepare us for what can potentially happen in the future. 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. And the efficient market hypothesis does not consider that sometimes humans get too far ahead of 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 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 the 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. 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. Merriweather 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. 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, then 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 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. And 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. By the spring of 1996, leverage expanded and their asset base reached 140 billion. The

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 contractual demands in favorable terms, Bear Stearns wasn't so kind. They refused to clear long-term 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 Asken Capital had suffered extraordinary losses in the mortgage market, and they collapsed after receiving margin calls from Bear Stearns.

Ever since, Long Term 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 buddying up with their managers and working to lock in more favorable terms in writing. At this point, Long Term had grown to well over 100 employees, and the partners' 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,

A couple of years in, they had dropped their conservative measure of not getting involved in leveraged 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. 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."

Although the results were extraordinary, Merriweather 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 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 a force spreads tighter and tighter, which would make achieving the same results going forward much more difficult without taking on more 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 an equity tends to be slightly less mathematical and more qualitative than valuing 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 it's

than an arbitrage like long-term, they'll come in, short the overvalued shares, 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. And 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 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, but I think Wall Street has proven that some level of oversight and regulation is needed. Robert Leonard :

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 skid off the tracks. 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." So with the system awash with liquidity,

Long-term was in a good position to get insane credit lines from all these banks. In a lot of these banks, they assumed that they were the biggest lender to long-term, but some of them might have been number 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 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 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 they earned in Japan. Luckily 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. 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 leveraged. The partners used the

their stake in long-term to take on even personal debt as well to invest more. It almost hurts for me to read this and share it with our listeners today. In October of '97, Merton and Sholes won the Nobel Memorial Prize in Economic Science. Academics praised the two for their contributions to finance, and one economist called the Black-Soles 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 frisk, 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.

Throughout the book, Lowenstein touches on a number of the partners and how they viewed long-term. Some partners were all in, others were hedging their bets and saw potential flaws in the strategy. Scholz, 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. Randy 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. Hillibrand was estimated to be worth half a billion dollars, and Merriweather was worth a couple hundred million dollars.

This brings us to the section of the book on the downfall. Lowenstein 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% 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-Scholes 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. 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. 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, 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. 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, Sukka was forced to resign from Lehman. And Travelers Insurance had discovered that their fixed income arbitragers within their newly acquired subsidiary, Salomon 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. This brought to question, were the arbitrageurs 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 cycle of selling as firms encountered forced liquidations, which led to long-term having their worst month ever at a minus 6.7% 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 US treasuries for safety, and about the only firm that was going short US 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 arbitrage business, and a memo that was leaked to the Wall Street Journal stated, opportunity for arbitrage 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 arbitrage trades to prevent being on the wrong end of a potential leverage unwind. Yet, Merriweather 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. 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 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. 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.

Trust isn't just earned, it's demanded. Whether you're a startup founder navigating your first audit or a seasoned security professional scaling your GRC program, proving your commitment to security has never been more critical or more complex. That's where Vanta comes in. Businesses use Vanta to establish trust by automating compliance needs across over 35 frameworks like SOC 2 and ISO 27001, centralize your security workflows, complete questionnaires up to five times faster, and proactively manage vendor risk.

Vanta can help you start or scale your security program by connecting you with auditors and experts to conduct your audit and set up your security program quickly. Plus, with automation and AI throughout the platform, Vanta gives you time back so you can focus on building your company. Join over 9,000 companies like Atlassian, Quora, and Factory who use Vanta to manage risk and prove security in real time.

My audience gets a special offer of $1,000 off Vanta at vanta.com slash billionaires. That's V-A-N-T-A dot com slash billionaires for $1,000 off.

This is a message from our sponsor, Intuit TurboTax. Taxes was waiting and wondering and worrying if you were going to get any money back, and then waiting, wondering, and worrying some more. Now, Taxes is matching with a TurboTax expert who can do your taxes as soon as today. An expert who gives your taxes their undivided attention as they work on your return while you get real-time updates on their progress so you can focus on your day.

An expert who will find you every deduction possible and file every form, every investment, every everything with 100% accuracy. Also, you can get the most money back guaranteed. No waiting, no wondering, no worries. Now this is taxes. Get an expert now on TurboTax.com. That's TurboTax.com. Only available with TurboTax Live full service,

Real-time updates only in iOS mobile app. See guarantee details at TurboTax.com slash guarantees.

For decades, real estate has been a cornerstone of the world's largest portfolios, but it's also historically been complex, time-consuming, and expensive. But imagine if real estate investing was suddenly easy. All the benefits of owning real, tangible assets without all the complexity and expenses. That's the power of the Fundrise flagship real estate fund. Now you can invest in a $1.1 billion portfolio of real estate starting with as little as $10.

4,700 single-family rental homes spread across the booming Sunbelt, 3.3 million square feet of highly sought-after industrial facilities thanks to the e-commerce wave, the flagship fund is one of the largest of its kind, well-diversified, and managed by a team of professionals. And now, it's available to you. Visit fundrise.com to explore the fund's full portfolio, check out historical returns,

and start investing in just minutes. That's fundrise.com slash WSB. Carefully consider the investment objectives, risks, charges, and expenses of the Fundrise Flagship Fund before investing. This and other information can be found in the fund's prospectus at fundrise.com slash flagship. This is a paid advertisement.

All right, back to the show. During the second week of August in '98, Russia's market 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. Russia's stock market was down 75% on the year, and short-term interest rates skyrocketed to 200%. Investors continued to flock to US treasuries,

and 30-year yields in the US reached a new low of 5.5%. Long Term was now experiencing their third losing month in the last four months. To help stop the pain, Long Term offered to buy Solomon's entire arbitrage position they were unwinding, which was worth $2 billion. When times were good, Long Term set the rules and was able to secure favorable terms. In August of 1998, Solomon, JPMorgan, Bear Stearns, and Lehman

They sensed that long-term was in trouble as they reached out to Lehman to raise more capital, 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. Investors like those at Long Term assumed 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 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

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 unprecedented. But these types of spreads were also seen in the 1987 flash crash as well. According to long-term's 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. He's a lawyer with degrees from Penn, John Hopkins, and New York University. Rickards is also a New York Times bestselling author and has been a guest on our show many times in the past, such as on episode 514 and 233.

Now, long-term was 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 moving the market. There simply wasn't buyers for the positions that they held because of this sudden flight to safety. Now, Merriweather'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's merger arbitrage portfolio. Now, the credit spreads was long-term's bread and butter 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 Druckenmiller. 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.

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 if you're looking at it through the lens of a bell curve or normal distribution. Lowenstein shares the example of yields on news corporation bonds. They had recently traded 110 basis points above US 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, as markets were plummeting and commodity prices had hit a 20-year low. Hillibrand was calm with Buffett and transparent about the losses on their books. He pitched Buffett on the high perspective returns going forward.

and even offered to charge him half of the fees they charged the other investors. 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 $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. Robert Leonard :

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. 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, Meriwether called an old friend, Vinnie Matone, who had been the fund's first contact at Bear Stearns. Unlike Meriwether'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,' Meriwether said."

"You're finished," Matone replied, as if this conclusion needed zero explanation. For the first time, Meriwether sounded worried. "What are you talking about? We still have $2 billion. 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,

Meriwether and McEntee went for a drink at a local inn favored by Meriwether and other transplanted Wall Streeters. Sipping his trademark gin and tonic, Meriwether 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 was too much optimism and leverage that had suddenly become undone. Robert Leonard :

In August, long-term, we'll 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 Merriweather'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 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 of their positions go against them.

Robert Leonard : Long-term had met with Solomon Brothers and other banks in 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. 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. 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. 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 a 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. Robert Leonard :

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 their portfolio, hours before the 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 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 Meriwether wouldn't shop around for another offer, Buffett gave him just 50 minutes to make his decision. Meriwether was

Shocked, to say the least, to receive such a lowball 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. He would just own the portfolio's assets and not necessarily the portfolio company that was a separate entity.

Orzine 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 partners' shares would be liquidated 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. 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. Merriweather was well known as the face of long-term and he never spoke publicly about the downfall of the firm. After the bailout from the banks, the credit spreads continued to widen and long-term continued to lose money. So

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's 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 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 the irrationality of other traders portraying themselves as victims of outside events. 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. Buff and Emunger have stated that their investment returns would have been higher had they 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 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 economy's in disarray, I can see the case for holding a good amount of cash in an emergency fund. Perhaps it can be used for emergencies, such as if you temporarily lose your job, or if

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. Related to this is another Buffett quote, never risk what you have and need for what you don't have and don't need. The partners at 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, you're

we should also account for the unthinkable happening, that card in the deck that you just don't simply know about. In Michael Batnett's book, Big Mistakes, he added, the lesson us mere mortals can learn from this seminal blowup is obvious. Intelligence combined with overconfidence is a dangerous recipe when it comes to markets, end quote. 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 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 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 the market's falling, these firms are forced to sell their positions, which causes the market 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.

Robert Leonard : 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 and 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. Robert Leonard : Had the stock been priced lower, they

they may not have been able to execute on their strategy near as successfully as they have, and actually, it might be 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

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." 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 should not use that as a way to just say we're taking less risk or we're adequately diversified. 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 risk management. So it sounds good when you say that you're chasing the highest possible 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 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's

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, 2025 in Big Sky, Montana.

The event is called The Investor's 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 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 planned 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. 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. So if this sounds interesting to you, you can go to theinvestorspodcast.com slash summit.

That's theinvestorspodcast.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. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.