By Roger Lowenstein - This is a fascinating story of a hedge fund started in the '90s called Long-Term Capital Management. If you've read Liar's Poker by Michael Lewis, many of the same characters are in this book. I find it funny in that if you read enough Wall Street history books, you find the same guys doing the same dumb things over and over again. Borrowing money, over-leveraging themselves, blowing sh!t up. Rinse and repeat.
LTCM was started by a Wall Street bond guy that wasn't necessarily a genius by himself. Rather he just gathered some smart people together, had the right contacts to raise and borrow crap-tons of money, and thought "what's the worst that could happen?" The PhD's that developed the strategies were taking their theories and using very large amounts of money to make bets that their theories were correct. It never occurred to them that they might be wrong. They never shared the specifics of their strategies, it was mostly a 'black box.' Their investors trusted them, the banks trusted them, nobody asked enough questions.
The first 3 years they knocked the ball out of the park. If I remember correctly they had returns of roughly 40% after fees trading BONDS, in the middle of a raging tech-led bull market in stocks. Institutions were falling over themselves to be allowed to invest. They thought these guys had finally figured out how to control the market. Getting returns like this out of bonds and currencies is much more attractive to big institutions, as the markets are giant compared to the stock market (more room to make money before you overwhelm the market with your activity).
Today we'd call what LTCM was doing as Relative-Value for their main strategy. They were looking at the relationship between 2 securities, and when that relationship would get get out of whack compared to it's historical relationship, they would make a very large bet that the relationship would eventually return to normal. This isn't too unlike what you might think of Buffett doing. He sees stocks as going up over the long term. In the short term, when he sees stocks down 20 or 30%, he jumps in and buys with everything he has. Except LTCM was doing this with 100x leverage!
Everything was going great until the 2 standard deviation event turned into an 8 standard deviation event (Asian financial crisis and Russia defaulting on it's bonds). They never expected that to happen in their models. But yet it happened. And they were so over-leveraged (expecting the markets to return to normal, but they just kept getting more and more abnormal) that it quickly sunk the fund and threatened to take down the entire financial system along with it. Only then did the banks and the Federal Reserve find out what was really going on inside the fund. All the banks that were involved were forced by the Fed to put up money to take over the fund and bail it out. The trades were wound down and the fund was eventually shut down.
For the rest of us, this is like seeing the real estate market in Florida in 2007 is down 20%. Historically you say to yourself, 'well gee, Florida real estate is a great place to get fantastic returns, so this is a great time to buy!' So you go out and borrow every dollar the bank will lend you and buy some some condos for a quick flip. But then you watch in horror as the value of your condos continues to fall, far greater than you ever imagined. The condo's price falls another 60%, and you don't have the money to keep paying the loans since you were expecting a quick flip. You are now bankrupt and the game is over.
It's a great story (because it didn't happen to me!) and is pretty much required reading before any hedge fund will hire you. I can't remember who said it, but a common quote on Wall Street is "there's nothing more dangerous than a smart kid who's never had his teeth kicked in." This is absolutely true in regards to the markets. Without the proper respect you can blow yourself up.
