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When Genius Failed: Lowenstein Talks LTCM

Roger Lowenstein: It's cumbersome to say that the spread rate is overpriced at default risk and therefore I'll short that and buy a bunch of risky credits. It's cumbersome and you sort of have to wait a long time until people realize that the market's overpricing credit risk. For instance, if the market is overpricing the default risk of Amazon.com (AMZN) , you can just buy the bonds, say, because they're so cheap, and as the bonds come in, you'll make money. It's more cumbersome, and there are great debates about what the spread precisely represents, but it's certainly true that as fear grows, it grows and vice versa.

They had that bet in the U.S., they had that bet in England, and both of those bets were bets on the perception of risk and fear and were false. The bet in Europe was mitigated somewhat because they were betting the other way in Germany. They had an analogous bet on equity volatility, which is to say the volatility of stock markets, and they were betting that the amount that a stock market moved around, the volatility would lessen or that the perceived future volatility of risk would drop. These are all bets on lessened risk perception, lessened volatility. They took a riskier side of the Russian bond spectrum, the riskier side of the mortgage-backed spectrum and the riskier side of the junk bond spectrum.

Brett D. Fromson: They were betting on a reduction in volatility.

Roger Lowenstein: They were betting that the world would look a little rosier.

Brett D. Fromson: And they were wrong.

Roger Lowenstein: And in each of these things, with the exception of, say, the German case where the hedge was in England, most of their bets were bets that the world would seem a tamer, safer, less volatile place. It's certainly true that some of the individual bets had little to do with others. But, when people decided that they no longer knew what the boundary of risk was, they just wanted out of risk, they were on the wrong side of all those bets.

Brett D. Fromson: Why did LTCM blow up, whereas none of the big derivative dealers blew up?

Roger Lowenstein: You mean like Morgan?

Brett D. Fromson: Morgan, Goldman, some of the Swiss banks.

Roger Lowenstein: Well, that was LTCM's only business. I think J.P. Morgan was a better-managed firm. Goldman was up to its neck in trading, and it lost a billion dollars, but it was 1 billion, not 4 billion, and they had other businesses, it was more diversified. Merrill also lost a billion or so in bonds, but they were obviously more diversified.

"So, $1 from start to finish turned into 33 cents at a time when the stock market was doubling."

Brett D. Fromson: Do you think the bank regulations caused them to be not only less monomaniacal in the business focus, but also to hold more capital relative to position sizes, or were they equally leveraged?

Roger Lowenstein: I don't know the answer to whether they were equally leveraged, but people who are running public companies are much more cognizant of the riskiness of the trading business. Sandy Weill hated that business. He was very pressured. He got Salomon Smith Barney out, or halfway out, but they still had big losses.

Brett D. Fromson: Out of Russia?

Roger Lowenstein: Out of Russia, and out of funds that they closed down, divesting their U.S. fixed-income arbitrage group. He and Jamie Dimon did it at Salomon Smith Barney. They did still have heavy losses, but it could have been a lot worse. Those guys want regular, rising profits every quarter, which you don't get in this business. Goldman was preparing for its IPO, and the extent to which they should rely on trading has always been an issue there.

But, if you looked at that question in a different light, as a company that is going public as soon as LTCM would have, Merrill thought it had no exposure. Merrill was shocked and a lot of heads rolled in bond trading afterwards. It has based its business really on the idea of having no exposure. The problem is, anybody who holds an inventory in bonds is going to hedge them in Treasuries. So they were sort of inadvertently in the LTCM trade.

Brett D. Fromson: In what sense?

Roger Lowenstein: In the sense that they were long riskier stuff and short Treasuries.

Brett D. Fromson: Their relationship with LTCM was that they were an investor, or a lender, or both?

Roger Lowenstein: They were both. I mean, they were a supplier of credit, a supplier of swaps and they were the firm that had taken LTCM on the road. They had done the dog-and-pony show and raised the first billion, but David Komansky had been offered the chance to become a big investor, put $100 million in, and he said, "No, thanks." So, the basic answer to your question is yes, all these firms, public firms, either because of what they disclosed or because of what they knew they would have to disclose in the event of a lawsuit, had different mindsets about taking these risks.

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