When Genius Failed
"John Meriwether, a famously successful Wall Street trader, spent the 1980s as a partner at Salomon Brothers, establishing the best - and the brainiest - bond arbitrage group in the world. A mysterious and shy midwesterner, he knitted together a group of Ph.D.-certified arbitrageurs who rewarded him with filial devotion and fabulous profits. Then, in 1991, in the wake of a scandal involving one of his traders, Meriwether abruptly resigned. For two years, his fiercely loyal team - convinced that the chief had been unfairly victimized - plotted their boss's return. Then, in 1993, Meriwether made a historic offer. He gathered together his former disciples and a handful of supereconomists from academia and proposed that they become partners in a new hedge fund different from any Wall Street had ever seen. And so Long-Term Capital Management was born.". "When Genius Failed is the cautionary financial tale of our time, the saga of what happened when an elite group of investors believed they could actually deconstruct risk and use virtually limitless leverage to create limitless wealth."--BOOK JACKET.
Stats for nerds
34recommend
70mentions
59people
2007–2025years
60% recommend37% neutral3% critical
Mentions per year
What Hacker News says
- What's funny to me is that, not only is this also how the financial industry is structured, but that a) this is the currently fashionable means of reducing risk and b) it is seen as a feature not a bug.
Citation: Any book about the 2008 financial crisis, or the 1998 crisis, or the 1987 crisis, e.g.
[0] 'The Quants', Scott Patterson
[1] 'When Genius Failed', Lowenstein.
[2] 'Demon of Our Own Design', Richard Bookstaber.
- Firstly I would be surprised if they were doing vetting and due dilligence over and above what a normal broker does before allowing shares to be lent as this is a regulatory requirement. It really is just most likely them ripping off their customers.
To answer your question about continuous rebalancing, generally it is done daily using a process known as "Variation Margin"[1], and it's incredibly standard and done by every broker. In order to take out any kind of margin position (and stock borrow is included in this because the reason you would borrow is so you can sell short, which gives you a leveraged position and therefore margin is required) with a broker you post some collateral (usually the assets you already have in the account) and they give you some credit which you can think of as buying power. You can now trade using this rather than just using your cash, however on a daily basis as the present value of your positions changes, if it dips below a limit, they will ask you to post some additional collateral (this is known as a "margin call") and if you can't post, then the broker will begin liquidating your positions to get you back within the limits.
So, if you're lending your stock, then someone with that kind of margin arrangement is borrowing them and selling short and Archegos[2] and Peleton[3] are much closer to the situations you need to worry about than FTX and SVB. That is, the risk you are concerned about is that between their margin being adjusted one day and the next, the counterparty who borrowed your stock jumps to default (Meaning they go directly from being fine to being bust in one jump like in Monopoly where it says "Go directly to jail, do not pass go, do not collect $200") before they get asked to post additional collateral or their position gets liquidated (and the stock returned to you).
Non-technical explanation: You lent them your stock. What you're worried about is they go bust so quickly that the risk controls don't kick in and now your stock is among assets going through a bankruptcy and it could be ages before you get it back.
Notice that in both of the peleton and archegos cases big investment banks with big risk management functions, a ton of inside information and a _lot_ of money at stake lost a ton because they allowed counterparties to take more risk than they should. LTCM would be another great example[4]. RH is going to do a far inferior job of counterparty risk management than they were able to do. Counterparty default is a significant risk, which is why 15% is really inadequate compensation, and you're much better off using someone else. But in my view, RobinHood is a really terrible broker anyway so I would never recommend them. It sort of baffles me that people use them at all.
[1] https://www.investopedia.com/terms/v/variationmargin.asp
[2] https://www.bloomberg.com/news/features/2021-04-08/how-bill-...
[3] https://www.ft.com/content/9995c125-8ac0-3e15-ae52-5c28aca92... Fun fact, when I was at Goldman, after peleton went down people used to sometimes refer to counterparty overnight jump-to-default risk informally as "Peleton risk"
[4] Read "When Genius Failed" if you're at all interested in the history of financial markets. It's a great book.
- There's also a great story that speaks more towards the detriment of using Black-Scholes as an investment thesis.
https://www.amazon.com/When-Genius-Failed-Long-Term-Manageme...
- You made me watch this :-) still another book worth reading and not mentioned there:
"When Genius Failed: The Rise and Fall of Long-Term Capital Management"
- LTCM wasn't caused by anything like mortgage-backed securites.
LTCM was doing ultra-leveraged short-term trades of various kinds. When they started these were arbitrages of various kinds so they had low risk and a solid edge but as more capital flowed into their fund, the capacity of those trades was exhausted and they put money into riskier other trades. Some of their counterparties were big banks who parked overnight funds in LTCM and then when they got spooked by some losses and yanked those funds, LTCM lost a staggering amount of money very quickly as a result and went bust. If you want an excellent book about LTCM, "When Genius Failed" is one of the best books ever written about the history of financial markets.
The origins of the subprime mortgage crisis were a lot more complicated than most people give credit for and in particular I really wouldn't take "the big short" as any kind of reliable guide. For a good critical view of the crisis written by someone who actually knows what they are talking about I would recommend "Fools Gold" by Gillian Tett.
Financial crises and crashes have happened since the dawn of human history and will probably continue to happen. Suffice to say that the 2008 crisis had nothing to do with thing things that caused LTCM to fail, and neither of them have anything to do with the insight behind the Black/Scholes/Merton model other than the fact that Scholes and Merton were I think on the board of LTCM.[1]
[1] Fun fact, the other one of the three, Fischer Black was a quant at Goldman Sachs. So there's your 2008 crisis connection[2]
[2] Or not. Fischer Black died in 1995.
- Here are 5 I have recently read that I really enjoyed:
1. "When Genius Failed": about the failure of the hedge-fund LTCM
2. "The First Tycoon": Detailing Vanderbilt's life (he was a bad-ass businessman). Far more interesting than I expected.
3. "Made in America": I didn't really care about walmart or Sam Walton before reading this, but he's a man to be admired.
4. "Barbarians at the Gate": Private equity tries the largest hostile takeover ever (dramatic and exciting with a hilarious group of characters).
5. "The Smartest Guys in the Room": Enron was an absurd company run by absurd people. Jeff Skilling claims he didn't do anything wrong.
