Tuesday, June 20, 2006

Second Chance Club For High-Achievers

In our careers, we are constantly reminded not to make huge mistakes, the ones that would jeopardise our careers. Well, back in the 90s, there was a group of very smart people who made a huge boo-boo ... where are they now? John Meriwether was the bond king at Salomon Brothers but after a Treasury bond scandal in 1991, he left and later set up Long Term Capital Management, supposedly a hedge fund. The brilliant thing is that he managed to raise US$1.25 billion, a huge sum then, probably equiv to raising US$10 billion today in hedge fund money.

Funds were keen mainly due to Meriwether's ability to rope in the following people as partners in LTCM. They include:
David Mullins, former Federal reserve vice-chairman
Robert Merton, Nobel prize winner for Economic Science
Myron Scholes, Nobel prize winner for Economic Science

Of course, Scholes is the one-half of the famous valuation methodology, the Black-Scholes model. You'd think with such brilliant minds, the best computers and simulation models money can buy, and probably the few rocket scientists in their firm ... that LTCM would flourish. well, they did for a while. However, in 1998, the betted heavily on Russian bonds and other financial assets. In fact LTCM should really be called Leveraged Capital Management cause they leveraged their bets to magnify the miniscule returns projected. The miniscule returns were justifiable as their computers controlled the volatility. They invested in various asset classes so as to locate exposures that were not closely correlated. They supposedly hedged their exposure on one asset class and went the other way in another asset class that was supposedly negatively correlated. They would go short on the overbought asset class and reverse their exposure for the asset class that was oversold - the returns they were aiming for were small, hence the need to gear up.

What killed them was that asset classes that was not supposed to be correlated in their betas, suddenly correlated (moved together in the same direction) when the Russian bonds tanked. The double and triple whammy forced LTCM into a tailspin. These very smart people mortgaged their reputation on LTCM, ... what a horrendous few weeks they must have had to endure. LTCM's bustup might have even brought down the US financial system were it not for a US$3.6 billion bailout organised by the Federal Reserve Bank of New York.

What went wrong... well, the best of intentions can sometimes be thwarted. The best trading tools and simulation models can only be based on historical data. Certain data streams might not be "long enough" to predict betas and correlation.

It would have been so embarressing for those involved in LTCM... their careers in tatters, .... who would listen to Merton or Scholes in academic circles ... the best they could hope for is to write a book entitled "What I Did Wrong At LTCM" ... or "Seven Lessons From My Stint At LTCM".

Still, they had to lie low, it took a lot of swallowing of pride to continue with their careers ... they were all rich professionals already ... but it would take a long time to repair their reputation. Now, Meriwether runs a fund called JWM Partners, with a very low profile. Scholes is now the chairman of the private equity firm of Oak Hill Platinum Partners. Merton is the founder and chief science officer of Integrated Finance Ltd (a corporate strategy adviser that uses his options theory). Muillins is chief economist of hedge fund Vega Asset Management. The thing is, there are so many financial firms in the US, one big boo-boo won't kill you, there'd be plenty of others willing to take a risk on you still.

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