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Speaker 1: Pushkin too quick. No, it's perfect push kid stuff. You

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Speaker 1: got it.

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Speaker 2: You can take me back to the nineteen nineties, baby,

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Speaker 2: and then.

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Speaker 3: The seventies and then the nineties.

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Speaker 2: Okay, Robert Smith.

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Speaker 3: This is a story about some of the smartest people

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Speaker 3: in the world, incredibly successful in their fields. They decide

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Speaker 3: to come together start a new thing, and they are

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Speaker 3: so successful they make billions of dollars. They win the

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Speaker 3: Nobel Prize as they are making billions of dollars, and

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Speaker 3: then the next year they get destroyed, and in fact,

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Speaker 3: they get destroyed so hard that they almost take the

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Speaker 3: global economy down with them.

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Speaker 2: I'm Jacob Goldstein, I'm Robert Smith, and this is Business.

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Speaker 3: Sure, the history of business today on the show, the

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Speaker 3: story of long Term capital Management.

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Speaker 2: Wooh, you are so amped for this.

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Speaker 3: The mid nineties, the Cold War has just ended, free

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Speaker 3: market capitalism is triumphant, and the.

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Speaker 2: Economy was fantastic in the nineteen nineties, best economy, my

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Speaker 2: favorite economy. And the people who started Long Term Capital

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Speaker 2: Management looked at the economy not just in the US

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Speaker 2: but around the world, and they said, yes.

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Speaker 3: Yes, this is the moment we've been waiting for. We

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Speaker 3: are going to ride this global capitalism wave, and they did.

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Speaker 2: What they did not know was that that wave was

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Speaker 2: about to crash. Let's start before the nineteen nineties. Let's

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Speaker 2: let's let's start in the nineteen eighties, the early eighties,

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Speaker 2: Go Go Go all the street with.

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Speaker 3: A bond trader named John Merriweather. Meriweather had grown up

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Speaker 3: working class South side of Chicago, worked as a golf

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Speaker 3: caddy as a kid that was like his you know,

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Speaker 3: path up old school, got his MBA at the University

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Speaker 3: of Chicago, and in the mid seventies he went to

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Speaker 3: work at Solomons and Solomon Brothers was about to become

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Speaker 3: the heart of nineteen eighties Masters of the Universe. Wall

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Speaker 3: Street Bonfire the Vanities was based on Solomon Brothers. Michael

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Speaker 3: Lewis and Liar's Poker wrote about Solomon Brothers. It was

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Speaker 3: where he worked right out of college in the eighties.

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Speaker 3: And a key thing to know is at this time

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Speaker 3: the kind of legendary traders at Solomon Brothers were like,

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Speaker 3: very rough, They were street smart. They ate cheeseburgers for breakfast.

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Speaker 3: They traded, you know, based on their cheeseburger filled guts.

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Speaker 3: And Michael Lewis wrote beautifully about these guys in Liar's Poker,

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Speaker 3: most famously about a trader named Louis Raniery. Louis Raniery

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Speaker 3: started out in the mailroom. He was from Brooklyn. He

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Speaker 3: worked his way up and Robert, I want you to

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Speaker 3: read one sentence from Liar's Poker that describes the life

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Speaker 3: of a guy who worked with Ranier and just captures

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Speaker 3: this culture.

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Speaker 2: At Solomon Brothers, he traded bonds while being hollered at

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Speaker 2: by six salesman, eating a morning cheeseburger, and watching Ranieri

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Speaker 2: hold a big lighter under the balls of a fellow trader.

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Speaker 2: I wasn't prepared for that.

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Speaker 3: This, this is Slivin Brothers. At this time, you don't

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Speaker 3: see the lighter coming. John Merriweather was not this kind

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Speaker 3: of guy. He was working class, but he was calm.

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Speaker 3: He was even tempered. He didn't yell, didn't hold big

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Speaker 3: lighters under his colleagues balls, but he did love to

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Speaker 3: take risks. He was a trader at heart, and he

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Speaker 3: was really good at it. And he got promoted and

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Speaker 3: he started running a desk, which meant he had to

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Speaker 3: hire people to come work with him. Higher traders. And

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Speaker 3: this is when he has his big idea. For the

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Speaker 3: past decade or so. By this point, this is the

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Speaker 3: early eighties, professors at places like MIT and the University

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Speaker 3: of Chicago had been developing these really mathematical theories of

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Speaker 3: finance about prices.

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Speaker 2: Right.

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Speaker 3: Some of this had filtered into Wall Street, but not much.

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Speaker 2: It was an academic endeavor. They had found data sets

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Speaker 2: and they were tracking the stock market, and they knew

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Speaker 2: there was money involved, but they were doing it to

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Speaker 2: pass their dissertations, not necessarily to like blow up the market.

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Speaker 3: Yeah, and still the culture on Wall Street was this

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Speaker 3: very kind of cheeseburgers for breakfast culture, not an academic culture.

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Speaker 3: But Merriweather's idea was basically, oh, maybe these nerds know

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Speaker 3: what they're talking about, you know, like maybe they could

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Speaker 3: actually come to Wall Street. We could do a bunch

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Speaker 3: of math and make money. And so he decides to

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Speaker 3: test this theory, starts hiring a bunch of you know,

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Speaker 3: guys with PhDs from a MIT and they come work

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Speaker 3: with him at Solomon Brothers.

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Speaker 2: He's like, stay away from the guy with a big light.

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Speaker 3: Yeah, and it's unsurprising now now, if you have a

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Speaker 3: PhD from MIT, the easiest thing to do is not

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Speaker 3: to be a professor, but to go work at Jane

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Speaker 3: Street or some.

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Speaker 2: Quant Yeah, they're actually recruiting at MIT in Stanford and Harvard.

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Speaker 3: A banker who worked with Merriweather said, these guys that

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Speaker 3: Merriweather is bringing in, these academics, were considered freaks. Here's

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Speaker 3: a line, those.

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Speaker 2: Guys would be playing with their slide rules at Bell

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Speaker 2: Labs if it wasn't for John.

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Speaker 3: Slide rules, slide rules. Three things about that quote. Those

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Speaker 3: guys would be playing with their slide rules at Bell

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Speaker 3: Labs if it wasn't for John. One, it comes from

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Speaker 3: Roger Lowenstein's book When Genius Failed, excellent excellent nonfiction book

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Speaker 3: about the rise and fall of long term capital management,

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Speaker 3: the key source for today's show. Two, slide rules were

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Speaker 3: what people used to do complicated math before graphic calculators

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Speaker 3: came along. Scientific calculators I had.

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Speaker 2: One, Yeah you would like actually move little little slides?

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Speaker 2: And yeah in a little little clear window.

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Speaker 3: I love that. And Three Importantly, this quote was an

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Speaker 3: anachronism even in nineteen eighty three, because if they would

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Speaker 3: not have been playing with slide rules, they would have

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Speaker 3: been playing with computers. The rise of the computer is

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Speaker 3: what empowers these people to do real work.

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Speaker 2: I'm going to give you a number four too, because

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Speaker 2: we're starting to see the shift in the economy. In

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Speaker 2: this quote, they're not at Bell Labs anymore. They're not

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Speaker 2: working for American manufacturing, an American invention, They're working for

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Speaker 2: American finance. This is when we're seeing this big shift

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Speaker 2: in the economy.

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Speaker 3: Yes, financialization, financialization, the rise of Wall Street.

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Speaker 2: Yes.

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Speaker 3: And in fact, it's no coincidence that Jim Simons, who

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Speaker 3: you did a show about.

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Speaker 2: Who is a math PhD, who is a math PhD.

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Speaker 3: Is starting his fund Renaissance Technologies right around the same time.

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Speaker 3: So Meriweather brings the nerds to Wall Street and they

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Speaker 3: work with him on what's called the arbitrage desk. Robert Smith,

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Speaker 3: what's arbitrage? Sweet sweet free money?

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Speaker 2: Arbitrage is this very specific idea in finance, and it's

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Speaker 2: this very big idea and very simple idea I would say,

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Speaker 2: which is is, if you can buy and sell the

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Speaker 2: same thing at different prices, you can make money with

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Speaker 2: almost no risk. So let's say silver is trading in

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Speaker 2: New York at one hundred dollars and is trading in

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Speaker 2: London at one hundred and one dollars.

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Speaker 3: It's a very high price for silver. It's very exciting moment.

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Speaker 2: Yes, you could buy the silver in New York for

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Speaker 2: one hundred dollars and simultaneously sell it in London for

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Speaker 2: one hundred and one dollars. You know, you don't have

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Speaker 2: to ship it, and then you make a dollar profit. Yes,

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Speaker 2: no work whatsoever.

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Speaker 3: Yes, Now, arbitrage is like this tend to be hard

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Speaker 3: to find because people arbitrage them away. When you buy

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Speaker 3: the cheap one and sell the expensive one, you cause

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Speaker 3: the prices to converge at.

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Speaker 2: One hundred dollars and fifty cents.

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Speaker 3: So the kinds of arbitrage is that Merriweather and his

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Speaker 3: nerds are finding are a little more subtle, but they are.

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Speaker 3: But they exist in the world. And these guys come

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Speaker 3: in and indeed start making money, a lot of money.

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Speaker 3: In some years, they account for most of Solomon's profits.

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Speaker 3: And that might have been the end of the story.

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Speaker 3: They might have just got rich on Wall Street, but

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Speaker 3: for one thing in nineteen ninety one. So they've been

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Speaker 3: at this for a while. They're doing well. Merriweather gets

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Speaker 3: in trouble because a guy who worked for him rigged

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Speaker 3: Treasury bond auctions and actually told Merriweather about it, and

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Speaker 3: Merriweather told his boss, but they didn't do anything. They

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Speaker 3: said on it. Sorry comes out, they lose their jobs.

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Speaker 3: We talked about this.

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Speaker 2: In the Warren Buffett Show because Warren Buffett was a

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Speaker 2: huge investor in Salomon Brothers had to come in and

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Speaker 2: run the company from Omaha.

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Speaker 3: Yes, with all of these.

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Speaker 2: New York traders, just to fix the reputation.

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Speaker 3: Yes, so Merriweather, I think he resigned under pressure. I

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Speaker 3: don't think Ashley got fired, but he's out. He's out.

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Speaker 3: So he decides not long after that he wants to

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Speaker 3: get his band of nerds back together, but not working

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Speaker 3: for somebody else, not at a Wall Street firm. He

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Speaker 3: wants to start a hedge fine. Ooh, wasn't his reputation

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Speaker 3: bat well? I will know he didn't get fired for

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Speaker 3: losing money. Yes, that fired for unethical laps and making

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Speaker 3: a lot of fun making a lot of money. So

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Speaker 3: o contrare ethical laps plus making a lot of money.

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Speaker 2: Perfect, And so he decided to start a hedge fund.

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Speaker 2: In nineteen ninety three, hedge funds were not that popular,

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Speaker 2: but there was this idea which was you could have

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Speaker 2: a fund that was not correlated to the market, and

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Speaker 2: this was very useful because you would make money on stocks,

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Speaker 2: but you're worried about losing money, so you put a

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Speaker 2: fraction of your wealth into a hedge fund and they

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Speaker 2: would do sophisticated mathematical things to make sure that if

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Speaker 2: the market were to crash, you wouldn't lose all your money.

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Speaker 2: That was the hedge part. That's the hedge right.

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Speaker 3: They make different kinds of bets, so it's not just

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Speaker 3: market goes up, you make money. Market goes down, you

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Speaker 3: lose money. This was the original idea. Hedge funds had

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Speaker 3: been around for decades by this point. By the time

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Speaker 3: Merriweather comes along and the Nine Days, not all hedge

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Speaker 3: funds are even hedged. The main thing they are is

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Speaker 3: special funds for rich people and institutions that charge high fees.

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Speaker 3: And Meriweather decides he's going to launch the biggest hedge

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Speaker 3: fund ever. And in order to launch the biggest hedge

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Speaker 3: fund ever and to charge higher fees than usual, which

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Speaker 3: is also part of his plan, he needs to nerd up.

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Speaker 3: He needs to go even nerdier than before, and he

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Speaker 3: goes and recruits two professors. Two super nerds who are

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Speaker 3: going to make his dreams come true. They are Robert

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Speaker 3: Merton and Myron Scholes. Merton was a Harvard professor who

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Speaker 3: was sort of the father of the finance math nerds

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Speaker 3: in Shoals. Scholes was at Stanford and hiring Shoals was like,

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Speaker 3: I couldn't quite nail this one. It was like hiring

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Speaker 3: doctor band aid for your hospital or I don't know it.

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Speaker 3: Because Schole's name was on this famous equation that was

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Speaker 3: widely used in finance. Shouls and another guy, Fisher Black

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Speaker 3: had come up with Black Shoals, an equation that I

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Speaker 3: know is dear to your heart.

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Speaker 2: Yeah, if you know anything about finance, Matthew, you know

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Speaker 2: the Black Shoals formula. And what they did was solve

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Speaker 2: this classic problem in finance, which is how to price

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Speaker 2: an option. So an option is a contract between two

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Speaker 2: people that essentially says I have the right to buy

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Speaker 2: something you own in the future at a certain price

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Speaker 2: at a certain price. So Jacob's, you know, all in

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Speaker 2: on SpaceX and I I'm a little bit wary, So

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Speaker 2: I say to him, I want the right to buy

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Speaker 2: SpaceX at two hundred dollars in six months. Okay, that's

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Speaker 2: a normal contract. But how much should I pay Jacob

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Speaker 2: for that right to buy it in the future, the right,

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Speaker 2: but not the obligation right. And so people had used

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Speaker 2: their guts, they essentially guessed what this was worth. And

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Speaker 2: what Shoals and Black and Merton did was come up

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Speaker 2: with this way to essentially price the future in the

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Speaker 2: present by creating a little insurance portfolio. Theoretically, yeah, the

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Speaker 2: way you predict future risk now is through essentially an

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Speaker 2: insurance contract. So now Meriwether has Merton and Shoals. He

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Speaker 2: also hires a guy who had worked at the FED.

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Speaker 3: It's incredible team, and history, in a really profound way

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Speaker 3: is on their side. Like, think about this moment. It's

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Speaker 3: nineteen ninety three. Communism fell, you know, the Soviet Union

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Speaker 3: just fell apart. The Cold War is over, and it's

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Speaker 3: clear right free market capitalism one command and control communism lost.

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Speaker 3: Even Russia at this point is becoming a market economy.

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Speaker 3: And there's this famous, kind of controversial book that has

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Speaker 3: just come out around this time that kind of nails

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Speaker 3: this moment, a book with the title that people love

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Speaker 3: to mock. The title was The End of History was

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Speaker 3: by a professor named Francis Fukuyama, and let me just

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Speaker 3: say he didn't actually mean the end of history the

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Speaker 3: way people who mocket say.

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Speaker 2: Things would still happen. Things would still happen.

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Speaker 3: His argument was, there has been this long arc of

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Speaker 3: humanity figuring out how to organized people in economies, you know,

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Speaker 3: monarchical feudalism, and we had communist dictatorships, and now in

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Speaker 3: the nineties we have arrived at a winner free market

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Speaker 3: capitalism and liberal democracy.

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Speaker 2: And if you think all the other countries in the

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Speaker 2: world are going to become more like the US, more efficient,

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Speaker 2: then you can make bets on that.

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Speaker 3: This is the world that Merton and Shoals have been

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Speaker 3: doing their math for the rational so called rational if

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Speaker 3: you like, world where the market becomes more efficient, where

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Speaker 3: prices more and more closely reflect fundamentals.

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Speaker 2: This is their moment. The world is breaking their way.

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Speaker 3: And so when Merton and Shoals and Meriwether go out

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Speaker 3: to pitch their fund the world wants in. Italy's Central

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Speaker 3: Bank invests, the biggest investment bank in Brazil invests. Money

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Speaker 3: is coming in from Japan, from Taiwan, from Kuwait, from

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Speaker 3: Wall Street. Phil Knight, founder of Nike invests Michael Ovitz.

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Speaker 3: Avitz don't know Ovits Hollywood superagent invests. You know all

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Speaker 3: Meriweather raises over a billion dollars, which was a hedge fund. Ever,

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Speaker 3: and in February of nineteen ninety four they launch Long

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Speaker 3: Term Capital Management becomes a thing. They got an office

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Speaker 3: in Greenwich, Connecticut. Of course, they got like forty people,

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Speaker 3: and they got a bunch of computers and they are

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Speaker 3: ready to start making money. We're going to run an

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Speaker 3: ad now. If you don't want to hear ads, you

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Speaker 3: can join Pushkin Plus at pushkin dot fm, slash plus.

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Speaker 4: We'll be back in a minute.

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Speaker 3: The ads are over. We're going to talk about one

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Speaker 3: of the first big trades they did at Long Term

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Speaker 3: Capital because it explains the basic way that the firm worked.

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Speaker 3: So the traders at the firm saw this gap, this

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Speaker 3: price gap basically an arbitrage opportunity, and what it was

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Speaker 3: was a gap in the price between newly issued thirty

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Speaker 3: year treasury.

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Speaker 2: Bonds fresh it could still smell the inc.

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Speaker 3: Us government debt and thirty year treasury bonds that had

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Speaker 3: been issued just a few months earlier. So this is

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Speaker 3: basically the same thing. But there was an unusually large

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Speaker 3: gap between the prices of the two of them for

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Speaker 3: sort of kind of regulatory reasons about the way Wall

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Speaker 3: Street had to work. The key thing is it was

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Speaker 3: clear that this gap should close over time. It was

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Speaker 3: bigger than made sense. So this is perfect for the nerds.

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Speaker 3: It's an irrational gap on really safe assets. They don't

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Speaker 3: have to bet on whether you know the treasury market

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Speaker 3: is going to go up or down. They just have

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Speaker 3: to bet that this irrational price gap is going to close,

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Speaker 3: and it almost certainly will close.

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Speaker 2: This is the age of rationality. Of course it's going

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Speaker 2: to close, and they can help it do that.

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Speaker 3: The only problem is that the gap between the prices

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Speaker 3: was really small. It was like one and a half percent.

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Speaker 3: So even if the gap closes entirely, and it might

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Speaker 3: not do that, the most they could make is ish

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Speaker 3: one and a half percent too low.

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Speaker 2: That's too low.

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Speaker 3: Yes, you're not starting this great hedgehunt with a billion

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Speaker 3: dollars for a return like that. So you have an

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Speaker 3: investment that you're very confident in, it's a smaller intern.

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Speaker 3: What do you do.

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Speaker 2: You lever up. You borrow money. You borrow massive amounts

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Speaker 2: of money because when you borrow money, you can turn

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Speaker 2: a tiny percentage increase into a large percentage increase. Yes,

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Speaker 2: let's do the math. Okay, give it to me. Okay.

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Speaker 2: So if I have a million dollars and it's going

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Speaker 2: to return one percent, that's ten thousand dollars.

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Speaker 4: Boom.

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Speaker 2: No, that doesn't even buy me a Masarati.

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Speaker 3: I want my Mazarin and buy you a bad car.

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Speaker 2: So I take my one million dollars, I go to

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Speaker 2: a bank and say give me nineteen million more dollars.

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Speaker 2: Now I have twenty million dollars, same investment only. Now

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Speaker 2: I make two hundred thousand dollars. I get my Masarati,

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Speaker 2: and that's a twenty percent return. I pay back the

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Speaker 2: nineteen million. Sure, and by borrowing that money, I can

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Speaker 2: make myself rich even on tiny opportunities.

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Speaker 3: This is the game.

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Speaker 2: Still is the game. Still, this is not a historical thing.

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Speaker 2: This is what happens today.

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Speaker 3: So they do this, They borrow something like twenty five

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Speaker 3: dollars for every dollar they have. Yes, and they make

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Speaker 3: a billion dollar bet on this to treasury arbitrage play,

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Speaker 3: and it works, and very quickly they make fifteen million

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Speaker 3: dollars in profit, putting up very little of their own money.

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Speaker 3: It's working. It's important to know that they're not the

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Speaker 3: only ones who see this gap. You know, the quants

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Speaker 3: are emerging by this point, there are lots of nerds

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Speaker 3: following in their footsteps, and so as other traders are

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Speaker 3: getting in on this kind of bet, the spreads are closing,

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Speaker 3: and the traders at Long term Capital have to look

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Speaker 3: farther out into the world and make bets that are

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Speaker 3: a little bit more speculative. One big one they do

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Speaker 3: early on is on Italian bonds.

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Speaker 2: So I don't want to give a hard time to

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Speaker 2: the Italian economy, but let's just say they've had a

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Speaker 2: lot of problems, especially at this point, a lot of

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Speaker 2: different governments, and so Italian bonds are a little bit

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Speaker 2: riskier than the other countries of Europe or US bonds. Yes,

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Speaker 2: and this is before the euro right, so even more so.

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Speaker 2: But a trader at Long.

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Speaker 3: Term Capital is convinced that the market is overestimating a

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Speaker 3: particular risk. And again this isn't like some wild speculation.

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Speaker 3: He thinks the market is overestimating the risk that Italian

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Speaker 3: companies will default on their bonds relative to the risk

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Speaker 3: that the Italian government will default. Right, So it's still

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Speaker 3: a spread trade, right, a convergence trade.

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Speaker 2: But you know, it's interesting that there is this principle

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Speaker 2: in behavioral economics that says that people overestimate the odds

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Speaker 2: that bad things will happen.

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Speaker 3: Uh huh.

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Speaker 2: So in the stock market, you hear news about all

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Speaker 2: time highs or the stock market crashing. Most days, the

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Speaker 2: stock market is boring. You know, the price at the

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Speaker 2: end of the day is very similar to the price

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Speaker 2: at the beginning of the day. You know, we worry

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Speaker 2: about Italian bonds or Italian company bonds. Oh no, they're

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Speaker 2: going to default, but most of the time they don't.

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Speaker 2: But weirdly, as humans, we think about the bad thing

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Speaker 2: that can happen, and that's the price we put on it.

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Speaker 3: So Long Term Capital decides to take the other side

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Speaker 3: of that bet to decide, no, the world is going

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Speaker 3: to continue to just be faught. Yeah, to be boring.

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Speaker 3: They make this bet. Italy in fact did not default,

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Speaker 3: and Long Term Capital made something like six hundred million

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Speaker 3: dollars in two years on that trade. So the firm

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Speaker 3: is doing the thing that they said they would do.

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Speaker 3: They're making these trades that profit, you know, whether or

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Speaker 3: not the market goes up or down, that things will

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Speaker 3: tend to converge over time. They're borrowing a lot of

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Speaker 3: money to do it, and it works so well. It works,

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Speaker 3: in fact, better than they thought it would. In nineteen

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Speaker 3: ninety five, long Term Capital made a fifty nine percent return.

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Speaker 3: They took a bunch of fees out of that, and

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Speaker 3: they returned to their investors forty three percent in one year.

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Speaker 3: Take all my money, Take all my money, acts, Yeah, yeah, please.

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Speaker 3: And one interesting thing about this moment is the people

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Speaker 3: running the firm, Merton and Cholls and the rest of them,

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Speaker 3: they knew that this was extraordinary. This was more than

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Speaker 3: they expected. And I don't just mean that in a

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Speaker 3: kind of hand wavy way. They weren't like, oh, that's

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Speaker 3: more and we expected. It was more than their math

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Speaker 3: told them was likely.

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Speaker 2: And at this point there are traders who are not

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Speaker 2: PhDs in the firm, who are, you know, popping the

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Speaker 2: champagne and saying we're geniuses. They're you know, they're like,

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Speaker 2: we're we're going to do this again and again and again.

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Speaker 2: But the math guys in the room are looking at

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Speaker 2: this saying, this is off our calculations, this is better

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Speaker 2: than we thought, which is just as bad as worse

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Speaker 2: than we thought.

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Speaker 3: It's not. It's not actually no mathematical perspective. So they

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Speaker 3: they have done all them me And in fact, you know,

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Speaker 3: all firms tell their their investors we might lose money, right,

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Speaker 3: your lawyers make you say we might lose money. But

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Speaker 3: there is this amazing investor letter. It's actually an addendum

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Speaker 3: to the investor letter that the firm sends out. The

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Speaker 3: addendum is written by Merton and Shoals. Lowenstein talks about

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Speaker 3: this in his book. And they don't just say yes,

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Speaker 3: our firm might lose money. They put numbers on how

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Speaker 3: much they might lose. So, for example, they say, yes,

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Speaker 3: there is a twelve percent ants that the fund will

402
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Speaker 3: lose at least five percent of its money in any

403
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Speaker 3: given year. This is their worldview that outcomes are mathematically

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Speaker 3: knowable in a probabilistic way. And this is the worldview

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Speaker 3: that is spreading. You know, this is kind of the

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Speaker 3: end of history worldview, the triumph of free market capitalism.

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Speaker 3: And in nineteen ninety seven, this worldview is validated in

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Speaker 3: the most validating way possible when Merton and Shoals win

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Speaker 3: the Nobel Prize.

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Speaker 2: Very rare for an investment trader to win the Nobel prize.

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Speaker 3: Yes, like they're making billions of dollars for their firm

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Speaker 3: and many millions of dollars for themselves. Like, oh, by

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Speaker 3: the way, you're a genius. The way here you go,

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Speaker 3: and you know the prize is specifically for that work

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Speaker 3: figuring out how to price options. But the committee, there's

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Speaker 3: this phrase from the committee that is important here. The committee,

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Speaker 3: the Nobel Committee says their work facilitated more efficient risk

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Speaker 3: management in society.

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Speaker 2: Which is a beneficial thing for the world. You know,

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Speaker 2: there's a lot of risk out there, and if you

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Speaker 2: don't know how to price that risk, that's concerning things

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00:23:21,720 --> 00:23:23,600
Speaker 2: can blow up all the time. But if you have

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Speaker 2: formulas that allow us to figure out exactly how much

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Speaker 2: risk something is taking and how to price that risk,

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Speaker 2: everyone can calm down. Part of the calm nineties we're talking.

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Speaker 3: About the world is better when when prices more accurately

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Speaker 3: reflect fundamentals. I should mention, by the way, Blackfish or

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00:23:40,720 --> 00:23:44,040
Speaker 3: black of Black Shoals would have won as well, but

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Speaker 3: he had died by this point and you can't win

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Speaker 3: the Nobel posthumously. So now long term capital has extraordinary returns,

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Speaker 3: and on top of that, they just won the Nobel Prize.

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Speaker 2: The line forms to the right. Just be calm all

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Speaker 2: the way around their building in grengeng Connecticut. People want

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Speaker 2: to give them money, clearly, but they can't take more

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00:24:06,480 --> 00:24:08,359
Speaker 2: money at this point. This is a problem.

436
00:24:08,440 --> 00:24:11,520
Speaker 3: It's a classic hedge fund problem, where you know they're

437
00:24:11,560 --> 00:24:14,280
Speaker 3: not just putting money into the stock market and these

438
00:24:14,680 --> 00:24:18,520
Speaker 3: giant liquid markets. They're making these weird arbitrage bets on

439
00:24:18,720 --> 00:24:21,439
Speaker 3: bonds in Italy, and there's only so much money you

440
00:24:21,480 --> 00:24:24,639
Speaker 3: can put into those bets before it starts to move markets.

441
00:24:24,720 --> 00:24:27,040
Speaker 3: Or at least this is what they tell their investors

442
00:24:27,720 --> 00:24:30,359
Speaker 3: in the fall of nineteen ninety seven, around the time

443
00:24:30,680 --> 00:24:33,359
Speaker 3: that Mertin Inchuls win the Nobel Price. Here Robert read

444
00:24:33,520 --> 00:24:36,760
Speaker 3: from this letter that merriweather sends to investors around this time.

445
00:24:37,000 --> 00:24:40,600
Speaker 2: The fund has excess capital. This has occurred primarily because

446
00:24:40,640 --> 00:24:43,280
Speaker 2: of a substantial increase in the capital base from the

447
00:24:43,400 --> 00:24:47,000
Speaker 2: larger than expected past realized rates of return and high

448
00:24:47,040 --> 00:24:51,960
Speaker 2: reinvestment rates elected by the funds investors. Oh we're too good,

449
00:24:52,080 --> 00:24:54,360
Speaker 2: We're too good at our jobs. We just made too

450
00:24:54,440 --> 00:24:56,040
Speaker 2: much money, is what they're saying.

451
00:24:56,160 --> 00:24:58,600
Speaker 3: They're saying that, and what they decide to do is

452
00:24:59,640 --> 00:25:02,080
Speaker 3: force the investors to take back their money. And a

453
00:25:02,080 --> 00:25:03,959
Speaker 3: lot of the investors are like, no, don't give us

454
00:25:03,960 --> 00:25:06,360
Speaker 3: our money back. Keep it. And of course the partners

455
00:25:06,440 --> 00:25:09,320
Speaker 3: keep their own money in crucially, but in late nineteen

456
00:25:09,400 --> 00:25:12,320
Speaker 3: ninety seven, Long Term Capital does in fact payout two

457
00:25:12,320 --> 00:25:17,879
Speaker 3: point seven billion dollars to its investors. Now, the next

458
00:25:17,880 --> 00:25:21,720
Speaker 3: thing that happens is amazing. The fund does not trim

459
00:25:21,800 --> 00:25:24,280
Speaker 3: its bets, does not say, oh, now that we've given

460
00:25:24,320 --> 00:25:26,520
Speaker 3: this money back, we're gonna, you know, be a little

461
00:25:26,520 --> 00:25:30,479
Speaker 3: bit more modest. What they do is they borrow more money,

462
00:25:30,520 --> 00:25:34,439
Speaker 3: They increase their leverage and keep the same bets going.

463
00:25:34,880 --> 00:25:37,240
Speaker 2: It works, so well, why not double down?

464
00:25:37,280 --> 00:25:39,919
Speaker 3: Why not double down? So now a bigger share of

465
00:25:39,960 --> 00:25:42,840
Speaker 3: the fund is the partner's own money. It's levered up

466
00:25:42,840 --> 00:25:47,119
Speaker 3: even more so if it works, if they keep making money,

467
00:25:47,119 --> 00:25:50,800
Speaker 3: the partners will go from really really rich to really

468
00:25:50,840 --> 00:25:53,800
Speaker 3: really really really rich. By the way, we haven't mentioned

469
00:25:53,800 --> 00:25:57,160
Speaker 3: the other side of leverage, which is the market goes

470
00:25:57,200 --> 00:26:01,119
Speaker 3: against you. Instead of losing a little, you lose a lot.

471
00:26:01,880 --> 00:26:03,679
Speaker 3: What is going to happen after the ad break?

472
00:26:03,840 --> 00:26:06,240
Speaker 2: They're Nobel Prize winning geniuses. They are going to be

473
00:26:06,320 --> 00:26:31,719
Speaker 2: rich forever. Willsone, and we're back on the roller coaster.

474
00:26:32,760 --> 00:26:34,560
Speaker 2: The cars have just gone up the hill at the

475
00:26:34,560 --> 00:26:38,720
Speaker 2: beginning of the roller coaster. It's to the very very top.

476
00:26:38,840 --> 00:26:40,280
Speaker 5: And do you know we're going to talk about now

477
00:26:40,640 --> 00:26:45,600
Speaker 5: bond spreads. Okay, let's do bond spreads. If you have

478
00:26:45,640 --> 00:26:49,440
Speaker 5: two different bonds, they may pay different interest rates. If

479
00:26:49,440 --> 00:26:52,160
Speaker 5: you have a very safe bond, like US government bond,

480
00:26:52,200 --> 00:26:55,119
Speaker 5: it may pay four percent. If you have a risky.

481
00:26:54,800 --> 00:26:58,080
Speaker 2: Bond, it may pay eighteen percent to compensate for the risk.

482
00:26:58,119 --> 00:26:59,879
Speaker 3: Eight ten percent is crazy, I know.

483
00:27:00,040 --> 00:27:03,080
Speaker 2: So the spread risky bond, the spread is the gap

484
00:27:03,119 --> 00:27:06,560
Speaker 2: between them, so in this case, fourteen percent eighteen minus four.

485
00:27:07,240 --> 00:27:09,480
Speaker 2: The key thing to know is the magnitude of the

486
00:27:09,520 --> 00:27:13,280
Speaker 2: spread is a measure of fear. Really, the wider the spread,

487
00:27:13,800 --> 00:27:16,239
Speaker 2: the more worried investors are.

488
00:27:16,280 --> 00:27:18,640
Speaker 3: When they're really confident about the economy, the spread will

489
00:27:18,680 --> 00:27:19,680
Speaker 3: be narrower.

490
00:27:19,280 --> 00:27:21,680
Speaker 2: Because they think everyone's going to pay out their bonds.

491
00:27:21,720 --> 00:27:23,560
Speaker 3: The risk bond isn't that risky.

492
00:27:23,480 --> 00:27:26,639
Speaker 2: But if the economic conditions start to get worse, you

493
00:27:26,680 --> 00:27:29,520
Speaker 2: start to worry about your higher risk bonds, you demand

494
00:27:30,080 --> 00:27:33,600
Speaker 2: a higher interest rate, and the gap wid.

495
00:27:33,760 --> 00:27:36,400
Speaker 3: Widens and people flee to the safe bond, which makes

496
00:27:36,400 --> 00:27:37,360
Speaker 3: that interest rate even lower.

497
00:27:37,440 --> 00:27:37,600
Speaker 2: Yung.

498
00:27:37,960 --> 00:27:40,600
Speaker 3: So it's the beginning of nineteen ninety eight, and in

499
00:27:40,640 --> 00:27:44,160
Speaker 3: a lot of parts of the world, bond spreads are

500
00:27:44,680 --> 00:27:48,560
Speaker 3: wider than usual. They're not insanely wide. It's not like

501
00:27:48,640 --> 00:27:52,199
Speaker 3: financial crisis wide, but they're wide. You know, there are

502
00:27:52,240 --> 00:27:54,560
Speaker 3: reasons for this. In nineteen ninety seven there was the

503
00:27:54,600 --> 00:27:59,560
Speaker 3: Asian financial crisis that flowed through Thailand, Indonesia, South Korea.

504
00:27:59,880 --> 00:28:02,159
Speaker 3: So investors are still worried about this, and this is

505
00:28:02,200 --> 00:28:05,879
Speaker 3: reflected in wide bond spreads. And the partners at Long

506
00:28:05,960 --> 00:28:10,480
Speaker 3: Term Capital, and more importantly they're financial models, thought global

507
00:28:10,480 --> 00:28:14,520
Speaker 3: bond investors were too worried about this. They thought bond

508
00:28:14,560 --> 00:28:18,359
Speaker 3: prices would converge, spreads would fall, things would go back

509
00:28:18,440 --> 00:28:21,399
Speaker 3: to historic norms. And if you zoom out to that

510
00:28:21,560 --> 00:28:25,240
Speaker 3: broader historic arc we were talking about earlier, this makes sense.

511
00:28:25,280 --> 00:28:28,119
Speaker 3: You know, fall of the Soviet Union, triumph of the

512
00:28:28,160 --> 00:28:32,320
Speaker 3: free market, progress of rational economic actors. All of this

513
00:28:33,040 --> 00:28:38,920
Speaker 3: points in the direction of a smoother, less volatile, calmer

514
00:28:39,240 --> 00:28:41,720
Speaker 3: market and lower bond spreads.

515
00:28:41,960 --> 00:28:44,680
Speaker 2: And the economy in the US is doing tremendously. Well,

516
00:28:44,760 --> 00:28:47,640
Speaker 2: we have the Internet. Finally, there's all these dot com stocks.

517
00:28:47,920 --> 00:28:50,080
Speaker 2: It looks like a new age and economy.

518
00:28:49,760 --> 00:28:52,720
Speaker 3: Around the time we balance the budgets running a surplus

519
00:28:52,760 --> 00:28:56,240
Speaker 3: somewhere around here. Yeah, so long term capital puts on

520
00:28:56,480 --> 00:29:00,040
Speaker 3: debts all over the world, that volatility will go down,

521
00:29:00,360 --> 00:29:03,560
Speaker 3: that spreads will converge in Europe and in Latin America.

522
00:29:03,600 --> 00:29:06,440
Speaker 3: And they're also putting on bets in Russia in the

523
00:29:06,520 --> 00:29:10,640
Speaker 3: new capitalist frontier, and the Russian economy was kind of

524
00:29:10,640 --> 00:29:14,040
Speaker 3: a mess by this point. People were starting to worry

525
00:29:14,040 --> 00:29:17,600
Speaker 3: that Russia might default on its debts. But there was

526
00:29:17,600 --> 00:29:20,120
Speaker 3: this thing people said at the time, which was, no

527
00:29:20,360 --> 00:29:23,800
Speaker 3: nuclear power has ever defaulted, meaning no, you know, big

528
00:29:23,920 --> 00:29:27,760
Speaker 3: serious country has ever defaulted. Just kind of a nuclear

529
00:29:27,760 --> 00:29:29,120
Speaker 3: power is kind of weird, but it was a thing

530
00:29:29,160 --> 00:29:32,200
Speaker 3: people said. And you know, the International Monetary Fund, the

531
00:29:32,280 --> 00:29:35,680
Speaker 3: IMF had been really active in countries around the world

532
00:29:35,800 --> 00:29:38,720
Speaker 3: helping them stave off defaults. And so the traders at

533
00:29:38,760 --> 00:29:40,560
Speaker 3: long term capital look at Russia and they think, no,

534
00:29:40,680 --> 00:29:43,680
Speaker 3: these fears are you know, one more example of irrational fears.

535
00:29:43,840 --> 00:29:46,160
Speaker 3: They figure Russia is going to pay its debts, spreads

536
00:29:46,160 --> 00:29:50,040
Speaker 3: will converge, and also they do hedge some of their

537
00:29:50,080 --> 00:29:51,720
Speaker 3: bets for additional safety.

538
00:29:52,040 --> 00:29:55,720
Speaker 2: I do love, though, that they're kind of optimists. I

539
00:29:55,760 --> 00:29:57,959
Speaker 2: know it's the data and it's backed by the computers,

540
00:29:58,000 --> 00:30:00,040
Speaker 2: but what they are saying is that the world is

541
00:30:00,080 --> 00:30:02,520
Speaker 2: going to be a calmer, better place. It's kind of

542
00:30:02,560 --> 00:30:05,280
Speaker 2: a beautiful thought. I wouldn't borrow a bunch of money

543
00:30:05,320 --> 00:30:07,840
Speaker 2: and put billions of dollars on it.

544
00:30:07,920 --> 00:30:11,560
Speaker 3: But yes, yes, I mean in a certain way, not exactly,

545
00:30:11,600 --> 00:30:14,080
Speaker 3: but kind of like you and I both just do

546
00:30:14,200 --> 00:30:18,040
Speaker 3: the boring retirement thing of just buy index funds mostly

547
00:30:18,080 --> 00:30:20,840
Speaker 3: of stocks, and that's a version of that. Right, We're

548
00:30:20,840 --> 00:30:23,160
Speaker 3: just going to ride a growing economy because that's what

549
00:30:23,200 --> 00:30:24,840
Speaker 3: has happened, but we don't borrow a bunch of money

550
00:30:24,840 --> 00:30:25,160
Speaker 3: to do it.

551
00:30:25,240 --> 00:30:25,600
Speaker 2: We don't.

552
00:30:25,760 --> 00:30:28,800
Speaker 3: So Long Term Capital is betting that around the world

553
00:30:28,920 --> 00:30:32,280
Speaker 3: spreads are going to converge. This is not what happens.

554
00:30:32,600 --> 00:30:35,040
Speaker 3: In the spring and early summer of nineteen ninety eight,

555
00:30:36,000 --> 00:30:38,640
Speaker 3: spreads start to get a little bit wider, and in

556
00:30:38,760 --> 00:30:43,360
Speaker 3: June of nineteen ninety eight, long Term Capital loses ten percent,

557
00:30:44,560 --> 00:30:49,640
Speaker 3: biggest ever one month loss. Not disastrous, but big. In July,

558
00:30:49,880 --> 00:30:55,480
Speaker 3: their return stabilize and then comes August, and on August seventeenth,

559
00:30:56,040 --> 00:31:00,960
Speaker 3: the thing happened that was not supposed to happen. Russia defaulted.

560
00:31:01,600 --> 00:31:03,840
Speaker 3: Russia said we are not going to pay some of

561
00:31:03,880 --> 00:31:07,680
Speaker 3: our debts. And also the Russian banks where Long Term

562
00:31:07,680 --> 00:31:10,320
Speaker 3: Capital had put their hedges, like we're not going to

563
00:31:10,400 --> 00:31:13,040
Speaker 3: pay those foreign investors going to pay out on those

564
00:31:13,240 --> 00:31:14,080
Speaker 3: on those contracts.

565
00:31:14,320 --> 00:31:16,280
Speaker 2: Who would have thought, you can't trust the Russians.

566
00:31:16,760 --> 00:31:19,600
Speaker 3: Kind of surprisingly, it actually takes a few days for

567
00:31:19,720 --> 00:31:23,600
Speaker 3: it to hit global markets. Robert Smith, I have I've

568
00:31:23,640 --> 00:31:26,440
Speaker 3: pasted here a paragraph from a nineteen ninety eight Wall

569
00:31:26,440 --> 00:31:29,040
Speaker 3: Street Journal story for you to read.

570
00:31:29,880 --> 00:31:33,480
Speaker 2: It was August twenty first, a sultry Friday, and nearly

571
00:31:33,480 --> 00:31:36,360
Speaker 2: half the partners at Long Term Capital Management LP were

572
00:31:36,360 --> 00:31:40,480
Speaker 2: out of the office. Outside the funds glass and granite headquarters,

573
00:31:40,800 --> 00:31:45,960
Speaker 2: a fountain languidly streamed over a copper osprey clawing its prey.

574
00:31:47,400 --> 00:31:49,080
Speaker 3: I said this to you. I said this to you,

575
00:31:49,320 --> 00:31:52,720
Speaker 3: and I have like a running thing about newspaper stories

576
00:31:52,720 --> 00:31:56,640
Speaker 3: with like gratuitous descriptions of place number one.

577
00:31:56,880 --> 00:31:59,800
Speaker 2: It means that the reporter did not get inside the building.

578
00:32:00,320 --> 00:32:03,000
Speaker 2: So the reporters describing whatever they can. But number two.

579
00:32:03,240 --> 00:32:08,080
Speaker 2: It means settle in for a long story of hubris. Yes.

580
00:32:08,240 --> 00:32:10,880
Speaker 3: I mean, if you are a financial firm and the

581
00:32:10,920 --> 00:32:14,120
Speaker 3: Wall Street Journal is describing the fountain outside your office,

582
00:32:14,920 --> 00:32:18,200
Speaker 3: you are in terrible trouble. Something very wrong has happened.

583
00:32:18,920 --> 00:32:22,200
Speaker 3: In this case, what has happened on this sultry August

584
00:32:22,280 --> 00:32:25,680
Speaker 3: day is that investors all around the world, all around

585
00:32:25,720 --> 00:32:28,240
Speaker 3: the world are terrified by what has happened in Russia,

586
00:32:28,320 --> 00:32:32,320
Speaker 3: and they are reacting by selling risky bonds and buying

587
00:32:32,400 --> 00:32:33,160
Speaker 3: safe bonds.

588
00:32:33,160 --> 00:32:35,920
Speaker 2: But not just in Russia. They're afraid of risky bonds

589
00:32:35,960 --> 00:32:41,200
Speaker 2: around the world, any country that could conceivably be related

590
00:32:41,200 --> 00:32:43,120
Speaker 2: to Russia in some way. They're like, we got to

591
00:32:43,160 --> 00:32:44,720
Speaker 2: get out of there. We got to get out of there.

592
00:32:45,040 --> 00:32:48,120
Speaker 3: And you will recall, yes, that when this happens, it

593
00:32:48,160 --> 00:32:52,520
Speaker 3: makes bond spreads get wider. And this is the opposite

594
00:32:52,800 --> 00:32:55,760
Speaker 3: of the bet that long term capital has made all

595
00:32:55,800 --> 00:33:00,360
Speaker 3: around the world, and they're widening in a more correlated

596
00:33:00,400 --> 00:33:04,760
Speaker 3: way than long term capitals models would have predicted, right like, sure, okay,

597
00:33:04,760 --> 00:33:07,080
Speaker 3: maybe they'll widen in Russia, but they hadn't guessed that

598
00:33:07,080 --> 00:33:09,080
Speaker 3: they would widen everywhere all at the same time.

599
00:33:09,120 --> 00:33:11,880
Speaker 2: In this way, which is why they spread their bets

600
00:33:12,040 --> 00:33:15,080
Speaker 2: around the world, because you're thinking, Okay, one country, this

601
00:33:15,160 --> 00:33:17,440
Speaker 2: could go wrong, two countries it could go wrong, but

602
00:33:17,680 --> 00:33:21,160
Speaker 2: other countries halfway around the world would not react the

603
00:33:21,160 --> 00:33:21,600
Speaker 2: same way.

604
00:33:21,640 --> 00:33:25,360
Speaker 3: Wouldn't be rational. And so because the world is reacting

605
00:33:25,400 --> 00:33:28,040
Speaker 3: in this way, because these things are happening, long term

606
00:33:28,120 --> 00:33:33,360
Speaker 3: capital is getting destroyed. Their models had predicted that the

607
00:33:33,400 --> 00:33:36,240
Speaker 3: most they could lose in a single day was thirty

608
00:33:36,240 --> 00:33:40,760
Speaker 3: five million dollars. On that sultry Friday, they lost more

609
00:33:40,800 --> 00:33:44,560
Speaker 3: than five hundred million dollars. Time to reboot the computer.

610
00:33:44,720 --> 00:33:48,560
Speaker 3: Something's wrong here, unplugging, unplugged it turn off, turn thosees

611
00:33:48,640 --> 00:33:54,320
Speaker 3: back on. So it's late August in Connecticut, so of

612
00:33:54,320 --> 00:33:57,840
Speaker 3: course all the rich guys, the partners are off on vacation,

613
00:33:58,120 --> 00:34:00,720
Speaker 3: and the traders at the office are picking up the

614
00:34:00,720 --> 00:34:02,560
Speaker 3: phones and calling them because that's what you had to

615
00:34:02,600 --> 00:34:03,640
Speaker 3: do in the nineties.

616
00:34:03,280 --> 00:34:04,400
Speaker 2: And their giant cell phones.

617
00:34:04,480 --> 00:34:08,520
Speaker 3: Yes, they get Merryweather at a dinner in Beijing. Some

618
00:34:08,640 --> 00:34:10,880
Speaker 3: other guy was in Sun Valley, Idaho, another one was

619
00:34:10,880 --> 00:34:14,760
Speaker 3: in Italy. They they were on top by Sunday morning.

620
00:34:14,840 --> 00:34:17,000
Speaker 3: Two days later, they are all back in the office

621
00:34:17,120 --> 00:34:20,120
Speaker 3: in Connecticut. Trying to figure out what to do, and

622
00:34:20,160 --> 00:34:24,080
Speaker 3: they think, Okay, this is going to fix itself. Like

623
00:34:24,120 --> 00:34:27,479
Speaker 3: there's no fundamental reason why spreads are doing what they're doing.

624
00:34:27,520 --> 00:34:30,239
Speaker 3: It's not like there's a war and economies have been

625
00:34:30,280 --> 00:34:32,480
Speaker 3: blown up and destroyed. Things are going to go back

626
00:34:32,480 --> 00:34:35,160
Speaker 3: to normal, and when that happens, we'll make more money.

627
00:34:35,600 --> 00:34:38,680
Speaker 3: So all we need is some cash, some capital to

628
00:34:38,760 --> 00:34:41,359
Speaker 3: ride this out, because remember, when you've borrowed a lot

629
00:34:41,360 --> 00:34:43,320
Speaker 3: of money against a little capital, people are going to

630
00:34:43,360 --> 00:34:45,080
Speaker 3: start asking for the money back. You're going to need

631
00:34:45,160 --> 00:34:48,080
Speaker 3: some money essentially in the bank to ride out the storm.

632
00:34:48,200 --> 00:34:49,960
Speaker 2: But if you have a pile of money that you

633
00:34:50,000 --> 00:34:52,320
Speaker 2: can pay that back, that's fine. You can keep going

634
00:34:52,360 --> 00:34:56,200
Speaker 2: and keep going and eventually make untold billions.

635
00:34:56,280 --> 00:34:58,319
Speaker 3: Yeah, you can make your money back in more. This

636
00:34:58,360 --> 00:35:02,080
Speaker 3: is their plan. And around this time Merriweather calls this

637
00:35:02,239 --> 00:35:05,879
Speaker 3: old Wall Street friend of his for advice, maybe some

638
00:35:05,920 --> 00:35:09,920
Speaker 3: contacts for raising money. The guy's name is Vinnie Matone.

639
00:35:10,360 --> 00:35:13,320
Speaker 3: Vinni is the old school stuff trader, you know, that

640
00:35:13,400 --> 00:35:17,440
Speaker 3: cheeseburger for breakfast kind of guy. And Lowenstein in When

641
00:35:17,480 --> 00:35:20,959
Speaker 3: Genius Sailed has a beautiful description of this scene of

642
00:35:21,320 --> 00:35:23,320
Speaker 3: a Vinnie coming to talk to Merriweather.

643
00:35:23,440 --> 00:35:25,640
Speaker 2: Oh, this is going to be good. Vinnie wore a

644
00:35:25,680 --> 00:35:28,440
Speaker 2: gold chain and a pinky ring, and he showed up

645
00:35:28,480 --> 00:35:31,759
Speaker 2: at Long Term in a black silk shirt, open at

646
00:35:31,760 --> 00:35:36,000
Speaker 2: the chest. Where are you? Matone asked bluntly. We're down

647
00:35:36,040 --> 00:35:41,799
Speaker 2: by half. Merriweather said, you're finished. Matone replied for the

648
00:35:41,800 --> 00:35:44,879
Speaker 2: first time. Merriweather sounded worried. What are you talking about.

649
00:35:44,960 --> 00:35:48,840
Speaker 2: We still have two billion dollars we have half, Matone

650
00:35:48,880 --> 00:35:52,480
Speaker 2: smiled sadly. When you're down by half, people figure you

651
00:35:52,520 --> 00:35:54,799
Speaker 2: can go down all the way. They're going to push

652
00:35:54,800 --> 00:35:56,960
Speaker 2: the market against you. You're finished.

653
00:35:57,640 --> 00:36:01,520
Speaker 3: I like to think of Vinnie Matone as this street

654
00:36:01,600 --> 00:36:06,439
Speaker 3: smart Yoda telling Merriwether that the force is not with him.

655
00:36:06,680 --> 00:36:11,319
Speaker 2: It's beautiful because long term capital management was depending on

656
00:36:11,360 --> 00:36:15,399
Speaker 2: computers and logic and this optimistic view of the world,

657
00:36:15,640 --> 00:36:20,400
Speaker 2: and Vinnie, the street smart guy is like, what you

658
00:36:20,440 --> 00:36:23,160
Speaker 2: didn't factor in is the fact that this is a

659
00:36:23,200 --> 00:36:28,120
Speaker 2: competitive game, and much like the osprey in the fountain

660
00:36:28,200 --> 00:36:32,880
Speaker 2: outside of your office, other investment firms are going to

661
00:36:33,080 --> 00:36:37,279
Speaker 2: grab you out of the water and consume you. And

662
00:36:37,360 --> 00:36:40,720
Speaker 2: so it's just such a beautiful moment that Vinnie knows

663
00:36:40,760 --> 00:36:44,000
Speaker 2: the way the world really works outside computers.

664
00:36:44,320 --> 00:36:47,160
Speaker 3: Meriweather isn't ready to give up, though. On September second,

665
00:36:47,239 --> 00:36:50,880
Speaker 3: he sends this letter to Long Term Capital's investors, tells

666
00:36:50,920 --> 00:36:54,120
Speaker 3: them that the fund was down forty four percent in

667
00:36:54,160 --> 00:36:56,920
Speaker 3: August one month month. That's a very bad month. But

668
00:36:56,920 --> 00:36:59,480
Speaker 3: he says, you know, spreads are going to close again.

669
00:37:00,080 --> 00:37:02,520
Speaker 3: Our strategies are sound. This is, in fact a good

670
00:37:02,560 --> 00:37:06,880
Speaker 3: time to invest. And he makes this move in this

671
00:37:07,000 --> 00:37:09,680
Speaker 3: letter that at a certain level I am just in

672
00:37:09,800 --> 00:37:12,600
Speaker 3: awe of I can't believe he did it. It's fantastic.

673
00:37:12,680 --> 00:37:15,360
Speaker 3: So Robert here read this paragraph from the letter.

674
00:37:15,960 --> 00:37:19,120
Speaker 2: Since it is prudent to raise additional capital, the fund

675
00:37:19,200 --> 00:37:22,080
Speaker 2: is offering you the opportunity to invest in the fund

676
00:37:22,400 --> 00:37:25,360
Speaker 2: on special terms. If you have an interest in investing,

677
00:37:25,400 --> 00:37:29,000
Speaker 2: please contact Richard Leahy at Long Term Capital Management two

678
00:37:29,000 --> 00:37:31,480
Speaker 2: O three five five to two five five one one

679
00:37:31,840 --> 00:37:32,920
Speaker 2: for further information.

680
00:37:33,600 --> 00:37:36,120
Speaker 3: Call now. Operators are standing by.

681
00:37:36,280 --> 00:37:38,080
Speaker 2: It's my phone. Where's my phone?

682
00:37:39,000 --> 00:37:39,320
Speaker 3: Actually?

683
00:37:39,320 --> 00:37:41,440
Speaker 2: Have you called this phone? Put it on speaker? Okay,

684
00:37:41,520 --> 00:37:45,360
Speaker 2: well one two oh three one.

685
00:37:45,320 --> 00:37:47,880
Speaker 3: Oh, I'm trying to reach I want to invest. What

686
00:37:47,960 --> 00:37:48,440
Speaker 3: are you going to say?

687
00:37:48,440 --> 00:37:55,319
Speaker 2: If they answer no, The number you dialed is not

688
00:37:55,480 --> 00:37:56,040
Speaker 2: in service.

689
00:37:56,680 --> 00:38:04,160
Speaker 3: Spoiler alert, Robert, the investors did not call now, and

690
00:38:04,200 --> 00:38:06,879
Speaker 3: in fact, the letter leaked to the press before even

691
00:38:06,880 --> 00:38:08,799
Speaker 3: all the investors had got the letter. Some of them

692
00:38:08,840 --> 00:38:10,760
Speaker 3: found out about it by reading about it in the news,

693
00:38:11,080 --> 00:38:15,200
Speaker 3: and now in case they hadn't before, everybody knew that

694
00:38:15,280 --> 00:38:18,760
Speaker 3: Long Term Capital Management was screwed. Knew, like Vinnie said,

695
00:38:19,080 --> 00:38:21,600
Speaker 3: they were going to be screwed. They called it the

696
00:38:21,760 --> 00:38:25,839
Speaker 3: LTCM death trade, where everybody is getting out ahead, right,

697
00:38:25,840 --> 00:38:29,000
Speaker 3: because think about it, these are thinly traded markets. Long

698
00:38:29,080 --> 00:38:32,000
Speaker 3: term capital has huge positions. You know they're going to

699
00:38:32,080 --> 00:38:35,480
Speaker 3: have to sell. So even just to protect yourself, like

700
00:38:35,520 --> 00:38:37,560
Speaker 3: if you own anything that they own, you want to

701
00:38:37,600 --> 00:38:39,480
Speaker 3: sell before they sell, because they're going to drive the

702
00:38:39,480 --> 00:38:42,719
Speaker 3: price down. So everybody is selling the stuff that they own,

703
00:38:42,800 --> 00:38:45,240
Speaker 3: so the prices are falling, right. So this, in addition

704
00:38:45,320 --> 00:38:49,280
Speaker 3: to the market behavior, is compounding Long Term Capital's troubles.

705
00:38:49,800 --> 00:38:54,080
Speaker 3: On a single day September twenty first, they lose again

706
00:38:54,160 --> 00:38:56,560
Speaker 3: more than five hundred million, like that bad day in August,

707
00:38:56,600 --> 00:39:01,160
Speaker 3: five hundred and fifty three million dollars more, and they're

708
00:39:01,480 --> 00:39:03,359
Speaker 3: still have all this leverage. In fact, in a way

709
00:39:03,400 --> 00:39:05,840
Speaker 3: your leverage ratio goes up the more you lose. Right,

710
00:39:05,920 --> 00:39:08,439
Speaker 3: Because they still owe all this money, their capital base

711
00:39:08,520 --> 00:39:12,879
Speaker 3: is shrinking, and now the lenders are afraid that long

712
00:39:12,960 --> 00:39:14,839
Speaker 3: term capital is not going to be able to pay

713
00:39:14,880 --> 00:39:16,239
Speaker 3: them back. So they start saying, no, you have to

714
00:39:16,280 --> 00:39:17,640
Speaker 3: give us our money back, or we're not going to

715
00:39:17,760 --> 00:39:19,960
Speaker 3: roll over these short term loans that we've been rolling over.

716
00:39:20,120 --> 00:39:21,680
Speaker 2: And if you're not rolling over the loans, you have

717
00:39:21,719 --> 00:39:24,239
Speaker 2: to sell even more. And the more you sell, the

718
00:39:24,280 --> 00:39:26,960
Speaker 2: more loans you have to pay off. And so that's

719
00:39:27,000 --> 00:39:28,960
Speaker 2: the death spiral. That's the death spiral.

720
00:39:29,040 --> 00:39:31,440
Speaker 3: And then there's if we widen the circle, there is

721
00:39:31,719 --> 00:39:35,200
Speaker 3: now a bigger concern because long term capital is so

722
00:39:35,360 --> 00:39:40,000
Speaker 3: big and so intertwined with all these other Wall Street firms,

723
00:39:40,080 --> 00:39:43,200
Speaker 3: there is a bigger fear, which is, if they blow

724
00:39:43,280 --> 00:39:46,480
Speaker 3: up and can't pay back their debts, then all of

725
00:39:46,520 --> 00:39:49,600
Speaker 3: these other banks that they owe money to might not

726
00:39:49,640 --> 00:39:52,239
Speaker 3: be able to pay their debts, and then we'll have

727
00:39:52,239 --> 00:39:55,280
Speaker 3: a financial crisis. We'll have all of these firms linked

728
00:39:55,280 --> 00:39:59,280
Speaker 3: to each other going down and potentially hurting the whole economy,

729
00:39:59,360 --> 00:40:00,680
Speaker 3: bringing down the whole economy.

730
00:40:00,719 --> 00:40:03,720
Speaker 2: And this is super important because this is how crises happen.

731
00:40:04,200 --> 00:40:07,520
Speaker 2: Nobody really cares about Nobel Prize winners losing all their money. No,

732
00:40:07,600 --> 00:40:09,680
Speaker 2: they should be able to like that's we want firms

733
00:40:09,680 --> 00:40:13,480
Speaker 2: to fail. And even the bank that lent the money,

734
00:40:13,719 --> 00:40:16,200
Speaker 2: they took a risk and they might lose money on

735
00:40:16,239 --> 00:40:20,799
Speaker 2: the deal. But the situation is you don't know the

736
00:40:20,880 --> 00:40:24,440
Speaker 2: full list of everyone who lent money to long term capital.

737
00:40:25,360 --> 00:40:27,759
Speaker 2: And so when you're out in Wall Street and you

738
00:40:27,800 --> 00:40:30,239
Speaker 2: want to make a deal, you have to ask yourself constantly,

739
00:40:30,480 --> 00:40:32,520
Speaker 2: Wait a minute, is the person about to make a

740
00:40:32,560 --> 00:40:35,280
Speaker 2: deal with Are they exposed to this? Are they exposed

741
00:40:35,280 --> 00:40:38,120
Speaker 2: to someone who's exposed to this? It can slow down

742
00:40:38,320 --> 00:40:41,479
Speaker 2: all investment at once because you just don't know where

743
00:40:41,520 --> 00:40:43,040
Speaker 2: the risk is. This is the problem.

744
00:40:43,120 --> 00:40:46,160
Speaker 3: Yes, this is why in the eighteen hundreds there were

745
00:40:46,280 --> 00:40:50,160
Speaker 3: panics every few years because this would happen again and again,

746
00:40:50,480 --> 00:40:52,920
Speaker 3: and in fact, to stop it from happening, or at

747
00:40:52,960 --> 00:40:56,120
Speaker 3: least reduce the risk of it happening, America created a

748
00:40:56,160 --> 00:41:00,040
Speaker 3: central bank, the Federal Reserve. And as long term capital

749
00:41:00,120 --> 00:41:02,560
Speaker 3: is about to blow up in September, the Federal Reserve

750
00:41:03,280 --> 00:41:06,120
Speaker 3: does its job. They say, oh wait, we better make

751
00:41:06,200 --> 00:41:09,120
Speaker 3: sure this doesn't cause a financial crisis. You know, there

752
00:41:09,200 --> 00:41:11,480
Speaker 3: is a branch of the FED in New York that

753
00:41:12,080 --> 00:41:14,160
Speaker 3: deals with Wall Street. A guy we used to work

754
00:41:14,200 --> 00:41:16,480
Speaker 3: with said, the New York Fed is actually more baller

755
00:41:17,000 --> 00:41:19,880
Speaker 3: than the main FED headquarters in Washington, the Board of Governors.

756
00:41:20,200 --> 00:41:23,759
Speaker 2: And they have a special conference room there just for

757
00:41:23,880 --> 00:41:27,040
Speaker 2: moments of crisis. And they invite everyone into this conference room.

758
00:41:27,160 --> 00:41:29,960
Speaker 3: Yes, it's Wednesday, September twenty third when they use the

759
00:41:30,000 --> 00:41:34,000
Speaker 3: special crisis conference room, which is not a special crisis

760
00:41:34,000 --> 00:41:35,920
Speaker 3: conference room, and they call all the heads of the

761
00:41:35,920 --> 00:41:39,600
Speaker 3: big Wall Street banks to a meeting. And the FED

762
00:41:39,760 --> 00:41:43,440
Speaker 3: says to all these bankers, look, you're all doing business

763
00:41:43,640 --> 00:41:47,200
Speaker 3: with long term capital. You're all screwed if they go under.

764
00:41:48,560 --> 00:41:51,160
Speaker 3: Figure something out. We have a FED. We're not going

765
00:41:51,239 --> 00:41:53,160
Speaker 3: to put money in. We're not going to bail you out.

766
00:41:53,719 --> 00:41:56,160
Speaker 3: You're all in this together. Work together to figure it out.

767
00:41:56,640 --> 00:41:58,840
Speaker 2: Oh kumbaya, Just run together. Now.

768
00:41:58,880 --> 00:42:01,360
Speaker 3: A bunch of Wall Street bankers love to hold hands

769
00:42:01,360 --> 00:42:02,239
Speaker 3: and help each other out.

770
00:42:02,320 --> 00:42:04,880
Speaker 2: Hyper competitive, they want to stab each other in the back.

771
00:42:05,160 --> 00:42:07,839
Speaker 2: This is their normal day. And now the FED, and

772
00:42:07,840 --> 00:42:10,560
Speaker 2: this does happen occasionally. The FED is saying, hey, for

773
00:42:10,640 --> 00:42:15,200
Speaker 2: the good of everyone, can we set aside our immense

774
00:42:15,400 --> 00:42:18,200
Speaker 2: greed and hatred of each other on this day and just.

775
00:42:18,160 --> 00:42:20,759
Speaker 3: Be a little more long term greedy, right, Like it

776
00:42:20,840 --> 00:42:23,480
Speaker 3: is in your greedy interest for this not to blow up.

777
00:42:24,160 --> 00:42:26,800
Speaker 3: And so the bankers sit in this room and over

778
00:42:26,840 --> 00:42:29,919
Speaker 3: the next several hours they actually come up with a plan.

779
00:42:29,960 --> 00:42:33,360
Speaker 3: They're going to put in three point sixty five billion

780
00:42:33,440 --> 00:42:35,960
Speaker 3: dollars into the fund of their own money, of the

781
00:42:36,000 --> 00:42:40,000
Speaker 3: bank's money, and the partners at long Term Capital, their

782
00:42:40,040 --> 00:42:42,680
Speaker 3: equity will be wiped out, right, they won't get any

783
00:42:42,719 --> 00:42:45,319
Speaker 3: of this money, and they won't own any of the

784
00:42:45,360 --> 00:42:50,440
Speaker 3: fund anymore. And Meriweather, you got to love him, negotiates

785
00:42:50,960 --> 00:42:53,920
Speaker 3: is like, because part of it is they need Merriweather

786
00:42:54,000 --> 00:42:56,320
Speaker 3: and his traders to stay on. There's like literally thousands

787
00:42:56,320 --> 00:43:00,480
Speaker 3: of trades they have put on and they're not worthless importantly, right,

788
00:43:00,520 --> 00:43:02,560
Speaker 3: they need somebody to run this fund, not to just

789
00:43:02,640 --> 00:43:06,520
Speaker 3: liquidate it at firesale prices. And so Meriwether's like, well,

790
00:43:06,560 --> 00:43:07,800
Speaker 3: if you want us to stay on, you're gonna have

791
00:43:07,840 --> 00:43:09,280
Speaker 3: to pay us. You're gon have to give us a bonus.

792
00:43:09,320 --> 00:43:12,160
Speaker 3: And so in fact, Meriweather and a bunch of other

793
00:43:12,239 --> 00:43:15,319
Speaker 3: people agree to stay on at long term capital get

794
00:43:15,320 --> 00:43:19,279
Speaker 3: paid hundreds of thousands of dollars for their labor, and

795
00:43:19,360 --> 00:43:21,600
Speaker 3: in fact, over the next year, the thing happens that

796
00:43:21,640 --> 00:43:25,399
Speaker 3: they said would happen. Spreads do converge, they actually turn

797
00:43:25,440 --> 00:43:27,920
Speaker 3: a profit. The banks got all the money back that

798
00:43:27,960 --> 00:43:31,080
Speaker 3: they put into the fund in that emergency moment, and

799
00:43:31,200 --> 00:43:36,839
Speaker 3: in early two thousand, long term capital management ceased to exist.

800
00:43:37,120 --> 00:43:40,960
Speaker 2: I love this story because this is a classic issue

801
00:43:41,040 --> 00:43:43,319
Speaker 2: in finance, which is, if you could go back and

802
00:43:43,360 --> 00:43:48,360
Speaker 2: replay history one hundred times, long term capital management would

803
00:43:48,360 --> 00:43:52,200
Speaker 2: be great. Ninety nine of those times, like they knew

804
00:43:52,239 --> 00:43:54,720
Speaker 2: what was going to happen, they made the correct bet

805
00:43:54,760 --> 00:43:57,440
Speaker 2: on that maybe borrowed too much money on this, but

806
00:43:57,480 --> 00:44:01,560
Speaker 2: they weren't wrong. Their timing was off, their liquidity was off,

807
00:44:01,600 --> 00:44:04,040
Speaker 2: they didn't have the money to deal with the kind

808
00:44:04,080 --> 00:44:07,320
Speaker 2: of debt and leverage that they had. But it's interesting

809
00:44:07,400 --> 00:44:10,719
Speaker 2: that you can be right and still almost destroy the

810
00:44:10,719 --> 00:44:11,400
Speaker 2: world economy.

811
00:44:11,480 --> 00:44:14,320
Speaker 3: Yeah, I mean, they weren't wrong in terms of this

812
00:44:14,400 --> 00:44:19,600
Speaker 3: sort of mathematical risk. But for me, there's this idea

813
00:44:20,600 --> 00:44:25,200
Speaker 3: that is really useful here, which is the distinction between

814
00:44:25,320 --> 00:44:30,000
Speaker 3: risk and uncertainty. And you know, colloquially we use those

815
00:44:30,040 --> 00:44:34,360
Speaker 3: words largely interchangeably. But there was this economist in the

816
00:44:34,400 --> 00:44:39,839
Speaker 3: twenties named Frank Knight who wrote this book called Risk, Uncertainty,

817
00:44:39,960 --> 00:44:43,680
Speaker 3: and Profit, and his argument was, you know, we use

818
00:44:43,960 --> 00:44:47,239
Speaker 3: risk in really different ways at different times. We use

819
00:44:47,360 --> 00:44:50,960
Speaker 3: one word to mean quite different things. In particular, we

820
00:44:51,080 --> 00:44:54,880
Speaker 3: use risk when we can really really measure the probability

821
00:44:54,880 --> 00:44:57,000
Speaker 3: of what's going to happen, and also when we cannot.

822
00:44:57,360 --> 00:45:00,600
Speaker 3: Here's an example. You're betting on a coin toss. You

823
00:45:00,600 --> 00:45:04,880
Speaker 3: bet on heads. You know that there's a fifty percent

824
00:45:05,200 --> 00:45:08,879
Speaker 3: risk that you're going to lose. Now say that coin

825
00:45:08,920 --> 00:45:12,839
Speaker 3: happens to be a Russian ruble and it's nice ninety eight.

826
00:45:13,640 --> 00:45:16,600
Speaker 3: What's the risk that Russia is gonna devalue the ruble

827
00:45:17,200 --> 00:45:19,080
Speaker 3: which would make the ruble worth a lot less if

828
00:45:19,080 --> 00:45:20,960
Speaker 3: you win. I mean, you can go back and look

829
00:45:21,000 --> 00:45:24,719
Speaker 3: at history in terms of nuclear power, countries and default,

830
00:45:24,960 --> 00:45:29,440
Speaker 3: and what is that ten twelve? You can talk for experts,

831
00:45:29,600 --> 00:45:32,359
Speaker 3: you can study history, you can do a lot and

832
00:45:32,400 --> 00:45:36,360
Speaker 3: you can come up with some probabilistic estimate of a

833
00:45:36,440 --> 00:45:39,360
Speaker 3: Russian devaluation. Maybe it's ten percent, maybe it's fifty percent.

834
00:45:39,400 --> 00:45:43,759
Speaker 3: You can put a number on it. But Crucially, that

835
00:45:43,880 --> 00:45:47,560
Speaker 3: number is not the same kind of number as the

836
00:45:47,719 --> 00:45:49,880
Speaker 3: risk that it'll come up tails if you bet heads.

837
00:45:49,960 --> 00:45:53,440
Speaker 3: It is fundamentally different. You're fooling yourself when you put

838
00:45:53,440 --> 00:45:56,000
Speaker 3: a number on it. You don't actually know the way

839
00:45:56,040 --> 00:45:58,560
Speaker 3: you know the fifty percent with the coin flip. This

840
00:45:58,840 --> 00:46:02,600
Speaker 3: unknowable outcome is what Frank Knight calls uncertainty. So risk

841
00:46:02,680 --> 00:46:07,279
Speaker 3: is the coin flip. Uncertainty is will Russia devalue? And

842
00:46:07,520 --> 00:46:11,560
Speaker 3: I think you can argue that the big mistake that

843
00:46:11,640 --> 00:46:17,040
Speaker 3: long term term capital made was they confused risk and uncertainty.

844
00:46:17,480 --> 00:46:21,680
Speaker 3: They thought the world was measurable, that risk could be

845
00:46:21,760 --> 00:46:25,280
Speaker 3: modeled with math, and a lot of the world is measurable.

846
00:46:25,320 --> 00:46:29,880
Speaker 3: To your point, math is really powerful at predicting market outcomes.

847
00:46:30,560 --> 00:46:35,839
Speaker 3: But there is still some amount of unquantifiable uncertainty. And

848
00:46:35,960 --> 00:46:38,319
Speaker 3: if you're highly leveraged, if you borrowed a lot of

849
00:46:38,360 --> 00:46:41,240
Speaker 3: money and mail a lot of bets sooner or later,

850
00:46:41,680 --> 00:46:45,160
Speaker 3: that unquantifiable uncertainty will destroy you.

851
00:46:45,640 --> 00:46:49,480
Speaker 2: And that is what happened to long term capital management. Jacob,

852
00:46:49,480 --> 00:46:52,839
Speaker 2: We love it when our listeners write in. We got

853
00:46:52,880 --> 00:46:56,560
Speaker 2: a note from someone who talked about their seven year

854
00:46:56,560 --> 00:47:01,160
Speaker 2: old who missed her dance class almost mister dance guest

855
00:47:01,239 --> 00:47:05,319
Speaker 2: because she was listening to the Ice episode and the

856
00:47:05,640 --> 00:47:08,719
Speaker 2: daughter asked for a show about Crayola.

857
00:47:08,960 --> 00:47:12,439
Speaker 3: But Kranz please email us whatever age if you are

858
00:47:12,840 --> 00:47:16,000
Speaker 3: at Business History at pushkin dot Fm, or you can

859
00:47:16,080 --> 00:47:20,360
Speaker 3: find me on x at Jacob Goldstein or on LinkedIn. Robert.

860
00:47:20,400 --> 00:47:24,400
Speaker 3: You're on Twitter at Radiosmith shout Out Radio. Our show

861
00:47:24,480 --> 00:47:29,400
Speaker 3: today was produced by Gabriel Hunter Chang, engineered by Sarah Bruguier.

862
00:47:29,520 --> 00:47:32,440
Speaker 3: Our video editor, yes we're on YouTube, is Matt Nielsen,

863
00:47:32,719 --> 00:47:36,480
Speaker 3: and our showrunner and editor is Ryan Dilly. One quick note,

864
00:47:36,520 --> 00:47:38,879
Speaker 3: we're going to be off taking a little summer break

865
00:47:38,920 --> 00:47:41,240
Speaker 3: for the next couple of weeks, but we're still making shows.

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Speaker 3: We'll be back later in July. I'm Jacob Goldstein, I'm

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Speaker 3: Robert Smith.

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Speaker 2: Thanks for listening.