Here is a fantastic summary of the LTCM (Long Term Capital Management) collapse. It has relevance for every collapse from Rome, Nazi Germany and of course that other over blown 'leader' we all love so much:
With multi-billions of losses and running the prospect of ruining the financial system LTCM was bailed out by the Federal Reserve and a consortium of dealers – the first and only time in history that a hedge fund has had to be bailed out by the US’s supreme financial authority.
So what went wrong? Was it Meriwether? Hubris? Bad luck? In fact, none of the three. Meriwether, indeed, appears to have been a good guy: “When you’re that successful people build up myths around you – the Master of the Universe thing, Meriwether is a very nice guy but kind of quiet, not bombastic at all and his decision making was consensus driven.”
The weakness at LTCM was the lack of cognitive diversity. Running on pure talent was not enough. The men behind LTCM had studied at the same schools, learned or taught each other the same theories and shared the same blind spots. LTCM would have done better to fire a couple of partners and hire a landscape gardener for an opposing point of view. All these guys had 160 IQs – it was like a meeting of the fathers of financial theory. But they were all the same. We were missing the dissenting point of view.
By 1998, the company had equity of $4.7bn but was running off-balance sheet derivative positions with a notional value of $1.25 trillion over 106 different strategies. Statistically speaking, they could not all fail. What happened was, they all failed at the same time.
With leverage we were getting brilliant returns on equity and it was impossible to lose money on all of the strategies at the same time. Statistically that was true. But there was a thread that ran through all of them and created a conditional correlation. The thread was they were all short volatility.”
When the market moved against it the whole thing shifted at once. Its lack of diverse thinking was its weakness – and it came up against a ruthless market. There was no denying Wall Street’s piranhas.