In the late 1990s, the world's largest hedge fund at the time, Long Term Capital Management (LTCM), failed.
The failure sent shockwaves across Wall Street and the rest of the financial world. The hedge fund had been one of the largest players in the global derivatives markets, and when it failed, it dragged its counterparties with it.
Eventually, the Federal Reserve was forced to bail out the fund instead of risking a global financial crisis (though, no federal funds were used - the Fed merely brokered a deal on LTCM's behalf with a consortium of Wall Street Banks). However, before the central bank stepped in, Warren Buffett (Trades, Portfolio) also made a bid for the fund's portfolio of assets.
It later emerged that Buffett made a bid of $250 million for LTCM. On top of the purchase price, Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) would have to put $3.75 billion into the fund to meet other obligations. If the deal had succeeded, Buffett would have paid $250 million for $100 billion worth of securities and over $1 trillion worth of derivative contracts.
LTCM had been forced into a corner because it could not meet margin calls on its extensive portfolio of derivatives and other assets. It seems Buffett was betting that if Berkshire bought the assets, LTCM's former counterparties would back down, giving the firm breathing room to unwind the positions. This may have produced enormous profits for Buffett and his investors.
Ultimately, the deal fell apart. As Buffett later described, due to the deal's size and volatility in the underlying portfolio, he gave LTCM a short window to accept the offer. They declined, and the deal fell through.
Smart people and dumb decisions
LTCM became a case study of how even the smartest people can make dumb decisions. The 16 people who managed the business were considered some of the smartest economists and financiers in the world, including two Nobel laureates. However, their intelligence didn't stop them from taking on too much risk. This ultimately became their downfall.
Buffett later called this situation "fascinating." Speaking at the 1999 Berkshire annual meeting, he said:
"So here you had super bright, extremely experienced people operating with their own money. And, in effect, on that day in September, they were broke. And to me, that is absolutely fascinating."
He went on to add that most of these managers were already rich, and he couldn't see why they'd want to take on more risk when they were already well off. He said:
"And why do people, very bright people, risk losing something that's very important to them, to gain something that's totally unimportant? The added money has no utility whatsoever."
There was no specific answer to this question. However, Buffett did go on to note that in his experience, whenever a wealthy person suddenly loses everything, leverage is usually to blame:
"Whenever a bright person, a really bright person, goes broke that has a lot of money, it's because of leverage. It you simply you basically can't it would be almost impossible to go broke without borrowed money being in the equation."
LTCM was a disaster for its managers and investors. For those on the outside, however, it was a great case study.
As Buffett said in 1999, you only need to get rich once. There's no need to take on extra risk to get richer. Taking on risk through leverage is one of the fastest ways to the poorhouse, as you risk losing everything.
Getting rich is the easy part; staying rich is the hard part. Many investors overlook this simple principle and risk everything to gain a few more percentage points of performance.
Even if it works 99% of the time, the 1% when it does not can be terminal. Why is it worth taking this risk when you can already live quite comfortably?
Disclosure: The author owns shares in Berkshire Hathaway.
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