The Nobel Winners Who Almost Crashed the Economy | From Business History

Summary

Against the Rules with Michael Lewis – Podcast Summary

Episode: The Nobel Winners Who Almost Crashed the Economy (From Business History)
Date: July 1, 2026
Hosts: Jacob Goldstein & Robert Smith

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Overview of the Episode's Main Theme

This episode of "Against the Rules" dives into the dramatic rise and fall of Long Term Capital Management (LTCM), a hedge fund founded by some of the brightest minds in finance, including Nobel laureates. Hosts Jacob Goldstein and Robert Smith explore how LTCM’s data-driven, academic approach to finance briefly conquered Wall Street—delivering enormous returns—before nearly causing a global financial meltdown due to overconfidence, excessive leverage, and a fatal misunderstanding of risk and uncertainty. The episode acts as both a cautionary tale and a historical reflection on financial markets, expertise, and the limits of mathematical models.

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Key Discussion Points & Insights

1. The Origins: From Trading Floors to Ivory Towers

• Setting the Stage (03:00–09:00):
  • John Meriwether, a calm, working-class trader at Salomon Brothers in the 1980s, successfully brought mathematicians and academics (“nerds”) into the rough-and-tumble world of Wall Street.
  • The finance industry was shifting—from gut-driven, “cheeseburgers for breakfast” traders to highly mathematical, model-driven approaches enabled by computers.
  • "They're not at Bell Labs anymore. They're not working for American manufacturing and American invention. They're working for American finance. This is when we're seeing this big shift in the economy." — Robert Smith (08:47)
• Cultural Shift:
  • Academics at firms like Salomon Brothers were seen as outliers (“freaks”) but quickly became valuable for their ability to identify complex arbitrage opportunities.
  • The rise of “financialization” is highlighted, with expertise moving from manufacturing to finance.

2. Building LTCM: Assembling the Dream Team

• From Scandal to Hedge Fund (11:05–13:35):
  • After a scandal involving rigged Treasury bond auctions, Meriwether leaves Salomon and gathers a new team to form LTCM.
  • He recruits top academics including Robert Merton and Myron Scholes, co-creator of the Black-Scholes equation—key for pricing financial options.
• Mathematical Prowess:
  • Advanced models were seen as revolutionary for pricing risk and options, shifting Wall Street further towards quantitative methods.
  • "What Scholes and Black and Merton did was come up with this way to essentially price the future in the present by creating a little insurance portfolio." — Robert Smith (14:17)

3. Context: The Triumph of Market Rationality

• Global Optimism (14:39–16:38):
  • Early 1990s: The Cold War is over, communism has fallen, and free-market capitalism appears unstoppable.
  • The sense of technological and economic progress creates a belief in rational, self-correcting markets.

4. The LTCM Model: Arbitrage, Leverage, and Early Success

• How They Made Money (21:11–26:52):
  • LTCM used complex arbitrage trades, betting that small, irrational price gaps in safe assets (like US Treasuries) would close.
  • Returns were amplified—sometimes 25:1—using massive leverage (borrowing).
  • Early successes included a famous Italian bond trade.
  • "If I have a million dollars and it's going to return 1%, that's $10,000. But if I borrow $19 million and invest $20 million, now that's a $200,000 return. That's the magic of leverage." — Robert Smith (23:13)
• Extraordinary Returns (26:52–27:39):
  • In 1995, LTCM returned 43% to investors after fees. Even the founders felt their own models underpredicted the success.

5. Hubris Sets In: Nobel Prizes & Influx of Capital

• Worldview Encoded in Math (28:17–31:35):
  • Merton and Scholes win the Nobel Prize in 1997; their models are seen as providing “more efficient risk management in society.”
  • Money flooded in, but LTCM claimed to have “excess capital,” as their strategies could only absorb so much before moving the market.
  • Instead of scaling back, they returned capital to investors but increased leverage for bigger profits.
  • "They're not just putting money into the stock market, they're making weird bets on Italian bonds ... but they borrow more to keep their bets big. If it works, they'll be 'really, really, really, really rich.'" — Jacob Goldstein (31:35)

6. The Fall: Russia, Bond Spreads, & the Limits of Models

• The Crisis Unfolds (35:22–39:19):
  • LTCM bets that global bond spreads will converge (“the world is going to be a calmer, better place”).
  • The Asian financial crisis and then the shock—Russia defaults in August 1998, contradicting the “no nuclear power has ever defaulted” belief.
  • Bond spreads widen globally, markets panic, LTCM’s highly leveraged bets go catastrophically wrong.
  • "Their models said the most they could lose in a day was $35 million. On that sultry Friday, they lost more than $500 million." — Jacob Goldstein (42:16)
• Human vs. Mathematical Insight (44:16–44:59):
  • Legendary street trader Vinnie Matone tells Meriwether, "When you're down by half, people figure you can go down all the way. They're going to push the market against you. You're finished."
  • This moment highlights the human/competitive instincts missing from LTCM’s models.

7. Death Spiral and Rescue

• The Downward Spiral (46:09–49:36):
  • Markets anticipate LTCM’s forced selling; others sell ahead, worsening the firm’s losses in a feedback loop.
  • "That's the death spiral." — Robert Smith (48:21)
• Systemic Risk & Federal Reserve Action (49:36–51:11):
  • LTCM’s collapse threatens to infect all of Wall Street due to the interconnectedness of their debt and investments.
  • The NY Fed convenes major Wall Street banks and tells them to “figure something out.”
  • The solution: banks collectively inject $3.65 billion into LTCM (partners wiped out), and the firm is nursed through the crisis.

8. Aftermath: Risk, Uncertainty, and Lessons Learned

• Right for the Wrong Reasons? (52:30–54:12):
  • LTCM was “right” in that markets eventually normalized, but their timing and risk management were fatally flawed.
  • Distinction between “risk” (measurable probabilities) and “uncertainty” (unknowable outcomes).
  • "Their mistake was they confused risk and uncertainty. They thought the world was measurable ... but there is still some unquantifiable uncertainty. And if you're highly leveraged, sooner or later that unquantifiable uncertainty will destroy you." — Jacob Goldstein (55:26)

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Notable Quotes & Memorable Moments

• Wall Street Culture Clash:
  "He traded bonds while being hollered at by six salesmen eating a morning cheeseburger and watching Ranieri hold a Bic lighter under the balls of a fellow trader. I wasn't prepared for that." — Robert Smith reading from Liar's Poker (05:34)

• On Financialization:
  "We're starting to see the shift in the economy . . . they're not at Bell Labs anymore, they're working for American finance." — Robert Smith (08:47)

• Understanding Arbitrage & Leverage:
  "You lever up. You borrow money. Because when you borrow money, you can turn a tiny percentage increase into a large percentage increase." — Robert Smith (22:50)

• Limits of Models:
  "The most they could lose in a single day was $35 million. On that sultry Friday, they lost more than $500 million." — Jacob Goldstein (42:16)

• Street Wisdom vs. Academic Genius:
  "Vinnie wore a gold chain and a pinky ring, and he showed up at Long term in a black silk shirt ... 'You're finished,' Matone replied." — Robert Smith (44:26)

• Death Spiral:
  "If you're not rolling over the loans, you have to sell even more. And the more you sell, the more loans you have to pay off. That's the death spiral." — Robert Smith (48:13)

• Conceptual Takeaway on Risk:
  "Risk is the coin flip. Uncertainty is: will Russia devalue? ... There is still some unquantifiable uncertainty, and if you're highly leveraged, sooner or later, that unquantifiable uncertainty will destroy you." — Jacob Goldstein (55:26)

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Important Timestamps

• Background on Wall Street & Salomon Brothers: 04:20–07:24
• Hiring of academics and the rise of quant trading: 07:24–09:10
• Creation of LTCM and arrival of Nobel Prize winners: 11:35–14:39
• Launch and initial arbitrage strategy: 21:11–24:39
• Use of leverage explained: 22:39–23:45
• LTCM’s early returns and investor mania: 26:52–31:35
• Doubling down on leverage after returning capital: 31:35–32:04
• Financial environment & bond spreads: 35:22–37:46
• Russian default and collapse unfolds: 39:19–42:16
• Human warning from Vinnie Matone: 44:16–44:59
• Federal Reserve rescue: 49:36–51:11
• Lessons on risk and uncertainty: 53:04–55:42

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Tone and Style

• The episode is witty, conversational, and occasionally irreverent, using pop culture references and self-deprecating humor to make complex financial concepts accessible.
• The hosts frequently riff on each other, making abstract concepts like arbitrage and leverage understandable through analogies (e.g., “I want my Maserati!”).
• The show celebrates both the brilliance and folly of LTCM, highlighting how hubris and overconfidence can emerge even amidst genius.

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Summary for Non-Listeners

This episode of "Against the Rules" delivers a gripping, entertaining, and thorough account of LTCM’s spectacular rise and fall. It explains how some of the world's smartest finance minds—and Nobel Prize winners—engineered a hedge fund that made mountains of money using sophisticated math, only to nearly collapse the global financial system when their models failed to anticipate the real-world messiness of markets. The episode distills critical lessons about the limits of expertise, the dangers of leverage, and the difference between managing calculable risks and facing true uncertainty. The cautionary tale stands as a reminder: Trust in genius, markets, and models is not enough if you ignore what you can’t model.

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Transcript

[Podcast Host/Advertiser]

This message is a paid partnership with Apple Card. There's something interesting about how seamlessly certain tools fit into daily life. Apple Card is one of those things. It can be applied for right in the Wallet app on iPhone and approval can happen in minutes. So it's ready to use immediately with Apple Pay. I'm so glad the days of finding my wallet, fishing out the credit card, using it, putting it back in my wallet, or oops, maybe I use cash. Where's the atm? Enough. The first time I used Apple Pay on my phone with my Apple Card I was like this is the future. There's no going back. With Apple Card purchases earn daily cash up to 3% with no points to track and no waiting for rewards. It's simply daily cash back that I earn on every purchase. There's even an option to open a high yield savings account through Apple Card and while I haven't done it yet, if I do, my daily cash can grow automatically over time without any extra effort. Because Apple Card lives in the Wallet app, it's always accessible on iPhone and can be used with Apple Pay at over 85% of merchants in the US and the security of Face ID and Touch ID prevents unauthorized purchases. Whether using iPhone or Apple watch. To explore it yourself, you can apply for Apple Card in the Wallet app on your iPhone subject to credit approval. Savings is available to Apple Card owners subject to eligibility. Savings in Apple Card by Goldman Sachs Bank USA Salt Lake City Branch Member FDIC terms and [e-mail] hey, it's Ryan

[Ryan Seacrest]

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[Jacob Goldstein]

The Second World War was the largest

[Robert Smith]

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[Jacob Goldstein]

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[Robert Smith]

No part of the globe was untouched, no life unchanged. Experience the account of World War II. Every single person had a story. These are the stories that make us who we are. World War II with Tom Hanks new episode Monday at 8. Part of history honors 250 only on the history Channel. Pushkin too quick?

[Jacob Goldstein]

No, it was perfect.

[Robert Smith]

Push kit.

[Jacob Goldstein]

Stop. You got it.

[Robert Smith]

You going to take me Back to the 1990s, baby.

[Jacob Goldstein]

And then the 70s and then the 90s. Okay, Robert Smith. This is a story about some of the smartest people in the world. Incredibly successful in their fields, they decide to come together, start a new thing. And they are so successful, they make billions of dollars. They win the Nobel Prize as they're making billions of dollars. And then the next year they get destroyed. And in fact, they get destroyed so hard that they almost take the global economy down with them. I'm Jacob Goldstein.

[Robert Smith]

I'm Robert Smith. And this is Business History, a show

[Jacob Goldstein]

about the history of business. Today on the show, the story of Long Term Capital Management.

[Podcast Host/Advertiser]

Woo.

[Robert Smith]

You are so amped for this.

[Jacob Goldstein]

This is the mid-90s. The Cold War has just ended. Free market capitalism is triumphant.

[Robert Smith]

And the economy was fantastic in the 1990s.

[Jacob Goldstein]

The best economy, my favorite economy. And the people who started Long Term Capital Management looked at the economy not just in the US but around the world. And they said, yes, yes, this is the moment we've been waiting for. We are going to ride this global capitalism wave. And they did. What they did not know was that that wave was about to crash.

[Robert Smith]

Let's start before the 1990s.

[Jacob Goldstein]

Let's, let's, let's start in the 1980s, the early 80s.

[Robert Smith]

Go, go, go, go.

[Jacob Goldstein]

Wall street with a bond trader named John Merriweather. Meriwether had grown up working class, south side of Chicago. Worked as a golf caddy as a kid. That was like his, you know, path up old school. Got his MBA at the University of Chicago. And in the mid-70s, he went to work at Solomon Brothers. And Solomon Brothers was about to become the heart of 1980s Masters of the Universe. Wall Street.

[Robert Smith]

Yeah.

[Jacob Goldstein]

Bonfire, the Vanities was based on Salomon Brothers. Michael Lewis in Liars Poker wrote about Salomon Brothers. It was where he worked right out of College in the 80s. And a key thing to know is at this time, the kind of legendary traitors at Solomon Brothers were very rough. They were street smart. They ate cheeseburgers for breakfast. They traded, you know, based on their, their cheeseburger filled guts. And Michael Lewis wrote beautifully about these guys in Liars Poker, most famously about a trader named Louis Ranieri. Louis Ranieri started out in the mailroom. He was from Brooklyn. He worked his way up. And Robert, I want you to read one sentence from Liars Poker that describes the life of a guy who worked with Rainier and just captures this culture.

[Robert Smith]

At Salomon Brothers. He traded bonds while being hollered at by six salesmen eating a morning cheeseburger and watching Ranieri hold a Bic lighter under the balls of a fellow trader. I wasn't prepared for that.

[Jacob Goldstein]

This is, this is Salman Brothers. At this time you don't see the lighter coming. John Merriweather was not this kind of guy. He was working class, but he was calm, he was even tempered. He didn't yell, didn't hold Bic lighters under his colleagues balls. But he did love to take risks. He was a trader at heart and he was really good at it. And he got promoted and he started running a desk which meant he had to hire people to come work with him, hire traders. And this is when he has his big idea. For the past decade or so, by this point, this is the early 80s, professors at places like MIT and the University of Chicago had been developing these really mathematical theories of finance, about prices. Right. Some of this had filtered into Wall street but not much.

[Robert Smith]

It was an academic endeavor. They had found data sets and they were tracking the stock market. They knew there was money involved, but they were doing it to pass their dissertations, not necessarily to like blow up the market.

[Ryan Seacrest]

Yeah.

[Jacob Goldstein]

And still the culture on Wall street was this very kind of cheeseburgers for breakfast culture, not an academic culture. But Meriwether's idea was basically oh, maybe these nerds know what they're talking about. Like maybe they could actually come to Wall Street. We could do a bunch of math and make money. And so he decides to test this theory, starts hiring a bunch of guys with PhDs from MIT and they come work with him at Salomon Brothers.

[Robert Smith]

He's like stay away from the guy with the Bic lighter.

[Jacob Goldstein]

Yeah. And it's unsurprising now. Now if you have a PhD from MIT, the easiest thing to do is not to be a professor, but to go work at Jane street or some quant fund.

[Robert Smith]

Yeah, they're actually recruiting at MIT and Stanford and Harvard.

[Jacob Goldstein]

A banker who worked with Meriwether said these guys that Meriwether is bringing in, these, these academics were considered freaks. He, he give he, here's a line.

[Robert Smith]

Those guys would be playing with their slide rules at Bell Labs if it wasn't for John. Slide rules, Slide rules.

[Jacob Goldstein]

Three things about that quote. Those guys would be playing with their slide rules at Bell Labs if it wasn't for John. One, it comes from Roger Lowenstein's book When Genius Failed. Excellent, excellent non fiction book about the rise and fall of Long Term capital management. The key source for today's Show 2, slide rules were what people used to do complicated math before graphing calculators came along. Scientific calculators.

[Robert Smith]

I had one. Yeah. You would, like, actually move little slides and. Yeah, and a little clear window.

[Jacob Goldstein]

I love that. And three importantly, this quote was an anachronism even in 1983, because they would not have been playing with slide rules, they would have been playing with computers. The rise of the computer is what empowers these people to do real work.

[Robert Smith]

I'm going to give you a number four, too, because we're starting to see the shift in the economy in this quote. They're not at Bell Labs anymore. They're not working for American manufacturing and American invention. They're working for American finance. This is when we're seeing this big shift in the economy.

[Jacob Goldstein]

Yes. Financialization. Financialization. The rise of Wall Street. Yes. And in fact, it's no coincidence that Jim Simons, who you did a show

[Robert Smith]

about, who is a math PhD, who

[Jacob Goldstein]

is a math PhD, is starting his fund Renaissance Technologies right around the same time. So Meriwether brings the nerds to Wall street and they work with him on what's called the arbitrage desk. Robert Smith, what's arbitrage? Sweet free money.

[Robert Smith]

Arbitrage is this very specific idea in finance, and it's this very big idea and very simple idea, I would say, which is if you can buy and sell the same thing at different prices, you can make money with almost no risk. So let's say silver is trading in New York at $100 and it's trading in London at $101.

[Jacob Goldstein]

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

[Robert Smith]

Yes. You could buy the silver in New York for $100 and simultaneously sell it in London for $101. Know, you don't have to ship it and then you make a dollar profit.

[Jacob Goldstein]

Yes.

[Robert Smith]

No work whatsoever.

[Jacob Goldstein]

Yes. Now, arbitrage is like this tend to be hard to find because people arbitrage them away. When you buy the cheap one and sell the expensive one, you cause the prices to converge.

[Robert Smith]

Yeah. At $100.50.

[Jacob Goldstein]

So the kinds of arbitrages that Meriwether and his nerds are finding are a little more subtle, but they are. But they exist in the world. And these guys come in and indeed start making money, a lot of money. In some years, they account for most of Solomon's profits. And that might have been the end of the story. They might have just got rich on Wall Street. But for one thing, in 1991. So they've been at this for a while. They're doing well. Meriwether gets in trouble because a guy who worked for him rigged treasury bond auctions and actually told Meriwether about it. And Meriwether told his boss about. But they didn't do anything. They sat on it, story comes out, they lose their jobs.

[Robert Smith]

We talked about this in the Warren Buffett show because Warren Buffett was a huge investor in Solomon Brothers, had to come in and run the company from Omaha with all of these New York traders just to fix the reputation.

[Jacob Goldstein]

Yes. So Meriwether, I think he resigned under pressure. I don't think he actually got fired. But he's out. He's out. So he decides not long after that, he wants to get his band of nerds back together, but not working for somebody else, not at a Wall street firm. He wants to start a hedge fund.

[Robert Smith]

Ooh. Wasn't his reputation bad?

[Jacob Goldstein]

Well, I will note, he didn't get fired for losing money. He got fired for unethical lapse.

[Robert Smith]

And making a lot of money.

[Jacob Goldstein]

And making a lot of money. So, au contraire, ethical lapse, plus making a lot of money. Perfect.

[Robert Smith]

And so he decided to start a hedge fund. In 1993. Hedge funds were not that popular, but there was this idea which was you could have a fund that was not correlated to the market. And this was very useful because you would make money on stocks, but you worried about losing money. So you'd put a fraction of your wealth into a hedge fund, and they would do sophisticated mathematical things to make sure that if the market were to crash, you wouldn't lose all your money. That was the hedge part.

[Jacob Goldstein]

That's the hedge.

[Ryan Seacrest]

Right.

[Jacob Goldstein]

They make different kinds of bets. So it's not just market goes up, you make money, market goes down, you lose money. This was the original idea. Hedge funds had been around for decades by this point. By the time Meriwether comes along in the 90s, not all hedge funds are even hedged. The main thing they are is special funds for rich people and institutions that charge very high fees. And Meriwether decides he's going to launch the biggest hedge fund ever. And in order to launch the biggest hedge fund ever and to charge higher fees than usual, which is also part of his plan, he needs to nerd up. He needs to go even nerdier than before. And he goes and recruits two professors, two super nerds who are going to make his dreams come true. They are Robert Merton and Myron Scholes. Merton was a Harvard professor who was sort of the father of the finance math nerds. And Scholes. Scholes was at Stanford. And hiring Scholes was like. I couldn't quite nail this one. It was like hiring doctor Band Aid for your hospital or I don't know it, because Scholl's name was on this famous equation that was widely used in finance. Scholes and another guy, Fischer Black, had come up with Black Scholes. An equation that I know is dear to your heart.

[Robert Smith]

Yeah, if you know anything about finance math, you would know the Black Scholes formula. And what they did was solve this classic problem in finance, which is how to price an option. So an option is a contract between two people that essentially says, I have the right to buy something you own in the future at a certain price. At a certain price. So Jacob's all in on SpaceX and I'm a little bit wary. So I say to him, I want the right to buy SpaceX at $200 in six months. Okay, that's a normal contract. But how much should I pay Jacob for that right to buy it in the future?

[Jacob Goldstein]

The right, but not the obligation. Right.

[Robert Smith]

And so people had used their guts. They essentially guessed what this was worth. And what Scholes and Black and Merton did with was come up with this way to essentially price the future in the present by creating a little insurance portfolio. Theoretically. Yeah. The way you predict future risk now is through essentially an insurance contract. Yeah.

[Jacob Goldstein]

So now Meriwether has Merton and Scholes. He also hires a guy who had worked at the Fed, this incredible team. And history, in a really profound way, is on their side. Like, think about this moment. It's 1993. Communism fell. You know, the Soviet Union just, just fell apart. The Cold War is over. And it's clear, right? Free market capitalism won command and control. Communism lost. Even Russia at this point is becoming a market economy. And there's this famous, kind of controversial book that has just come out around this time that kind of nails this moment. A book with the title that people love to mock. The title was the End of History, was by a professor named Francis Fukuyama. And let me just say, he didn't actually mean the end of history the way people who mock it say, right,

[Robert Smith]

things would still happen.

[Jacob Goldstein]

Things would still happen. His argument was there has been this long arc of humanity figuring out how to organize people in economies, you know, monarchial feudalism. And we had communist dictatorships. And now in the 90s, we have arrived at a winner. Free market capitalism and liberal democracy.

[Robert Smith]

And if you think all the other countries in the world are going to become more like the us more efficient. Then you can make bets on that.

[Jacob Goldstein]

This is the world that Merton and Scholz have been doing their math for. The rational, so called rational, if you like world where the market becomes more efficient, where prices more and more closely reflect fundamentals. This is their moment. The world is breaking their way. And so when Merton and Scholes and Meriwether go out to pitch their fund, the world wants in Italy's central bank invests the biggest investment bank in Brazil invests money is coming in from Japan, from Taiwan, from Kuwait, from Wall Street. Phil Knight, founder of Nike invests Michael Ovitz.

[Ryan Seacrest]

Ovitz.

[Jacob Goldstein]

Ovitz, don't know. Ovitz Ovitz, Hollywood super agent, invests in all Meriwether raises over a billion dollars which was the biggest hedge fund ever. And In February of 1994 they launch long Term Capital Management becomes a thing. They got an office in Greenwich, Connecticut. Of course they got like 40 people and they got a bunch of computers and they are ready to start making money. We're going to run an ad now. If you don't want to hear ads, you can join Pushkin plus at Pushkin FM plus. We'll be back in a minute.

[Podcast Host/Advertiser]

This message is a paid partnership with Apple Card. There's something interesting about how seamlessly certain tools fit into daily life. Apple Card is one of those things it can be applied for right in the wallet app on iPhone and approval can happen in minutes. So it's ready to use immediately with Apple Pay. I'm so glad the days of finding my wallet, fishing out the credit card, using it, putting it back in my wallet or oops, maybe I use cash. Where's the atm? Enough. The first time I used Apple Pay on my phone with my Apple Card, I was like, this is the future. There's no going back. With Apple Card purchases earn daily cash up to 3% with no points to track and no waiting for rewards. It's simply daily cash back that I earn on every purchase. There's even an option to open a high yield savings account through Apple Card. And while I haven't done it yet, if I do, my daily cash can grow automatically over time without any extra effort. Because Apple Card lives in the wallet app, it's always accessible on iPhone and can be used with Apple Pay at over 85% of merchants in the US and the security of Face ID and Touch ID prevents unauthorized purchases whether using iPhone or Apple Watch. To explore it yourself, you can apply for Apple Card in the Wallet app on your iPhone subject to credit approval. Savings is available to Apple Card owners subject to eligibility Savings in Apple Card by Goldman Sachs Bank USA Salt Lake City Branch Member FDIC terms and [e-mail] running a small business means every hire matters. A bad hire can cost you time, money and momentum. A good hire? They can help grow your business. But finding great talent isn't easy, especially when you don't have the time or or resources to sift through piles of resumes to find the right fit. That's why LinkedIn built Hiring Pro, your new hiring partner that screens candidates for you. So instead of sorting through applications, you spend your time talking to candidates who are actually a good fit. You know what this makes me think of my beloved Boston Celtics. Three years ago they chose a new coach, Joe Mazzulla, who was like the third or fourth assistant off the bench. Never had any NBA coaching experience. Everyone was expecting him to fail. And you know what? Turns out he was one of the best coaches in the game. And without him there's no way the team would have made the playoffs this year, let alone be contenders for the Finals. Sometimes the right hire makes all the difference. With Hiring Pro, you can hire with confidence, knowing you're getting the best talent for your business. In fact, Those hiring with LinkedIn are 24% less likely to need to reopen a role within 12 months compared to the leading competitor. Join the 2.7 million small businesses using LinkedIn to hire. Get started by posting your job for [e-mail] Pushkin terms and conditions apply.

[Ryan Seacrest]

Hey, it's Ryan Seacrest for Albertsons and Safeway. Save up to 50% off your favorite self care brands this summer. Stock up on wellness products like Cortisone 10 Ultra Soothing Cream, Dualcolax Stool Softener Gels, Claritin 24 Hour Allergy Tablets, Nature's Truth Magnesium Cortisone 10 Cooling Spray, Dual Collax Stimulant Tablets and Nature's Truth Elderberry Gummies. Enjoy savings on top of savings when you shop in store or online for easy pickup or delivery, restrictions apply. See the website for full terms.

[Jacob Goldstein]

The ads are over. We're going to talk about one of the first big trades they did at Long Term Capital because it explains the basic way that the firm worked. So the traders at the firm saw this gap, this price gap, basically an arbitrage opportunity. And what it was was a gap in the price between newly issued 30 year treasury bonds.

[Robert Smith]

Oh fresh. You could still smell the ink US

[Jacob Goldstein]

government debt and 30 year treasury bonds that had been issued just a few months earlier. So this is basically the same thing. But there was an unusually large gap between the prices of the two of them for sort of kind of regulatory reasons about the way Wall street had to work. The key thing is it was clear that this gap should close over time. It was bigger than made sense. So this is perfect for the nerds. It's an irrational gap on really safe assets. They don't have to bet on whether, you know, the treasury market is going to go up or down. They just have to bet that this irrational price gap is going to close. And it almost certainly will close.

[Robert Smith]

This is the age of rationality. Of course it's going to close. And they can help it do that.

[Jacob Goldstein]

The only problem is that the gap between the prices was really small. It was like one and a half percent. So even if the gap closes entirely and it might not do that, the most they could make is ish, one and a half percent.

[Robert Smith]

So too low. That's too low.

[Jacob Goldstein]

Yes. You're not, you're not, you're not starting this great hedge fund with a billion dollars for a return like that. So you have an investment that you're very confident in. It's a small return. Yeah. What do you do?

[Robert Smith]

You lever up. You borrow money. You borrow massive amounts of money. Because when you borrow money, you can turn a tiny percentage increase into a large percentage increase.

[Jacob Goldstein]

Yes.

[Robert Smith]

Let's do the math.

[Jacob Goldstein]

Okay, give it to me.

[Robert Smith]

Okay, so if I have a million dollars and it's going to return 1%, that's $10,000.

[Ryan Seacrest]

Boom.

[Robert Smith]

No, that doesn't even buy me a Maserati. I want my Maserati.

[Jacob Goldstein]

I didn't buy you a bad car.

[Robert Smith]

So I take my $1 million, I go to a bank and say, give me 19 million more dollars. Now I have $20 million, same investment, only now I make $200,000. I get my Maserati and that's a 20% return. I pay back the 19 million. Sure. And by borrowing that money, I can make myself rich, even on tiny opportunities.

[Jacob Goldstein]

This is the game.

[Robert Smith]

Still is the game. This is not a historical thing. This is what happens today.

[Jacob Goldstein]

So they do this. They borrow something like $25 for every dollar they have. And they billion dollar bet on this treasury arbitrage play. And it works. And very Quickly they make $15 million in profit, putting up very little of their own money.

[Robert Smith]

It's working.

[Jacob Goldstein]

It's important to know that they're not the only ones who see this Gap, you know, the, the quants are, are emerging by this point. There are lots of nerds following in their footsteps. And so as other traders are getting in on this kind of bet, the spreads are closing and the traders at Long Term Capital and have to look farther out into the world and make bets that are a little bit more speculative. One big one they do early on is on Italian bonds.

[Robert Smith]

So I don't want to give a hard time to the Italian economy, but let's just say they've had a lot of problems, especially at this point, a lot of different governments. And so Italian bonds are a little bit riskier than the other countries of Europe. Or U.S. bonds.

[Jacob Goldstein]

Yes. And this is before the euro. Right. So even more so. But a trader at Long Term Capital is convinced that the market is overestimating a particular risk. And again, this isn't like some wild speculation. He thinks the market is overestimating the risk that Italian companies will default on their bonds relative to the risk that the Italian government will default. Right. So it's still a spread trade. Right, A convergence trade.

[Robert Smith]

But you know, it's interesting that there is this principle in behavioral economics that says that people overestimate the odds that bad things will happen. So in the stock market, you hear news about all time highs or the stock market crashing. Most days the stock market is boring. You know, the price at the end of the day is very similar to the price at the beginning of the day. You know, we worry about Italian bonds or Italian company bonds. Oh no, they're going to default. But. But most of the time they don't. But weirdly, as humans, we think about the bad thing that can happen and that's the price we put on it.

[Jacob Goldstein]

So Long Term Capital decides to take the other side of that bet to decide, no, the world is going to continue to just be fine.

[Robert Smith]

Yeah, it's being boring.

[Jacob Goldstein]

They make this bet. Italy, in fact did not default. And Long Term Capital made something like $600 million in two years on that trade. So the firm is doing the thing that they said they would do. They're making these trades that profit whether or not the market goes up or down, that things will tend to converge over time. They're borrowing a lot of money to do it and it works so well. It works in fact better than they thought it would. In 1995, Long Term Capital made a 59% return. They took a bunch of fees out of that and they returned to their investors 43% in one year.

[Robert Smith]

Take all my money.

[Jacob Goldstein]

Take all my money. Brainiacs yeah, yeah, please. And one interesting thing about this moment is the people running the firm, Merton and Scholes and the rest of them, they knew that this was extraordinary. This was more than they expected. And I don't just mean that in a kind of hand wavy way. They weren't like, oh, that's more than we expected. It was more than their math told them was likely.

[Robert Smith]

And at this point, there are traders who are not PhDs in the firm who are, you know, popping the champagne and saying, we're geniuses. They're, you know, they're like, we're, we're going to do this again and again and again. But the math guys in the room are looking at this saying, this is off our calculations. This is better than we thought. Which is just as bad as worse than we thought.

[Jacob Goldstein]

Well, it's not actually, from a mathematical perspective.

[Robert Smith]

Yes.

[Jacob Goldstein]

So they, they have done all the math. And in fact, you know, all firms tell their investors, we might lose money. Right. Your lawyers make you say, we might lose money. But there is this amazing investor letter. It's actually an addendum to the investor letter that the firm sends out. The addendum is written by Merton and Scholes. Lowenstein talks about this in his book. And they don't just say, yes, our firm might lose money. They put numbers on how much they might lose. So, for example, they say, yes, there is a 12% chance that the fund will lose at least 5% of its money in any given year.

[Podcast Host/Advertiser]

Right.

[Jacob Goldstein]

This is their worldview that outcomes are mathematically knowable in a probabilistic way. And this is the worldview that is spreading. You know, this is kind of the end of history worldview, the triumph of free market capitalism. And in 1997, this worldview is validated in the most validating way possible when Merton and Scholes win the Nobel Prize.

[Robert Smith]

Very rare for an investment trader to win the Nobel Prize.

[Jacob Goldstein]

Yes. Like, they're making billions of dollars for their firm and many millions of dollars for themselves.

[Robert Smith]

And like, oh, by the way, you're a genius.

[Jacob Goldstein]

Here you go. And, you know, the prize is specifically for that work, figuring out how to price options. But the committee, there's this phrase from the committee that is important here. The committee, the Nobel committee says their work facilitated more efficient risk management in

[Robert Smith]

society, which is a beneficial thing for the world. You know, there's a lot of risk out there, and if you don't know how to price that risk, that's concerning. Things can blow up all the time. But if you have formulas that allow us to figure out exactly how much risk something is taking and how to price that risk. Everyone can calm down. Part of the calm 90s we're talking about.

[Jacob Goldstein]

The world is better when prices more accurately reflect fundamentals. I should mention, by the way, Black, Fisher Black of Black Scholes would have won as well, but he had died by this point. And you can't win the Nobel posthumously. So now Long Term Capital has extraordinary returns, and on top of that, they just won the Nobel Prize.

[Robert Smith]

The line forms to the right. Just be calm. All the way around their building in Greenwich, Connecticut, people want to give them money, clearly, but they can't take more

[Jacob Goldstein]

money at this point.

[Robert Smith]

This is a problem.

[Jacob Goldstein]

It's a classic hedge fund problem where, you know, they're not just putting money into the stock market in these, you know, giant liquid markets, they're making these weird arbitrage bets on bonds in Italy. And there's only so much money you can put into those bets before it starts to move markets. Or at least this is what they tell their investors. In the fall of 1997, around the time that Merton and Scholes win the Nobel Prize. Here, Robert, read from this letter that Meriwether sends to investors.

[Robert Smith]

Around this time, the fund has excess capital. This has occurred primarily because of a substantial increase in the capital base from the larger than expected past realized rates of return and high reinvestment rates elected by the fund's investors. Oh, we're too good. We're too good at our jobs. We just made too much money is what they're saying.

[Jacob Goldstein]

They're saying that. And what they decide to do is force the investors to take back their money. And a lot of the investors are like, no, don't give us our money back.

[Robert Smith]

Keep it.

[Jacob Goldstein]

And of course, the partners keep their own money in, crucially. But in late 1997, Long Term Capital does in fact pay out $2.7 billion to its investors. Now, the next thing that happens is amazing. The fund does not trim its bets, does not say, oh, now that we've given this money back, we're going to be a little bit more modest. What they do is they borrow more money, they increase their leverage and keep the same bets going.

[Robert Smith]

It worked so well. Why not double down?

[Jacob Goldstein]

Why not double down? So now a bigger share of the fund is the partner's own money. It's levered up even more. So if it works, if they keep making money, the partners will go from really, really rich to really, really, really, really rich. By the way, we haven't mentioned the other side of leverage, which is if the market goes against you, instead of losing a little, you lose a lot. What is going to happen after the ad break?

[Robert Smith]

They're Nobel Prize winning geniuses. They're going to be rich forever.

[Jacob Goldstein]

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[Podcast Host/Advertiser]

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[Ryan Seacrest]

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[Robert Smith]

And we're back on the roller coaster. The cars have just gone up the hill at the beginning of the roller coaster. It's to the very, very top.

[Jacob Goldstein]

And you know what we're going to talk about now? Bond spreads.

[Robert Smith]

Okay, let's do bond spreads. If you have two different bonds, they may pay different interest rates. If you have a very safe bond like US government bond, it may pay 4%. If you have a risky bond, it may pay 18% to compensate for the risk.

[Jacob Goldstein]

18% is crazy.

[Robert Smith]

I know. So the risky bond, the spread is

[Jacob Goldstein]

the gap between them. So in this case, 14%, 18 minus 4. The key thing to know is the magnitude of the spread is a measure of fear, really. Right. The wider the spread, the more worried investors are. When they're really confident about the economy, the spread will be narrower because they

[Robert Smith]

think everyone's going to pay out their bonds.

[Jacob Goldstein]

The risky bond isn't that risky.

[Robert Smith]

But if the economic conditions start to get worse, you start to worry about your high risk bonds. You demand a higher interest rate and the gap widens, widens.

[Jacob Goldstein]

And people flee to the safe bond, which makes that interest rate even lower.

[Ryan Seacrest]

Yeah.

[Jacob Goldstein]

So it's the beginning of 1998, and in a lot of parts of the world, bond spreads are wider than usual. They're not insanely wide. It's not like financial crisis wide, but they're wide. There are reasons for this. In 1997, there was the Asian financial crisis that flowed through Thailand, Indonesia, South Korea. So investors are still worried about this. And this is reflected in wide bond sp. And the partners at Long Term Capital, and more importantly, their financial models, thought global bond investors were too worried about this. They thought bond prices would converge, spreads would fall, things would go back to historic norms. And if you zoom out to that broader historic arc we were talking about earlier, this makes sense. You know, fall of the Soviet Union, triumph of the free market, progress of rational economic actors. All of this points in the direction of a smoother, less volatile, calmer market and lower bond spreads.

[Robert Smith]

And the economy in the US is doing tremendously well. We have the Internet. Finally, there's all these dot com stocks. It looks like a new age in economics.

[Jacob Goldstein]

Around the time we balance the budget, start running a surplus somewhere around here.

[Robert Smith]

Yeah.

[Jacob Goldstein]

So Long Term Capital Puts on bets all over the world that volatility will go down, that spreads will converge in Europe and in Latin America. And they're also putting on bets in Russia in the new capitalist frontier. And the Russian economy was kind of a mess by this point. People were starting to worry that Russia might default on its debts. But there was this thing people said at the time which was no nuclear power has ever defaulted. Meaning no, you know, big serious country has ever defaulted. Which is kind of a. Nuclear power is kind of weird, but it was a thing people said. And you know, the International Monetary Fund, the IMF, had been really active in countries around the world helping them stave off defaults. And so the traders at Long Term Capital look at Russia and they think, no, these fears are, you know, one more example of irrational fears. They figure Russia's going to pay its debts, spreads will converge. And also they do hedge some of their bets for additional safety.

[Robert Smith]

I do love though that they're kind of optimists. I know it's the data and it's backed by the computers, but what they are saying is that the world is going to be a calmer, better place. It's kind of a beautiful thought. I wouldn't borrow a bunch of money and put billions of dollars on it. But yes, yes.

[Jacob Goldstein]

I mean, in a certain way. Not exactly, but kind of like you and I both just do the boring retirement thing of just buy index funds, mostly of stocks. And that's a version of that. Right? We're just going to ride a growing economy because that's what has happened. But we don't borrow a bunch of money to do it.

[Robert Smith]

We don't.

[Jacob Goldstein]

So Long Term Capital is betting that around the world spreads are going to converge. This is not what happens. In the spring and early summer of 1998, spreads start to get a little bit wider. And In June of 1998, long term capital loses 10% biggest ever one month loss, not disastrous, but big. In July their returns stabilize and then comes August. And on August 17, the thing happened that was not supposed to happen. Russia defaulted. Russia said we are not going to pay some of our debts. And also the Russian banks where Long Term Capital had put their hedges, we're not going to pay those foreign investors, we're not going to pay out on those contracts.

[Robert Smith]

Who would have thought you can't trust the Russians.

[Jacob Goldstein]

Kind of surprisingly, it actually takes a few days to, for it to hit global markets. Robert Smith, I have, I've pasted here a paragraph from a 1998 Wall Street Journal story. For you to read.

[Robert Smith]

It was August 21, a sultry Friday, and nearly half the partners at Long Term Capital Management LP were out of the office. Outside the fund's glass and granite headquarters, a fountain languidly streamed over a copper osprey, clawing its prey.

[Jacob Goldstein]

I sent this to you. I sent this to you. You and I have, like, a running thing about newspaper stories with, like, gratuitous descriptions of place.

[Robert Smith]

Number one, it means that the reporter did not get inside the building, so the reporter's describing whatever they can. But number two, it means settle in for a long story of hubris.

[Jacob Goldstein]

Yes. I mean, if you are a financial firm and the Wall Street Journal is describing the fountain outside your office, you are in terrible trouble. Something very wrong has happened in this case. What has happened on this sultry August day is that investors all around the world, all around the world are terrified by what has happened in Russia. And they are reacting by selling risky bonds and buying safe bonds.

[Robert Smith]

But not just in Russia. They're afraid of risky bonds around the world. Any country that could conceivably be related to Russia in some way, they're like, we gotta get out of there.

[Jacob Goldstein]

We gotta get out of there. And you will recall, yes, that when this happens, it makes bond spreads get wider. And this is the opposite of the bet that Long Term Capital has made all around the world. And they're widening in a more correlated way than Long Term Capital's models would have predicted. Right? Like, sure, okay, maybe they'll widen in Russia. But they hadn't guessed that they would widen everywhere all at the same time in this way.

[Robert Smith]

Which is why they spread their bets around the world. Because you're thinking, okay, one country, this could go wrong. Two countries, it could go wrong. But other countries halfway around the world would not react the same way, wouldn't be rational.

[Jacob Goldstein]

And so because the world is reacting in this way, because these things are happening, Long Term Capital is getting destroyed. Their models had predicted that the most they could lose in a single day was $35 million. On that sultry Friday, they lost more than $500 million.

[Robert Smith]

Time to reboot the computer. Something's wrong here.

[Jacob Goldstein]

Just unplug it. Unplug it.

[Podcast Host/Advertiser]

Turn it off.

[Jacob Goldstein]

Turn those machines back on. So it's late August in Connecticut. So of course, all the rich guys, the partners, are off on vacation and the traders at the office are picking up the phones and calling them, because that's what you had to do in the 90s on their giant cell phones.

[Robert Smith]

Yes.

[Jacob Goldstein]

They get Merryweather at a Dinner in be. Some other guy was in Sun Valley, Idaho, another one was in Italy. They were on top. By Sunday morning, two days later, they are all back in the office in Connecticut trying to figure out what to do. And they think, okay, this is gonna fix itself. Like there's no fundamental reason why spreads are doing what they're doing. It's not like there's a war and economies have been blown up and destroyed. Things are gonna go back to normal. And when that happens, we'll make more money. So all we need is some cash, some capital to ride this out. Because remember, when you've borrowed a lot of money against a little capital, people are going to start asking for the money back. You're going to need some money essentially in the bank to ride out the storm.

[Robert Smith]

But if you have a pile of money that you can pay that back, that's fine. You can keep going and keep going and eventually make untold billions.

[Jacob Goldstein]

Yeah, you can make your money back and more. This is their plan. And around this time, Meriwether calls this old Wall street friend of his for advice, maybe some contacts for raising money. The guy's name is Vinnie Matone. Vinnie is the old school style trader, you know, the cheeseburger for breakfast kind of guy. And Lowenstein in When Genius Hailed has a beautiful description of this scene of Vinnie coming to talk to Meriwether.

[Robert Smith]

Oh, this is going to be good. Vinnie wore a gold chain and a pinky ring, and he showed up at Long term in a black silk shirt, a open at the chest.

[Ryan Seacrest]

Where are you?

[Robert Smith]

Maton asked bluntly. We're down by half, Merriweather said. You're finished, Matone replied. For the first time, Merriweather sounded worried. What are you talking about? We still have $2 billion. We have half. Matone smiled sadly. When you're down by half, people figure you can go down all the way. They're going to push the market against you. You're finished.

[Jacob Goldstein]

I like to think of Vinnie Matone as this street smart Yoda telling Meriwether that the Force is not with him.

[Robert Smith]

It's beautiful because Long Term Capital Management was depending on computers and logic and this optimistic view of the world. And Vinnie, the street smart guy is like, what you didn't factor in is the fact that this is a competitive game. And much like the Osprey in the fountain outside of your office, other investment firms are going to grab you out of the water and consume you. And so it's just such a beautiful moment that Vinnie knows the way the world really works outside computers.

[Jacob Goldstein]

Meriwether isn't ready to give up, though. On September 2nd, he sends this letter to Long Term Capital's investors. Tells them that the fund was down 44% in August.

[Robert Smith]

One month.

[Jacob Goldstein]

It's a very bad month. But he says, you know, spreads are going to close again. Our strategies are sound. This is in fact, a good time to invest. And he makes this move in this letter that at a certain level, I am just in awe of. I can't believe he did it. It's fantastic. So, Robert, here, read. Read this paragraph from the letter.

[Robert Smith]

Since it is prudent to raise additional capital, the fund is offering you the opportunity to invest in the fund on special terms. If you have an interest in investing, please contact Richard Leahy at Long Term Capital Management, 203-552-5511. For further information, call now.

[Jacob Goldstein]

Operators are standing by.

[Robert Smith]

Where's my phone? Where's my phone?

[Ryan Seacrest]

Actually?

[Robert Smith]

Have you called this phone number? Put it on speaker. Okay, well, 1203 1.

[Jacob Goldstein]

Okay, you say, I'm trying to reach. I want to invest. What are you going to say if they answer?

[Robert Smith]

I don't know. The number you dialed is not in service.

[Jacob Goldstein]

Spoiler alert,

[Podcast Host/Advertiser]

Robert.

[Jacob Goldstein]

The investors did not call now. And in fact, the letter leaked to the press before even all the investors had got the letter. Some of them found out about it by reading about it in the news. And now, in case they hadn't before, everybody knew that Long Term Capital Management was screwed. Knew, like Vinnie said, they were going to be screwed. They called it the LTCM Death trade, where everybody is getting out ahead, right? Because think about it. These are thinly traded markets. Long Term Capital has huge positions. You know, they're gonna have to sell. So even just to protect yourself, like if you own anything that they own, you wanna sell before they sell. Cause they're gonna drive the price down. So everybody is selling the stuff that they own. So the prices are falling, right? So this, in addition to the market behavior, is compounding Long Term Capital's troubles. On a single day, September 21st, they lose again. More than 500 million. Like that bad day in August, $553 million more. And they still have all this leverage. In fact, in a way, your leverage ratio goes up the more you lose, right? Because they still owe all this money. Their capital base is shrinking. And now the lenders are afraid that Long Term Capital is not going to be able to pay them back. So they start saying, no, you have to give us our money back or we're not going to roll over these Short term loans that we've been rolling over.

[Robert Smith]

And if you're not rolling over the loans, you have to sell even more. And the more you sell, the more loans you have to pay off. And so that's the death spiral.

[Jacob Goldstein]

That's the death spiral. And then there's, if we widen the circle, there is now a bigger concern. Because Long Term Capital is so big and, and so intertwined with all these other Wall street firms, there is a bigger fear, which is if they blow up and can't pay back their debts, then all of these other banks that they owe money to might not be able to pay their debts. And then we'll have a financial crisis. We'll have all of these firms linked to each other going down and potentially hurting the whole economy. Bringing down the whole economy.

[Robert Smith]

And this is super important because this is how crises happen. Nobody really cares about Nobel Prize winners losing all their money.

[Jacob Goldstein]

No, they should be able to. Like that's, we want firms to fail.

[Robert Smith]

And, and even the banks that lent the money, they took a risk and they might lose money on this deal. But the situation is you don't know the full list of everyone who lent money to Long Term Capital. And so when you're out in Wall street and you want to make a deal, you have to ask yourself constantly, wait a minute, is the person I'm about to make a deal with, are they exposed to this? Are they exposed to someone who's exposed to this? It can slow down all investment at once because you just don't know where the risk is. This is the problem. Yes.

[Jacob Goldstein]

This is why in the 1800s there were panics every few years because this would happen again and again. And in fact, to stop it from happening or at least reduce the risk of it happening, America created a central bank, the Federal Reserve. And as Long Term Capital is about to blow up in September, the Federal Reserve does its job. They say, oh wait, we better make sure this doesn't cause a financial crisis.

[Robert Smith]

Yes.

[Jacob Goldstein]

You know, there is a branch of the Fed in New York that deals with Wall Street. A guy we used to work with said the New York Fed is actually more baller than the main Fed headquarters in Washington, the Board of Governors.

[Robert Smith]

And they have a special conference room there too, just for moments of crisis. And they invite everyone into this conference room.

[Jacob Goldstein]

Yes, it's Wednesday, September 23rd, when they use the special crisis conference room, which is not a special crisis conference room, and they call all the heads of the big Wall street banks to a meeting and the Fed says to all these bankers, look, you're all doing business with Long Term Capital. You're all screwed if they go under. Figure something out. We, the Fed, we're not going to put money in. We're not going to bail you out. You're all in this together. Work together to figure it out.

[Robert Smith]

Oh, kumbaya. Just, just work together.

[Jacob Goldstein]

Yeah. A bunch of Wall street bankers love to hold hands and help each other out.

[Robert Smith]

Hyper competitive, they want to stab each other in the back. This is their normal day. And now the Fed, and this does happen occasionally, the Fed is saying, hey, for the good of everyone, can we set aside our immense greed and hatred of each other on this day and

[Jacob Goldstein]

just be a little more long term greedy, right? Like it is in your greedy interest for this not to blow up. And so the bankers sit in this room and over the next several hours, they actually come up with a plan. They're going to put in $3.65 billion into the fund of their own money, of the bank's money. And the partners at Long Term Capital, their equity will be wiped out, right? They won't get any of this money and they won't own any of the fund anymore. And Meriwether, you gotta love him, negotiates. He's like. Because part of it is they need Meriwether and his traders to stay on. There's like literally thousands of trades they have put on. And they're not worthless. Importantly, right, they need somebody to run this fund, not to just liquidate it at fire sale prices. And so Meriwether's like, well, if you want us to stay on, you're gonna have to pay us. You'll have to give us a bonus. And so in fact, Meriwether and a bunch of other people agree to stay on at Long Term Capital, get paid hundreds of thousands of dollars for their, for their labor. And in fact, over the next year, the thing happens that they said would happen. Spreads do converge. They actually turn a profit. The banks got all the money back that they put into the fund in that emergency moment. And in early 2000, long term capital Management ceased to exist.

[Robert Smith]

I love this story because this is a classic issue in finance, which is if you could go back and replay history a hundred times, Long Term Capital Management would be great. 99 of those times, like, they knew what was going to happen. They made the correct bet on that. Maybe borrowed too much money on this. But they weren't wrong. Their timing was off. Their liquidity was off. They didn't have the money to deal with the kind of, of debt and leverage that they had. But it's interesting that you can be right and still almost destroy the world economy.

[Jacob Goldstein]

Yeah, I mean, they weren't wrong in terms of this sort of mathematical risk. But for me, there's this idea that is really useful here, which is the distinction between risk and uncertainty. And, you know, colloquially we use those words largely interchangeably. But there was this economist in the twenties named Frank Knight who wrote this book called Risk, Uncertainty and Profit. And his argument was, you know, we use risk in really different ways at different times. We use one word to mean quite different things. In particular, we use risk when we can really, really measure the probability of what's going to happen, and also when we cannot. Here's an example. You're betting on a coin toss. You bet on heads. You know that there's a 50% risk that you're going to lose. Now say that coin happens to be a Russian Ruble and it's 1998. What's the risk that Russia is going to devalue the ruble, which would make the ruble worth a lot less if

[Robert Smith]

you win, I mean, you can go back and look at history in terms of nuclear power countries and default, and what is that, 10, 12?

[Jacob Goldstein]

You can talk for experts, you can study history, you can do a lot, and you can come up with some probabilistic estimate of a Russian devaluation. Maybe it's 10%, maybe it's 50%. You can put a number on it. But crucially, that number is not the same kind of number as the risk that it'll come up tails. If you bet heads, it is fundamentally different. You're fooling yourself when you put a number on it. You don't actually know the way. You know the 50% with the coin flip. This unknowable outcome is what Frank Knight calls uncertainty. So risk is the coin flip. Uncertainty is will Russia devalue? And I think you can argue that the big mistake that Long Term Capital made was they confused risk and uncertainty. They thought the world was measurable. That risk could be modeled with math. And a lot of the world is measurable. To your point, math is really powerful at predicting market outcomes, but there is still some amount of unquantifiable uncertainty. And if you're highly leveraged, if you've borrowed a lot of money and made a lot of bets, sooner or later that unquantifiable uncertainty will destroy you. And that is what happened to long term capital management.

[Robert Smith]

Jacob we love it. When our listeners write in. We got a note from someone who talked about their seven year who missed her dance class, Almost missed her dance class. Almost missed her dance class because she was listening to the Ice episode and the daughter asked for a show about Crayola, about crayons.

[Jacob Goldstein]

Please email us whatever age you are at BusinessHistoryUshkin FM or you can find me on XacobGoldstein or on LinkedIn. Robert, you're on Twitter RadioSmith, shout out radio.

[Robert Smith]

I am indeed.

[Jacob Goldstein]

Our show today was produced by Gabriel Hunter Chang, engineered by Sarah Brugiere. Our video editor. Yes, we're on YouTube is Matt Nielsen and our showrunner and editor is Ryan Dilley. One quick note. We're going to be off taking a little summer break for the next couple of weeks, but we're still making shows. We'll be back later in July. I'm Jacob Goldstein.

[Robert Smith]

I'm Robert Smith. Thanks for listening.

[Ryan Seacrest]

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[Jacob Goldstein]

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[Ryan Seacrest]

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[Jacob Goldstein]

The Second World War is the largest

[Robert Smith]

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[Jacob Goldstein]

A 20 part documentary series with Tom Hanks.

[Robert Smith]

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