When Wall Street's Dream Team Failed

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On this day in economic and business history...

Long Term Capital Management, the massive hedge fund led by some of the brightest lights in the financial universe, effectively failed on Sept. 23, 1998. The 4-year-old fund did not declare bankruptcy that day, but its $3.6 billion bailout by a group of Wall Street's largest commercial and investment banks only delayed the inevitable. LTCM's assets were liquidated early in 2000 to pay back its creditors, and the firm is now a cautionary tale: Even the best minds in business can fail spectacularly to beat the market.

LTCM was founded in 1994 by John Meriwether, former head of bond trading at Salomon Brothers. You may remember him from such books as Michael Lewis' Liar's Poker, in which Lewis painted his old boss as a high-stakes gambler -- understanding that fact will help you figure out why LTCM eventually failed. Meriwether recruited Myron Scholes and Robert Merton, the living creators of the Black-Scholes options-pricing model, to serve on LTCM's board of directors -- the two economists would win the Nobel Prize for their formula in 1997, a year before the firm's collapse. Federal Reserve Vice Chair David Mullins also joined the firm, which was otherwise heavily stocked with Meriwether's former Salomon Brothers colleagues. This assemblage was dubbed "Wall Street's Dream Team," and its early years proved immensely successful.

LTCM's trading strategy hinged on the use of arbitrage deals, which most often involved exploiting the differences between government bonds of different terms. However, LTCM's high-leverage strategy backfired in 1998 when Russia defaulted on its debts. By this point, the firm was already falling toward deep losses as a result of the East Asian financial crisis that began percolating in 1997. It had bet huge amounts of money on the continued stability of governments that proved anything but stable. You can guess what happened next.

The discrepancy between different bonds is typically so small that effective arbitrage at scale involves deploying billions of dollars, and by 1998 LTCM had amassed about $125 billion in debts against $4.7 billion in assets, and the notional value of its derivative positions had ballooned to well more than $1 trillion. LTCM was leveraged to the hilt. If the history of modern booms and busts teaches us anything, it's that the greater the leverage, the greater the impact. LTCM's bets on Asian and Russian government bonds caused the firm to lose billions when these governments fell into crisis and (in some cases) default. An ill-timed arbitrage position in Royal Dutch Shell's dual listings further shredded LTCM's assets when the shares failed to converge to the same price quickly.

On the eve of the bailout, LTCM's leverage ratio had ballooned to 50-to-1, but investor flight further reduced the firm's capital base before the bailout could calm the herd. By the end of September, LTCM held just $400 million in assets against more than $100 billion in liabilities. It had lost $4.6 billion in a few short months.

For a while, investing in LTCM seemed like a no-lose proposition. A stake bought shortly after its inception in 1994 grew 500% by the end of 1997 -- nearly twice the gain of the Dow Jones Industrial Average (DJINDICES: ^DJI  ) over the same period. However, by the end of 1998, that LTCM investment was worth pocket change, and the Dow was still roughly twice as high as it had been in 1994.

The Communists have the bomb
A Russian crisis of a different sort played out on Sept. 23, 1949. That day, President Harry Truman announced to the American public that the Soviet Union had successfully tested an atomic bomb. This development took place years before most U.S. experts had anticipated, and it launched the two global superpowers into the multidecade standoff known as the Cold War. This period of history produced a number of amazing technological breakthroughs as the two nations sought to one-up each other without prompting the launch of planet-annihilating nuclear missiles.

You can thank one technology for your ability to read this article today: The Advanced Research Projects Agency Network, or ARPANET, was designed in the depths of the Cold War to be a highly resilient, decentralized communications network. Its descendant, the Internet, might even be able to withstand an isolated nuclear attack -- but we should all hope that it never has to.

Greasing the wheels of commerce
WD-40 (NASDAQ: WDFC  ) was invented on Sept. 23, 1953. According to the company's site:

In 1953, a fledgling company called Rocket Chemical Company and its staff of three set out to create a line of rust-prevention solvents and degreasers for use in the aerospace industry, in a small lab in San Diego, California. It took them 40 attempts to get the water displacing formula worked out. But they must have been really good, because the original secret formula for WD-40 -- which stands for Water Displacement perfected on the 40th try -- is still in use today.

Rocket Chemical's new product first saw use on the Atlas missile, which was later used to launch the first four American astronauts to reach orbit. In 1958, the first cans of WD-40 hit store shelves in California, and by 1960 the company was selling 45 cases a day, many out of the trunks of its seven employees' cars. In 1969, Rocket Chemical renamed itself WD-40 -- an appropriate move, given that it only had one product. It still remains almost exclusively a purveyor of one particularly useful solvent, but that laser focus brought the company over $340 million in annual sales in 2012.

Is that a Donkey Kong trading card?
Nintendo (NASDAQOTH: NTDOY  ) was created on Sept. 23, 1889 in Kyoto, Japan. Its founder, Fusajiro Yamauchi, would never live long enough to see the company become the console-gaming kingpin, but he did get the company started off on an entertaining foot: Nintendo Koppai, as it was then called, was originally created to make Japanese playing cards. The characters for Nin-ten-do, according to the company, translate to "leave luck to heaven," which is a fairly accurate description of the way most people play card games.

The company made its first foray into the electronic entertainment for which it is most well-known in 1966 with the creation of an "Ultra Hand," a sort of electronic extendable arm that might explain the company's later obsession with marketing the Power Glove. However, it wouldn't be until 1975 when Nintendo entered the gaming industry with the launch of the arcade game EVR Race, which took place around the time the company hired now-legendary game-designer Shigeru Miyamoto.

Miyamoto first made his mark on Nintendo (and the world) with the release of Donkey Kong in 1981, and this arcade smash hit convinced the company to marshal its strength behind the launch of a console system, known as the "Famicom" in Japan and the Nintendo Entertainment System, or NES, everywhere else. The rest, of course, is history: Nintendo reported lifetime sales (across all models) of 269 million consoles and 385 million handheld systems in 2013, on the 30th anniversary of the original NES' release.

Nintendo was one of the strongest companies in the living room for the past three decades, but its dominance is eroding as impressive all-in-one systems muscle into the picture. But competing consoles aren't the only threat to Nintendo -- there's an all-out $2.2 trillion media war raging in every home that pits cable companies like Cox, Comcast, and Time Warner against technology giants like Apple, Google, and Netflix. The Motley Fool's shocking video presentation reveals the secret Steve Jobs took to his grave, and explains why the only real winners are these three lesser-known power players. Click here to watch today!

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Alex Planes

Alex Planes specializes in the deep analysis of tech, energy, and retail companies, with a particular focus on the ways new or proposed technologies can (and will) shape the future. He is also a dedicated student of financial and business history, often drawing on major events from the past to help readers better understand what's happening today and what might happen tomorrow.

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5/24/2016 4:32 PM
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