The recklessness of the nerds

What went so spectacularly wrong? Lowenstein explains that the professors' core belief was that financial markets behaved in a supremely rational and coolheaded manner, much like they did. That was the basis for their elaborate models and computer analyses. Indeed, it was a basic tenet of modern financial theory that went virtually unchallenged in academia. Unfortunately, that tenet is incorrect. Financial markets are no more rational than the humans who buy and sell securities, and humans are maddeningly unpredictable. They're often driven by wild emotion rather than cold reason, especially during periods of crisis. So when the Asian economic crisis exploded and Russia defaulted on its debt in the late '90s, the financial markets lost their mind and went totally berserk, and Long-Term Capital's computer models couldn't help.

The other problem was that when Long-Term was still flying high, the professors -- intoxicated by their success -- diverged from their smoothly scientific methods. They began making huge and surprisingly risky investments based more on faith than reason. It was as if the geeky card counter got caught up in the excitement and distractions of Las Vegas -- the emotional thrills and the chips piling up in front of him -- and started betting on sheer impulse, rather than waiting countless hours for the perfect hand.

"When Genius Failed" isn't as flashy as "Liar's Poker," but it is a commendable book -- well reasoned and revealing. Lowenstein, a financial journalist and the author of an earlier study of investing legend Warren Buffett, excels at explaining financial matters in a concise way that illuminates without oversimplifying. It's rare enough for someone to be able to explain business so smoothly and cogently, but Lowenstein also has a deftness with descriptions. (He says that Meriwether was so unpretentious that "he could have been the State Farm agent down the street.") He also has a reporter's eye for telling detail, showing how one Long-Term Capital partner, once worth zillions on paper, ultimately was forced to use his wife's checkbook.

Could a Wall Street debacle such as Long-Term happen again? For the moment, it looks like we're safe. The prestige and mystique that hedge funds enjoyed in the '90s have been diminished by the failure of Long-Term Capital and several other high-profile players. The next big blowout was Julian Robertson's famous Tiger Management, which for years had enriched investors, including writer Tom Wolfe. (That's why he could afford to spend 11 years writing a novel.) Then Tiger lost billions in assets and ultimately closed down. And the loudest-mouthed hedge fund honcho, James Cramer, now of TheStreet.com, capped a decade-long winning streak with an embarrassingly lousy year when many of his backers rushed to pull their money out of his partnership. Suddenly it seemed as if even the biggest geniuses were as prone to screwing up as the day trader next door, and Wall Street wasn't nearly as eager to entrust the gurus with huge bankrolls.

But memories are fleeting in the financial markets, and when the next wave of speculative fervor arrives, it's likely that a fresh bunch of hotshots will emerge, with a new buzzword or twist on the same old game. Lowenstein shows that Washington hasn't done anything to preempt another Long-Term-like crisis. He faults Federal Reserve Chairman Alan Greenspan, who, in the name of free-market ideology, has stubbornly resisted calls for more regulation of derivatives, the financial instruments that helped Long-Term Capital control such vast assets.

While there are margin requirements that limit the amount of stocks investors can buy with borrowed funds, those rules don't apply to the newer, fancier derivatives, which are like side bets on securities prices without governmental oversight. There's nothing to stop the big investment banks from lending billions to another firm playing dangerous games. And if it can count on the feds to arrange a bailout, then why not roll the dice again?

Astonishingly, Meriwether and his crew are already back in action. Last November, they launched a new hedge fund, JWM Partners, which raised $250 million from many of the same investors who backed Long-Term Capital. As for me, I'd feel a lot safer entrusting my savings to the day trader next door.

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