The story of Long-Term Capital Management is an interesting episode in financial history. In the midst of the 90’s Internet Bubble, a bailout took place to prevent a ripple effect into the financial sector.
In September 1998, Warren Buffett played a bit part in the bailout. His offer was eventually turned down. A few weeks later, he was asked about his role by a University of Florida student. Buffett’s answer offers some insight into the lessons of risk, probability, and leverage when math collides with behavior-driven markets.
The excerpt below was transcribed from the Q&A session with University of Florida School of Business in October 1998 (emphasis mine).
Well, there’s a story in the current Fortune Magazine that has Rupert Murdoch’s picture on the cover that tells the whole story of our involvement. It’s kind of an interesting story because…it’s a long story so I won’t go into all the background.
I got the really serious call about Long Term Capital four weeks ago this Friday, whenever it was. I got it in mid-afternoon. My granddaughter was having her birthday party that evening and I was flying that night to Seattle to go on a 12 day trip with Gates to Alaska on a private train and all kinds of things were I was really out of communication.
But I got this call on a Friday afternoon, saying that things were really getting serious there. I had some other calls before – that the article gets into – a few weeks earlier. I know those people, most of them pretty well, a lot of them are Salomon when I was there. And the place was imploding and the Fed was sending people up that weekend. And between that Friday and the following Wednesday when the NY Fed, in effect, orchestrated a rescue effort but without any Federal money involved. I was quite active but I was having this terrible time because we were sailing up through these canyons, which held no interest for me whatsoever, in Alaska. And the captain was saying, “If we just steer over here we might see some bears and whales.” And I said, “Steer where you get a good satellite connection.” In fact, there’s a picture in Fortune were Old Faithful is going off behind me and I’ve got my back to it and I’m on my phone.
We put in a bid on Wednesday morning. By then I was in Bozeman, Montana and I talked to Bill McDonough, the head of the NY Fed, about 10 o’clock. They were having a meeting with the bankers at 10 o’clock that morning in New York and I caught him. We actually delivered a message to him. He called me out there a little before 10:00 New York time.
We made a bid. Because it was being done over long distance it was really an outline of a bid. In the end, it was a bid for $250 million for, essentially, the net assets but we would have put in $3.75 billion on top of that. It would have been $3 billion from Berkshire Hathaway, $700 million from AIG and $300 million from Goldman Sachs. And we submitted that but we put a very short time fuse on it because when you are bidding on $100 billion worth of securities that are moving around, you don’t want to leave a fixed price bid out there very long, plus we were worrying about it getting shopped. In the end the bankers made the deal, but it was an interesting period.
The whole Long Term Capital Management – I hope most of you are familiar with it – the whole story is really fascinating because if you take John Meriwether, Eric Rosenfeld, Larry Hillenbrand, Greg Hawkins, Victor Haghani, the two Nobel prize winners Merton Scholes… If you take the 16 of them, they probably have as high an average IQ as any 16 people working together in one business in the country, including Microsoft or where ever you want to name. So an incredible amount of intellect in that room. Now you combine that with the fact that those 16 had had extensive experience in the field they were operating in. These were not a bunch of guys who had made their money, you know, selling men’s clothing and all of a sudden went into the securities business. They had in aggregate, the 16, probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor that most of them had virtually all their very substantial net worths in the business. So they had their own money up. Hundreds and hundreds of millions of dollars of their own money up, super high intellect, working in a field they knew, and essentially they went broke. That to me is absolutely fascinating.
If I ever write a book it will be called “Why Smart People Do Dumb Things”. My partner says it should be autobiographical. But this might be an interesting illustration. These are perfectly decent guys. I respect them and they helped me out when I had problems at Salomon. They are not bad people at all.
But to make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish. That is just plain foolish. It doesn’t make any difference what your IQ is. If you risk something that is important to you for something that is unimportant to you it just does not make any sense. I don’t care whether the odds are 100 to 1 that you succeed or 1000 to 1 that you succeed. If you hand me a gun with a million chambers in it, and there’s one bullet in a chamber and you said, “Put it up to your temple. How much do want to be paid to pull it once,” I’m not going to pull it. You can name any sum you want, but it doesn’t do anything for me on the upside and I think the downside is fairly clear. So I’m not interested in that kind of a game. Yet people do it financially without thinking about it very much.
There was a lousy book written once with a great title by Walter Gutman. The title was “You Only Have to Get Rich Once”. Now that seems pretty fundamental doesn’t it? If you got $100 million at the start of the year and you’re going to make 10% if you are unleveraged and 20% if you are leveraged 99 times out of a 100, what difference does it make at the end of the year whether you got $110 million or $120 million? It makes no difference at all. I mean, if you die at the end of the year, the guy who writes the story might make a typo and he may say 110 even if you have 120. You have gained nothing at all. It makes absolutely no difference. It makes no difference to your family. It makes no difference to anything.
Yet, the downside, particularly managing other people’s money, is not only losing all your money, but it’s disgrace, humiliation, and facing friends whose money you have lost. I just can’t imagine an equation that makes sense for. Yet 16 guys with very high IQs, who were very decent people, entered into that game. You know, I think it’s madness. It’s produced by an over reliance to some extent on things. Those guys would tell me back when I was at Salomon, “A six sigma event wouldn’t touch us. Or a seven sigma event.” They were wrong. History does not tell you the probability of future financial things happening. They had a great reliance on mathematics. They felt that the beta of the stock told you something about the risk of the stock. It doesn’t tell you a damn thing about the risk of the stock in my view. Sigma’s do not tell you about the risk of going broke in my view and maybe in their view now too.
But I don’t even like to use them as an example because the same thing in a different way could happen to any of us probably, where we really have a blind spot about something that is crucial, because we know a whole lot about something else. It is like Henry Kauffman said the other day, “The people who are going broke in this situation are of two types, the ones who knew nothing and the ones who knew everything.” It’s sad in a way.