Market Upside Down: How to Invest Profitably in a Shrinking Economy

3. The Root Causes: Leveraging and Excess

Remember the implosion of the hedge fund firm Long Term Capital Management (LTCM) in 1998? Led by the defunct Salomon Brothers’ famed trader John Meriwether, and with a roster of Nobel laureates and celebrity Harvard professors as well as a former Federal Reserve Board vice chairman among its leadership, LTCM was a practitioner of fixed income arbitrage. Its expertise was investing in fixed income securities that carried higher yields, and it hedged with short positions in lower-yielding bonds. No matter that the higher-yielding bonds were also among the riskiest—the difference in the yields of the two types of securities accounted for the profits of the trades. Because the yield differentials were small, ...