Charlie Munger, Vice Chairman of Berkshire Hathaway, used to say “there are only three ways a smart person can go broke: liquor, ladies, and leverage.” While a dictionary might suggest that leverage simply is another name for debt, leverage often is associated with very high multiples of debt (200%+) used by “sophisticated” investors.
Leverage continuously provides reminders that it is very, very dangerous. To illustrate why, we’ll start with a short recap and review of the book When Genius Failed: The Rise and Fall of Long Term Capital Management which illustrates how, 25 years ago, Nobel-prize winning geniuses nearly destroyed the global financial market.
We will then show how this same pattern repeats for the 2008 housing crash, the Situational Awareness hedge fund collapse, and the Korean stock market crash of 2026. “Genius” traders continue to ignore these lessons and repeat mistakes, but after reading this column, I hope at least you will learn the lesson!
When Genius Failed: Quick Book Recap and Review
Roger Lowenstein wrote, When Genius Failed: The Rise and Fall of Long Term Capital Management, in 2001. Random House published the original book and the additional updates added by Lowenstein after the crash of 2008 to provide additional perspectives and updates.
For a 532 page book, it is a quick, easy read because it focuses on the people and their decisions instead of the hard math. You don’t have to read the book to learn of the negative consequences of highly leveraged trading, but the book illustrates in clear detail how very smart people can do very stupid things when initial success breeds arrogance.
LTCM Early Success
Long Term Capital Management (LTCM) started with a core team of rock star traders, a prominent member of the Federal Reserve Bank of New York, and two Nobel-prize-winning economists that developed the foundational mathematical models used to value options and develop modern financial theory. The firm then obtained $1.2 billion in seed funds from national banks, large corporations, and very wealthy individuals.
From 1994 to 1997, LTCM made gains as large as 50% per year by using huge leverage – as much as 31 dollars for every dollar owned! So despite their own huge returns, on the ultimately $1.25 trillion dollars they invested globally, their actual return overall was less than 5%- it was only the leverage that made it seem bigger.
It was their debt leverage that did the heavy lifting. As we will see later, as they began to lose money, this ratio became even worse and contributed directly to their downfall.
For now, we need to understand the scale of their efforts. When their trading balance hit $1.25 trillion it exceeded the gross domestic product (all money earned by all companies, citizens, etc.) for all but seven countries in the world in 1997, falling just short of Italy’s $1.45 trillion GDP.
The Hidden Danger
No one in Wall Street nor the US Government understood LTCM’s methods or exposure. LTCM worried that their methods would be copied, so they tried to hide their trades as much as possible and spread them out not just to different banks and brokerages on Wall Street, but also around the world.
Each individual bank looked at LTCM’s trades just for their institution and saw huge numbers. They assumed the numbers were so big that they must be LTCM’s largest partner.
No one realized LTCM placed enormous bets all across the world and would jeopardize the global financial market. No one knew the total value of the legal, but perhaps unwise loans.
LTCM also avoided oversight by trading primarily in derivatives (options to buy or sell bonds or stocks). The government excluded options from the trading rules used to monitor bond and stock ownership and thus LTCM stayed below the radar of regulators.
LTCM Bad Assumptions
The hedge fund of math-loving and gambling-addicted traders began to ignore possible downsides. Their early success prevented them from critically examining three key assumptions in their trading and in the math backing their models:
- Market volatility stays in a predictable range
- Perfect markets lead to rational, value-oriented pricing
- Diversification eliminates risk
Let’s quickly examine how they were wrong.
Predictable Range for Market Volatility
The LCTM team examined the largest market changes in history and assumed that the most dramatic changes (aka: volatility) of the past limited how much the market could change. They made huge multi-million dollar bets expecting price changes in the market to remain within their predicted range.
They failed to understand how the sheer size of their bets created market conditions impossible earlier in history. With LTCM’s huge leverage, modest changes could create huge net valuation swings – and then lead to unprecedented volatility that violated all of their mathematical models.
Perfect Markets
LCTM’s Nobel laureates not only helped to develop the Perfect Market Theory, they also taught the theory to the top traders and top finance professors throughout the US. I was still being taught their theories as the basis for my finance classes when I earned my MBA in 2004.
The Perfect Market Theory includes the idea that for every seller, there will naturally be a buyer who also understands the value of the product (bond, stock, etc.). In theory, a rational buyer will snatch any product before it falls too far below its real value.
For example, if there were two bonds that should both be valued at $1,200 each and one bond traded at $1,300 and the other traded at $1,100, LCTM would place a huge bet that the $1,300 bond would drop and the $1,100 bond would rise in price. It was inconceivable to them that the market could remain irrational and price the bonds differently.
Although this makes for an accurate rule of thumb, the Perfect Market isn’t 100% true for 100% of the time. In extreme market conditions, greed or fear will overwhelm traders and prices will remain too high or too low respectively.
LTCM also didn’t realize that they operated outside of the market. They made such specific trades that banks actually created products (mostly options) just for LTCM.
Additionally, when LTCM made huge bets that the market would remain stable, many banks and insurance companies took the other side of the trade as a hedge (insurance) in case the market did not remain stable.
So if the market ever actually became unstable, those buyers would never want to undo those trades!
Diversification Eliminates Risk
We understand that for our personal investing, we can reduce risk by making a diverse range of purchases (stocks, bonds, etc.) or by purchasing a diverse spread of companies (an index fund). We base this diversification on the theories the LTCM mathematicians developed.
The LTCM team fully believed the theory would apply regardless of scale so they felt leverage would be safe because they could eliminate risk by placing bets spread out in different countries and in different types of markets- currencies, bonds, stocks, and options.
They saw no possible link between Russian bonds and a US telecom stock and therefore assumed that big bets placed on one could not possibly affect the other. However, they fundamentally misunderstood how their leverage created the link.
LTCM was making trades larger in value than the investment banks that loaned them the money. If the market turned, the investment banks would have to sell anything of value to stay financially solvent if LTCM could not pay them and, in fact, might have similar trades putting them in jeopardy.
If LTCM’s big bet on Russian bonds began to fail, the global financial markets might not be able to sell the low value Russian bonds to pay off their own loans and trades, so other hedge funds and trading banks would have to sell off the more valuable assets – such as telecom stocks.
Spoiler alert! The Russian bonds bet failed.
The End Result
Early success bred arrogance and reckless levels of leverage, but then the global markets began to sour. When government bond crashes in Korea, Thailand, and Indonesia that should have provided warning, but LTCM ignored the signs because they believed each country was perfectly isolated from other countries and they still invested heavily in Russian debt futures.
LTCM believed the most they could lose in a month was $35 million, but when Russia defaulted on their bonds in July 1998, LTCM lost $553 million in a single day – and no buyer could be found to let them out of their bad trades. LTCM desperately tried to sell their positions or raise new capital, but losses became more profound by the day and in the month of August 1998 alone, LTCM lost $1.9 billion.
The enormous pressure on the markets from LTCM’s positions drove a huge portion of hedge funds, investment banks, insurance companies, and national banks to liquidate their risky portfolios and buy US treasuries. Of course these actions further increased volatility and destroyed the value of LTCM’s no-longer-diversified giant bets.
With leverage reaching $88 dollars for every dollar they had left, LTCM could not make their required payments and would have to declare bankruptcy. But if they did so, the major world banks that LTCM owed money to would probably also have to declare bankruptcy and financial markets would crash world-wide.
Ultimately, 14 Wall Street banks, coerced by the US Federal Reserve Bank of New York, pulled together $3.6 billion in financing to save LTCM and had to work out the legal agreement using 70 lawyers working non-stop for 5 days. The resulting agreement destroyed the value of the LTCM partner’s equity, driving several partners into bankruptcy and also stripped LTCM traders of their ability to operate independently without oversight.
LTCM used the financing to stabilize the markets, avoid a global financial meltdown, and eventually pay off their loans. In the long run, the LTCM trades could have become profitable, but before that could happen, their leverage drove them bankrupt.
The unrepentant partners never admitted fault for their failure and firmly believed that greedy bankers turned against them and tried to sabotage their trades. Fifteen months after LTCM later liquidated, the partners launched a new fund, JWM partners, but they never reached the same level of success and were forced to liquidate after huge losses from the 2008 mortgage crisis.
Recent Repeated Mistakes
You would think that a highly publicized disaster would help investors and bankers to wake up to the dangers of leverage to prevent future disasters. Sadly, no.
As with the LTCM disaster itself, success breeds lax oversight and more reckless behavior that leads both individuals and institutions to over extend themselves. Perhaps people share in the arrogance of the LTCM traders, the blind faith in mathematics, or simply don’t understand enough about what they are doing to be afraid.
In any case, we find the same mistakes repeated in the 2008 housing crash, the 2026 Situational Awareness hedge fund collapse, and the 2026 Korean stock market crash. We might also see signs of a future crash in our current levels of US leverage.
2008 Housing Crash
The Black Scholes options pricing that won the Nobel Prize for the LTCM partners allowed for beneficial developments such as the adjustable rate mortgage loan that can help buyers purchase a home with a lower introductory interest rate. The option pricing also allowed for banks to bundle together many different home loans and sell them as marketable securities.
Ideally, the bundle was supposed to mix a small percentage of high-default-risk (stop paying risk) mortgages and a large percentage of low-default-risk mortgages so that more banks and insurance companies could buy safer-overall mortgage-backed securities.
However, the product became so successful that banks and mortgage companies ran out of low-risk loans. They began to recklessly offer increasingly risky loans to people who could not afford the homes they moved into – and were not savvy enough to understand it.
Meanwhile the investors buying the mortgage-backed securities assumed the risk had been removed, so they used leverage to invest heavily. A bunch of investors taking out loans to buy huge amounts of products they didn’t fully understand assuming it was no-risk? Yes, this is the LTCM mistake all over again.
As to be expected, once the true risk of the mortgages became revealed, the banks that backed the risky products suffered huge losses and several of the big banks in the LTCM story (Lehman Brothers, Solomon Barney, etc.) ceased to exist or had to sell themselves to competitors. For a more complete overview, I recommend watching the movie, The Big Short, or the book it was based upon.
2026 Situational Awareness Hedge Fund Collapse
Leopold Aschenbrenner graduated valedictorian from Columbia University at 19 and worked as a researcher for OpenAI before he wrote his 165 page love note, Situational Awareness, on the future of artificial intelligence. Based on it content, Aschenbrenner launched a hedge fund of the same name and initially enjoyed great success investing in SK Hynix, CoreWeave, and many other AI-related companies.
To help juice his returns, he sold short (borrowing stock from the brokerage company to sell it and hope to buy it back later, cheaper) on software companies like Adobe that would suffer losses should AI succeed. He also borrowed money and leveraged the fund up to 400% (400:1) to reach a valuation of $45 billion.
Just as with LTCM, this strategy only works if you are absolutely right in the short term. Unfortunately for Aschenbrenner, a July 2026 sell-off of a few of his AI tech stocks and an increase in the software company stocks reversed his fortunes and caused margin-calls on his positions.
His fund was forced to sell off the public stocks at a steep discount and his fund plummeted to $10 billion in value. Just because you are smart and even probably right, doesn’t mean you can ignore reality forever and take reckless bets.
Perhaps he should have read When Genius Failed?
2026 Korean Stock Market Crash
Sadly, Aschenbrenner wasn’t alone in taking a big hit this year. A huge number of Korean retail (individual) investors also suffered huge losses.
Korea introduced very risky leveraged exchange traded funds (ETFs) similar to the 3x Long Samsung Electronics fund offered by Leverage Shares that has lost 69.96% of its value this year. How does the fund lose so much value when the stock itself is up 150% for the year? That pesky leverage.
The fund, trying to meet its performance requirement to move 300% of the Samsung Electronics movement daily, settles every day. So on big loss days, the ETF suffers 300% of the losses of the stock itself and locks in that loss daily.
Samsung began the year at a price of 128,500 Korean Won and reached a high of 374,500 Korean Won. When it was going up, the 3x ETF and similar funds soared, but when Samsung began to drop in June and July, the ETF tanked.
An excellent and funny summary can be watched on the Big A channel on YouTube (thanks for sharing it Nate!). The video explains how the stagnant Korean Stock Exchange Index (KOSPI) began to go crazy just as the Korean government approved the leveraged ETFs.
The first fuel to the fire was the huge jump in value for Samsung Electronics and SK Hynix which provide memory chips required for the AI Boom (yes, the same stocks Aschenbrenner heavily invested in for his fund). Their success grew their value such that their stocks became 50% of the value of the KOSPI.
People’s social-pressure-fueled fear of missing out (FOMO) on huge stock market wealth became amplified by national pride over the Korean stock performance to further drive appetite to invest. The excitement only increased when the President of Korea, Lee Jay Myung, announced he sold his apartment to invest more of his money into the stock market!
TV channels in Korea interviewed individual investors who bought the leveraged funds on margin so they could make up to 15 times their potential profit. Was there a financial check or any brokerage evaluation to see if the investors had sufficient financial understanding to take out the big loans?
Heck no. All anyone had to do was click a button on the app to unlock 5x margin loans for their purchase. Very few considered what would happen if the stock stopped going up.
Then the market dropped 44% in July. The leverage that had driven their prices up quickly also acted as rocket fuel to push stocks down even faster.
South Korea’s margin balance of $28.75 billion dollars only represented 0.6% of the market capital overall, but 1 out of every 30 Koreans received a margin call on the same day requiring them to add funds or sell the investment bought with margin. Most didn’t have the money to pay their way out of margin calls, so they simply had to sell at a loss.
The TV stations reinterviewed the “successful” investors and they had lost all of their money. The government’s finance ministry is also forced to go on TV and apologize that they didn’t realize this could happen.
I guess they also needed to read When Genius Failed…
Future Stock Market Crashes?
Is anyone learning the lessons from LTCM? It would appear not, because the USA, China, and Japan all seem primed to crash:
- US Investors have $188.73 billion in leveraged ETFs and $1.4 trillion in margin debt
- China’s margin balance exceeds $200 billion
- Japan’s margin trading balance now exceeds $35 billion
All of these exceed South Korea’s margin balance suggesting each market is primed for a big drop if there are any market performance hiccups.
Even though I think a crash is coming, I’ll keep in mind a famous quote by John Maynard Keynes: the market can remain irrational longer than you can remain solvent.” This means I’m not going to make any big bets, especially using leverage, on a future when I can’t predict when it will arrive! Although I might just hold a bit of extra funds to the side in case an opportunity comes my way.
Avoid Unnecessary Debt – Especially Investing Leverage
How does this leverage story affect you? Right now, you can access margin in a stock brokerage account and you can buy the same leveraged funds that crushed the Korean investors.
Judging from the numbers above, many in the US have already done so. Please remember the lessons of LTCM before you do!
There are many ways to lose money investing. My hope is that by reading this article, you at least learn to avoid repeating the same mistakes that continue to sink many other smart, but arrogant investors.
Let’s not be boring and make the same mistakes as LTCM! Don’t take huge loans to invest money and use brokerage margin sparingly, if at all.
After all, there are all kinds of new and exciting mistakes to make! Fortunately, as long as you don’t use leverage, you can be wrong some of the time and still come out ahead.