Before the financial crisis and the billions of dollars in corporate bailouts, and trillions more in central bank quantitative easing, the world of investing was simpler.

Back then, markets moved in two directions, traders trusted their models, and hedge funds stacked with PhDs and top executives from well-respected bond trading houses were expected to make money hand over fist. And for three glorious years in the mid-1990s, Long Term Capital Management did exactly that. But when the fund suddenly imploded in 1998, stung by economic crises in Russia and Asia that caused it to lose $4 billion in a bizarre six-week stretch, it almost brought the entire financial system down with it.

In a recent interview on Real Vision's Adventures in Finance podcast, former LTCM Founding Partner Victor Haghani, who was at the epicenter of the firm’s meteoric rise and catastrophic collapse, discusses the birth of the fund, its flawed investment strategy and the impact its collapse had on the broader financial landscape.

His story begins shortly after the 1991 Salomon Brothers scandal, when the Treasury banned the firm, then one of Wall Street’s most aggressive and well-respected bond-trading shops, from participating in Treasury bond auctions. After the firm's dramatic fall, prospective investors encouraged several senior executives who either left the firm, or were forced out, to consider starting a hedge fund.

“I was married in January 1993, and that’s when it was starting. I decided I definitely wanted to leave Solomon with John [Gutfreund] having left and some of my other mentors having left, it was time to smell the roses and take some time off. I didn’t need to make both decisions at the same time.

It was a period of great change at Salomon Brothers when John Gutfreund, Tom Strauss and John Meriwether had all taken leave from the firm because of the 1991 Treasury bond auction scandal, I forget what the rulings were but John Meriwether could’ve come back to Salomon. In this period of months when those three executives were kind of defending themselves over the Treasury bond scandal and trying to set the record straight, a number of investors came to John Meriwether who said ‘listen you should start a fund and do what you did at Salomon on the outside,’ and that sort of got things going.

And there were other people. Bob Merton and Myron Scholes also were interested in doing this projectoutside of Salomon Brothers. It’s hard to remember exactly how it all took shape but it took shape pretty quickly in 1993 and by January of 94 we were up and running and investing.”

With Meriwether at the helm, and not one but two Nobel Laureates, the firm sought to pioneer a computer-driven approach in which its models would identify arbitrage opportunities for the firm to capitalize on. Real Vision recalled the culture of risk taking at Salomon brothers, which was inculcated in the new firm as well. During one quarter when Salomon’ trading business lost a lot of money, Gutfreund, then CEO, explained that they staked the firm’s whole balance sheet on a European convergence trade that would eventually result in enormous profits.

Back to Haghani, the former LTCM partner describes how the successes of the firm’s early years helped instigate its collapse as the firm became emboldened to use an increasing amount of leverage.

“We were surprised by the high returns we were earning in our first three years and the reason was there was a lot of capital coming in to these trades. We were doing them and there were a lot of people coming to the beach to come swimming with us.

We never understood why they were so high, we just saw everything converging really quickly.”

Haghani's views on what caused the firm’s collapse have evolved since the financial crisis, explaining that employing leverage in a relative-value trading strategy that includes a universe of exotic and illiquid investments, just wasn't - and isn’t - smart for a small hedge fund.

“Post 2008, the view I have and that a lot of people share is what we were doing just wasn’t a good idea. It’s not a question of how we were doing it, it’s just a question of leverage. Relative value investing as a hedge fund isn’t a good idea.

That basic model isn’t a good idea because at some point things will move far enough that you will be forced to liquidate positions. You can’t really run this business with a tight stop loss approach. It’s not consistent with an expansive relative value frame work.

You could say well we could have tight stop losses, do relative value and limit ourselves to liquid investment but that wasn’t our model. Ours was a model where the only sort of stop loss was as we lost money, we would reduce positions. We would reduce risk in line with our capital.”

Thanks to the billions of dollars in leverage extended to LTCM by a coterie of banks, the Fed was forced to step in and demand that the firm’s lenders agree to a bailout.

“The world’s financial system ground to a halt as the fed had to cut rates just for this firm, and it was a hedge fund,” Haghani added.

To summarize, the lesson from LTCM was clear though, as the financial crisis nearly a decade later would demonstrate, none of the bankers, regulators or central bankers were paying attention. These guys, Haghani explains, were the smartest guys in the world. So nobody was checking their numbers. But of course, all traders inevitably get certain things wrong. And liquidity was what LTCM got wrong. Oh, and finally, LTCM got bailed out, setting the stage for the longest period of institutionalized moral hazard, in which nobody is allowed to fail any more, in the process destroying the risk/return calculus, but making a mockery of capitalism.

The Haghani interview begins roughly 20 minutes into the podcast below.