When Genius Failed: The Rise and Fall of Long-Term Capital Management

Introduction

The Federa l Reserve Bank of 1\:ew York is perched i n a gray sand­ !>tone siJh in the heart of Wa l l Street. Though a city l a n d m a rk build­ ing constructed in 1924, the hank is a m uted, al most unseen presence among its l i vely, entrepreneurial neighbor,. The a rea is d otted with discount store' and luncheonettes-and, almost everywhere, broker­ age fi rms a n d banks. The Fed\ i mmediate neigh bors incl ude a shoe repa i r stand and a reri yaki house, and also Chase M a n hattan Ban k ; J. P. �1organ is a few blocks away. A hit farther t o t h e we,t, .\1erri l l Lynch, t h e people's brokerage, gazes at t h e H udson R i ver, across which lie the rest of America and most of .\lerril l 's customers. The hank sk yscrapers project an open, accommoda tive a i r, hut the Fed build ing, a F l orentine Renai ssance showpiece, is distinctly forbid­ ding. I t' a rched windows a re encased in meta l grille, and irs main en­ trance, on L i bcrtv Street, is guarded by a row of black cast-iron sentries. The 1\:ew York Fed is only a spoke, though the most i m portant spoke, in the U.S. Federal Reserve System, America's central h a n k . Because o f the N e w York Fed's proximity t o Wal l Street, it acts as the eyes and ea rs i nto ma rkets for the hank's governing board, in Wash-

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ington, w h i c h is r u n hy t h e oracular A l a n G reenspa n . William J. McDonough, the hedy pre�ident of the New York Fed, ta lks to hank er' and traders often. McDonough want� to be kept a brca!>t of the gossip that traders share with one a nother. l ie especi a l l y wants ro hea r about an ything that m ight u pset markets or, in the extreme, the financial system. But :Vk Donough tries to stay in the background. The red has a l ways been a controversial regu lator-a servant of the people that is el bow to d how with Wa ll Street,
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a utumns, it had seen some hacksl iding. Since m id-August, w hen R us­ sia had defa u l ted on its ruhle deht, the glohal hond m a rkets in par­ ticular had hecn highly u nsettled. But that wasn't why M c D onough had cal led the hankers. Long-Term, a bond-trading fi rm, was on the brink of fai li ng. The fund was run by J ohn W. �1eriwerher, formerly a well-known trader at Salomon Brothers. Meriwether, a congeni a l though cautious mid­ westerner, had heen popu l a r among the bankers. It was heca use of him, m a i n l y, that the hankers had agreed to give financing to Long­ Term-an d had agreed on highly generous terms. But Meri wether was o n l y the puhlic face of Long-Term. The heart of the fund was a grou p of hra i n y, Ph.D.-cerrified a rhitrageurs. �1 any of them had been professors. Two had won the N o hel Prize. A l l of them were very <>mart. A n d they knew they were very sma rt. For fou r yea rs, Long-Term had been the envy of Wa l l Street. The fund had racked up returns of more than 40 pen.:ent a year, with no losing stretches, no volati l ity, seemingly no risk a t a l l . I ts intellectual supermen had apparently been a hlc to reduce an u ncertai n world to rigorous, cold-blooded odds-on form, they were the very hest that modern fi n ance had to offer. This one obscure arbitrage fund had amassed a n amazing $ 1 oo billion in a ssets, virtually a l l of it borrowed-borrowed, that is, from the bankers at .\kDonough's table. As monstrous as this indebted­ ness was, it was by no mean s the worst of Long-Term's problems. The fund had entered into thousands of derivative contracts, which had endlessl y intertwined it with every hank on Wa l l Street. These contr;lcts, essentia l l y side hers on marker prices, covered an astro­ nom ica l su m-more than $1 tril l ion worth of exposure. I f Long-Term defa ulted, all of the hanks in the room would he left hold ing one side of a contract for which the other side no l onger ex­ isted. In other words, they would he expmed to tremendous-and u ntena b le-risks. Undoubtedl y, there would he a frenzy as every hank rushed to escape its now one-sided obligations and tried to sell its colla teral from Long-Term. Pan ics a rc as old as markets, but derivatives were rela t i vely new. Regulators had worried about the potential risks of these in ventive new securities, w hich linked the cou ntry's financial institutions in a complex c h a i n of reciprocal obl igations. O fficials h a d w ondered what w o u ld h appen if one big l i n k in the chain should fa i l . .\lcDon-

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INTRODUCTION

ough feared that the markets would stop working; that trading would cease; that the system itself would come crashing down . James Cayne, the cigar-chomping chief executive o f Bear Stearns, had been vowing that he would stop dearing Long-Term\ trades­ which would put it out of b u siness-if rhe fu nd's available cash fell below Ssoo m i l lion . At rhe starr of the year, thar would have seemed remote, for Long-Term's capital had been $4 . 7 billion. B u t d u ring rhe past five weeks, or since R ussia's default, Long-Term had su ffered numbing losses-day after day after day. Its capital was down ro rhe minimum. Cayne didn't t h i n k i t would survive ;mother day. The fund had already asked Warren Bu ffett for monev. I t had gone to George Soros. I t had gone to M erri l l Lynch. One by one, it had asked every hank it could th i n k of. :--low it had no place left to go. That was w h y, like a godfather s u m moning rival and poten tial l y war­ ring fam i l ies, McDonough had i n v i ted the hankers. If e;Jch one moved to u n load bonds i ndi v idual l y, the result could he a worldwide panic. If they acted in concert, perhaps a cata>trophe could be avoided. A l though McDonough didn't say so, he wanted the ban ks to in vest $ 4 b i l l ion and rescue the fund. He wanted them to do i t right then-tomorrow would he roo late. Bur the bank ers felt that Long-Term had al ready caused them more than enough trouble. Long-Term's secreti ve, close-k n i t mathemati­ cians had treated everyone else on Wall Street with utter di sdai n . Merrill Lynch, t h e firm rhar had brought Long-Term i n to being, had long tried to establish a profitable, m utually rewarding rl'lationship wirh the fund. So had many other banb. But Long-Term had spu rned them. The professors had been w i l l ing ro trade on their terms and only on thei rs-not to meet the ban k s hal fway. The bankers did nor like ir that the once haughty Long-Term was pleading for their help. And the ban kers themselves were h u rting from the turmoil that Long-Term had helped to u nleash. Goldman Sachs's CEO, Jon Corzi ne, was faci ng a revolt by h i s partners, who were horri fied by Goldman's recent trading losses and who, u n l i k e Cor z i ne, did not want to usc their diminishing capi tal to help a competitor. Sanford I . Wei l l , chairman o f Travclers/Salomon Smith Barney, had s uffered big losses, too. Wei l l was worried that the losses would j eopardize hi, company's pending merger with C:iticorp, w h ich Wei l l saw as the crowning gem to his l ustrous career. He had recently s h uttered his own arbitrage u n i t-which, years earlier, had been the launching pad for Meriwether's career-and was not keen to bai l o u t another one.

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As M cDonough looked around the table, every one of h is guests was in greater or lesser trouble, many of them directl y on account of Long-Term. The value of the bankers' stocks had fallen p recipitously. The bankers were afraid, as was McDonough, that the global storm that had begun, so innocently, with devaluations in A sia, and had spread to R ussia, Brazil, and now to Long-Term Capital, would en­ velop all o f Wall Street. Richard ruld, chairman of Leh man Brothers, was fighting off ru­ mor� that his company was on the verge of fai l ing due t o i rs supposed overexposu re ro Long-Term. D;wid Solo, who represented the giant Swiss bank Un ion Bank of Switzerland, thought his bank was al ready in far too deeply; it had foolishly invested in Long-Ter m and had s u f­ fered titanic losses. Thomas Labrecque's Chase M anhattan had spon­ �ored a loan to the hedge fund of $ soo m i l l ion; before Labrecq u e thought a b o u t investing more, h e wanted rhar loan repaid. David Komansk y, the portly M erri l l chairman, was worried most of all . In a matter of two months, M errill's stock had fal le n by half­ $ I') b i l l ion of its market val u e had simply melted away. Merr i l l had suffered shocking bond-trading losses, too. Now its own credit raring was at risk. Komansky, w ho personal l y had invested almost $ 1 m i l lion in the fund, was terri fied of the chaos that would res u l t i f Long-Term col­ lapsed. But he knew how m uch antipathy there was in the room toward Long-Term. l ie thought the odds of getting the ban kers to agree were long at best. Komansky recognized that Cayne, the maverick Bear Stearns chief executive, would he a p i votal player. Bear, which cleared Long-Term's trades, knew the guts of the hedge fund better than any other firm. As the other bankers nervously s h i fted in their scats, l lerbert A l l i son, Komansky's n u m be r two, asked Cayne where he stood. Cayne stated h i s position clearly: Bear Stearns would not invest a nickel in Long-Term Capital. For a moment the bankers, the cream of Wal l Street, were si lent. And then the room exploded.

THE RISE OF LONG-TERM CAPITA MANAGEMENT

MERIWETHER

one: article of fai t h that John �1criwcthcr d i scovered to ride your lossc:s u n t i l they t urned i nto gains. I t is possible to pinpoi n t the momen t of �eriwerher's rev­ clarion. I n 1 'J7'J, a securities dealer named J. F. Eck stein & Co. was on the brink of fai l i ng. A pan icked Eckstein went to Salomon and met with a group that i nclu ded several of Salomon's partners and also Meriwether, then a cheru b-faced trader of thirty-one:. "I got a great trade, h u t I can 't stay in i t , " Eckstein pleaded w i th them. " ! low about b u y i n g m e out ?" The s i t uation was this: Eckstein t raded in Trc:asury h i l l fut u res­ which, as t h e n ame suggests, arc contract� that provide for t h e deliv­ ery of U.S. Treasu r y b i l ls, a t a fi xed price in the: fut u re:. They often traded at a slight discou n t to the price of the act u a l , u n derl y i n g b i l ls. I n a classic b i t of arbitrage, Eckste i n would buy the futu res, sell the hills, and then wait for the two prices to converge. S ince most people wou ld pay abo u t the same to own a b i l l in the proximate fut u re as they would to own it now, it was reasonable to t h i n k t h at the prices tl'ould converge. And there was a b i t of magic in the trade , w h ich was the secret of Eck s tei n 's business, of Long-Term Capital's fut u re busi1 1111 IU WA�

I at Salomon Brothc:rs, it was

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ness, and indeed of every arbitrageur who has ever plied the trade. Eckstein didn't k now whether the two securities' prices would go u p o r down, ,md Eckstein didn't uzrc. A l l that mattered t o h i m w a s how the two prices would change reb tive to each other. By buying the hill futures and shorting (that is, betti ng on a decline in the prices of) the actual bills, Eckstein rea l l y had twu heb going, . each in opposite directions.,, Depending on wherher prices moved up or down, he would expect to make money on one trade and lose it on the other. Bur as long a<. the chea per asset-the futures-rose by a l ittle more (or fell by a little less ) than did the bil ls, Eckstei n's profit on his winning trade would he greater than his loss on the other side. This is the basic idea of arbitrage. Eckstein had made this bet many ti mes, typica l l y with success. As he made more money, he gra d u a l l v raised his stake. For some reason, in J u ne 1 '17';), the normal pattern was reversed: futu res got murc ex­ pensive than bilk Confident that the cu<,tomary relationship would rea!-.sert ir,clf, Eckstein pur on a z•cry big trade. Bur in,tead of con­ verging, the gap widened even further. Eckstein was hit with massive margin calls and became desperate to sel l . Meriwether, as it h a d happened, had recent ly set u p a bond­ arbitrage group within Salomon . He in stantly saw that Eckstein's trade made sense, because sooner or later, the prices shuuld converge. But in the meantime, Salomon would be risking tens of m i l lions of its capital, which totaled only about $2oo million. The partners were nervous but agreed to take over Eckstein "s position. For the next cou­ ple of weeks, the spread conti nued to widen, and Salomon su ffered a serious loss. The firm's capital account used to be scri bbled in a little book, left ourside the office of a partner named Allan Fine, and each a fternoon the partners would nervo usly tiptoe over to Fine's to see how much they had lost. M eriwether coolly insisted that they would come out ahead. "We better, " John Gutfreund, the managing partner, told h i m , "or you 'II be fired. " The prices did converge, and Salomon made a bundle. l la rdly any­ one traded fi nancial futures then, bur Meriwether u n derstood them. l ie was promoted to partner the very next year. ,\1ore i mportant, his ,,. I n practical term>, those who g o short sell a security they have horrowed. They must return the security later-hy which time, they helievc, the price will have declined. The principle of huying cheap and selling dear still holds. Short sellers merely reverse the order: sell dear, then huy cheap.

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little �ection, the inauspiciously titled Domestic Fi xed I ncome Arbi­ trage Grou p, now had carte b lanche to do spread trade� with Sa­ lomon's capital. Meriwether, in fact, had found his l i fe's work. Born i n 1 9 47 , Meriwether had grown up in the Rosemoor section of Roseland on the South Side of Chicago, a Democratic, I rish Catholic stronghold of Mayor R i chard Daley. He was one o f three children but part of a larger extended family, including fou r cousins across an alleyway. In real ity, the entire neighborhood was fami ly. Meriwether knew v i rt ual l y everyone in the area, a sel f-contained world that revolved around the basketball lor, soda shop, and parish. It was bordered to the cast b y the tracks of the I l l inois Central Rail­ road and to the north by a red board fence, beyond w h ich lay a no-man\-land of train yards and factories. I f it wasn't a poor neigh­ borhood, it certainly wasn't rich . Meriwether's father was an ac­ countant; h i s mother worked for the Board of Educatio n . Both parents were strict. The Meriwethers l ived in a smallish, cinnamon­ brick house with a trim lawn and tidy garden, much as most of their neighbors did. Everyone sent their chi ldren to paroch ial schools (the few who didn't were ostracized as "publics " ) . Meri wether, attired in a pale b l ue s h i rt and dark blue ric, attended St. Joh n de Ia Salle Ele­ mentary and later M endel Catholic High School, taught by A ugus­ tin ian priests. D iscipline was harsh. The boys were rapped w ith a ruler or, in the extreme, made to k neel on their k n uck les for an entire class. Educated in such a Joycean regime, Meri wether grew u p ac­ customed to a pervasive sense of order. As one of Meriwether's friends, a barber's son, recal led, "We were afraid to goof around at lclementaryJ school because the nuns would punish you for l i fe and you'd be sent to Hel l . " As for their mortal destination, it was said, on l y half in j est, that the young men of Rm.emoor had three choices: go to col lege, become a cop, or go to jail . Meriwether had no doubt .1 bout h i s own choice, nor did any of h i s peers. A popular, bright student, he was seemingly headed for s uccess. He qual i fied for the National J lonor Society, scoring especiall y h igh marks in mathematics-an indispensable subject for a bond trader. Perhaps the orderl iness of mathematics appealed to h i m . l ie was ever guided by a sen se of restraint, as if to step out of hounds would in­ vite the ru ler's slap. Although Meriwether had a bit o f a mouth on h i m, as one c h u m recal led, he never got into serious tro u ble. ' Private with h i s feel ings, h e kept any reckless impulse strictly u nder wraps

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and cloa ked his drive heh i nd a comely reserve. l ie w a s clever hut n o t a prodigy, well l i ked hut nor a standout. He was, i ndeed, a verage enough in a neigh horhood and time i n which it wou l d have heen hell to have been anything hut average. Meriwether also liked to gam hie, hut only when the odds were suf­ ficiently in h i s favor ro give h i m a n edge. Gam bli ng, indeed, was a field in which his cautious approach to risk-raking could he applied to his advantage. l ie learned to bet on horses and also to play black­ jack, the l a tter cou rtesy of a card-playing grand m a . Parlaying an i n ­ nate sense of t h e odds, he w o u l d b e t o n t h e Chicago C u hs, but not until he got the weather report so he k new how the winds would be blowing at Wrigley Field.' I l i s fi rst foray i n to in vestmen ts was at age twel ve or so, but it would be wrong to suggest that i t occurred to any of his peers, or even to Meriwether hi m�elf, that this modestly bui lt, chestn u t-haired boy was a Horatio A l ger hero desti n ed for glory on Wa l l Street. "John and his older brother made money i n h igh school buying stocks, " his mother recal led decades later. "I lis father advised him." And that was that. Meriwether made his escape from Rosemoor h y means of a singu­ lar passion: nor investing but gol f. From an early age, he had haunted the courses at public parks, an u n u sual pastime for a Rosemoor boy. l ie was a standout member of the Mendel school team and twice won the Chicago Suburban Catholic League gol f tournament. He also cadd ied at the Flossmoor Country Club, which i n volved a sig­ nificant train or bus ride south of the city. The superin tendents at Flossmoor took a shine ro the earnest, l i kable young man and let h i m caddy for the richest players-a lucrative privilege. One of t h e mem­ bers rahhed h i m for a Chick Evans scholarship, named for an earl y­ twentieth-century golfer who h a d had the happy idea of endowing a college scholarsh i p for caddies. Meriwether picked North western University, in Evanston, I l li nois, on the chilly waters of L1ke \1 ichi ­ gan, twenty-five m iles a n d a world away from Rosenwor. I l i s l i fe story up to then had h ighlighted two rather confl icting verities. The first was the sense of wel l-heing to be derived from fitting int o a group s uch as a neigh borhood or c h u rch: from rel igiouslv ad hering to its values and rites. Order and c ustom were v i rtues in themselves. But second, Meriwether had learned, it paid to develop an edge-a low handicap at a game that n ohody else on the block even pLlycd. A fter Northwestern, he taught h igh school math for a vear, then

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Wl'nt to the U n i versity of Ch icago for a business degree, where a grain fanner's son named Jon Corzine ( later Meriwether's rival on Wa l l Street) was one of his classmates. Meriwether worked h i s way th rough business school as a n anal yst at C:"\:A Financial Corporation, .ulll graduated in 1 9 7 3· The next year, Meriwether, now a sturd i l y h u i l t twenty-seven-year-old w i t h beguiling eyes and r o u n d , di mpled checks, was h i red by Salomon . It was sti ll a sma l l fi rm, but it was in t he cen ter of great changes that were convulsing bond m a rkets every­ where. Unt i l the mi d-I 96os, bond trading had been a d u l l sport. An in­ \'l"'itor bought bonds, often from the trust depart ment o f h i s local hank, for steady income, and as l ong a s the bonds didn't defa u lt, he \\ as general l y happy with his p u rcha se, if indeed he gave it any fur­ t her th ought. Few in vestors acti vely traded bomb, tant relative of the painter Winslow l lomcr, and son of a .\!letro­ poliran O pera soprano. l lomcr, a uthor of the massive tome ;\ /lis­ tory o/ Interl.'st Ratl.'s: 2000 HC to thl.' T'ri.'SI.'Ill, was a gentleman '>L·hola r-a breed on Wa ll Street that was shortly to disappear. l l omcr's markets, at least in contrast to those of today, were char­ ,Jctcrized by fi xed relationship'>: fi x ed cu rrencies, regul ated interest rates, and a fi xed gold price ( $ ) s an ounce ) . But the epidemic of in­ flation that i n fected the West in the late 1 9 60s destroyed this cozy world forever. As i n flation rose, so did i nterest rates, a n d those gilt­ edged bonds, bought when a 4 percent rate seemed attractive, lost half their v a l ue or more. In 1 97 1 , the United States freed the gold price; then the A rabs embargoed o i l . If bondholders sti l l ha rbored ,my i l l usion of stability, the bankruptcy of the Penn Central R a i l road, which was widely owned by blue-chip accounts, w recked the i l l usion forever. Bond in vestors, most of them knee-deep in losses, were no longer comfo rtable standing pat. Gradually, governments around the globe were forced to drop their restrictions on i nterest rates and on cu rrencies. The world of fixed relationsh ips was dead. Soybeans sudden l y seemed q u a i nt ; money was the hot commodity now. Futures e xchanges devised new contracts in fin a nc i a l goods .,uch as Treasury b i l l s and bonds and .Japanese yen, a nd everywhere

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there were new in struments, new options, new bonds to trade, j ust when professional portfolio managers were waking u p and wanting to trade them. By the end of the I 9 70s, finns such as Salomon were slicing and dicing bonds in ways that l lomcr had never dreamed of: blending mortgages together, for i nstance, and disti lling them into bite-si zed, easi l y chewable securities. The other big change was the computer. As late as the end of the I 9 6os, whenever t raders wanted to price a bond, they would look it up i n a thick blue book. I n I 969, Salomon h i red a m�uhematician, Marrin Lei bowitz, who got Salomon's first comput e r. Lei bowitz be­ came the most popular mathematician in h i,tory, or so it seemed when the bond market was hot and Salomon's traders, who no longer had time to page through the blue book, crowded aro u n d h i m to get bond prices that they now needed on the double. By the early I 9 70s, traders had their own crude handheld calculators, which subtly q u ickened the rhythm of the bond markets. Meriwether, who joined Salomon on the financing desk, k nown as the Repo Department, got there j u st as the bond world was t u rning topsy-turvy. O nce predictable and relatively low risk, the bond world was pulsating with change and opportunity, especially for younger, sharp-eyed anal ysts. :\1eriwether, who didn't know a 'ou l when he arrived i n New York, rented a room at a Manhattan athletic c l u b and soon discovered that bonds were m ade for him. Bonds have a partic­ u lar appeal to mathematical types because so much of what deter­ mi nes their val ue is readily q u an t i fiable. Essential l y, two factors dictate a bond's price. One can be gleaned from the coupon on the bond itse l f. If you can lend money at I o percent today, you would pay a premi u m for a bond that y ielded I 2. percent. I low m uch of a pre­ m i u m ? That would depend on the matu rity of the bond, the timing of the p�lyments, your outlook ( i f you have one) for i n terest rates in the future, plus all manner of wrink les devised hy clever issuers, ' uch as whether the bond is callable, converti ble i n to eq u i t y, and so forth. The other factor is the risk of default. I n most ca,es, that is not strict ly quantifiable, nor is it very great. Still, it exists . General Elec­ tric is a good risk, hut not as good as Uncle Sam. Hewlett-Packard i s somewhat risk ier than G E; A mazon .com, riskier sti l l . Therefore, bond investors demand a h igher i nterest rate when t hey lend to Ama­ zon as com pared with GE, or to Bol ivia as compared with Fmnce. Deciding how m uch h igher is the heart of bond trading, h u t the point

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is that bonds tradt: on a matht:matica l spre,uf. Tht: riskit:r tht: bond, tht: wider tht: spread-that is, tht: greatt:r the difference between the yield on it a n d the yield on ( v i rt u a l l y risk free ) Treasurys. Gt:nt:ral l y, though not a l ways, the sprt:ad a lso increases with time-that is, in­ \'estors demand a slightly h ight:r yidd on a two-yt:ar note than on a thi rty-day b i l l beca u st: the unct:rta i n ty is greater. Tht:sc r ult:s a rc tht: catechism of bond trading; tht:y ordai n a vast matri x of yields and spreads on debt secu rities throughout tht: world. They a rc as i n tricate and i m m u t a b le a-; tht: rules of a great religion, a nd it i s no wonder that ,\;kriwethcr, who kept rosary beads and prayer ca rds i n his bricfca�c, fou nd them satisfying. Eagt:r to learn, he pt:ppt:rt:d h i s bosses with q ut:stions l i ke a divinity student. Sensing his promi,c, the s u i ts at Salomon p u t h i m to trading govcrn mt:nt agt:ncy bonds. Soon a fter, Nt:w York City nea rly defa u lted, a n d tht: spreads on various a gt:ncy bonds soared. ,Vtcriwether rt:ckoncd that the m a r­ kt:t had goofed-surely, not t:vt:ry govcrnmt:nt entity was a bout to go bust-a nd ht: bought a l l tht: bonds ht: could. Spreads did contract, and Mt:riwetht:r's tradt:s made m i l lions.; The Arbitrage G roup, which h e forrnt:d in 1 977, m a rk ed a s ubtle but important s h i ft in Salomon's evol ution . It was a lso the model that Long-Term Capital was to rt:plicatc, brick for brick, i n tht: 1 ')')OS-a la boratory in w h ich Mcriwctht:r would bccomt: accustomed to, a nd comfortahk with, taking big risks. A l though Salomon had always traded bonds, its primary focus had been the rel atively safer business of buying and sel l i ng bonds for c ustomers. But the Arbitrage Group, led by ."vtcriwcthcr, became a principal, ri�king Sa lomon's own capi­ tal. Bt:cJ ust: tht: field was new, N1t:riwt:thcr had few com pt:titors, and tht: pick i ngs wt:re rich. As i n the Eckste i n tradt:, ht: often bet that a 'lxt:ad-say, bt:twt:cn a futu rt:s contract and tht: underlying bond, or between two bonds-wou ld converge. l ie could a l so bet on spreads to widt:n, hut con vergence was h i s dom in a nt theme. Tht: people on tht: otht:r sidt: of his tradt:s m ight be insurt:rs, ha nks, or speculators; N1criwctht:r wouldn 't k now, and usually he wouldn't care. Occasion­
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W H E N G E N I U S FA I L E D

count o n , years later, at Long-Term Ca pital. B u t there w a s a di fferent lesson, equ a l l y valua ble, that M eriwether might have d rawn from the Eck stei n business, had his success not come so fast: while a losing trade may well turn around cuentually ( assumi ng, of cou rse, that it was properly conceived to begin w i t h ) , the turn could a rrive too late to do the trader any good-meaning, of course, t h a t he might go broke in the interim . •

By the early r yilo �, Meriwether wa� one of Salomon\ bright young �ta rs. H is shyness and implacable poker face played perfecrlv to his skill as a trader. Wi lliam Mcintosh, the Salomon partner who had in­ terviewed him, said, "John has a stee l-trap mind. You have no clue to what he's thinking." .\leriwether's former colleague, the writer .\ l ichael Lewis, echoed this a ssessment of .\k riwethcr in Liars l'ukcr: He wore the s;lme blank h a l f-tense expre��ion when he won a� ht: did when he lost. I le had, I think, a profound ahrlity to con­ trol the two emotions that com monly destrov tr,Jdn..,- fear and greed-an d it made him as noble a' a nu n who p••r..,uc.., hi' ..,elf­ interest so fiercely can be.' It was a pity that the book emphas11.nl .1 'lii'J'o''·d incident in which .VIeriwether al legedly da red Cutfrcund to pl.11 . 1 "nglc hand of poker for $ 1 o mil lion, not merely hcc.lll'c d1c ..,t, >r1· \Ct'lll" apoc­ ryphal, but hecwse it canonized Meriwcthn for .1 n·c k l,·.., s n e o; -, that wasn't h i s . ' ,\leriwether was the priest ot IIH· ',i/, ulo�f<',/ g;nnble. I le was cautious to a fa ult; he gave away norlnn�: o f ltnm. .lf. I lis hack­ ground, h is fa m i l y, his entire past were ;1.., IIIII< h c >I .1 hLm k to col­ leagues a s i f, one said, he had " d rawn a line 111 1h,· ,,111.! . ., I k was �o intensely private that even when the Long l.-1111 ( ·IJ'It.d .1 fb ir was front-page news, a New York Times wr itn, .dll'l 11 1 111.1: 1 o determine if J\leriwether had any siblings, settled for 11,1t I<'II<TIItT was a perfect attri b ute for a trader, b u t it wa' 11ot <'II< lll)',h. \X ' h, t t .\leri­ wether lacked, he m ust have sensed, was ;111 ,·,f.t:•' '"111.. 'Jl<'t'l;ll forte like the one he had developed on the link' 111 l11glt "!tool, '"mething that would d istinguish Salomon from ew rv ot hl'l bo11d 1 r.ll l n. His sol ution was deceptively s i m ple: Why IIC!I l111 ,. ll.ltkr.., who were smarter? Traders who would treat n u r k t ·t, . I, .111 llllc·ll,·,tu.tl dis-

MERIWETHER

•

II

cipli ne, as opposed to the fol k loric, u n scienti fic Neanderthals who traded from their bell ies? Academia was teeming with nerdy mathe­ maticians who had been publishing u nintelligible d i ssertations on markets for }'Cars. Wal l Street had started to h ire them, b u t o n l y for research, w here they'd be out of harm's way. On Wall Street, the eggheads were stigmatized as "quants," u n fi t for the man's game of trading. Craig Coats, Jr., head o f government-bond trad ing at Sa­ lomon, was a type typical of t rad i ng floors: tall, l i kable, handsome, hound to get along with clients. S u re, he had been a goof-off in col­ lege, hut he had played forward on the basketball team, and he had trading in h i s heart. It was j ust t h i s element of passion that .\1eri­ wether wanted to elimi nate; he preferred the cool d i scip l i n e of schol­ •lf'i, with thei r rigorous and highly q uantitati ve approach to markets. \1ost Wal l Street executives were mystified by the academic world, hut ."vleriwether, a math teacher with an M.B.A. from C hicago, was comfortable with i t. That would he his edxe. In 1 9 83, M e ri wether called Eric Rose n feld, a sweet-natured M I T-trained Harvard Business School assistant professor, to see if Rosenfeld cou l d recommend any of his students. The son of a modestly successful Concord, .\1assa­ chusetrs, money manager, Rosenfeld was a compu ter freak who had a l ready been using q uantitat i ve methods to make i n vestments. At Harvard, h e was struggl ing. Laconic and dry, Rosen feld was com­ pel li ngly bright, but he was less than commanding in a classroom. At a distance, he looked like a thin, bespectacled mouse. T h e students were rough on h i m; "they heat the shit out of h i m , " according to a fut ure col league. Rosenfeld, who was grading exams w h e n Meri­ wether cal led and was mak i ng, as he recal led, rough l y $ 3 0,000 a year, i n stan t l y offered to audition for Salomon h imse l f. Ten days later, he was h i red.' Meriwether didn't stop there. A fter Rosenfeld, he h i red Victor J. l laghan i, an I ranian American with a master's degree in finance from the London School of Econom ics; Gregory Haw k ins, an A rkansan who had helped run Bil l Cl i nton's campaign for state attorney gen­ eral and had then gotten a P h . D . in financial economics from .\1 IT; and W i l liam Krasker, an i ntense, mathematically m inded economist with a Ph.D. from-once again-M IT and a colleague o f Rosen feld at 1-larvard . Probably the nerdiest, and surely the smartest, was Lawrence H i l i b rand, who had two degrees from M IT. l l i l i hrand was h i red by Salomon's research department, the tradi tional home of

12

•

W H E N G E N I U S FAI L E D

quants, but Meriwether quickly moved him into the A rbitrage Group, w h ich. of course, was the heart of the future Long-Term Cap­ ital. The eggheads i mmediately took to Wa l l Street. They downloaded into their computers all of the past bond prices they could get their hands on. They distilled the bonds' h i storical rclatiomhips, and they modeled how these prices should behave in the futu re. And then, when a market price somewhere, somehow got out of l i ne, the com­ purer models told them. The models d idn't order them to trade; they provided a contextual argument for the human computers to consider. They simplified a com pl icated world. :VIaybc the yield on two-year Treasury notes was a bit closer than it ordinarily was to the yield on ten-yea r bonds; or maybe the spread between the two was unusua l l y na rrow, compared with a similar spread for some other country's pa per. The models condensed the markets into a pointed inquiry. As one of the group said, " G i ven the state of th ings aro u n d the world-the shape of yield curves, volatil ities, interest rates-arc the financial markets making statements that a rc inconsistent with each other ? " This is how they talked, and this is how they thought. Every price was a ''statement"; i f two statements were in confl ict, there might he a n opportunity for arbitrage. The whole experiment would surely have fa iled, except for two happy circumstances. First, the profcs�or� ll'l'r<' '>llU rt . The y stuck to their kni tting, and opporrunitie� were plcnr iful, l''>J1t'ci a l l y in newer markets such as derivatives. The profcs"> or'> '> pok,· ot o pportunities as inefficiencies; in a perfectly efficient markl'l . 111 w inch :dl prices were correct, no one would have anything to trade. \inu· 1 he nu rkets they traded in were sti l l evolvi ng, though, price' wn<· ott,·n incorrect and there were opportunities aplenty. M oreover. 1 hl' p ro t,· .,.,o rs brought to the job an abiding credo, learned from ac.Jktn .tnd les� risky bonds would tend to narrow. This fol l owed logtt.tllv h<·<.IIN' spreads reflect, in part, the uncertainty that is atLI< hnl to tll.lnun assets. Over time, if ma rkets did become more dfiu,·tll, '>II< h n,k llT bonds would be less volatile and therefore more ccrLtttt '<"<'ltttn)� . . nlll '>0 the prem i u m demanded by investors would tend to ,Jmnk. In thl' t'a rly 1 9 8os, for i nstance, the spreads o n swaps--.1 1 VI"' ot dnw .111 V<' t rade,

MERIWETHER

•

1 3

of which more later-were 2. percentage points. "They looked at t h i s and said, ' I t c a n 't be right; there can't b e that m u c h risk," ' a j un ior member of A r b itrage recal led. " They said, 'There is goi n g to be a sec­ ular trend toward a more efficient market.'" And swap spreads did tighten-to 1 percentage point and eventu­ ally to a q uarter point. All of Wa l l Street did thi� trade, including the Salomon government desk, run b y the increasi ngly wary Coats. The di fference was that Meriwether's A rbitrage Gro u p did i t in z•ery big dollar,. If a trade went
14

•

W H E N G E N I U S FA I L E D

The professors were bri l l i a n t a t reducing a trade to p l u ses and mi­ nuses; they could strip a h a m sandwich to its component risks; hut they could ba rely carry on a normal conversation. Meriwether cre­ ated a safe, self-contained place for them to develop thei r skil ls; he adoringly made A rbitrage i nto a world a pa rt. Beca use of Meri wether, the traders fr;Hernized with one a nother, a nd they didn 't feel the need to fratern ize with an yone else. Meriwether would say, ''We're playing gol f on S u nday," and he didn't have to add, 'Td like you to be there." The traders who hadn't p l a yed gol f before, such as H i l i brand and Rosen feld, q u ick ly le1rned. Meri wether also developed a passion for horses and ac­ quired some thoroughbreds; n a r u r;l lly, he took his traders to rhe track, too. He even shepherded rhe gang a nd their spouses to A nt igua every year. f ie didn't want them j ust during trading hours, he wa nted a l l of them, a l l rhe ri me. He n urtured h i � traders, a l l the while bui ld­ ing a protective fence around rhe group as sturdy as rhe red boa rd fence in Rosemoor. Typica l of :VIeriwerher, he made gambling an i nt i m a te parr of rhe group's sha red l i fe. The arbitrage u rs devi sed ela borate betting pools over golf weekends; they bet on horses; they rook day trips to At­ lantic City together. They her on elections. They her on a n ything rhar aroused their passion for odds. When they talked <.ports, it wasn't about the game; it was a bout rhe pui11t Sfircad. .Vleri werher loved for his traders ro pLty liar\ poker, a g;l me rhar i n volves m a k i n g poker h a nds from rhe �ni.1 l n ttm hcr-, on dollar bills. f ie l i ked to rest his traders; he th ought till' g;um· honed their insti ncts, a n d h e would get c h u r l i s h and thre,lft·n to q u i t when rhev played poorly. It sta rted as fun, but rhen it got '>tTiou'>; the trader'> would pl;ly for hours, occa sion a l l y for sta ke� tn the tem of thou­ sands of dol l a rs. Rosenfeld kept an en velope '>llllfed w i t h h u ndreds of single b i l l s in h i s desk. Then, when it �t·cnH·d th.tt cert;lin hills were cropping u p too often, they did a w a y with h i l l' .tnd got . 1 com ­ puter to generate random l i sts of n u m bn�. Tht· .\rhitr;tge boys seemed addicted to ga mbl ing: "You could nevn go out to dinner wirh J.:VI.'s guys without playing l i a r's poker to �� ' l" who wo u l d pick up the check," Gerald Rose n feld, Sa lomon\ dnd tin;liKial officer, reca l led. Meriwether was a good player, and so w,l\ Frtt Rmenfeld (no relation ), who had a n i n scrutable poker Ia�·�·. The -,r raighr­ a rrow f ii l i brand was a hit too l i teral. He was incap;thlc ot lying and

MERIWETHER

•

1 5

for a long time never bluffed; mustach ioed and eeri l y i n te l l igent, he h,ld a detachment that was a lmost extrahuman. Once, when asked whether it was a wk wa rd to have a wife who worked in mortgages (which l l i l i brand traded), he answered flatly, " Well, I never ta l k to Ill\' wife a bout busi ness.·· The Arbitrage Group, about twel ve in all, became incredibly dose. I hey sat in a double row of desks in the middle of s,,lomon 's raucous trading floor, which was the model for the in vestment bank in Tom Wolfe's The Ron/ire o/ the V<�nities. Randy Hiller, a m ortgage trader in Arbitrage, found irs cliquish aspect overhearing and left. Another defector was treated like a traitor; Meriwether vengefu l l y o rdered the crew nor to even golf with him. Bur very few traders left, and those who rema i ned a l l but worshiped �lcri wether. They spoke of him in hu�hed tones, as of a �loses who had brought their tribe to Pa lestine . .\lcriwether d idn't exactly return the praise, but he ga ve them some­ thing more worth while. His interest and curiosity sti m u l a ted the pro­ fessors; it chal lenged them and made them better. And he rewarded them with hea rtfelt loya l ty. He never screamed, but it wouldn't have mattered if he had. To the traders, the two initials "J. M . "-for that was his u n fa i l ing sobriquet-were as powerful as any two letters could be. Though he had a pri vate office upstai rs, Meriwether usually sat on the trading floor, at a tiny desk sq ueezed in with the others. l ie would chain-smoke w h i le doing Eurodollar trades, and supervise the pro­ fessors by ask ing probing questions. Somehow, he sheathed great am­ bition in an a ffecting mode�ty. l ie l iked to say that he never h i red anyone who wasn't smarter than he w<1s. He didn't ta l k a bout h i m­ -.clf, but no one noticed because he was genuinelv i nterested i n what the or hers were doing. He did n't build the models, but he grasped what the models were saying. And he trusted the models bec<1use his guys had b u i lt them. One time, a trader na med Andy who was losing money on a mortgage trade asked for permission to double up, and J. M. gave it rather offhanded ly. " Don't you want to know more about this trade ? " Andy asked. Meriwether's trusting reply deeply af­ fected the trader. J . M . sa id, ".\ly trade was when I h i red y o u . " .\1eriwether h a d ma rried M i m i .\l urray, a serious equestrian from Ca lifornia, in 1 9H 1, and the two of them l ived in a m odest two­ bedroom apa rtment on York Avenue on the Upper East Side. They wanted c h i l d ren, according to a colleague, hut remained childless.

16

•

W H E N G E N I U S FA I L E D

Aside from Mimi, J . M . 's fa m i l y was Salomon. H e d i d n 't leave his desk even for l unch; in fact, his noontime was a s routinized as the professors' m odels. Salomon did a china-service lunch, and for a long rime, every day, a waiter would waft over ro .'vleri wether bea ring a bologna sandwich on white bread, two apples, and a T1 h hidden under a s i l ver dome. J."-'1 . would ear one of the a pple� and randomly offer the ot her to one oi the troops a s a son of to ken. The rest of t he gang m ight order Ch inese food, and if any sa uce lea ked onto his desk, J . M . , his precious territory violated, would scowl and �ay, " Look, I guess I'm going to have ro give up mv desk and go hack to my office and work there." A misfit a mong Wa ll Strecr\ Wa spish han kers, J ."-'1. identified more with the parochial school boys he had grown up with than with the rich executi ves whose number he had j oined. U n l i ke other fi­ nanciers in the roaring eighties, who were fast becoming t rendy habitue s of the social pages, .\1eri wet her di ,da ined a ttention ( he purged h i s picture from Salomon\ annual report) and refused to dine on any food that smacked of French. When in Tokyo, he went to McDonald's. Ever an outsi der, he molded hi� group into a tribe of outsiders as cohesi ve, loyal, and protective as the world he h
MERIWETHER

•

I 7

grn:ner past u re�. But other� in Salomon began to seet h e . .J.!'vl. would �end one of his boys-H i l ibrand o r Victor Haghani-to Sa lomon 's London office or its Tokyo office, a n d the emissary would dec l a re, "This trade is very good, but you should be ten times bigger in i t . " \: ot t w o ti mes, but ten times! A s i f t h e y couldn't fa i l . l l i l i brand and l laghani were in their twenties, and they might be t a l k i n g to guys twice their age. Then they started to �ay, " Don't do this trade; we're better at this than an yone else, so we'll do all of this trade on the a r­ bitrage des k . " H i l i brand w;ls particularly a nnoyi ng. l ie was formal a n d polite, but he struck old hands as condescendi ng, infuriating them w ith h i s mathematica l certitude. One time, he tried t o persuade s o m e com­ modity traders that they should bet on oil prices fol lowing a pattern similar to that of bond prices. The traders listened d u biously w h i le Hilibrand bobbed h i s head back a n d forth . Suddenly he raised a hand and sonorously declaimed, " Consider the following h y pothesis." It was as i f h e were delivering 3Il ed ict from on high, to be etched in stone. Traders h a d an a n x ious l i fe; they'd spend the day shouting into a phone, hollering across the room, a nd nervously eyebal ling a com­ puter screen. The A rbitrage Group, right in the middle of this con­ tro l led p a n d e m o n i u m , seemed to be a mysterious, p r i v i l eged subculture. H a l f the time, the boys were d iscussing trades in obscure, esoteric language, as if in a sem i nar; the other half, they were l a ugh­ ing and playing liar's poker. I n their cheap suits and with their leisurely mien, they could seem ingly c herry-pick the best trades w h i l e everyone else worked at a frenetic pace. The group was e xtremely private; it seemed to have adopted J .Y! . 's innate secretiveness as a protective coloring. Though a n y trader is well advised to be d iscreet, the professors' refusal to s h a re any i n for­ mation with their Salomon colleagues fueled the resentment felt by Coats and others. T hough A rbitrage soaked up all of the v a l u a ble tid­ bits that passed t h ro ugh a prem ier bond-trading floor, it set up i ts own private research arm and strictly forbade others i n Salomon to learn about its trades. One time, the rival Prudential- Bache h i red away a Salomon mortgage trader, which was considered a coup. "What was the fi rst thing he wanted ? " a then-Pru-Bache manager l a ughingly remembered. "Ana l ytics? Better computer system or soft­ ware? No. He wanted locks on the fi ling cabinet. I t reflected their

18

•

WHEN GENIUS FAILED

mentality!" Driven by fanatical loyalty to Meriwether, the Arbitrage Group nurtured an us-against-them clannishness that would leave the future Long-Term dangerously remote from the rest of Wall Street. Hilibrand became so obsessed with his privacy that he even refused ro

let Salomon Brothers take his picture."

•

As other areas of Salomon floundered, Arbitrage increasingly threw its weight around. Hilibrand pressed the firm

to

eliminate investment

banking, which, he argued with some justification, rook home too much in bonuses and was failing that Arbitrage shouldn't have

to

to

carry its weight. Then he declared

pay for its share of the company

cafeteria, because the group didn't eat there. True

to

his right-wing,

libertarian principles, Hilibrand complained about being saddled with "monopoly vendors," as if every trader and every clerk should negotiate his own deal for lunch. The deeper truth was th
;t

hmtde hid for Sa­

lomon. Gutfreund feared, with ample j usti fication, that Jl Perelman won, Salomon's reputation as a trusted bank n would go down the tubes (indeed, Salomon's corporate diems c·ould like!\' find them­ selves on Perelman's hit list). Gutfreund fended l'ndnt;tn off by sell­ ing control of the firm

to

a distinctly friendlv ntl·,·,tor, t he billionaire

Warren Buffett. Hilibrand, who weighed ,·vnltlung terms, was incensed over what he reckoned w;t'<

.1

111

mathematical

poor deal for Sa­

lomon. The twenty-seven-year-old wumlcrknHI, though unswervingly honest himself, couldn't sec that an in t

ll all y tlew out

to

Omaha to

try to persuade Buffett, now a member of Salomon\ hoard,

to

sell

back his investment, but Buffett, of course, refu,ed . .J.M. tried

to

temper his impatient young Turks and imbue them

MERIWETHER

•

19

with loyalty to the greater firm. When the traders' protests got louder, j .M . invited H i l i brand and Rosenfeld to a dinner with W i l l ia m .'vlcln­ tosh, an older partner, to hear a bout Salomon's histo ry. A l i beral Democrat in the Irish Catholic trad ition, J . .'vl . had a stronger sense of the firm's common welfare and a grace that softened the hard edge of his cutthroat profession. l ie shrugged off his lieutenants' occasional cries that Arbitrage should separate from Salomon. l ie would tell them, " I 've got loyalty to people here. And anyway, you're being greedy. Look at the people in Harlem . " He pressed Salomon to clean house, but not without showing concern for other departments. Thoughtfu l l y, w hen the need arose, he would tell the chief financial officer, " We have a big trade on; we could lose a lot-I J USt want you to know. " I n the crash of I ';) X 7 , A rbitrage did drop $ I 2o m i l lion in one day. ' · Other� at Salomon weren't sure qu ite what the group was doing or what its leverage was, b ur they instinctively trusted Meri­ wether. Even his rivals in the firm l iked him. And then it a l l came crashing down .

•

Pre��ed by h i s young trader�, who simply wouldn't give up, i n I 9 X9 \1eriwether persuaded Gutfreund to adopt a formula under which his arbitrageu rs would get paid a fi xed, 1 5 percent share of the group's profits. The deal was cut in secret, after l l i li brand had threat­ ened to bolt . " Typica l l y, .J . M . left h imself out of the arrangement, telling Gutfreund to pay him whatever he thought was fa i r. Then A r­ bitrage had a banner year, and H i l i hrand, who got the b iggest share, rook home a phenomenal $2 .; m i llion. Although H i l ihrand modestly contin ued to ride the train to work and d rive a Lexus, news of his pay brought to the surface long-si m mering resentments, particularl y as no other Salomon department was paid under such a formu l a . As Charlie \1 unger, B uffett's partner and a Salomon d irector, put it, "The more h y perthyroid at Salomon went sta rk, raving m a d . " I n particular, a thirty-four-year-old trader named Paul M ozer was enraged. M ozer had been part of Arbitrage, hut a couple of years ear­ lier he had been forced to leave that l ucrative area to run the govern­ ment desk. M ozer had a wiry fra me, close-set eyes, and an intense manner. In I 99 I , a year after the storm over H i l i brand's pay, M ozer went to Meriwether and made a sta rt l i ng confession: he h a d submit-

20

•

W H E N G E N I U S FA I L E D

ted a false hid to the U.S. Treasury to gain an unauthorized share of a government-bond auction. Stunned, Meriwether asked, " Is there anything else ? " "-1ozer said there wasn't. Meriwether took the matter to G utfreund. The pair, a long with two other top executi ves, agreed that the matter was seri ous, hut they somehow did nothing about it. Although upset with .\!lozer, .\1eri­ wethcr stayed l oyal to him. It is hard to imagine the clannish, fa ith­ ful J.M . doing otherwise. I le defended Mozer as a h a rd worker who had slipped but once and left him in charge of the government desk. This was a m ista ke-not an ethical mistake but an error in j udgment brought on by J. M . 's singular code of a llegiance. In fact, Mozer was a volatile trader who-motivated more by pique than by a real istic hope for profit-had repeatedly and reck lessly broken the ru les, jeop­ a rdizing the reputation of Meriwether, his supervisor, and the entire firm. It must be said that .\1ozer\ crime had been so fool ish a� to be easi ly slipped by his superiors. Q uite naturally, �1eri wether, now head of Salomon's bond business, hadn't thought to i n q u i re if one of his traders had been lying to the U.S. Treasu ry. But .J . M . \ len ience after the fact is hard to fathom. A few month� later, in A ugust, Sa­ lomon discovered that :V1ozer's confession to Meriwnhcr had it�elf been a lie, for he had committed n umerou� other i n fract i ons, too. Though now Salomon did report the matter, the Tre.J-.ury nd-floor of­ fice and told h i m that he should quit for t lw good ol t h l fi rm. And al most he fore the A rbitrage Gro u p could Lu hoJJJ i t , t h , · J r chid had re­ signed. It was so unexpected, .\!lcriwet lwr tell It w . J -. -.u rre.t l ; more­ over, he suffered for being front-p
"

MERIWETHER

•

2 1

introspective person," he later noted to Business Week . ' ' The ful l truth w a s more bitter: J. M . w a s being pushed aside-even i m p l icitly bla med-despite, in his opinion, having done no wrong. This painfu l dollop of l im e l ight made h i m even more �ecretive, t o Long-Term Cap­ ita l's later regret. Mean while, within the Arbitrage G roup, resurrect­ ing .J . �I . became a crusade. H i l i brand and Rosenfeld kept J . M .'s office i ntact, with hi� gol f c l u b, desk, and computer, as if he were merely on an extended holiday. Deryck Ma ughan, the new C :FO, as­ tutely surmised that as long as this shrine to J . M . remained, J . .'\1 . was alive as h i s potential riva l. S ure enough, a year later, w hen ,\ll eri­ werher resolved his legal issues stemming from the M ozer a ffa i r, l l i l i ­ brand a n d Rosenfeld, now the heads of A r b i t rage a n d the government desk, re�pecti vcly, lobbied for J . .'\l . 's ret u rn as co-C : F O . '';\laughan, a bureaucrat, was too smarr to go for th is and tried to refash ion Salomon into a globa l, full -service hank, with A rbit rage as a mere department. l l i l i brand, who was dead opposed to this course, increasingly asserted hi mself in _j . .'\1.\ absence. He wanted Salomon to fire ih in vestment hankers and retrench around Arbitrage . .'\1ean­ while, he made a ncar-catast rophic her in mortgages ecuritiL·s ;md Exchan�e Commission filed a civil complaint c·h.u�in� that Meriwether had b ilcJ to properly o;upcrvisc \lozer. Without admirrin� or Jenyin� �uilt, �leriwethcr settled the case, a�rcein� to a three -month suspension from the sccurities r �oR MU NI TI PETALING JA 1 A ij �

�

��

b

? INJAMA

"11 n 1 l:" ') 0 4 (\

22

•

W H E N G E N I U S FAILED

brand lect ured them for hours. I n short, how much-if, sometime, the Slinky did not bounce back�ould A rbitrage potentia l l y lose? :\either Buffett nor M unger ever felt quite comforta ble with the mathematical tenor of I l i lihrand\ repl ies . ' ' Buffett agreed to take J . :V1 . hack-hut not, a' l li l i brand wanted, to trust him with the en­ tire firm. Of course, there was no way Meri wether would settle for 'uch a qualified homecom ing. The M ozer sca ndal had ended a n y hope that J . !VI . would take his place at the top of Salomon, hut it h;Jd sown the seed<> oi a greater drama. 1\'ow iortv-five, with h a i r that di pped in a wa vy, bovish a rc toward impenetrable eyes, J . M . broke off t;J l k s with Salomon. l ie laid plans for a new and independent a rbitrage fund, perhaps a hedge fund, and he proceeded to raid the Arbitrage C roup that he h;Jd, so lovingly, a-;semhlcd.

HEDGE FUND I louc -HF�RY l'mphcsy

ds

hedge, sir.

much as you like, but always hedge. -

Y T I I F F A R l Y I ':) ':)OS,

u

hU.DII\G, 1 7 ' 6

()II \'1 R W F �Ill

II

I I < ll .\ I I

'o,

r X6 r

as !'vkriwether began to resuscitate his career,

B investing had entered a golden age. More Americans owned invest­

ments than ever before, and stock prices were rising ro astonishing heights. Time and again, the marker indexes soared past once u nthink­ able harriers. Time and again, new records were set and old standards eclipsed. I n vestors were giddy, hut they were far from complacent. It was a golden age, hut also a nervous one. Americans filled their empty moments by gazing anxiously at l u minescent monitors that registered the market's latest move. Stock screens were everywhere-in gyms, ar airports, in singles bars. Pundits repeatedly prophesied a correction or a crash; though a lways wrong, they were hard to ignore. In vestors were greedy hut wary, too. People who had gotten rich beyond their wi ldest dreams wanted a place to reinvest, but one that would not unduly suf­ fer if-or when-the stock market finally crashed. And there were plenty of rich people a bout. Thank s in large part to the stock m arket boom, no fewer than 6 m i ll ion people around the world counted themselves as dollar m i l lionaires, with a total of $ I 7 trillion in assets . ' for these l ucky 6 m i l lion, at least, i nvesting in hedge funds had a special a l l ure.

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W H E N GENIUS FAILED

As far as securities law is concerned, there is no such thing as a

hedxe (u11d. In practice, the term refers to a l i m i ted partnershi p, a t least a s m a l l number of w h i c h have operated since t h e I ') 20S. Ben­ j a m i n Graham, k nown as the father of value i nvesting, ran what was perha ps the first. Unlike m utual funds, their more common cousins, these pa rtnerships operate i n Wa l l Street's shadows; they are private and largely unregulated in vestment pool s for the rich. They need not register with the Securities and Exchange Commission, though some must make limited fi li ngs to a nother Washi ngton agency, the Com­ modity Futures Trading Commission. For the m ost pa rt, they keep the contents of their portfolios h idden. They can borrow as much as they choose (or as much a s their han kers will lend them-which often amounts to the same thing). And, u n l i ke mutual funds, they can con­ centrate their portfolios with no thought to di versification. I n fact, hedge funds arc free to sample any or all of the m ore exotic species of investment flora, such as options, derivati ves, short sales, ex­ tremely h igh leverage, and so forth. In return for such freedom, hedge funds m ust l i m i t access to a se­ lect few in vestors; indeed, they operate like pri vate clubs. By l a w, funds can sign up no more than ninety-nine in vestors, people, or in­ sti tutions each worth at least S I m i l lion, or u p to fi ve h undred in­ vestors, a ssuming that each has a portfolio of a t least $ s m i l l ion. The implicit l ogic is that if a fund is open to only a s m a l l group of mil­ lion a i res and institutions, agencies such as the SEC need not trouble to monito r it. Presumably, m i l l ionaires know what they a re doi ng; if nor, thei r losses a re nohody 's business but thei r own. Until recently, hedge fund managers were complete u n knowns. But in the 1 ') 8 os and '')os, a few la rge operators gained notoriety, most notably the emigre cu rrency speculator George Soros. I n 1 ') ') 2 , Soros's Q ua ntum Fund became celebrated for " brea king" t h e B a n k of England and forcing it to devalue t h e pound ( which he h a d relent­ lessly sold short), a coup that netted him a $ 1 b i l l i o n profit. A few years later, Soros was blamed-perhaps u n j usti fia b l y-for forcing sha rp deval uations in Southea st Asian currencies. Thanks to Soros and a few other h igh-profile managers, such as .J u l i a n Robertson a n d M ichael Steinhardt, hedge f u n d operators acq u i red a n image of dar­ ing buccaneers capable of roiling ma rkets. Stei n h a rd t bragged that he and his fellows were one of the few remain ing bastions of frontier capitalism.' The popular image was of swash buckl ing risk rakers who

HEDGE FUND

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captured outsized profits o r suffered horrendous l osses; the I ') ') II Webster's College Dictionary defi ned hedge funds as those t h a t usc " high-risk spec u lative methods. " Despite their bravura image, however, most hedge funds arc rather tame; indeed, that is their true appeal. The term "hedge fund" is a col­ loquialism derived from the expression " to hedge one"s bets," meaning ro limit the possibility of loss on a speculation by betting on the other side. This u�agc evolved from the notion of the common garden hedge a� a boundary or limit and was used by Shakespeare ( " England hedg'd in with the maine" ). No one had thought to apply the term to an in­ vestment fund u ntil Al fred Winslow .Jones, the true predecessor of N1criwcrhcr, organ ized a partnership in I 949.' Though such partner­ ships had long been in existence, .Jones, an Australian-born Fortu11e writer, was the first to run a balanced, or hedged, portfolio. fearing that his stocks would fa ll during general market slumps, .Jones decided to neutralize the marker factor by hedging-that is, by going both long and short. Like most investor�, he bought stocks he deemed ro be cheap, but he also sold short seemingly overpriced stocks. At least in theory, .Jones's portfolio was " marker neutra l . " Any event-war, im­ peachment, a change in the weather-that moved the marker either up or down would simply elevate one half of .Jones's portfolio and depress the other half. His ncr return would depend only on his abil ity to �in­ gle our the relatil'c best and worst. This is a conservative approach, likely to make less but a lso to lose less, which appealed to the nervous investor of the 1 ') ') O S . Eschewing the daring of Soros, most modern hedge funds boasted of their steadi­ ness as much as of their profits. Over ri me, they expected to make handsome retu rns but not to track the broader market blip for blip. Idea lly, they would make as much a� or more than genera lit.ed stock funds yet hold their own when the averages suffered . At a time w hen A mericans compa red investment retu rn s as ob­ sessively as they once had soa ring home prices, these hedge funds­ though d i m l y understood-attained a mysterious cachet, for they had seemingly found a route to riches w h i le circumventing the usual risks. People at barbecues tal ked of nothing but their m u tu a l funds, but a mutual fund was so-common ! for people o f means, for peo­ ple who s u mmered in the Hamptons and decorated their homes with Warhols, for patrons of the arts and charity dinners, i n vesting in a hedge fu nd denoted a certain status, an inclusion among Wal l

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Street's sma rtest a n d sa vviest. When t h e world w a s ta lking invest­ ments, what could be more thrilling than to dem u rely d rop, at cou rt­ side, the name of a young, sophi sticated hedge fund manager who, di screetly, sh rewdl y, and a uspici ously, was handling one's resources ? Hedge funds became a symbol of the richest and the best. Paradox­ ica l l y, the pri ncely fees that hedge fund managers cha rged enhanced their a l l u re, for who could get away with !>uch ga udy fees except the except ionally talented ? 1\:ot only did hedge fu nd managers pocket a fat share of their investors' profits, they greedily claimed a percent­ age of the assets. For such reasons, the n u m ber of hedge funds in the United Stares exploded. In I 9 6 S , when the SEC: went looking, it could find only 2 I 5 of them . ' By the I ') ') O S there were perhaps _:; ,ooo ( no one knows the exact nu mber) , spread among many in vesting styles and asset types . .\1ost were small; all told, they held perh a ps $ wo billion in capital, compared with $ 3 . 2 tri llion in equity mutual funds.'' How­ ever, i nvestors were h ungry for more. They were seeki ng an a lterna­ tive to plain vanilla that was both bold and sa fe: not the riskiest i nvesting style but the most certain; not the l oudest, merely t h e smartest. This wa' exactly t h e sort of hedge fu nd Meriwether h a d in mind. Emulating Al fred Jones, Meriwether envi sioned that I .ong-Term Capital Management would concentrate on " relative value" trades in bond ma rkets. Thus, I .ong-Term would buy some bonds and sel l some others. It would bet on spreads between fhiirs of bond, to either widen or contract. If interest rates in Italy were sign i ficlllrly higher than in Cermany, meaning that Italy's bonds were cheaper than Ger­ many's, a trader who in vested in Italy and shorted Cermany would profit i f, and as, this di fferential na rrowed. Th is i s a relatively low­ ri'k strategy. Si nce bonds usua l l y rise and fal l i n sync, spreads don 'r move as much as the bonds t hemselves. As with J ones's fund, Long­ Term would in theory he una ffected if ma rkets rose or fell, or even i f they crashed. But there was one sign i ficant di fference: Meriwether planned from the very start that Long-Term would leverage its capital twenty to thi rty ti me' or even more. Th i' was a nece-;sary pa rt of Long-Term's strategy, because the gaps between the bonds it intended to buy and those it intended to sell were, most often, min uscule. To make a de­ cen t profi t on such tiny spreads, Long-Term would have to multiply

HEDGE FUND

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its bet many, many times b y borrowing. The allure of t h i s strategy is apparent to a n yone who has visited a playground. J ust as a seesaw enables a c h i l d to raise a much greater weight than he could on his own, fi nancial leverage multiplies your "strength " -that is, your earning power-because it enables you to earn a retu rn on the capi­ tal you have borrowed as well as on your own money. Of course, your power to l ose is also m u ltiplied. If for some reason Long-Term's strategy ever fa i led, its losses would be vastly greater and accrue more quickly; indeed, they might be l i fe-th reatening-an eventual i ty that surely seemed remote . •

Early in I 9 9 3 , Mcriwetht:r paid a c a l l on Danid Tul l y, c h a irman of \1nrill Lynch . Sti ll anxious about the unfair tarnish on h i s name from tht: !'v1ozcr affa i r, J . M . i mmediately asked, " Am I damaged good s ? " Tu l l y sa id he wasn 't. Tu lly put Meriwether in touch with the Mnrill Lynch pt:oplc who ra ist:d capital for hedge fu nds, and shortly th�:rcaftcr, Merril l agreed to take on the assignment of raising Clpiral for Long-Tt:rm. J . !'v1 .'s design was staggeringly a mbitious. I Ic wantt:d nothing less than to repl icate the Arbitrage G roup, with its global r�:ach and abil­ ity to take huge positions, bur without the hack ing of Sa lomon's bil­ lions in capital, credit l i nes, i n formation network, and seven thou�and employees. f laving done so much for Salomon, he was bit­ ter about h a ving been forced into exile under a cloud and eager to be vindicated, perhap� by creating something better. And \1eri wcther wanted to raise a colossal sum, $ 2 . 5 b i l l i on . ( The typical fu nd starts with perh aps I percmt as much. ) I ndeed, every­ thing a bout Long-Term was ambitious. Its fcc� would be considera bly h igher than average. J.M. and his partners would rake i n 25 percent of the profits, in LZdditioll to a yearly 2 percent c h a rge on assets. ( Most fund� took only 20 percent of pro fib and I percent on a �scts . ) Such fees, J . M . felt, were needed to sustain a global operation-but this only pointed to the far-reaching nature of his aspirations. Moreover, the fund insisted that in vestors commit for at least three years, an al most unheard-of locku p in the hedge fund worl d . The lockup made sense; if fickle ma rkets turned against it, Long-Term would have a cushion of truly " long-term " capita l; it would be the hank that could tel l depositors, " Come back tomorrow. " Sti ll, it was

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asking investors to �how enormous trust-particularly since J.:vt. did nor h;1ve a formal track record to show them. While it was k nown anecdota lly rhar Arbitrage had accounted for most of Salomon's re­ cent earni ngs, the group's profits hadn't been disclosed. Even in­ vestors who had an inkling of what Arbitrage had earned had no understanding of holl' it had earned it. The n uts and bolts-the mod­ els, the spreads, the exotic derivatives-were too obscure. Moreover, people had serious qualms about investing with Meri wether so soon after he had been sanctioned by the SEC in the .V1ozer a ffa i r. As \1erri l l began to chart a strategy for raising money, J . M .\ old team began to peel off from Salomon. Eric Rosenfeld left early in 1 'J'J 3 · Victor l laghani, the Iranian Sephardi, was next; he got an ova­ tion on Salomon's trad ing floor when he broke the news. In J u l y, Greg Hawkins q u it. Although J . M . sti l l lacked H i l i brand, who was ambiva lent in the face of Salomon\ desperate pleas that he sta y, ,'v! eriwether was now h;Hching plans with a nucleus of h i s top traders. He stil l felt a strong loya lty to his former colleagues, and he touch­ ingly offered the job of nonexecutive chairman to ( ; utfreund, Sa­ lomon's fa llen chief-on the condition that Gurfreund give up an acri mon ious fight that he was waging with Salomon for back pay. Though overlooked, Gutfreund had pla yed a pi votal role in the Ar­ bitrage Group's succes�: he had been the brake on the tr;1ders' occa­ sional tendencies to overreach. But i t was not to he. At Long-Term, J.,\1 . would have to restrain his own disciple.,. In any case, J . \1. wanted more cachet than ( ; utlreu nd o r even his talented but unheralded young arbitrageurs could deli ver. l ie needed an edge-something to j ustify h i s bold plan' with investors. He had to rec1st his group, to showcase them ;ls nor ju.,t < 1 hunch of bond traders but as a grander experiment in fi n
HEDGE FUND

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scientist, Robert K . Merton, who had studied the behavior o f scien­ tists. Shortly a fter his son was horn, Merton pcre coined the idea of the "self-fu l fi l l ing prophecy," a phenomenon, he �uggested, that was i l l ustrated by depositors who made a run on a bank out o f fear of a default-for h i s son, a prophetic i l l ustration .- The younger M erton, who grew up in Hastings-on-l ludson, outside New York City, showed a k nack for devising systematic approaches to whatever he tackled. A devotee of baseball and cars, he stud iously m e morized first the batting averages of pla yers and then the engine specs of virtually every American a utomobile.' Later, when he played poker, he would 'tare at a l ightbulh to contract h i s pupil' and throw off opponents. As if to e m u l ate the scientists his father 'tudied, he was a l ready the per,on of whom a later writer would say that he " l ooked for order <1 l l aro u n d h i m . , ., While he was an undergrad at Cal Tech , another int erest, in vest­ ing, blossomed. :\1crton often went to a local brokerage at 6 : ) o c\ . \1 . , when the New York markets opened, to 'pend a few h o u rs trading and watc h i ng the ma rket. Providentially, he transferred to M IT to study economics. In the late I y6os, econom ists were j ust beginning to tran,form finance into a mathematical d i,cipline. :Vt erton, working under the wing of the famed Pa u l Sam uelson, did not h i ng less than invent a new field. Up unt i l then, economists had constructed models to describe how ma rker; look-or in theory should look-at any point in time. \!lcrton made a 1'\ewton ian leap, model i ng prices in a series of i n fin itesimally tiny m oments. l ie called this " continuous time fi nance . " Years later, Stan J onas, a deri vati ves specia l ist with the French-owned Societe Ceneralc, would observe, " \!l ost everything else in fi nance has been a footnote on what Merton did in the I 97os . " H i s m i meographed hluc lecture notes became a keepsake. In the early I 9 70s, Merton tackled a problem that had been par­ tially solved by two other econo mists, Fi,cher Black and M y ron S. Scholes: deriving a formula for the " correL·t " price of a stock option. Grasping the intimate relation between ;1n option and the underlying stock, :\tenon completed the puulc with an elegantl y mathematical flourish . Then he graciously wa ited to publish until after his peers did; thus, the form ula would ncr he known as the B l ac k ­ Scholcs m o d e l . Few people w o u l d h a v e cared, given t h a t n o active ma rket for options existed. Bur coincidental l y, a month before the formula a ppeared, the Ch icago Board O ptions Exchange had begun

30

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W H E N G E N I U S FA I L E D

to list stock options for trading. Soon, Texas Instruments was adver­ tising in The Wall Street Journal, " !'\ow you can find the Black­ Scholes value using our . . . calcu lator. " '" This was the true beginning of the derivati ves revolution. Never before had professors made such a n impact on Wal l Street. In the I ') H os, .'VIeriwerhcr and many other traders became accus­ tomed to trading these newfangled instruments j ust a s they did stocb and bonds. As opposed to act ual securities, derivati ves were simply contracb that deri ved ( hence the name) their v a l ue from stocks, bonds, or other as�ets. For instance, the value of a stock option, the right to purchase a stock at a specific price and within a certa in rime period, va ried with the price of the underlying shares. �lerton j u m ped at the opportunity to join Long-Term Capital be­ cause it seemed a chance to showcase his theories in the real world. Derivati ves, he had recently been a rguing, had blurred the l ines be­ tween investment fi rms, hanks, and other financial institutions. I n the seamless world of derivatives, a world that Merton had hel ped to in­ vent, anyone could a ssume the risk of loaning money, or of pro v i d i ng equ ity, simply hy structuring an a ppropri ate contract. It was fu nction that mattered, nor form. This had a l ready been proved in the world of mortgages, once supplied exclusively by loca l ban k s and now largely funded by countless di sparate in vestors who bought tiny pieces of securitized mortgage pools. Indeed, M erton saw Long-Term Capita l nor as a " h edge fund," a term that he and the other partners sneered at, bur as a �tate-of-the­ a rt fhzanci<�l intermediary that pro v ided capital to ma rkers j ust as banks did. The bank on the corner borrowed from deposito rs and lent to local residents and businesses. It matched irs assets-that is, irs loa ns-with liabilities, attempting to earn a tiny spread by charg­ ing borrowers a slightly h igher interest rate than it paid to deposito rs. Similarly, Long-Term Capital would " borrow" by selling one gro u p of bonds and l e n d b y purchasing a nother-presu mably bonds that were slightly less in demand and that therefore yielded slightly h igher interest rates. Thus, the fund would earn a spread, j ust l i k e a bank. Though this description is high ly simplified, Long-Term, b y investing in the riskier ( meaning h igher-yielding) bonds, would be in the busi­ ness of " providing liq uidity " to markets. And what did ; 1 ha nk do bur provide liq uidity ? Thanks to Merton, the nascent hedge fu nd began to think of itself in grander terms.

HEDGE FUND

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Unfortunately, Merton was of l ittle use in sel ling the fu nd. H e was too serious- m i nded, and he was busy with classes at l la rvard . But in the summer of 1 9 9 _), J . \1. recruited a second academic star: M yron Scholes. Though regarded as less oi a heavyweight by other aca­ demics, Scholes was better known on Wa l l Street, thanks to the Black-Scholes formula. Scholes had also worked at Salomon, so he, too, was close to the .\1eriwether gro u p . And with two of the most brilliant minds in finance, each said to be on the shortlist of Nobel candidates, Long-Term had the equivalent of M ichael J ordan and Muhammad Ali on the same tea m . "This was mystique taken to a very h igh e xtreme, " said a money manager who u ltimately invested in the fund. In the fa l l o f 1 9 9 ) , Merrill Lynch launched a madcap drive to recruit investors. Big-ticker clients were ferried by l imousine to .rvter­ rill's headqua rters, at the lower tip of Manhattan, where they were ,hown a presentation on the fund, sworn to secrecy and then re­ turned to their limos. Then , Merr i l l and various groups of partners took their show on the road, making stops in Boston, Philadelphia, ·Llllahas,ee, A tla nta, Chicago, St. Louis, Cincinnati, :Vt adison, Kansas City, D a l las, Denver, Los A ngeles, Amsterdam, London, !\1 adrid, Paris, Brussels, Zurich, Rome, Sao Paulo, B uenos Ai res, "li>kyo, Hong K ong, Abu Dhabi, and Saudi Arabia. Long-Term set a minimum of S 1 o m i l l i on per investor. The road show started badly. J . M . was statesma n l i k e hut reserved, as if afra id that anything he said would betray the grou p's secrets. " People a l l wanted to see J .M . , b u t J . M . never talked , " :VIerril l 's Dale Meyer gri ped. The understated Rosenfeld was roo low-key; he struck one in vestor as nearly comatose. G reg Hawkins, a former pupil of Merton, was the worst-ful l of G reek letters denoting al gebra ic 'ym­ bols. The pa rtners didn't know how to tell a story; they sounded like math professors. Even the fund's name lacked pi tzao:; only the earnest Merton l i ked it. In vestors had any nu mber oi reason' to shy away. M a n y were put off by J . M . \ unwill mgness to discuss his in­ vestment strategies. Some were frightened hy the prospective lever­ age, which J . M . was careful to disclose. Institutions such as the Rockefeller Foundation and Loews Corporation bal ked at paying such h igh fees. Long-Term\ ent i re premise seemed u ntested, espe­ cially to the consultants who adv ise institutions and w h o decide where a lot of money gets invested . .

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WHEN G E N I U S FAILED

Meriwether, who was continua l l y angli ng to raise Long-Term's pedigree, went to Oma ha for a steak dinner with B u ffett, knowing that if Bu ffett i n vested, others would, too. The jovial b i l l ionai re was his usua l self-friendly, encouraging, and perfectly unwi lling to write a check . Rebu ffed by the country's richest investor, .J.!\1 . approached Jon Corzine, who had long envied !\1eri wether's unit at Salomon and who was trying to build a riva I business at Goldman Sachs. Corzine dan­ gled the prospect of Goldman's becoming a big in vestor o r, perhaps, of its ta king Meriwether's new fund in- house. Ultimately, it did nei­ ther. Union Bank of Switzerland took a long look, bur it passed, too. Not winning t hese big hanks hurt. Despite his bra v u ra, J . \1 . was worried a bout being cur out of the loop at Salomon. He badly wanted an i nstitution a l anchor. Turning necessity to advantage, J . M . next pursued a h a ndful of foreign ban ks to be Long-Term's quasi partners, to give t he fund an international gloss. Each partner-J. M . dubbed them " strategic invesrors "-wou ld invest $ 1 0o m i l l i on and share inside dope a bout irs local marker. I n theory, at least, Long-Term would reciprocate. The plan was pure Meriwether, flattering potentia I in vestors by ca ll­ ing them " strategic." Merton loved the idea; it seemed to val idate his theory that t he old institutiona l relationships could he overcome. It opened up a second track, with .J . M . independently courting foreign banks w h i le Merri l l worked on recruiting its clients. \1erril l moved the fund-ra ising forward by devising an i ngenious system of " feeders " that enabled Long-Term to solicit fun ds from in­ vestors in every imaginable tax and legal domain. One feeder was for ordinary U.S. investors; another for tax - free pensions; another for Japanese who wa nted their profits hedged in yen; sti l l another for Eu­ ropean institutions, which cou ld i nvest only in shares rhar were listed on an exchange (this feeder got a dummy l isting on the Irish Stock Exchange ). The feeders didn't keep the money; they were paper condu its that channeled the money to a central fund, known as Long-Term Capital Portfolio ( I TCP), a Cayman Islands pa rtnership. for a l l practical purposes, Long- · l erm Capital Portfo lio was the fund: it was the en­ tity that would buy and sell bonds and hold the a�set s. The vehicle that rail the fund was Long-Term Capita l Management ( lTCM), a l kLlware partnership owned by J. M . , h i s partners, and some of their

HEDGE FUND

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spouses. Though such a compl icated organization might have di�­ suaded others, it was welcome to the partners, w ho v iewed their a bi l­ ity to st ruct u re complex trades as one of their advantages over other traders. Physica lly, o f course, the partners were nowhere ncar either the Caymans or Delaware but in offices in Greenwich, Connecticut, and London. The partners got a break j ust as they started the m arketing. They were at the o ffice of their lawyer, Thomas Bell, a partner at Simpson Thacher & B a rtlett, when R osen feld excitedly j um ped up and said, " Look at this! Do you sec w hat Salomon did? " He threw down a piece of paper-Sa lomon's earnings statement. The bank had finally decided to brea k out the earni ngs from Arbitrage, so Long-Term could now point to its partners' prior record. Reading between the lines, it was clear that J. M. \ group had been responsi ble for mmt of Salomon\ previous profits-more than $ 5 00 m i l lion a year during his last five years at the firm. l lowever, even thi� was not enough to persuade i nvestors. And despite Merrill's pleading, the pa rtners re­ mained far too tight-lipped about their strategies. Long-Te rm even re­ fused to give examples of trades, so potential investors had l ittle idea of w ha t the pa rtners were proposing. Bon d arbitrage w a s n 't widely understood, a fter all. Edson .\1 itchell, the chain-smoking .\-terrill execut ive who oversaw the fund-ra ising, was desperate ior J . :V1 . to open up; it was a s if J . :Vl . had forgotten that he was the one asking for money. Even i n private sessions with \:1 itchell, J . \1 . wouldn't reveal the names of the banb he was calli ng; he treated every deta i l l i ke a state secret. With such a guarded client, Mitchell couldn't even sell the fund to h i s own bos>es. Although M itchell suggested that Merri l l become a strategic pa rtner, David Koman�k y, who oversaw capital markeh for :\1errill, warily refused. He agreed to in vest :V1erri l l's fcc, about 5 1 5 m i l lion, but ba l ked at p utting in more. At one poi n t d ur ing the road show, a group including Scho les, l lawkins, a nd some .\terri l l people took a grue l i ng trip to Indi­ anapol is to visit Conseco, a hig in�ura nce company. They a rrived ex­ hausted . Scholes started to talk about how Long-Term could make bund les even in relatively efficient mMkets. Suddenly, A ndrew Chow, a cheeky t h i rty-year-old derivatives trader, blurted o ut, "There a ren't that many opportunities; there is no way you can m a ke that kind of money in Treasury markets." Chow, whose academic credentials con-

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WHEN GENIUS FAILED

si!>ted of merely a master's in fi nance, seemed not at all a wed by the famed Black-Scholes inventor. Furious, Scholes angled forward in his leathn-backed chair and said, "Yo u' re the reason-beca use of fools l i ke you we can . " " The Conseco people got hu ffy, and the meeting ended badly. �terri l l demanded that Scholes apologize. Hawkins thought it was h i la rious; he was holding h i s stomach laughing. But in truth, Scholes was the fu nd's best !>a lesm;l n . I n vestor-; at least had heard of Scholes; a couple had even taken h i s class. And Scholes was a natural raconteur, temperamenta l hut extroverted. He u!>ed a vivid metaphor to pitch the fu nd. Long-Term, he e x p l a i ned, would be earning a tiny spread on each of tho usands of trade,, as i f i t were vac u u m i ng up nickels that others couldn't see. He would pluck a n ickel seemingly from the sky as he spoke; a little show­ manship never h u rt. Even when it came to the fund\ often a rcane dera il,, Scholes could glibly waltz through the math, lea v i ng most of h i -, prospects feel i ng l i k e humble students. "They used � yron to blow you away, " said Maxwell Bubl itz, head of C : onseco's in vest ­ ment
HEDGE FUND

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35

o f \:a im, collected Larry H i l i brands, who never pay more, never pay less than any security i s " worth . " Accordi ng ro Victor :'\! iederhoffer, who studied with Scholes at Chicago and would l a ter blow up an investment firm of his own, Scholes was part of a " R andom Wa lk Cosa l'\ostra, " one of the disciples who methodically rejected any suggestion rhar ma rkers could err. Swarthy and volu ble, Scholes once lectu red a real estate agent who u rged him ro buy in l lyde Pa rk, ncar the uni versity, and who cla imed that housing prices in the a rea were supposed to rise by 1 2 percent a ye.1r. If that were true, Scholes shot hack, people would buy a l l the houses now. Despite h i s credo, Scholes was never fully con v in\:ed that he couldn't beat the m arket. I n the late 1 ') hOS, he put his S;l l a ry i nt o stocks and borrowed ro pay his l iv i ng expenses. When the ma rket plummeted, he had ro beg his hanker for an extension to avoid being forced to sel l at a heavy loss. Even tua l ly, his stocb recovered-not the last rime a Long-Term p;l rtner would learn the value of a friendly banker. ' ' While �1crton was the consumm;lte theoret ician, S\: holes was ac­ cla imed for finding i ngen ious ways of testing theories. I l e was ;l'> ar­ gumentative a s Merton was reserved, feverishly promoting one brai nstorm a fter the next, most of wh ich were unl ikely to sec the light of day hut which often o;howed a creative spark. With his practical bent, he made a real comribution to Salomon, where he set up a derivative-trading subsidia ry. And Scholes was a foremost e xpert on tax codeo;, both in the United State'> and overseas. He regarded ta xes as ;1 vast i ntel lectual game: " No one actually {hi)'S taxes, " he once sna pped d i sd a i n fu l l y. ' Scholes could n ot believe there were people who would not go to extremes to avoid paying ta xes, perh aps because they did not fit the Ch icago School model of human beings a s eco­ nomic robots. At Long-Term, Scholes was the spea rhead of a clever plan that let the partners defer thei r cut of the profits for up ro tcn years in order ro put off pa ying taxes. He h;l rangued the a ttorneys with det a i l s, hut the partners tended to forgive his hot fl a shes. They were cha rmed by Scholes's energy and joie de vi vre. He was perpetu­ ally rei n venting h imself, tak ing up new o;port'> o,uch as s k i i n g an d-on account of M e ri wether-golf, which he pla yed with passi on. With Sch o les on board, the marketing campa ign gradually picked up stea m . The fu nd dangled a tantalizing plum before i nvestors, who were told that annual returns on the order of '\O percent ( a fter the partners took their fees) would not be out of reach . M o reover, though

36

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WHEN GENIUS FAILED

the partners stated dearly that risk was involved, they stres�ed that they planned to diversify. With their portfolio spread a round the globe, they felt that their eggs would be safely scattered. Thus, no one 'inglc market could pull the fund down. The partners doggedly pursued the choice'it in vestor!>, often invit­ ing prmpects hack to their pristine headquarters on Steamboat Road, at the water's edge in Creen wich. Some in vestors met with pa rtners a' many as seven or eight times. In their casual khakis and golf s h i rt,, the partners looked supremelv confident. The fact was, they had m�Jdt• a ton of m oney at Salomon, and in vestors wa rmed to the idea that rhev could do it again. In the face of s uch i ntel lect ual brill tance, investor>-having little understa nding of how .\1eriwether's gang ac­ ru a l l v operated-gradually forgot that thev were taking a leap of Llith. "This was a constel lation of people who knew how to make money." Raymond Baer, a Swiss hanker (�111 d eventual i n ve!>to r ) , noted. l h the e n d of 1 9 9 ) , comm itments for money were starting to roll in, ncn tho ugh the fund had not yet opened and was wel l behind sched ule. The partners' morale got a hig boost when l l i l i brand finallv defected from Sa lomon and joined them . .\1erton and Scholes might have added m �1 rketing l uster, hut l l il ibrand was the guy who would make the cash register si ng. j. .\1 . also offered partnerships to rwo of his longtime golfing cro n i es, Richard E Leahy, an executive ar Salomon, and J ame!> J . :V1cFntee, a close friend who had fo unded a bond-dea ling fi rm. :'\Jei­ rher fit the mold of Long-Term's nerdy trader>. Leah y, a n a ffa ble, eawgoing salesman, would he ex pected to deal with Wa ll Street ban kers-nor the headstrong traders' strong suit . .\1cEnree\ role, though, was a puzzle. A fter sel ling his business, he had l i ved in h igh !>tyle, commuting via hel icopter to a home in the Ha mpton' and jet­ ting to an island in the Grenadi nes, w h ich had earned him the <,ohri­ q uet "the Sheik . " In contrast to the egghead a rbi trageu rs, the Bron x-horn M c E ntee was a tradition a l i st who traded from his gut. But Meriwether l i ked having such friends a round; h.mtning with these pals, he was rela xed and even grega rious. 1\:ot comudcnra l l y, Leahy and McEntee were fellow I rish Americuh, .1 gro u p with whom J . M . always felt at home. Each was a lso
HEDGE FUND

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:17

David W. M ul l ins, vice chairman of the U . S . Federal Re�erve and sec ond in the Fed's h ierarch y to Alan Greenspan , the Fed chai rm;In. Mullins, too, was a former student of !\1erton\ at ,\1 1T who had gone on to teach at H a rvard, where he and R osenfeld had been friends. As a centra l hanker, he gave Long-Term incomparable access to interna­ tional bank>. Moreover, M ul l i n s had been the Fed's point man on the Mozer case. The implication was that Meriwether now had a clean hill of health from Washington . M u l l ins, l i ke Meriwether a onetime teenage i n vestor, was t h e son of a University of Arkansas president and an enormously popular lec­ turer at H arvard. I ronica l l y, he had la unched h i s career in govern­ ment as an e xpert on financial crises; he was e xpected to he Long-Term's disaster guru if markets came unstuck aga i n . A ftt:r the I 9 X 7 stock ma rket crash, M u llins had helped write a hl ue-ri bhon White l lo u'>C report, laying su bstantial blame on the new derivati ve� ma rkets, w here the snowball sel l i ng had gathered momentu m . Then he had j o i ned the Treasury, where he had helped d raft the law to ha il out the count ry's bankrupt savings and loans. As a regulator, he was acutely aware that markets-far from being perfect pricing ma· chi nes-periodica l l y and dangerously overshoot. "Our fi nancial sys· tem is fast-paced, enormously creative. It\ designed to have ncar mi sses with some freq uency," he remarked a yea r before j u mping sh ip for Long-Term. With more omn iscience regarding h i s futu re fund than he could have dreamed, M ul l i n s argued that part of the Fed\ mission should he saving private institutions that were threatened by " l iq u idity p roblems. " ''' Wry and soft-spoken, the intel lectual M u ll ins d ressed l i ke
38

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WHEN G E N I U S FAILED

bank to invest $ r 00 million. su�h entities simply do not invest in hedge funds. But Pierantonio Ciampi�ali, who oversa w investments for the Italian agen�y, thought of Long-Term not as a " hedge fund" but as an elite i nvesting organization " with a solid reputation . " ' Private in vestors were similarly awed b y a fund boasting the best minds in finan�e and a resident central hank er, who plausibly would he a step ahead in the obsessive Wa l l Street game of trying to outguess Greenspan. The li st was impressive. In Japan, Long-Term signed up Sumitomo Bank for $ I oo million. In E urope, it �orra l led the giant Germa n Dresdner Bank, the l .ie�hten stein Global Trust, and Bank J u l i u s Baer, a private Swiss bank that pit�hed the fund to its m i l l ion­ a i re cl ientele, for sums ranging from $ ) o million to $ r oo m i l l ion. Re­ rubli� :-..; e w York Corroration, a se�retive organization run by internationa l hanker Edmond Safra, was mesmerized by Long-Term's credentials and sedu�ed by the possibi lity of winning busi ness from the fund. ' ' It i nvested $6 5 mil lion. Long-Term also snared Ban�o Garantia, Brazil's biggest investment bank. In the United States, Long-Term got money from a di verse group of hotshot �elebrities and institutions . .VI i�hael Ovitz, the Hol lywood agent, in vested; so did Phil K night, �hicf exe�utive of N i ke, the sneaker giant , a s well as partners at the elite �onsulting firm ,\kKin­ sey & Company and i\ew York oil exe� utive Robert Belfer. Ja mes Cayne, the �hicf exe�utive of Bear Stearns, figured that Long-Term would make so mu�h money that its fees wouldn't matter. Like oth­ ers, C :ayne was �omforted by the will ingness of .J . M . and his rartners to invest $ q 6 mill ion of their own. ( Rosenfeld and others put their k ids' money in, too . ) A�ademe, where the professors' hrillian�e was well known, was an easy sel l : St. .John's Uni versity and Yes h i va Uni­ versity rur in $ I o million ea�h; the Uni versity of Pittsbu rgh �limbed aboard for half that. I n Shaker H eights, Paragon Advisors put its wealthy clients into Long-Term. Teren�e Sullivan, president of Paragon, had read \1erton and s�holes while getting a business de­ gree; he felt the operation was low risk. ''' In the �orporate world, Pai neWebber, thinking it would tap Long­ Term for in vesting ideas, in vested $ I oo mil lion; Donald M arron, its �hairman, added $ r o million personall y. Others in�l uded the Bla�k & Dc�ker Corporation pension fu nd, Continental Insura nce of \: e w York ( later a�q u i red by Loews), ;l nd P re o; i d e n t i al [ . i fe ( :orpor.l ! i o n . Long-Term opened for hw, i ne'' ; H r ill' e n d o f h·hru.1rv 1 ') ') -1 . :\kri-

HEDGE FUND

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wether, Rosen feld, Hawkins, and Lea hy celt:hrated h y p u rchasing a shi pment of fine Burgundies a m plt: enough ro last for years. I n addi­ tion ro its elt:ven partners, the fund had about t h i rty traders and clerks a n d $ 1 o mill ion worth of SPA RC: \\'ork stations, the powerful Sun \:l icrosystems machines favored by traders and engi neers. Long­ Term\ fund-raising b l i tz had nerred S t . 2. 5 bill ion-well short of J. M . \ goa l hut sti l l the largc�t st
ON THE RUN They f l .ollg - ' l i·rmf are in

eff(•ct

the

lies/ fhz.111ce t:u-u!tv 111

t h e U'ur!d.

-- /\' \ l l / 1 / f ( ) \ .-\ / I '\ \ 'I S / ( ) N

on Long-T�.:rm. I l a ving raised capital d u ring the ti mes, it put its mont:)' to work just t u rn rurhu lenr. When price\ a rc fla t, trading i-; a d u l l sport. When price!> begin to gy­ rate, it IS as if l ittle eddie\ and cu rrents begin to bubble in a formerly placid ri ver. This security i' dragged with the cu rrent, that one is wash�.:d upstrea m . Two bonds rhar once journeyed happily in tow a rc now wrenched apart, and onct.: pred ictable 'pread' arc j olted our of sync Sudden ly, investors feel cast
T hc\t

Of

ll

c

ON THE RUN

•

41

C n:cnsp�1n stunned Wal l Street b y ra ising short-term interest rate�. It was the fi rst s uch h i ke in fi ve years. But if the orac ular Fed chid had in mind c a l m i ng ma rkets, the move backfired. Bond prices t u mbled ( bond prices, of cou rse. move in the opposite di rection of i nterest rates ) . And given the modest nature of ( ; rcenspan's q ua rter-point in­ crease . bonds wen· fa lling more than they "should" have. Somebody was desperate to sel l. By \by, bare l y two months a fter Long-Term's debut, the thirty· vcar Treasury bond had plunged I 6 percent from its recent peak-a huge move i n the relatively ta me world of fixed-income secu rities­ rising in vield from i'i . 2 percent to 7 . i'i percent. Bonds in Furopc were crashing. too. Di verse in vestors, including hedge funds-many of which were up to their necks in debt-were fleeing from bonds. \lichacl Steinhardt, one such leveraged operator, watched in horror. Stei nh ardt, who had bet on F uropean bonds, was losing $7 milli on with cverv h111zdredth of a percentage point move in interest rates. The �washbuckling Steinhardt lost $ Hoo mill ion of his investors' moncv in a mere iou r days. Ceorge Soros, who was j o l ted lw a rico­ chet effect on internationa l cu rrencies, dropped S i'i s o m i l l ion for his clients in two days.' For \ l eri wcther, this tumult was the best of news. One morning d uring the heat oi the sell ing, J . M . wal ked over to one of his traders. Glancing a t the trader's screen, .f . \1 . marveled, " I t's wave a fter wave oi guy' throwing in the towe l . " As J . \l . knew, panicky investors wou ldn't be picky as they ran for the exits. In their eagerness to sel l, they were push ing spreads wider, creating just the gaps that :\ lcri ­ wcthcr was hoping to ex ploit. "The u n usually h igh volatility in the bond markets . . . has genera l l y been associated with a widen ing of spreads, " he chi rped in a-ior h i m-unusually revealing letter to in­ vestors. "This widening has created further opportunities to add to I TC:P\ convergence and relative-v a l u e trading posit ion,." A fter two flat months, Long-Term rose 7 percent in \l av, hegm n i n g a stretch of heady profits. It would hardly have ocn1rrnl to .\kriwcther that Long-Term would ever switch places with some oi those pan icked, overleveraged hedge fu nds. But the bond debacle of I 994, which un­ folded d u ring Long-Term\ very first months, merited Long-Term\ close attention . Commentato rs began to sec a new connectedness in i nternational bond markets. The Wall Street .fuunhzl observed that " i mplosions in

42

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WHEN G E N I U S FAILED

seemingly un related ma rkets were reverberat ing in the U .S. Trea sury bond marker. " ' Such disparat e development s as a slide in E u rope;J n bonds, new-; of t rading losses at Ban kers Trust, t h e col lapse of Askin Capit a l ,\1a nagemenr, a hedge fund t hat h;ld special ized in mortgage t rades, and t he assassi nat ion of Mexico's leading president i a l con­ render all accent uated t he slide in U . S . Trea surys t h at had begun wit h Greenspan's m odest adj ust ment . Suddenly m a rkets were more closely linked-a development wit h pivot a l sign i ficance for Long-Term . It meant that a trend i n one m;H­ ket could spread to t h e next . An i solat ed slump could become a gen­ eralized rout . Wit h deri vat ives, which could be cust o m -t a i lored t o a n y marker of one's fancy, it was a snap for a speculat o r in 1\ew York to t ake a fl ier on J a pan or for one in Amsterdam to gamble on Brat.il-ra ising t he prospect t hat t ro u ble on one front would leach int o t he next . For t raders tethered to elect ronic screens, t he dist inc­ t ion het wcen m a rkers-say, bet ween mortgage.., in America and gm·­ ernmcnr loans in Fra nce-almost ceased to exist . They were a l l points on a cont i n u u m o f risk, st itched toget her by derivat ives. Wit h t raders scrambling to pay back debts, Neal Sos,, an economist at Credit Suisse Fi rst Boston, expla ined to t h e .fuunhli, " You don't sell what you should. You sell what you can . " By leveraging one secu rit y, in­ vest ors had potentially given up cont rol of all o f t heir ot hers. This verity is well worth remembering: t he securit ies m ight he u n related, hut t he same investo rs owned t hem, i m plicit l y link ing t hem in t imes of st ress. And when armies of fi nancial sold iers were involved in t he same securit ies, borders shrank. The very concept of safet y t h rough di versificat ion-t h e basis of Long-Term\ own securit y-would merit ret h inking. St einhardt blamed his losses on a sudden n·aporation of " l iquid­ ity," a term t h at would be on Long-Term\ l i ps in years to come.' But " l iquidit y " is a st raw man. Whenever ma rkers plunge, investo rs arc stu nned to fi nd t h at t here arc nor enough buyers to go around. A s Keynes observed, t here cannot h e " l i q u idit y " for t h e com m unit y as a whole.'' The mist a ke is in t h inking t h at market s have a d ut y to st a y liquid or t h at buyers will a lways b e present t o accommodate sel l­ ers. The real culprit in 1 9 9 4 was leverage. I f you aren't in debt , you can't go broke and can't be made t o sel l , in which use " l i q u i d it y " is i rrelevant . Bur a leveraged firm may be jiJr,·cd to sell, lest fast ­ accu mulat ing losses put it out of business. l .cvL'LlgL' . J ! w;J y s g•n·s rise

ON THE RUN

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43

ro this �a m e brutal dynamic, a n d its dangers cannot be strcs�ed roo often. Long-Term wa� doubly fort unate: �preads widened before it in­ vested much of its capital, and once opportuni ties did arise, Long­ Term w�1s one of a very few firms in a position to exploit the genera l di�tre�'i. And its trade� were good trades. They weren't risk-free; they weren't s o good that the fu nd could leverage indiscri m in a te l y. But hv and large, they were intell igent and opportunistic. Long-Term started to make money on them a l most i m mediately. One of its fi rst trades in volved the same rhirty-vear Treasury bond. Trea� un s ( of all du rations) are, of course, issued by the l i . S . govern­ ment to fi n a nce the federa l budget. Some S 1 70 bill ion of them trade each dav, and they arc con�idered the lca�t risky i nvestment� in the world. Bur a fun n y thing happen� to t h i rty-yea r Treasurys �ix month� or '>O a fter they are issued: investors stuff them into safe� and dr:l\v­ ers for long-term keeping. With fewer left in circ ulation, the bonds become h a rder to trade. Meanwhi le, rhe Treasury i�sues a new thirty­ n·�u hond, wh ich now has irs day in the sun. O n Wa l l Street, the older bond, which has �1 bout 2.9 'f, years left to m a tu re, is k nown a� o/1 the ru11; the shiny new model is on the ru11. Being lcs� l i q u id, the off-the-run bond is considerl·d lcs� dcs1rahlc. l r hegim to trade at a sl ight discount ( that is, you G111 p u rcha�c it for ,1 link· le�'>. or at what amou nts to a s l ightly higher interest viel d ) . As arbitrage ur'> would -,av, ;1 spre;1d opens. In 1 994, Long-Term noticed that this spn:ad was u n usually wide. The 1-ehrua ry 1 99 .l issue was trading at a y ield of 7 . _:; h percent. The bond i-;sucd si x months later, in A ugust, was yielding only ' · 2.4 per­ cent, or 1 2. basis puilzts, les�. Fvcrv Tuesdav, Long-Term's partners held ,1 risk-ma nagcmem meeti ng, and ar one of the early meetings, severa l proposed that they her on this 1 2.-point gap to n;urow. It wasn't enough to say, "One bond is chea per, one bond is dearer. " The profe�sors needed to know zl'lry a spread existed, wh ich m ight shed light on the paramount i-,suc of whether it was l i kely to persist or even to widen. I n this case, the �pre�1d �eemed al most sil ly. After a l l , t h e U.S. government is no less likely to p a y off a h o n d t h a t mature� in 2.9 '/ years than it is one that e xpires in thi rty. But some in stitutions were so t i m id, so bureaucratic, that they refused ro own anything hut the most l i q uid paper. Long-Term bel ieved that many opportun ities arose from m a rket distortions created by the sometimes a rbitrary de-

44

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W H E N G E N I U S FA I L E D

mands of institutions. - The latter were w i l l ing to pay a pre m i u m for on-the-run pa per, and Long-Term's pa rtner>, who h;ld often done thi> trade at Salomon, happily collected it. They cal led it a "snap trade," hecau>e the two bonds usually sna pped together a fter only a few months. In effect, Long-Term would be collecting a fee for its will­ ingness to own a less liquid bond. "A lot of our trades were liquidity-providing," R osenfeld noted. "We were buying the st u ff that everyone wanted to sel l . " I t a ppar­ ently did not occu r to Rmenfeld that >ince Long-Term tended to buy the le>s liquid security in every m a rket, its ;lssets were not ent i rely in­ dependent of one another, the way one dice roll i> i ndependent of the next. Indeed, its assets would he susceptible to fa ll ing in u n i son if a time came when, l iterally, "everyone" wanted to sell . •

Twelve basis points is a tiny spread; o rdinari ly, it wou ldn't he worth the trouble. The price di fference was only S I 5 .Xo for each pair of S 1 ,ooo bonds. Even i f the spread n a rrowed two thirds of the way, say in a few months' time, Long-Term would earn on lv $ 1 o, o r 1 percent, on those $ 1 ,ooo bonds. But what i f, using leverage, that tiny 'ipread could he m ultiplied? What if, indeed ! With such a str he sure, they weren't l i k el y to lose very m uch of it. Since they were buying one bond and -,elling ;l llother, they were betting only that the bond-; would con verge, and, as noted, bond spreads vary m uch les'i than bonds themselves do. The price of your horne could crash, hut i f it doe>, the price of your neighbor's hou<;e will li kely crash as well. Of cour>e, there was some risk that the spread could w iden, at least for a brief period. If two bonds traded at a 1 :!.-point spread, who could say that the spread wou ldn't go to 1 4 points-or, in a ti me of e x t reme stress, to 20 poi nts ? Long-Term, with trademark precision, calculated that owning one bond and shorting a nother was one twenty-fifth as risky a s owning either bond outright.' Thus, it reckoned that it could prudent l y lever­ age this long/short arbitrage twenty-five ti mes. This m u l ti p l ied its po­ tential for profit h ut-as we have 'ieen-also its potential for lo>s. I n any case, borrow it d i d . It paid for t h e cheaper, off-the-run bonds

ON THE

RUN

•

4 !:>

with money that i t borrowed from a Wal l Street bank, o r from -; n ­ cral banks. And the other bonds, the ones it sold short, it o btained through a loan, as well . Actually, t h e tra nsaction w a s more involved, though it w a s a mong the simplest in Long-Term's repertoire. No sooner did Long-Term buy the off-the-run bonds than it loaned them to some other Wal l Street firm, w h ich t hen wi red cash to Long-Term as collatera l . Then Long-Term turned a round and u sed this cash as collateral on the bonds th a t it borrowed . On Wal l Street, such short-term, collatera l­ ized loans a rc known as "repo financing." The beauty of the trade was that Long-Term's cash tran sactions were i n perfect balance. The money that Long-Term spent going long ( buying) m a tched the money it collected going short ( selling). The collateral it paid equa led the colla teral it collected . In other words, Long-Term p u l led off the enti re $ 2. bill ion trade without usinR a dime

of its Oll'n cash.

''

N ow, normal ly, when you borrow a bond from, say, �terril l Lynch, you h a ve to post a l ittle bit o f extra collatera l-maybe a tota l of S I ,O I O on a S I ,ooo Treasury a n d more on a ri skier bond. That $ 1 0 initial m a rgin, equivalent to 1 percent of the bond's val ue, is called a haircut. I t's Merri l l Lynch's way of protecting itself in case the price o f the bond rises. The h a i rcut naturally acts as a check on how m uch you can trade. Bur if you could avoid the haircut, well, the sky would be the l i mit. It would be like driving a car that didn't burn gas: you cou l d drive as far as you wished. What's more, the rare of return would be s ubstan­ tially h igher-if you didn't h a ve that extra margin tied up a t .\1erri ll Lynch. And from the very start, it was Long-Term's policy to refuse to pay the hai rcut or else to substa nt i a l l y rcdun: i t . The policv surely flowed from Meriwether, who, for all his uuassunung charm, was fiercely competitive at trading, golf, h i l l i a rd-,, h o rst''>,
"·

:'vlaintaining the l'' "ition wasn't complete!� u "t tree. Though .1 -,im ple

trade, ir actually enta iled four di fferent pavnll'nt st rt\l llls. l .ong·· l crm o>llectcd interest on the collateral it paid our and fJ
.1

-;lightly higher rate)

on the collateral it took in. It made some ot rhis de tiut hack hec.wse it collected the 7 · _> 6 percent coupon on the bond it owned .1nd paid tlw lesser ; . 2...f percent rate on the bond it shorted. Overall, it cost l .ong-Term a few basis poi nts momh.

a

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W H E N G E N I U S FA I L E D

touched. Rosen feld and Leahy, two of the more conge n i a l and laid­ back partners, were usually the ones who met with ba nks, though H i l i brand also got in volved. In any case, the partners w o u ld insist, politely b ut fi rmly, that the fund was so well heeled that it didn't need to post an initial m a rgin-and, what's more, that it wouldn't trade with anyone that saw matters d ifferently. :V1crrill Lynch agreed to waive its u!>ual h a i rcut req u i rement a nd go a l ong. So did Goldman Sachs, .J . P. !\!! o rgan, M organ Sta n ley, and j ust about everyone else. One firm that bal ked, PaineWebber, got v i rtually none of Long­ Term\ husine,s. " You had no choice if you were going to do business with them, " reca l led Goldman Sachs's .Jon Corzine, J . M . 's a d m i ring riva l . Although Long-Term's trades could b e insanely complex a n d ulti­ mately num bered i n the thousands, the fund had no m ore than a dozen or so major strategies.·· Some, such as the Treasury arbitrage, invol ved buying and sell i ng tangible securities. The others, derivative trades, did not. They were simply bets that Long-Term made with hanks and other counterparties that h i nged on the fate o f various market prices. I magine, b y i l l u stration, that a Red Sox fan and a Ya nkees ian agree before the season that each w i l l pay the other $ 1 ,ooo for every run scored by h is rival's tea m. Long-Term's derivative contracts were not dissi m i l a r, e xcept that the payoffs were tied to movements in bonds, stocks, and so forth rather than halls and stri kes. The�e de­ rivative obl igations did not appear on Long-Term\ bala nce sheet, nor were they "debt" in the formal sense. But if ma rkets moved aga inst the fund, the result would obviously he the same. And Long-Term genera l l y was able to forgo paying in itial m a rgin on derivative deals; it made these bets without putti ng u p any initial capital wha tsoever. Freq uently, though not always, it got the same terms on repo fi­ nancing of actual secu rities. Also, Long-Term often persuaded hanks to lend to it ior longer periods than the hanks gave to other funds. '" Thus, Long-Term could he more patient. Even i f the hanks had wanted to call in Long-Term's loans, they couldn't have done so very q uickly. "They had everyone over a ba rrel," noted a sen ior executive at a top in vestment bank. This was where Meriwether's ma rketing strategy real l y paid divi­ dends. I f the hanks had given it a moment's thought , they would have l<'. d i !<'d t h t t I ong 'I(-rm was ;lt their na-rcv. Bur thl' b;t n k s s;t w the .

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4 '/

fund nor as a credit-hungry sta rt- up hut as a l uminous fi rm of cek brared schola rs and bri lliant traders, something l i k e that 1\ew AgL· " financial i ntermediary" con j u red up hy \1erton. A fter all, it W;J', genera l l y bel ieved that Long-Term had the benefit of superior, virtu ­ a l l y fa il-safe technology. And han k s, like some of the press, casually assumed that it was so. Business Week gushed that the fund's P h . D . � would g i v e rise t o "a new computer a g e " on Wa ll Street. " !\ever h a s this m uch academic t alent been g i v e n this much money to h e r with," the magazine o bserved in a cover story published during the fund's fir•;t year. " If a new age was comi ng, no one wanted to miss ir. Long­ Term was as fetching as a debuta nte on prom nigh t, and a l l the banks wa nted to dance. The banks had no trouble rationalizing their easy credit terms. The hanks did hold col lateral, after all, and Long-Term genera lly serried up ( i n cas h ) a t the end of each trading day, col lecting o n w i n ners and paying on l osers. And Long-Term u•as flush, so the risk o f irs fa il ing seemed slight. Only i f Long-Term lost money with unthin k able suddenness-o n l y i f, say, it was forced to dump the m a j ority of irs as­ sets all at once and into an i l l i q u i d ma rket-would the value of the bankers' collateral be threatened and would the banks them�el ves be exposed to l osses. Also, m a n y of the hanks' heads, such as Corzine and .Vlerri l l Lynch's Tu l l y, l i ked Meri wether personally, which tilted t h e i r orga n i ­ zations i n Long-Term's favor. Bur Long-Term's real sel l i n g poi n t was its connections to other powerful traders around the world. A firm that did busi ness with Long-Term m ight gai n valuable i n side k n owl­ edge-tota l l y legal i n the bond world-a bout the flow of markets. " How do you get people to come to your party ? You tell them that every cool person in town is com ing," said a ba nker i n Zurich who fi na nced Long-Term with a zero percent haircut. " So everyone said, 'OK, I'll do it, hut i f anyone else gets a ha ircut, I get one too."' This was espec i a l l y clever of Long-Term. The partners could say to each new bank, " I f we give you a ha ircut, we have to give it to everyone . " S o they ended u p giving it t o nobody. ( O n a small n umber of riskier trades they did agree to haircuts-but very skimpy ones . ) Since the banks, too, were doing arbitrage trading, .\leriwether viewed them, n ot u n j mtly, a s his m a i n competitors. ',' Long-Term re­ sembled other hedge funds such as Soros's Qu;uuu m Fund le�s than it did the proprietary desks of its hanks, such as Goldman Sachs. The

48

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W H E N G E N I U S FA I L E D

Street was slowly shifting from research and client services to the lu­ crative busi ness of trading for i ts own account, fostering a wary ri­ valry between Long-Term and its lenders. ! laving worked at a major Wa ll Street hank, J . .\1 . felt that invest­ ment hanks were rife with leaks a nd couldn't he trusted n ot to swipe his trade� for themselves. Indeed, most of them were plying sim i lar strategies. Thus, a s a preca ution, Long·Term would place orders for each leg of a t rade with a different broker. Morgan would see one leg, .\'t erri ll Lynch another, and Cold man yet a not her, h u t nobody would sec them a l l . Even Long-Term's la wyer was kept in the dark; he would hear the pa rtners speak about " trading strategy three," as though Long-Term were developing a nuclear arsenal. H i l i hrand, espec i a l l y, refused to give the banks ;1 peck a t h i s strate­ gies or to meet them ha lfway on terms. l ie would call a dealer, pur­ chase S 1 oo m i l l ion in bonds, and be off the phone in seconds. ' ' " l "m j ust concerned a bout margin req u i rement, and I'm not purring u p any margin," he bluntly told :Vlerrill Lynch. Kevin Dunlea vy, a Merrill Lynch salesman, sometimes cal led l l i l i hrand two or th ree times a day, trying to pitch strategies he had devised with the clever H i l i hrand in mind. But D unleavy was repeated ly frustrated by l li li hra nd\ obses­ sive -,ecrecy, wh ich made it nearly i m pos�ible to service the account. " Rarely cou l d you take your ideas and i m plement them into LTC:\1\ strategy, " noted D u nleavy, an unaffected :\cw Yorker with a m i l i tary brush cut. "It was very unusual, not to take input from the Street. La rry would never talk about the strategy. He would j u�t tell you what he wanted to do." The fund parceled out its business, choosing c-.1ch hank for partic­ ular services and keeping a distance from all of them. Chary of he­ coming dependent on any one hank, Long-Term tr<1dcd j u n k bomh with Goldman Sachs, government bonds ;md yen swaps with J. P. .\lorgan, mortgages with Lehman Brothers . .VIcrri l l Lynch was the fund's biggest counterparry in derivati ve-,, hut i t was far down the li�t in repo loans. ' I (> he sure, there was something shrewd a bout this divide-and-conquer strategy, for Long-Term did each set of trades with the hank that boasted the most specific expertise. B ut Long-Term rhus forfeited the benefits of a closer, ongoing relationsh ip. J. P. Mor­ gan, for one, was extremely curious a bout Long-Term and eager to de­ velop a closer working a l liance, hut it couldn't get past the fund's unwillingness to share confidences. "I low can vou propose ideas to

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49

them without k nowing what their appetite i s ? " wondered t h e head of risk management at a major Wal l Street firm. As arbitrageurs, the partners tended to sec every encounter as a discrete e xcha nge, with tallyable pluses and minuses. Every rclation�hip was a " trade"­ rcncgotiablc or revocable if someone else had a better price. The part­ ners' only close tics were U 'ithin Long-Term, mimicking the arrange­ ment within their beloved group at Salomon. They were a bred type-i ntel lectual, introverted, detached, con­ trol led. It didn't work to try to play one off aga in st the other; they were too m uch on the same wavelength. Andrew Sici l i ano, who ran the bond and c urrency depa rtments at Swiss Bank Corporation, was stunned by their uncanny closeness. One time, Sici liano cal led Vicror Haghani, the head of the London office, and followed up in C rccn ­ wich with J. �1 . and Fric R osen feld a month or two later. The American -based partners didn't miss a heat; Siciliano had the eerie feeling that he was cont in u i ng the same conversation he'd had with Hagh a n i . :\ o t t h a t there weren't tensions w i t h i n t h e fi rm. A s m a l l group­ j. .\1 . , H i l i brand, R osenfeld, and l laghan i-dominatcd the rest. A� at Salomon, compensation was skewed toward the top, with the i nner circle garnering more than half the reward-,. This gro u p al�o had vot­ ing con tro l . Lesser partners such as M y ron Scholes were forever an­ gling for m ore m oney, as well as more authority. But the i n ner circle had been together for years; as i n a family, their excl usive and i n bred a l l iance had became second nature. I f the firm could have been distil led i nto a single person, it would have been H i l i brand. While vetera n traders tend to he cynical and in­ secure, the resu l t of years of wrong guesses and n a rrow escapes, I I i ii­ brand was cool and madden ingly self-confident. An i ncredibly hard worker, he was the pure arbitrageur; he believed in the models, stuck to his prices, was u ntro u bled by doubt. Roscn kld hated to hedge by sel ling a fa l l i n g asset, as theory prc-,crihed; l l i l i brand {Jc/icl'ed and simply fol lowed the form. l l ili hra nd\ col leagues respected him im­ mensely; inevitably, they turned to him when they needed a q u ick read. He was highly articulate, but his answers were l ike u n refined crysta ls, d i fficu l t for novices to comprehend. " You could refract the light with La rry's mind," said Deryck .\1a ughan of Salomon Brothers. Like the other partners, hut to a greater degree, l l i l i brand saw every issue in black and wh ite. He was trustworthy and q u ick to take of-

50

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WHEN GENIUS FAILED

fense at perceived wrongdoing but blind to concerns o utside h is nar­ row sphere. I lis Salomon colleagues used to joke that, according to the libertarian l li l i brand, if the street in front of your home had a pothole you ought to pave it yourself. But money proba b l y meant less to him than to any of them. I le fou n d his passion in the i ntel lectual challenge of trading. Aside from his fam i l y, he showed interest i n l it­ tle else. If anyone brought I I i l i brand o u t of h imself a hit, it was J . .\1 . I l i l i hrand had a fi lial attachment to t h e ch ief, perhap� ste m m i ng from his close relationship to his own father. Rosenfeld had a s i m i l a r de­ votion to .\1eriwethcr. Outsiders couldn't q u ite explain J . M . 's hold on the gro u p. He was a n u n l i kely star, too bashful for the l i melight. He spoke in fragments and seemed uncomforta ble making eye contact. ' ' He refused to talk a bout his personal life, even to close friends. After orga nizing Long­ Term, J . M . and his wife moved out of Manhattan, to a $ 2 . 7 m i l lion, si xty-eight-acre estate in :'-Jorth Salem, in Westchester County-com­ plete with a I 5 ,ooo-square-foot heated i ndoor riding ring for .\1 i mi . ' ' The estate was set back three q u a rters o f a m i le o n a private drive that the .\1eri wcthers shared with their o n l y neigh bor, the entertainer David Lerterrnan. As if to make the property even more private, the .�1 criwethers did extensive remodel i ng, fort i fying the house with stone. j . .\1 . l iked to control his pri vate l i fe, a s i f to shelter it, roo, from un wanted volatil ity. Though he attended a ch urch ncar home and made sever. rood meant l i ttle to them. J . M . , .\1erton, and Scholes ( the latter two beca u se they didn 't

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�I

trade) had pri vate offices, but J . M . was usually on the trading floor, a mahogany-paneled room that looked out through a ful l -length pic­ ture window to the water, resplendent and often spec kled with sail­ boats. A side from the natty M u ll i n s, the partners dressed casu a l l y, in Top-Siders and chinos. The room h um med with trader talk, but it was a controlled hum, not like the chaos on the cavernous :\'ew York trading floors. Only occasiona l l y did the partners revert to their past l i fe for a few rounds of liar\ poker. Besides the Tuesday risk meetings, which were for pa rtners only, Long-Term had res<:arch sem inars on Wednt:sday morni ngs that were open to a s�ociat<:s and usua l l y a nother meeting on Th ursday a fter­ noons, wh<:n partners would focus on a specific trade. M <:rton, usu­ ally in Cam bridge, would join i n by telephone. The �hared close quarters fost<:red a fi rm togetherness, but the associat<:s and even some of the pa rtner� k new they cou l d never be part of th<: inner cir­ cle. One j u nior trader perp<:tu a l l y worried that his trades would be found out by the press, which he feared could cost h i m h is job. As­ sociat<:s in G reenwich, even senior traders, were kept so m uch i n the dark that some resorted to call ing their London counterpa rts to fi nd out what the firm was buying and st:ll ing. Associate'> were never i n ­ vited back t o t h e partners' homes-there seem<:d t o h e a n unw ritten rule against pa rtners and stafi fratern izing. Leahy, a col lege hockey player, excha nged the normal office banter with the employees, hut most of the pa rtners trea ted the 'ita ff with cool formality. They wer<: polite but interested only in one a nother and their work . The a n a l y�ts and legal a nd accounting sta ffs were second-class citizens, shu nted to a room in the back, where the pool table was. Like everyone else on Wa l l Street, Long-Term's employees made good money. The top staffer-, could make S 1 m i l lion to $2. m i l l ion a year. There was subtle pre"urc on the st;Jft to inveq their honust·� in rhc fund, hut m ost of them were eager to do <,o .tny w
J ust as pred icted, Long-Term's on -the-run and off-the-run bond., snapped back quick ly. Long-Term made a magic a l S 1 s m i l l ion­ magica l because it hadn't used any capita l . As Scholes had promised, Long-Term had scooped up a nickel and, with leverage, turned it into

52

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WHEN GENIUS FAILED

more. True, many other firms had done the same kind of trade. "Bur we could finance better," an employee of Long-Term noted. "ITC\1 was really a financing house." Long-Term preferred

to

reap a sure nickel than

gamble on mak­

to

ing an uncertain dollar, because it could leverage irs tiny margin� like a high-volume grocer, sucking up nickel after nickel and multiplying the process thousands of times. Of course, not even a nickel her was

ahsolutely sure. And as Steinhardt, the fund manager, had recently been reminded, the penalty for being wrong is infinitely greater when you arc leveraged. But in I 994, Long-Term was almost never wrong. In fact, nearly every trJde it touched turned

to

gold.

Long-Term dubbed irs safest hers coll!'£'TJ!,CIICC trades, because rhc instruments matured ar a specific date, meaning rhar convergence ap­ peared

to

he a sure thing. Others were known as rehlfiue ua lue trades,

in which convergence was expected bur not gu
to

the other) varies

according to the rate Jt which homeowners pay off their loans ahead of schedule. If you refinance your mortgage, you pay it off in one lump �um-that is, in one giant payment of principal. T herefore, no further cash goes

to

the interest-only pool. But if you stand pat and

keep writing those monthly checks, you keep making interest pay­ ments for up

to

thirty years. T herefore, if more people refinance, the

interest-only securities, known as "lOs," will fall; if fewer people pre­ pay, they will rise. T he converse is true for principal-only securities, or POs. And since the rate of refinancings can change quickly, betting on lOs or POs can make or lose you a good deal of money. In I99_'l, when Long-Term was raising capital , America was expe­ riencing a surge of rcfin;Jncings. With mortgage rates dropping below 7 percent for the first rime since the Vietnam War, baby boomers who

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had never given their mortgage� a second thought were suddenly delirious with the prospect of cutting their payments by h u n d red� of dollars a month. Getting rhe lowest rare became a point o f pride; roughly two in five Americans refin anced in rhar one yea r-in fact, some folks did it twice. Natura l l y, the prices of l O s p l u mmeted. Ac­ tually, they fel l too m uch. Un les� you assumed that the entire country was going to refinance tomorrow, t h e price of l Os was simply too low. In deed, :vleriwether, H i l i brand, Rosenfeld, H a g h a n i , and Hawkins bought buckets of l O s for their pcr�onal accounb. I n 1 <;) ') 4 , a s Long-Term was beginning to trade, lOs remai ned cheap for fear there would be a nother wave of refinancings. Bill K ra�ker had designed a model to predict prep a y m e n t s , and I iawkins-an outgoing, curly-haired mortgage trader with back­ woods charm-continually checked the model aga i n st the record of actual prepaymen ts. The 1 0 price seemed so out of wh ack that Hawkins wondered, "Is there someth i ng wrong with the m odel, or is this j ust a good opportunity ? " The methodical K rasker carefu l l y re­ tooled the model, and it a l l but screamed, Buy! So Long-Term­ once aga i n with massive leverage-started b u y i ng lOs bv rhc truck load. It acq u i red a huge sta ke, estimated at S.!. b i l l i on worth. :\ow, when interest rare� rise, people a ren't even going to think about refi n a n c i ng. But when rates fa l l , they run to the mortgage bro­ ker. That means that 10� rise and fa l l in sync with i nterest rates-so hettin� on f ( )s is like hcttin� un interest rates. Bur the pa rtners d idn't wanr ro forecast rates; such out right >peculation made them j ittery, even though they did it on occasion. Because interest rates depend on so many varia bles, they a rc essent i a l l y u npredictable. The partners' forte was m a king highly specific relative bets that did n ot depend on broad u nknowns. In short, the partners merely felt th�lt, given the pre�cm level of in­ terest rate<;, l O s were cheap. So t h e p�l rtnn-. -.hrcwd l y hedged their bet by purchasing Trcasurys, the price-. o f w i n c h mon· i n the o{Jf!o­ sitc d i rection from i nterest rate-;. The m·r dfecr wa> to remove any cl­ ement of rate forecasting. The partners excelled a t idenri fying particular m i spriced risks and hedging out all of the other risks. I f I I a i fa ora nges were cheap relative t o F u j i apples, they would find a series of trades to isolate that particu lar arbitrage; t hey didn't simply buy every ora nge and sel l nery apple. In the spring, when interest rates soared, Long-Term's lOs a lso ..

..

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WHEN GENIUS FAILED

soared, a lthough its Treasury honds, of course, fel l . Thus, it was ahead on one leg of its trade and hehind on the other. Then, in I ') l) 5 , when interest rates receded, Long-Term's Treasurys rose in price. But this time people did not rush to refina nce, so Long-Term\ lOs held on to m uch of their former gains. Presumahlv, people who had got­ ten new mortgages in I l) l) ; were not so eager to do it aga i n . Long­ Term made �everal hundred mi ll ion dollars. It was off to ;l sizzling start. Despite appearances, fi nding these " n ickels" was a n ything bur easy. Long-Term wa� sea rching for pairs of t rades-or often, m u l t i ple pairs-rhar were " balanced " enough to be safe but u n ba lanced in one or two very particular aspects, so as to offer a potential for profit. Put di fferently, in any given strategy, Long-Term typica l l y wa nted ex­ posure to one or two risk factors-but no more. In a common exam ple-yield-curve trades-i nterest rates in a given count r y might he oddly out of line for a certain duration of debt. For instance, med ium -term rates m ight he far h igher than short-term rates and al­ most as h igh as long-term rates. Long-Term would concoct a series of a rbitrages betting on this bu lge to disa ppea r. The best place to look for such complex trades was in interna­ tional bond ma rkers. :VIarkets in Europe, as wel l a s in rhe Third World, were less efficient than A merica's; they had yet to he picked clean by computer-wielding a rbitrageurs (or professors ) . For Long­ Term, these underexploited ma rkets were a happy h unting ground with a welter of opportunities. I n I l)')4, when the trouble in the U.S. bond ma rket rippled across the Atlantic, the spreads between Cer­ man, french, and British government deht and, respectively, rhe fu­ tures on each country's bonds, w idened to nonsensical levels. Long-Term plu nged in and made a fast profit.' It also sallied into Latin A merica, where spreads had widened as well . ' ' The positions were small, but Long-Term was pursuing every angle-you don't find nickels lying on the street. Then, Eric Rosenfeld found a few "coins" in Japan, arbitraging warrants on Japa nese stocks aga i nst options on the Tokyo index-one of Long-Term's first excursions into eq uities. By the mid- I ') ')OS, Furope had hecome a playground for i nter­ national bond traders, who were hotly debating the outlook for monetary union. Its ma rkers were increasingly unsettled by the prospect-sti l l much in dou bt-that France, Germany, Italy, and other age-old nation-states would rea l l y merge their cu rrencies, a ban-

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doning their francs, ma rks, and l i re for freshly m inted c u ros. Every trader had a d i fferent view-j u st the sort of uncertai n climate in which Long-Term th rived. M a n y in vestment hanks were herring that bonds issued by the weaker countries, such as Italy and Spain, would strengthen relative to those of Ccrmany, on the theory that i f un ion did come a b o ut, it would force a convergence of i nterest rates a l l across E u rope. Long-Term did some of these t rades, hut a s usual, the pa rtners were rel uctant to risk too much on a broad economic the­ ory. Long-Term's expertise was in the dera ils. When it came to fore­ casting geopol itical trends, it did not have any appa rent edge. W h at's more, the m ostly American pa rtners were Euro-skeptics. With Eu­ rope's highly regu lated econ om ics perennially tra iling America's, the Continent seemed hopelessly rigid. A Swiss pa rtner, l la ns l l uf­ schmid, tried to push the convergence theme, hut the A merican part­ ners, including Victor l laghani, the free-spirited London chief, resisted. Hagha ni p referred to focus on strategies that were confined to sin­ gle countries, where there would he fewer risk factors. For in stance, he a rbitraged two issues of gilts, the British eq uivalent of Treas urys, one of w h ich was cheaper owing to an unfa vorable ta x treatment. When the C . K . government reversed its stance, Long-Term q u ickly made S 2oo m i l l i on . : ·• Haghani frequently t raded the yield curve of a count ry agai nst it­ self. Thus, he m ight go long on Cermany's ten-year bonds and sell its fi ve-year paper, a subtle t rade th at req u i red command of the math a long w ith a keen appreciation for local economic tren ds. But at least it did nor req u i re comparing the trends in Germany with, say, the trends in Spain. :\cwspapcr accounts of Long-Term genera lly overlooked I laghani, who was intensely private. The press pla yed up !'vleriwether\ leader­ ship and Merton's and Scholes's " models." But in facr H agha n i was a critical player. While J.�l. prcs1ded over the firm and Rosenfeld ran it from day to day, l l aghani and the slightly sen ior l l ili b ra nd had the most influence on trading. Similarly brilliant and m a thematically adept, they spoke in a code that outsiders found i mpenetra ble. Although the two operated mostly a s a team, Haghani was fa r more daring. A natura l trader, l laghani had an intuitive feel ing for markets and a vol a t i le, impulsive streak. I f a model iden t i fied a secu­ rity as misp riced and if the firm felt it understood w h y the d istortion

56

•

WHEN G E N I US FAILED

had occurred, H i l i hrand tended to go right ahead. Haghani, who trusted his instincts, m ight gamble on the security's becoming even more mispriced first. Barely thirty-one years old when Long-Term started ( l l i l i hrand was thirty-four, Rosenfeld forty, and Meriwether forty-si x ), the swarthy, bearded Haghan i routinely swung for the fences. Though a lively raconteur, he was less direct than H i l i hrand: you could never tell i f l laghani was challenging you in ea rnest or playing poker. l ie had a youthful i mpetuousness and belief in hi mself, perhaps the result of hi' privileged background. The son of a wea lthy Iranian i m porter-exporter and a n A merican mother, l lagh a n i grew up keen l y aware of the political crosscurrents that often overwhelm the best-laid business plans. As a teenager, he had spent two years in I ran with his father, whom he adored; then the revolution had forced them to flee. At Salomon Brothers, Haghani had spent a lot of t i me in the London and Tokyo burea us, where he had pushed the local traders to adopt the Arbitrage Grou p's model of markets and had e x horted the often bewildered sta ffers to trade in bigger size. He returned to London with Long-Term Capital Man­ agement j ust as the Continent was huhhling with talk o f moneta ry u n iOn. Haghani shun ned the City, London's buttoned-down equivalent of Wa ll Street, and rented qua rters in Mayfa i r, a l ively fashion district. He ran the office i n forma lly, enco uraging the staff to join h i m in give­ and-take and spi rited banter. His traders and anal ysts w orked long hours, hut they were motivated hy the lure of Long-Term's growing profits and h um bled hy the sight of their boss trundling to the office on a bicycle. When the action a bated, the traders would drift to a poolroom off the trading floor, where l laghani would issue chal lenges to visitors. (J ..\1 ., too, on his visits to London, would inevitably pick up the cue stick and ta ke on all comers . ) Less introverted than some of his partners, Haghani freq uently invited traders home to dinner. After Long-Term's first big month, i n :Vlay, he assem bled the entire London sta ff, including the secretaries, and told them how the money had been made. This would have been heresy at the sti ffer and more secretive Greenwich headqua rters, where a rigid caste system pre­ vai led. Haghani's biggest trade was Ital y-a hold choice. Ita l i a n fin ance was a mess, as was Italian politics. The fea r that Italy might defa u lt on its loans, coupled with the stil l considerable strength of the Italian

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Commun ist Party, h a d pu�hed Italy's interest rates t o a s much a� X percentage points over German y's-a h uge spre fertile terri tory. Obviously, if Italy righted ibelf, people who had bet on Italy would make out like bandits. Hut what if it didn't? The Ital i a n market was further complicated beca u se Italy had a quirky t a x law and two types of government bonds-one of which paid a floating rate, the other a fi xed rate. St rangely, the Ital ian gov­ ernment was forced (by an u nr rusting bond market) to pay an i nter­ est rate that was h igher than the rate on a widely traded i n terest rate deri vative k n own as "swaps. " Swap rates a re genera lly dose to private-sector b,mk rate�. Thus, the bond market was raring the I tal­ ian government a> a poorer risk tha n private hanks. Hagh<� n i thought the ma rket was seriously overstating the risk of the govern ment\ dcfa ulting-rc/atiuc to the price it was putting on other risks. With characteristic derri ng-do, he recommended a k ing­ size arbitrage to exploit the �u ppmed mispricing. It was a calcu lated ga mble, beca u se if Italy did defa u lt, Long-Term's counterpa rties might w a l k a way from their contracts-a nd Long--lerm could lose its shirt. 'l(l the A merican partners, who remained skeptica l a bout Italy, this was a m a j or worry. The risk-a verse Bill K raskcr was especially concerned, and the partner� heatedly debated Italy for h o u rs . In simple terms, t h e arbitrage zeroed in o n the m a rk er\ utter lack of respect for Rome. But noth i ng at Long-'lerm was ever simple. Specific a l l y, Haghani, who even tually prevailed, bought the fi xed­ rate Ita l i a n government bond� and shorted the fi xed rate on Italian swaps. l ie a l so bought the floating- rate govern ment paper, a coup for Long-Term beca use few other� could get hold of t h i s t h i n l y traded se­ curity. Hagh a n i bala nced that with a �hort posi tion, too. At first, Long-Term hedged the entire position, ta king out
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letters were saturated with statistics on volatil ities bur m ute on what the firm was actua l l y doing. He covered for hi-; sh yness by adopting an aloof, i m personal tone, as though he were doing his in vestor' a favor by disclosing an ything. " I t is our intent ro maintain ongoing com munications with you, our investors, " he declared stiffly. Even the few dry n uggets that .J . \'1 . did disclose he
For all irs a ttention to risk, Long-Term\ management had a serious flaw. Un l i ke at banks, where independent risk managers watch over traders, Long-Term\ partners monitored rhemsclvc,. Though this en­ abled them to sidestep the rigidities of a hig organization, there was no one to call the partners to account. Traders needed approval from the risk-management com mittee to i nitiate a trade; however, l l ili hrand and l lagha ni, who would fight relentlessly for what rhev wanted, had a wav of getting it. Sooner or later, the other pa rtners would defer, i f only out of sheer e x h a ustion. :VIcriwcrher was largclv to blame for this tolerant regime. I f .J . .\ 1 . had a cardinal wea k n cs-;, it was his fa il ure to insert himself into the de­ bates. And there was no one else who could ha\'t: pla yed the role of nanny, as there had been at Salomon-no Gutfreund. The traders were their own watchdogs. The pa rtners did go to considerable lengths to research their trades, the Italian trade being a prime example. l laghani recruited a network of intell igence sou rces to hol ster h i s knowledge of I ta ly. l ie h i red-fi rst as a consu ltant, later fu ll-rime-Alberto Giovannini, a former official i n the Italian Treasury and professor at Col umbia Uni­ versity. Giovan n i n i , who had also studied a r \ 1 1 " 1 � would shuttle back and forth between London and Rome, where he could sec h i s fam i ly and gossip with Italian officials. Sri II not sati•>fied, I lagh a n i brought in Gerard Ccnnottc, yet another M IT grad, who was the son of Bel­ gium's ambassador to Italy and was fl uent in I ta l ian. " Victor was al­ ways keen on I ta l y, " an associate noted. And of cou rse, Long-Term was plugged in to Ita l y 's central bank, which had in vested S 1 oo mil­ lion in the fu nd and lent it S 1 5 0 m i l l ion more.

ON T H E R U N

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Howevn, Long-Term's approach w a s s o mathematica l , it's dou bt­ ful rhar a l l this intelligence made m uch difference. Irs models said simply rhar Italy was ··chea p" relative to historical patterns and an­ ticipated risks. The partners assumed that, all else being eq u a l , the fu­ ture would look like the past. Therefore, in they went. :VIoreover, irs models were h a rdly a secret. " You could pick up a .fourn,If of hnance and sec where someone was a pplying model s," a London-based trader ar Salomon Brothers noted with respect ro the Italy trade. " Anyone who had done first-year math at university could do it." In trut h, trader., a r other firms had been doing similar trades for years. By the time Long-Term started to trade, spreads in Italy had begun to na rrow; rival fi rms were bidding c�rriucdl'rci. l lagh a n i got h i s first bil­ lion doiL1 rs' worth or so of Italian bonds from Salomon, which wanted our. The common notion that Long-Term had a u n iq ue black box was a myth. Other Wa ll Street fi rms had also found thei r way to :\trC and most of rhe big hanks wen: employing s i m i l a r models­ and, what\ more, were applying them to the same couple of dozen spreads in bond ma rkets. Long-Term's edge wa•;n"t in ito; models but, first, in if'> ex perience in rl',uiilzK rhe models. The partners had been doing such trades for years. Second, rhe firm had better fina tKi ng. During i ts fi rst year, Rmcnfeld sewed up repo fi nancing with thirn hanks and derivative faci lities with twen ty-a ll on l i bera l terms.'' With fi nancing so acces­ sible-a nd with the partners so su premely confident-Long-Term traded on a greater scale, and it kept squeezing nickels long a fter othero, had quit. " We foc used on smal ler discrepancies than other people," one trader s;lid. " We tho ught we cou ld hedge further and leverage fu rther. " At least one observer had grave doubto, about the fu nd\ seemingly cav;l l icr approach to dehr. Seth K la rman, the gener;1 l partner of Bau­ posr Cro u p , a collection of smallish hedge fund., ha-.ed in Cam bridge, \1 assach uscrts, wrote to his lll veo,tor-. th.H Ill" h;Jd been o ffered a stake in a new fund run by former Salomon hond tra dcrs-olw iously Long­ Term-and had decl ined. K la rm;ln W;l o, perturbed hy a seemi ngly reckless trend on Wal l Street. In vestment banks possessed of the equivalent of fi nancial Veg-0 \Lnics were slicing and dicing financial assets into potent, newfangled securities-lOs and POs-rhar i n ­ vestors were scooping up with reck less L-l a n . What w a s worse, in­ vestors had rediscovered their thirst for leverage. With dou ble-digit bond yields a thing of the past, investors-pa rticu larly the new hedge

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funds that were " popping up all over"-were resorting to borrowing to inflate their retu rn�. How could in vestors be so certai n that rnar­ keb would a l ways he liquid?, K larman wondered. I k feared that in­ veo;rors were turning "a blind eye to the comeq uences of 'outlier' events,'' such as the �uddcn disturba nces
DEAR INVESTORS In a strict sense, there u•asn 't any risk-i( the ll'orld had fil:ihll'cd c�s it did 111 the past.

- .v\1 R I O � \1 1l.I I R , I·. CO :\ O ."'' I S.J A:-.Jll

:\O ill-. 1. I.Al:IU.A IL

o:-..: < .-Tl.K\1 2.1\ percent i n its first year of opera­ L tion. A fter fees to the partners, i ts invesrors' accounts rose by 2.0 h\ R '\ I I l

I Y 94,

percent. In a year in which the a verage in vesror i n bonds had lost money, this wa-; noth ing short of phenomenal. In October, w hen it was clear that the fund would finish with im pressive n u m bers, .\1 eri­ wether wa rned his invesrors not to count on a repeat. Long-Term would very l i kely have years in which i t lost money, J . M . stressed: " I t is clear that sign i ficant lmses c a n occu r even over a one-year hori­ zon . " All good money managers write such letters. If they un derstand their business, they know they can have h;ld yc;Jrs. If they a rc honest, they let their i n vestors know it or at ka'>t try to temper their expec­ tations. Yet J , .\1 . \ letter went a good dc;l l further. In an attachment penned by his two academic stars, Merton and Scholes, Long-Term did not merely concede the possihility of loss, it calcula ted the supposed odds of its occu rring, and ro precise mathematical degrees. J u st a s a hand­ book of poker m ight tell you that the odds of dra w i ng a n i nside stra ight were X . s 1 percent, the professors calculated that Long-Term would lose a t least 5 percent of i ts money 1 2. percent o f the time ( that

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is, in twelve of every hundred years ) . The letter went on to state the precise odds of the fund's losing at least 1 o percent, as well as 1 5 per­ cent and 20 percent. ' Of cou rse, Long-Term cou l d j i gger the odds by c h a nging certa in assumptions; thus the letter contained not j ust one c o l u m n of n u m ­ bers b u t m u lti ple columns, l i k e a page from the D<�ily R acing hmn. The point was, Long-Term predicted the odd, with precision. It wa� a� if the pro fessors had some secret knowledge or an a ltered view of the world, for no ordinary in vestor would hazard �uch forecasts. Most people, one hopes, know that their stoc k s can fa l l , bur if asked to spec i fy the odds, they would most l i kely b l i n k in puZ71e­ ment. I ndeed, Long-Term's letter betrayed a di fferent way of think ­ ing about the world. Imagine, for a moment, that a student at your child's school showed symptoms o f a contagious a n d potentially dangero us disease. You would e x pect a warn ing, perh a ps some ad­ vice on what preca utions ro take. But i f a letter a rrived from the principal sta ring that your child had a 1 9 percent cha nce o f catch­ ing the sickne�s, a 1 2 percent cha nce of mi,sing at le;l �t a week of school, and a 2 percent risk of fata lity, you would fi nd i t a trifle odd, not to mention presu mptuous. You would want to know more a bout the school 's doctor a nd, in particu lar, a bout the k i n d of med­ icine he practiced . •

In truth, Long-Term's letter told a great deal abo ut the fund's philosophical " medicine . " It mentioned no 'pecific trades or in vestments; it didn't have to. It is enough to know that for each in vestment, Long­ Term was ch iefly concerned with two q ue,rions: What was the antic­ ipated uucragc ret urn, and how m uch did the ret urn in any t ypical year tend to vary from that average? With a pair of d ice, for instance, the average rol l is 7, and the variation from the a ver;lge cannot be more than 5 ( you can't rol l more than 1 2 or less than 2 ) . What\ more, the odds in dice a rc such that rwn th irds of the time, you will roll either 7 or a number that is within two oi 7 . Therefore, i f a sen sible in vestor w a ' offered the chance t o bet even money on rol l ing between 5 and 9, he would take it. Of course, you wouldn't always roll between 5 and 9, so you wouldn't, one hopes, wager too much. Bur what if you could make that her on 1 million rolls and settle up only at the end? In that case, you should bet the

DEAR INVESTORS

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63

house. You might rol l snake eyes once, maybe a second time, perha ps a third. But over a m i l l ion rolls, the chance of losing is i n fi nitesi m a l l y smal l . Try it. It i' much harder ro calcu late the odds in investing; indeed, very few aspects of l i fe can be forecast so precisely (good fortune-te l lers arc scarce ) . We may deduce that if we buy a share of I BM at $ X o we have a greater chance of making a profit than if we buy at $90, j ust as your c h i l d is at greater risk if two of his buddies a rc sick, rather than only one. Bur hou' much greater? We simply don't h a ve enough facrs to q u a nt i fy either the risk of ma rket loss or the risk of conta­ gton. :\"oticc that there is a kcv di fference between a share of I B �1 (or an infecti ous disease ) and a P. Seen i n these terms, Long-Term\ letter represented a dra matic leap. While it heart i l y acknowledged risk, ir bani shed uncerta inty by putting n u merical odds on it'> l ikeli hood of loss. To J . �1 . and his traders, money nMn•l gemenr was less an " art" requ i ring a series of j udgments than it was a "science" that could he precisely q u an t ified. " Roughly, over a long period of rime," rhe letter stared, " in vestors may experience a loss of ; 'X, or more in about one month in five, and a loss of 1 o % or more in about one month in ten . " Only one year in fifty should it lose at least .!.O percent of ir, portfo l i o-and rhe Menon-Scholes encycl ical did nor entertain the possibi l i ty of losing more. The secret of this magical foretelling was breathta k ingly simple. J ust as the key n umber in the dice het was the typical variance from 7, the key n um ber for Long-Ttrm wa'> the usual variance, or volatil­ ity, in bond prices. By pl ugging tens of thousands of bond prices into irs S PA R C : computers, Long-Term's traders k new the historic volati lity-tha t is, how much bonds had fluctuated in the past. And that one n um ber (calculated over thousands of d a i l y, monthly, and yearly i nterv a l s and for n umerous types of bonds ) was the basis of

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their assessment of risk in the fitturc. Peter Rosenthal, Long-Term's press spokesman, glibly explained, " Risk is a fu nction of volati lity. These things a rc q uantifiable. " .\1eriwethcr, .\1 crton, Scholes, and company had no more carnc�t belief. Their portfolio was like a hat holding thou�ands of pairs of num­ bers, each representing the volati l ity and return they e x pected in a given trade. "They were thinking a l l rhe rime about the n um bers in rhe hat," noted Robert Stavis, who worked in the gro u p at Sa lomon. They were looking at the individual pai rs-the l Os, the l ra l ys, and so on-but they were a lso thinking about the correlations between the pair�. Would the re�u lts in mortgages tend to mimic those in Italy? Would one trade be up when the other wa> down? The pa rtners ad­ justed the weigh ting of each trade accord ing ro it� effect both on re­ turn and on volatil ity, singly and for the entire portfolio, Sravis said. "And they'd constantly be tuning the m i x . " •

-"kriwerher's traders were profo u n d l y concerned w i t h l i m i ting risk. The idea that they could do so by t a rget ing a specific level of volati l ­ i t y w a s central t o h o w they r a n the fun d . I f t h e portfo l i o was a lit­ ric roo q uiet, they'd borrow more, raising the " vol " ; i f it was roo volatile, they'd reduce their leveLlge, calming the fund down. Rather than ta rget a specific ret u rn , they engineered the " h a t " so rhar ( they bel ieved ) it would fl uctuate during most year� a bout as much a s the stock marker d i d . With any more v o la t i l i ty, the risk would be too high. With less, thev would be leaving money on rhe table. " To a n yone with their t heoretical backgro und," noted Merri l l \ D a l e .\1eyer, who helped sell the fu nd, " vo l a t i l i t y and re­ turn� were the same thing. I ncreased volatility meant incrca
DEAR INV ESTORS

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rain odds in shooting cra ps. And the conceit �remmed largely from �Ienon and Scholes. Every im-estment hank, everv trading floor on Wa l l Street was >ta ffed hy young, i nrell igent Ph . D .s w h o had stud ied under Menon, Scholes, or their di;ciples. The ;ame fi rms that spent tens of mil lions of dollar; per year on expensive research analysts­ i.e., stock pickers-sta fied their trading desks with fi n ance ma j ors who put capital at ri;k on the as�umprion rhar the marker was effi­ cient, meaning rhar stock prices were ever correct and therefore that -;rock pick ing was a fra u d . Some of Long-Term\ investors had learned this credo practic1 l l y i n r h e cri b. Terence Sull ivan, w h o kept note; on his meetings with Long-Term , bel ieved it would take a rare, "calamitous" evenr­ mavbe a once-in-a-hu ndrcd··year flood-ior l .ong-Tcrm to go scri­ ou;ly wrong. There would he ti mes, Sull ivan k new, when price; would devi a te from the norm a nd when market<; would move against l .ong-Tcrm, costing it money. Rut for the ma rkets in all o f their trades to consistently depart from the norm would he a statistical freak, like rol ling seven consecutive snake eyes or being hit by l ightning twice. Sullivan had lea rned this long before, in business school at the Uni­ versity of Pittsburgh-which, like all ;uch ;chools, was steeped in the teachi ng; of Merton and Scholes . •

:\!either \Ienon nor Scholes was in vol ved in trading at Long-Term except in a minor, advisorv sense. 1\:or, as some investors believed, did the professors create the "model s " that deta iled the cases for various trades. But .VIerton and Sch oles were the fund's phi losophical fathers. As Schole; remarked at its inception, " We're not j ust a fu nd. We're a fi na nci al-technology company. " · .VI ore speci iically, Long-Term was �1n experiment in ma naging risk by the n u mbers. A r the cenrcr of this experiment w a s rhe notion of volatil ity, which had supplanted lever­ age, in the p�Htners' minds, as rhe best pro x v ior risk. I ndeed, many of Long-Term's trades were attempt> to e\ ploit spreads that, in its view, reflected a n inaccurate esti mate of iuture volati l i ty risk-the one risk that ( to Long-Term ) rea l l y counted. Such strategies had evol ved directly from the Black -Scholes form ula. The form u l a had built on di scoveries in the physical sciences. Stat­ isticians had long heen aware of the " l a w of large n u m bers . " Roughly speaking, i f you have enough samples of a random event, they will

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tend to distri bute in the fam i l iar hell curve, with the most occurrences around the average and a sharp d rop-off at either e xtreme. This is called the normal distribution or, in mathematical terms, the lox­ normal distrilmti011. 1\ basketba l l coach knows that, given the usual di•mihution of heights, on a block with one h undred school -age boys he is likely to find sixty ro seven ty hoy'> of rough ly average height, a few who arc short and a few who a rc tall, and maybe one who could play starring center. If the coach i' l uc k y, he might fi nd two centers. Bur he would never fi nd, say, twenty -.even -footers on that single '>treer-assurn ing, of cour-;c, that the fa m i l ies a re u n rela ted, for oth­ erwise the selection would not he random . A, Peter Bernstein has written, nature's pattern emerge' onl�· from the chaotic disorder of many r,mdom events . ; To Black, Scholes, and \1crron, price cha nges in fina nci;l l markets ' were random, roo. ' ' �o one could predict any particul.zr change, hut over a long enough period, t hey assumed that the distri bution of a l l such prices w o u l d m i rror t h e pattern of other random event'>, l ike coin fl ips, d ice rolls, or the heights of h igh school students. The mar­ ker for Italian bonds and on-the-run Treasurys would also descri be a hell curve, with many days in which prices cha nged only a l i ttle either up or down and a very few observations at the extremes, represen t­ ing '>udden upswings or market pl unges. I f the a m o u n t of the typical change-the " v o l a t i l ity "-wcrc known, they bel ieved, the odd' th,n a stock, bond, or any other asset would rise or fa l l hy '>OI1lc p roportion over time could be de­ ri ved a'> wel l . The di fferential e q u a t ions used to solve the Black­ Scholcs form u l a were ada pted from physic'> equations rhar descri be, a mong other phenomena in the physical world, the w a y cream spreads through a cup of coffee. ' A n y one molec u le's trip i' ran­ dom, but as a group, the molecules distribute themselves in pre­ dictable fa shion, from the center our. The cream w i l l never go a l l to one side. Black-Scholcs says that prices don't ( predicta bly ) go to one side ei­ ther. I n v a l u i ng an option, which i ' the right to buy a secu rity at a '>tared " strike price" in the future, a l l that matters is the vola t i l ity, or ,. The Black-Scholes formula nplicirly ,t,Itc,, ''\X'c will as,umc ideal condi ­ t ion' i n the marker for the 'rock and ior t h e option . . . . The 'tock price iollmv' a random walk in continuous time. "

NORMAL BELL CURVE 0 . 09 ---,---- --0 08 0 07 >

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0 . 06

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-1.6

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standardized logarithmic returns

1 6

20

2 4

--2 8

I 3.2

3.6

I 40

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WHEN G E N I U S FAILED

the rate a t w h ich the underlying security j u mps a ro u n d . ,. This makes intuitive sense: the more a security fl uctuates, the more l i kely it i � to rise a hove the strike price. But Black-Scholcs makes a very key assumption: that the volatilit) of a security is crmstunt. "I() say that the value of an option to huy IBM depen ds on its volatil ity is meaningless un less you c1n agree on what its volatility is. Therefore, the professors treated the volatil ity of a security like a n inherent, unchanging trait. You have h l ue eyes; I B M has a vola tility of X . You or I might assume that the ma rket fl uctua­ tions of so many yesterdays rh.H determine an option\ price were known I on� before the Black-Schok' formula. Thcv include rhe d uration of rhe option, the le\'cl ot intcre't rare,, and rhe spread between the current price of rhe underlyin� 'ecurit\' and the price at which the option c•ln he exerci,ed.

DEAR INVESTORS

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couldn't keep pace with the panic t h a t broke out o n Wal l St reet and, i ndeed, lost their shirts . •

,\lerton's perfect-arbitrage as>umption was an essential b u i lding block in Long-Term's (and many other fi rms' ) hedging strategies. The partners, of course, had worked with the same risk assumptions a t Salomon Brothers a n d h a d racked u p phenomenal profits-a l beit with the occasional nasty loss. This gave them tremend o u s confi­ dence. Their trades usually were sensible, meaning that they were al igned with the odds. Nonetheless, the fact that the gro u p 's ship hadn't capsized in the past d i d n 't guarantee that the gro u p h a d prop­ erly calculated the odds of a tilb l wa ve-j ust that such w a ves were relatively i n freq uent. ,\1erron \ t heories were seductive not because they were mostly wrong hut beca use they were so nearly, or so nea rly o ften, right. Academics have debated and no doubt will continue to debate such models for years. A s the English essa yist G . K. Chesterton wrote, l i fe is "a trap for l ogicians" beca use i t is al most reasonable h u t not q u i te; it is usually sensible bur occasion a l l y otherwi'ie: It looks j ust a l ittle more mathematical and regular than it is; its e xactitude is obvious, hut its mexactitude is hidden; its wildness lies in w;l i t . ' :'v1erton w a s prey t o this very trap. I lis "conti nuous-ti me finance" seemed to wrap the financial universe in a tidy ball. On paper it solved, or pointed to the solutions for, virtually every problem in finance: how to value j un k bonds, how m uch to pay for deposit insura nce, you name it. His theories seemed to behold the elegance .1 11d order he had alw;lys craved. " :--l o t all that i'i he,wriful in science need ,ll'>o he pLlctica l," he wrote with satisfaction. " But here we havL· both."' Eric Rosenfeld, who had stuLhnl 'I I I\! IT 1 1 1 the 1 L', 1\lcrton\ entire oeu vre depended on h i s a ssumptions a bout r.1 ndom walks, w i t h their close tic-in to the physical world. A' t he un assuming Rosenfeld described i t, he and his fellow :Vlerton proteges used ro run to the ph ysics l i brary looking for formu l a i c solutions that they could " j a m into finance . "

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While 'itudying with Merton, Ro�enfeld played a cameo role in de­ veloping financial software, which was the bridge that brought the math to Wa l l Street. l ie and a friend, !'v1 itchell K apor, were early devotees of the Apple II, at a time when l i ttle software e x i sted for it. Kapor thought computer'> were cool, and Rosenfeld was using q u ,m ­ titative systems for investing a � well as for herring o n football. I n 1 <)7H, Rosen feld, w h o was writing h i s thesi' a n d spending gobs o f time a t t h e u n i versity computer center, asked Ka por if he c o u l d write a program that would run on the A pple. K apor did-and realized they were on to something. The two became pa rtners in a tiny com­ pany cal led M icro Finance Systems. They publ ished a desktop graph­ ics and statistics program k nown as Tiny TROLL that was j ust powerful enough to do useful wor k . It �old thousand, of copies, and Kapor and Rosenfeld made h undreds of thousands of dollars on ir. Kapor, a former disc j ockey a nd teacher oi transcendenta l medita­ tion, thought he had discovered the next wave. He hatched plans for a 'econd venture and invited Rosen feld to join h i m . But K a por had also ca ught the finance hug. l ie wa'i �o in trigued by his friend's ac­ count of how stocks mim icked molecu les that he enrolled at M I T. Bur after Kapor took Merton 's fi na nce course, he decided that q ua ntita­ tive finance was less a science than a fa ith-a doctrine for ideologues "bl inded by the power of the model . " It a ppealed to intel lect uals who craved a sense of order hut could lead them disasrromly a stray if ma rkets moved outside the model. K a por went on to form Lotus De­ velopment Corpora tion and became an icon of the '>ofrware indu>try. Ro>en feld, who had gotten a job reaching at l l arvard, staked hi' roy­ altie� from Tiny TROLL on two other ventu res-one of which, a chartered sail boat, al most '>ank on its ma iden voyage-and lost a lot of money. Kapor wasn't the only one who wondered if Merton's model m ight he too tidy for the real world. Pa u l Samuelson, Merton's mentor at !\1 [']� had dou bts when l .ong-Term was organized. Sam uelson, the first fi nancial economist to win a 1\:ohel Prize, recogn i zed that "con­ tinuous time" was merely an ideal state; in rea l rime, traders took sec­ onds, m i n u tes, or even hours to a n a l yze events a n d react. \X'hen events overwhelmed them, the ma rkets gapped . Hear molecules didn't j u m p out of l ine; I BM most certa i n l y did. "This is very im por· rant to the Long-Term story," Sa m uelson noted. "The essence of the Black-Scholes formula is that you k now, with certai nty, not what the

DEAR I NV E STORS

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deal of the cards will he hut what kind of universe is being �am pled, which gives you the assumption of the log-normal process. I won­ dered ha... : k then I when Long-Term started 1. "' The bea u tv of card� is that the univcr�c is known; there arc fifty-two card' in a deck, and only fi fty-two. Life insurance i� a hit di fferent: since new people arc always being added to the uni verse, actua ric' rclv on samplings. They a ren't perfect, but thcv work, beca use the <;ample of people i� very large and morta lity rates change only very ,lowly. But in markets, we a rc never sure that the sample is complete. The uni ver'ie of all trades looked one way throughout rhe I y 2os and another way after the Grear Depression. The pattern changed again d uring rhe in­ flationary I ':1 70', yet again in the effervescent I yyo,. A fter which of these periods was the pictu re " normal," and how do we k now that the next new period won't change rhe story aga i n ? To focus on a single company, IB.Vl li ves in a dynamic, ever-changing world, in whi...:h m;m­ agers perpetua l ly confront new possibilities, new problems, and novel products, the risb of each of wh ich would seem impo"iblc to q uan­ tify. If a manager a r Big Blue proposed to rely on the past as an accu­ rate gauge of future risk, he would probably he fired. Eugene Fa ma, Scholes's rhcsi'
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the "tails " ) . h11na \ thesis, which he undou btedl y discussed with Scholes, was rife with implications for the future Long-Term Capital. I n contrast to the idealized markeb in models, Fama warned, real-life ones experienced "di�conrinuous" price changes (those nasty j u m ps) and a higher proba bility of large losses; indeed, "�uch a m arket is in­ herently more risky. " '' By the time Long-Term W
CURVE WITH FAT TAILS: More Observations at the Ends 0 . 1 2 �-----

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0.4

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standardized logarithmic returns

1 6

2.0

211

2 8

3 2

3.6

4C

74

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W H E N G E N I U S FAI L E D

low the trend for no other reason than that they think enough others will do l ikewise. Such momentum trading has nothing to do w ith log­ ically appraising securities; it doesn't fit the idea l of rationa l investors in efficient markets. But it's human. A fter three bad " tlips" in the mar­ ket, the fourth flip may no longer he completely random. Some traders may have taken losses and be forced to sel l; other investors, looking over thei r shoulders, may panic and decide to beat them to it-as hap­ pened with Treasury bonds during Long-Term's inaugural spring. Wherever the human spirit is present, the little runs that Fama noticed, , ;md even big, Black M onday-sized rum,
Lawrence S u mmers, now the U .S. Trea s u ry secreta ry, told The W,d/ Strt:ct }our­ n,d aiter the crash, "The eifici ent m a rket h ypothl·sis i s the most rem a rk a b l e nror i n the hisrory of economic theory."

DEAR INVESTORS

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oi lett ing a v i v id, human adjective or two slip into h i s copy. I k h a d t h e disease of perfect belief, w h i c h ma kes compromise i mpmo,ihk. When Robert J . S h i l ler, an American economist, dared to s uggest th;lt ma rkets were too volatile to fit the model of perfect m a rkets, you could sense that for .\1erton, to entertai n any doubt at all was to risk seeing the entire ed ifice crumble: " We need hardly mention the sig­ n i ficance of such a concl usion. If Shiller's rejection o f ma rket effi­ ciency is susta ined, then serious doubt is cast on the v a l i d ity of this cornerstone o f modern fi nancia l economic theory. " "' The traders at Long-Term k new the models were i m perfect, of cou rse. " We know this doesn't work by rotc," said Robert Stavis, the former member of the Arbi trage C roup at Salomon. " But this is the best model we have. You look at the old-timers who went with their gut. You had this model, you had these n umbers, and in the end you thought they were a lot more powerful than a guy's gut." Long-Term\ traders were n o t a u tomatons. They debated, some­ times hotly, for hours every week, about what the models implied and whether to do what the models recommended. They were a l so aware of the " fat t a i l " criticism-the idea that unexpected disaster should he expected-and they tried to t fr<1 d 1 on, the o,u pposed amount by w h ich their trades could L1 ll in . u 1 y day, month, or year. Fven the Federa l Reserve was endors111g 'uch progr;1ms, which went by the generic n a me " Val ue-at-Ri.,k . " lkm-;Hh the progra ms' sophis­ ticated veneer, they amounted to a-,king, "If market., behave a s they have in the past, how much w i l l WL' lo.,e ? " But what if m a r kets did something di fferen t ? l l istory, M a rk Twain noted, rhymes; it docs not repeat. ' ,

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WHEN GENIUS FAILED

Such program� worked until they fa i led to work-as they did in .'v\ ex ico in I 9 9 5 . And they fai led precisely at moments of unexpected turbulence-when they were needed most. They were l i ke insurance for all the days when it didn't storm; they predicted what one would lose on a normul day hut not when the peso collapsed. David DeRosa. a currency trader who teaches at Yale. du bbed Va l ue-at-Risk "a lighthouse for the soon -to-he->hipwrecked . " J. P ."v1 orga n , which pioneered the methodologv ( un der the brand name R i s k :V1etrics ), candidh· adm itted its fl aws. In a document dated October I 994, the same month a� .\1cri wether's letter, .\1organ adm itted that ma rket� did not appear to he ra ndom or independent I ll the way of coin flip> and that volatil itie!> "a rc themsel ves q u ite volatile. " :'\Jonethclcss, the fi rm, and its i m i tators a l l over Wa l l Street, contin ued to u�e Va l ue-at­ Ri�k . .\!organ couldn't find any " per!>Ued that Long-Term e xpected its returm to be negatively correLned from one period to the next, meaning that a down month would l i kely be fol l owed hy a good month and so on, thus making susta ined losing strea k s even less li kely. " A low return in any one q u a rter nwy be more l i kely to be foll owed hy a h igher return in the su bsequent qua rter, " .\·I enon and Schole> argued. Over time, that was logica l , because over t i me mar­ kets do correct their mi stakes. Otherwise, there would he no point in buying m ispriced securities. But what i f, before prices corrected, they got further-drastica l l y fu rther-out of line, as had h a ppened to Eckstein in the I 970s? That was a possibil ity the letter didn't mention. A central tenet of the partners' philo>ophy was that ma rkets were steadily getting more efficient, more liquid, more "continuous"­ rnore as Merton had envisioned them .' With more investors h unting for mispriced securities and with market news tra veling faster, it seemed logical that i n vestors would take less time to correct m i staken prices. i\nd on most days, they probably did. An efficient ma rket is a less volatile one ( i t has no Black M ondays ) and, from day to day, a less risky one. Spreads shou ld therefore contract. This boosted the .

DEAR I N VESTORS

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partners' confidence that spreads would narrow. I ndeed, they were confident enough to leverage such hers many times over. •

A l though global investors were burned by the Mexica n fiasco, Long­ Term was una ffected, and i ts sti rring success conr i n ued. In fact, i n 1 9 9 S , as earlier trades bore fruit, t h e fi rm's results i m proved. I ta l y, n o longer looking l i k e the Continent's problem child, w a s bei ng h a i led as the design capital of Furopc, more creative than Germany and less hobbled by tradition than France. As other traders grasped Italy's po­ tential for growth, the bond ma rket in Rome began to percolate, and Long-Term's profits �welled . ' ' Thanks t o I ta l y and the I O m ortgage trade in pa rticular, Long­ Term in 1 9 9 5 earned an astounding 59 percent before fees and 4 .> percent a fter. A l ittle over h a l f of the gains came from Euro pe. Dur­ ing its first two years, in which Long-Term had earned a remarkable $ 1 .6 billion, Italy contributed an estimated S6oo m i l l i o n in profits. All told, i t was the fastest, most i mpressive starr by any fund ever. For an investor who had starred on day one, each origi nal dollar had swelled by 7 1 percent, even a fter the partnership gro u p had taken i ts robust cut. I t did not hun J . \>1 .\ mood that Salomon Hrothers was 'itruggling in his absenc�:. The bank had su ffered wrenching losses in 1 9 9 4 and was widely rumored to be up for -;ale. :\.leriwether\ only nagging worry was that I .ong-Term hadn't been volatile cnuuR!J. The fund had told investors to e xpect an accordion, with pockets of losses tucked between i ts bellows, hut over the first two years, in only one month had Long-Term lost more than 1 per­ cent. " Where\ the accordion ? " one investor wondered. To William E Sharpe, a N obel l'ri z�:-wi nning economist and an adviser to one of Long-Term 's in vestors . the retu rn s seemed .,u rre;l ll y smoot h . " We dis­ tinctly asked, 'Wh;lt \ the risk ? ' " Slu rpt· rl'C;l llt·d . .. !\1 y ron I Scholes I sa id, 'Well, o u r goa l is to get the ri ... k lncl I the ml.ni l ity l of the S & l' s oo.' I l c sa id, ' We're having tro u ble getting it that big. ' " With such a stellar st;Ht, l .ong-· l (:nn, aga in with \>l erri l l Lynch, had no tro u ble raising an addit io11;1l S 1 hill ion of new money. Meri­ wether al most a l l owed himself ;1 n o te ot pride. Wri ting to in vestors, he noted that Long-Term had swelled to sixteen partners and ni nety­ six people overa l l , about half of them involved in trading and strat­ egy. ' ' He stressed the firm's elite cha racter-its bilingual sta ffers, its

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m a n y P h . D . s, i t s sophisticated " financial technology. " J . :VL had heen parsing the odds a l l his l i fe: Long-Term was to be the pinnacle of his work-a grand, su premely orchestrated symphony of risk taking. Incl uding the money from new in vestors, the firm's equity capital had, in less than two years, virtu a l l y tripled, to a total of S ) . A bil lion. Long-Term\ assets had also grown, to the extraord inary s u m of S 1 0 2. b i l lion. Thu�, at the end of l l) l) ) , it was leveraged 2.X to 1 . Of course, its return on totLZI assets-both those that it owned and those that it had borrowed-was fa r, fa r less than the ga udy return cited a bove. This rerurn on tota l capital wa� approxi matelv 2. . 4 5 percent.' ' Thi<> min uscule figure is what Long-Term would have earned had it in­ vested only its own money. But even this figure i� too h igh because it doesn't reflect Long-Term's derivative trades, which, as noted, weren't recorded on its balance sheet. But deriv.uives most certa i n l y increased Long-Term's exposure. ( Whether y o u buy a b o n d or simply bet on its price, you arc exposed to the same potential ga i n or loss . ) A n d these off-halancc-<>hcct trades most definitely increased Long­ Term's riski ness. Ta king its derivati ve trades into account, its cash-clll-cash rcrurn was probably less than 1 percent. ' ' The exact number is u n i m portant. The point is that a lmost all of its heady 59 percent return was due to the remarkable power of leverage. Seen in this l ight, Sha rpe's q uestion-What was the risk ?-would be di fficult to answer. A cash investor risks his out-of-pocket investment, hut Long-Term didn't make such an up-front com mitment. Its deri vative trades, in p;lrticu­ lar, req uired no capital up front. The fu nd simply settled with its hanks each day, paying or receiving cash depending on which way a trade had moved. In l ieu of work ing capital, Long-Term designated a hypothetical slice of its equity as standing beh ind each trade. This so­ cal led risk capital represented the capital that Long-Term figured it needed to keep in the vault, j ust in c1 se. Rosenfeld recalled, Even though we didn't get charged a haircut, we had a risk man­ agement process where we calculated our hypothetical working capita l . We went thro ugh every trade and said, "Suppose we arc in a rea l l y stressful ti me, how m uch would the haircut h e ? " As Long-Term's strategies grew m o r e diverse, t h e fun d felt com­ forta ble taking bigger positions. I t focused on its portfo l i o as a whole, and thus it was w i l ling to pile bigger trades onto each of its " risk"

DEAR I NVESTORS

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dol lars hack i n rhc vaulr. The theory, of course, wa� that the l i k el i ­ hood of m a n y leveraged trades collapsing simul taneously w as sl im , j ust as a n i nsurer docs nor expect th at a l l of irs clients w i l l fi le cl a im s si mulrancously. Indeed, Long-Term thought of itsel f in exactly those terms: as an insurer of fina ncial risk . In effect, the fund pocketed prem i u ms for rhc hazard of o w n i ng less liquid and genera l l y riskier bonds-the prem i­ ums being the spreads rhar it ea rned on off-rhc-run Tre
TUG-OF-WAR This small group . . . attempted to mLZrry the /Jest o( (ilzazi<·e thmry li'ith the hest o/ /izi
- Rlll\1

IU

.\1 1

R I o�

ilL the season of �torms, seemed never to T come. Long-Term was not only phenomena l l y profitable, it was R :\ :--.i D O �I 1\ A D �t O :\ n t ,

eeri ly consistent, as though defying a law of natu re. The fund resem­ bled a hatter who hit for power but never <;truck out. The partners strode to the plate and rapped h it a fter hit, day after day. .\lore con­ fident than ever, they lengthened their �wing, which is to say they leveraged further. By the �pring of r 9 9 6, Long-Term had an astound­ ing S 1 40 b i l l i on in a ssets, thirty times its underlying capital . Though sti l l unknown to 99 percent of A mericans, Long-Term wa� two and a half times a s big as Fidelity \ll a gel lan, the hugest m utual fund, and four times the size of the next l a rgest hedge fund . .\·1eri wether, l l ili­ brand, l l agh a n i , and company now control led more assets than Lehman Brothers and Morgan Stanley and were within shouting dis­ tance of Salomon. Though they had only a couple dozen traders, their fund-barely two years old-was bigger than some of Wa l l Street's age-old institutions. A stealth m issile trusted to the care of supposed experts, it had a fearsome potency u n imagina ble to the man on the street. However, Long-Term was not a secret to its hanks. A fter the event,

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it was widely reported that Wa l l Street had somehow been ignorant of Long-Term's swollen asset total and leverage ratio. M erri l l Lynch would go so far as to state in a press release, "On Septe m ber 2 1 , [ 1 9 9 8 , [ this was the first time that we learned the overa l l si1.e and sca le of the positions and extent of leverage . " ' Komansky personally declared that Long-Term's lack of "transparency" had k ept h i m in the dark, a n d various other Wa l l Street C FOs professed to he shocked at Long-Term's leverage . ' I n a strict sense, this m a y have been true. Komansky a n d Corzine may have not known. Bur people beneath them k new. Long-Term dis­ closed its total assets and l i a b i l ities to its banks o n a q u a rterl y basis and to i nvestors every month. Long-Term also reported those num­ bers to the Commodity Futu res Trading Comm ission. I t reported its derivative totals only annually-too in freq uentl y to give an accurate picture of such a fast-growing fi r m . Sti l l , the n u rn bers indicated ( to anyone who cared to look ) that something hig was brewi ng. Long­ Term disclosed derivative hers as of the end of 1 9 9 5 on a total of $ 6 5 0 b i l l ion of securities-not exactly chicken feed . ' As Brooksley Born, chairwoman of the C:FTC, would candidly
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t o ask for m o r e spec i fic disclosure. A n d of course, t h e y c o u l d h a v e decl ined to d o b u s i ness w i t h Lon g-Term i f satisfacto ry a n swers were not forthco m i n g . B u r the h a n b w e r e fighting t o d o m o r e hedge fund b u s i n ess, not lcs>. Five 1·c a rs i n to a h u l l m a r k et, t h e h a n k s were a w a s h in l i q u i d i ty, a n d the hedge f u n d trade was a l ucrative way for Wa l l Street to e m ­ ploy i t '> s u r p l u s c a p i ta l . T h e h a n k s hed t h i s b y a practice k n own a> " re n t i ng out the b a l a nce s h eet "-l itera l l v, t r a n s fer r i n g t h e i r enormou-, borrowing power t o hedge i u n d s w i t h lesser cred i t ra r i n g-;, ,1

o,en·ice for w h ic h rhev c h a rged mere pennies on e v e rv

S 1 oo

of

cred i t . Long-Term, w h ich W
S 1 oo m i l l i on to $ 2oo m i l ­

l i on i n ices t o \'Va l l Street each year,
tiH.· m o,e l ves

to

make twenty ha-,is poi nts I' I

...

of

g i 1 L' ll the 1 m p l i cd risb, noted J o h n Succo, then

a


percenr l " -<1 tri fl e tra d i ng ma nage r at

l .ehman Brothers.

:\s many a s fi ft y - fi ve ha n k s were g i v i n g l .on g-Terrn f i n a n c i n g . Dan.led lw t h e partner-,· a i r of i n ia l l i b i l iry, the h a n b r;Ked to top one .1 110 t h e r \ offers. " People were l e n d i n g t h e m money at I . I BO R I a p r i i ;He-o,ector h a n k rare l p l u s fi fty b a s i s points when i t s h o u l d h a ve been I . I BO R p l m two h u n d red poi nts, " o, a i d A n d rew Sici l i a n o, rhe hond manager a t the Base l - based Swiss Bank, which spec i a l i zed in de­ ril ati1 e trad i n g . S i c i l i a n o worried that the ( ; ree n w i c h fund w a 'i get­ ring th<: better o f Swiss Ba n k . The firm sq ueezed even· c o u n rerparty to t h e m a x . Long-Term d e ft l y e x p l oited t h e h a n k s' h u nger for fee>, p u s h i ng them to do h u s i n <:ss on the most a d va nrag<:ous of te rms. The fu n d traded on razor-th i n ma rgi ns, c u t t i n g o u r rhe norma l p r o f i t the h a n k s could ex pect from servicing such a behemot h . Bur t h e h a n k s d i d n 't stop d re a m i ng t h a t Long-Term w o u l d d e l i ver them a profit at the end of the ra i n bow; l i k e frustrated h u t hopefu l paren ts, t h e y kept fa vor­ ing their i ncorrig i b l e c h i l d with treats. �1crri l l Lynch and S a l omon Brothers were Long-Term's b i ggest sugar d a d d ies, a t least in terms of financing. S a l o m o n counted Long-Term a s its biggest c u stomer, espe­ c i a l l y i n E u ropean swa ps,' but the two fi rms' i n tertw i n e d h i stories kept them a t a w a ry d i stance. �terr i l l Lyn c h , on the other h a n d , was i ncrea s i n g l y eager to n uzzle u p to Long-Te r m . A n d the hedge f u n d was h a ppy to reciproca te-on

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its own terms. j . M . quickly befriended Daniel Tu l l y, the :vl crrill Lynch chairman, and the Tul l ys and Meriwethers became a fou rsome . .J .:\1. even made Tul l y a partner in Waterville, .J . M . 's golf cou rse in County Kerr>, I reland. To Tu lly, who was so devoted to his a ncestral homeland that he signed his name in green, this cemented an a l re,1dy fast business a l l iance. Underlings at �1erri ll quickly grasped that the chairman considered Long-Term to he a special client. " I t was in­ cum bent not j ust on the salesperson hut on the entire orga n i zation to get beh ind the relationsh ip, " Tul l y stressed.'' .J .!vl . also n uzzled up to Komansky and I lerb A l lison, who were waiting in the wings to take the rei ns from Tully. Always comforta ble in betting fraternities, .J . !v1 . took the Merril l bosses to Belmont , a racetrack where he boarded h orses. Typically, j . !v 1 . a sked a lot of questions and let his guests do the talking, and All ison n oticed that he remembered the answers-even little th ings, such a s the n a me of Al lison\ w i fe-j ust as he remembered trades. j . M . was a l ways a good l istener. In s uch a sharp-el bowed busi ness, he stuck o ut as es­ sentia l l y decent. " You couldn't help but like h i m , " A l l i son thought . ' " The h i g h p o i n t of Long-Term's seduction of Merri ll was an a nnual three-day gol f competition ,lt W
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" I f thev could have earned a P h . D . a t gol f, they would have. " Stephen Bellotti, who ran foreign cu rrency trading at ;\lerril l , t u rned to \1yron Scholes ar one of these weekends and pbyfu l l y demanded, " Myron, what do you have more of-moncv or brains ? " Scholc� shot back : " Bra ins, but it's getting close ! " r\ <; the husi ne�s rebrionsbip grew closer, Long-Term began t o push \1 crri ll lynch for m ore fi nancing. Lea hy, who managed the rel arion­ -,hip for Long-Term, would say, "If you want us to trade, vou got to ., give u-; more bala nce sheet. Gradu a l l y, .\ lcrrill opened the 'pigot. By 1 ') ')6, it was pro v iding $6. ) b i l l i on of repo fi nancing ( roughly eq ual to \1crri l l 's total equirv ) ,tnd proportionately more on the derivative -,ide. Bur ;t sidc from plea-;ant weekend� in I reland, it wasn't clear what Merrill w;ts getting in retu rn. Long-Term simply shaved too much from the hid and asked prices to leave a normal profit for it'> broker. The broker m ight sq uawk, but Long-Term wouldn't budge. At one point, citing \terrill's growing exposure to the h igh-risk hedge fu nd, a person on .\lerri l l 's n:po dc-,k refused to a pprovc more cred it. Bur '>hortly before the firms' next golf weekend, the rcpo man heard from a n an xious salesman: 'Tm going to sec Dick Lea h y ! We don't want to be embarrassed. ! l ow about putting on another five h undred mil lion dollars?"' When the rcpo man resi'>ted, the salesman added, " You gottLI do these trades, or we lose the business. " \lcrri ll salesmen, eager to promote their prize account, rational­ ized that fi nancing Long-Term was the key to being able to trade with the firm and that trading would enabk .Vlcrrill to see long-Term's order flmv. Of course, si nce \lerri l l saw only one side of each trade, the information was of dubious val ue. The usua l l y healthy tension between the fi nancing and sales desks was tilted in Long-Term\ favor, because people at \terri l l k new the account was " special." Long-Term felt free to tap friends a t every level of rhc firm and did so. This starred with Tu l l y, the chairman, a former broker who was "damn pro u d " rhar .Ylerr i l l had won so much of Long-Term\ business. Even A l l i son, whom some deri ded as a ha rd-edged bean counter, got caught up in Long-Term 's gla mour and urged his underli ngs to expand the relationship. " Everybody was enamored with their intel lect," Dunleavv, the salesman, reca l led. " lr was like Kennedy 's inner ci rcle-Camelot ! They had rhe best and the bright, est. , However, the Merri l l executives eventu a l l y grew uneasy-nor be­ C.l l l '>l" of l .ong-Tcrm's leverage, bur because \llerri l l was m a k ing only

T U G - O F - WAR

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$ 1. 5 million a year off the account, peanuts con sidering the two firm,,' level of business. The financing desk hegan to fight hack: Since .\·t er­ ri l l 's b a l a nce sheet was a precious resource, why sq uander it on a chintzy client ? All ison, who was in charge of �terril l \ business with hig institu­ tions, including Long-Term, fin a l l y took .J . M . a side, suggeqing iron­ ically that it m ight he nice for Merrill to make a little m oney on it' t rades, too. Like others who dealt with Long-Term, A l l i ,on felt that the partners a na l yzed every deal i n terms of rhe profi t and loss on dis­ crete trades rather than in terms of the overa l l relationship. And he -;aid as m uch ro Meriwether. J. :'vt . repl ied sympathetica l l y, but Long-Term kept sq ueezing .\ter­ rill all the same. The fi rm seemed w i l l fu l l y tone-deaf, even at the risk of souring key a l l ia nces. One time, ir rook advantage of a technic1 l loophole i n a l oan document t o make $7 mil lion a t .\llerril l 's expense. When an executive protested, J . .V1 . frowned and said, "I didn't real­ ize . " But he didn't hack down. "He was si ncere," the M erri ll executive 'aid. "' It wa' how he looked at the world: someone wins, -;omeone lo-;e, . " Insultingly, the partners refu,ed to t ru 'r :vlerri l l with the fi nn\ <,e­ crets hut expected to get hig sl ugs of Merri ll Lynch bond u nderwrit­ ing,, a p l u m that in vestment hanb re'ierve for the cho icest cl ienrs. Even more ga l l i ng, Long-Term tried to sell �1crri l l on an unu,ual warrant that had been concocted hy M yron Scholes. The warrant would have been a cheap way for the partners to her m ore m onev on their own fu nd-while exposing Merri l l to serious risk. Merri ll quickly refused. By now, the famous hull was growing resrles-; . .\ter­ rill began to rake hack some of its balance sheet, though it rema ined one of Long-Term\ biggest han kers . .\1erri l l was dying to cle;H Long-Term\ tr;Hks, bur Long-Term re­ fused, beca use it gor this service from Bt'
86

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WHEN GENIUS FAILED

usual no-haircut basis. The street-savvy Bear had once turned down a similar request from a Prince of Liechtenstein who was eager to trade foreign currencies, and it wasn't about to relax the rules for a hedge fund. "Our decision was very clear," one executive recalled. "We don't do business without initial margin." What's more, Bear was wary about risking too much of its capital on Long-Term. The most important clearing function is providing inrraday credit. For Long-Term, which might do hundreds of trades in a day, Bear in ef­ fect acted as a bank, holding many of Long-Term's assets and paying and receiving monies on Long-Term's behalf to and from counter­ parties around the world. Without a clearing broker, Long-Term would not have been able to operate-at least not with anything like its customary flexibility or speed. :V1oreover, a prime broker typically has the right to stop clear­ ing without notice, and it is difficult to get a new clearing broker in a hurry. Therefore, Long-Term was dependent on Bear Stearns to a greater extent than on any other firm. And for a Wall Street broker­ age, Bear was an unconventional place. Alan Greenberg, the nearly septuagenarian chairman, despised the bureaucratic airs of the Mor­ gans and the Merrills. He still sat on the trading floor and answered his phone with a gruff hello. He was famous for exhorting employ­ ees not to waste paper clips. Greenberg\ partner, James C:ayne, the chief executive, had made his name by daring to make a marker in New York City bonds in the difficult 1970s, when a young J.M. had been pursuing a similar strategy. Under Greenberg's and C:ayne's un­ flinching management, Bear was informal, pragmatic, and relent­ lessly focused on irs own self-interest. This worried Long-Term. In 1994, as Long-Term was getting off the ground, Askin Capital, the hedge fund that had suffered crushing losses in the mortgage mar­ ker, had collapsed after Bear had issued a margin call. The realization that Bear held all the cards had been gnawing ar Long-Term ever since. In 1 996, the partners began to agitate for a change. Wh;H Long-Term wanted was a contractual promise from Bear that it would continue to clear Long-Term\ trades, even if the hedge fund encountered serious problems. But the broker was worried about irs own security. If Bear continued to clear a fund down to "dollar zero," it could be forced to make good on eleventh-hour desperation trades should the fund eventually collapse. In short, Long-Term and Bear wt:re each worried about the other's ability to do it harm.

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Over m a n y meeting�, the two sides came to a rough agreement. Basica l l y, Hear wa� w i l ling to pro m i se to keep clearing for Long-Term as long as the hedge fund kept S 1 . 5 b i l l ion on call at Bea r. Though this was acceptable to Long-Term, the partners w a nted to resolve some other issues before they �igncd; chiefly, and with uncanny pre­ science, they were a n xious to protect Long-Term's fle x i bi l i ty du ring a crisi s. 1- ! i li brand, hav ing read reports of the A sk i n debacle, realized that if long-Term ever did st umble, Hea r would be able to force a liq­ uidation, perh aps a t fire-sale pricc'i. Bear would also be in a position to div ulge Long-Term\ positions, potentially setting off a wave of selling. Thus, l l i l i brand wanted to nail down Long-Term\ right to hold Bea r l i a ble for any abuses, such as breach ing Long-Term's con­ fidcnri a l i tv. In typical l l il i brand style, he relen tlessly hammered away at Bear. M ichael r\ l i x, a senior credit e xecutive at Hear, thought l l i l i bra nd ex­ tremely d i fficult and a trifle paranoid, though some of h i s concerns would tu rn out to have merit. The winsome Eric Rosenfeld, who also took part i n the talks, seemed able to sec Bear's point of view; ! !i i i ­ brand couldn't. T h e discussions were like a lega l case in which l l i l i brand never ran out of a rgumcm-,. The parties negotiated in mounting fru-,tra tion, but noth ing W
Long-Term was also pressing Clusc \Ll n hatta n . The fund seemed to want to draw a l l of Wa ll Street imo it.. web, a n d the partners were shrewd enough to rcalit.c th;ll t h e time to line up banks was now, when res u l ts were good. C :ha�c had declined to become a counter­ party in 1 9 ':1 4 , feeling that Long-Term was too new_ But w hen J, \1 . returned in 1 ';) ') 6 , the reception was warmer. J . :VL had a contact cH

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WHEN G E N I U S FAILED

Chase, too: David Pflug, rhe portly head of global cred it, who han­ dled loans to clients on Wa ll Street. The suspcndered, b l u m-spoken Pflug ( pronounced " Fi uge " ) had advised .J . M . during the .\ I nzer cri­ sis, when he had convi nced the beleaguered Sa lomon Brothers to a rrange for emergency credit. :\ow, i n 1 y y 6 , Pfl ug agreed to fi nance Long-Term on interest rate swa ps-in which, rvpically, one side agrees to pay the other a fixed rare of i nrerest in retu rn for receiving a rate that floats with rhe market. Chase a I so backed Long-Term on yicld ·curve trades-aga in, a standard sonara in the fi xed-income trader\ repertoire. Long-Term deepened irs new a l l i a nce by sel ling Chase a $ 2.0 m i l lion in vestment in the fun d. Bur whar Long-Term really wa nted was a {hlrtna-a bank that would give ir cash on demand when special neech ( or even emergency needs) arose . In the pa rtners' endless negotiations with l\ l erri l l , Bear, and now Chase, they seemed to he looking for a firm that would sup­ port them as resol utely as Salomon had. Pfl ug was sym pathetic and arranged for a $ _<; o o m i l l ion revolving loan from a la rge syn dica te of hanb-in other words, a sta ndby L1cil ity that Long-Term could tap as needed. The hank synd icate demonstrated unusual fa ith in rhe hedge fund hy agreeing to fund rhe revolver without rhe fund\ hav­ ing to pur up any collatera l . Then , w i t h t h e revolver in i t 'i pocket, Long-Term t u rn ed up rhe heat on Chase. Various of rhe partn ers began to push the hank to sell them a pecu l i a r warrant. Of cou rse, this was the same wa rrant they had sought, without success, from .\terrill. A wa rr;lllt is an option; the partners wanted a warrant on thei r own fund to add a l a yer of personal leverage to the enormous ll'\'erage already in the portfo l i o. Even though they had virtually all of their personal a ssets in the fu nd, the partners, especi a l l y l l i l i brand, were h or for m ore ex posure. They su ffered from a curious blind spot; though rhey fought like tigers for a clearing agreement that would protect them during a crisis, when it came to investing their own upiral, they seemed nor to consider the possibility of fa il ing. The warrant would have exposed Chase to untenable risks. U nder Scholes's plan, the partners would pay the bank about $ 1 5 m i l lion a yea r, give or take, depending on interest rates. In return, Chase would pay the partners whatever they would have ea rned on a $ 200 m i l lion sl ice of the fund. ror relative peanut>, Chase would he comm itting to a h uge potenti a l l i a bi lity i f the fund contin ued to skyrocket. In the-

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ory, Cha�e could hedge it-; risk b y buy ing some o f the fund for itself. Then, 1f the ,-a l ue of the fund rose, Ch ase would make a profit on its inve'>tlllellt. Hut wh,n if the tund tel l ? According to options theory, wh ich \kr­ ton and Scholes had of cou rse devised, as the value of rhc fund de­ creased, Chase would need less of a hedge. In other words, if Long-Term fel l , Chase would want to gradually sell as�ets that mim­ icked those in the fu nd. Bur rh,n would not be so easv, heclll'>t' Long-Term's assets were se­ cret. And rhe pa rtners pointedly refused to discl ose them. Pfl ug was stun ned hy Long-Term\
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W H E N G E N I U S FAI L E D

By I <;� <;� 6 , Long-Term had grown to well over a h u nd red em ployees and the partners were building immense fortunes. All a long, they had been deferring the 25 percent of the outside inn·stors' profits that they rook as fees, thus lea ving the money in the fund, where, un­ touched by the ta x man, it could compound all the faster. A� their third yea r drew to a clo�e. the partners col lectivelv had a sta ke in the fund of $ I · 4 b i l l ion, nine time\ their initial $ I '\ O m i l l ion i mT�tmellt. I t was an incredi ble fortune to have made in so little time-a nd all from bond spreads! The partners' nervy decision to keep redoubling their hers had vaulted them into the ra nk., of the superrich m ern ight. Unlike corporate titans, who hedged their hers hy contin u a l l y peeling off shares, .J . :V1 . , 1 / ili hrand, Rmenfeld, and the rest left e\Tr\' nickel on the table. When they needed spending molll'\, they simply re­ deemed a hit of the fund, which they treated l i ke ;1 per.,ona l checking account. By the standards of Wa ll St reet m oguls, most of the pa rtners were not lavish spenders, and they frow ned on ostenta tion. They k idded the free-spending l l awkins for fly i ng in decorarors to h i s country home in Saratoga, near the track where l l awkin� kept thorough­ breds. When l la w k suggested they buy a company j et, the others wou ldn't hear of it. But each of them h�1d their moments . .J . .\1 . had his horses and membersh ips in three ton y gol f clu bs-Winged hJOt and Shin necock in �ew York State a nd Cypress Point in C a l i fornia­ in addition to Waterville." He also had a taste for pricey a u tomobi les, including a Ferrari Testa Rossa . Rosenfeld, who l i ved in a -;pacious waterfront home in Westchester, indu lged a passion for wine. He had a photogra phic memory for vin tages and stocked his ten-thousand­ bottle cel lar d i rectlv from France. " ' i f to add a twinkle to his -,oft­ spoken demeanor, the former professor sca rcely went visiting wi thout toting along one of his cherished Clos de Vougeors or other ch oice Burgundies. For l li l i hrand, the money meant added seclusion. He bought a fifteen-acre, $ 2 . 1 m i l l ion plot in a wooded pri vate n>mmu­ nity in Green wich and was spen ding S4 mi llion to build a lavish th irty-thousand-square-foot house. ' ' But c\·en �uch Indu lgences could hardly make a dent in the partner�· ba nk
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Fights over sha res were common; a s at Salomon Brothers, com­ pem�H i on w a s the n�Hu ral turf for venting interna l tensions. The ca­ sual a i r �H Ste
1110\'l'S

s u r faced. The iiery Scholes, who w,1s eager t o edge h i -,

way up the ladder, W<1S pric k l y with .\t u l l ins, each aca d e m i c t h i n k ing he w�1 s sma rter than the other. I I a w k i m, an easygoi ng sout herner, deep l y resented t h e secretive, d o m i neeri ng H i l i h r a n d . Even R osen­ feld, who was in charge oi opera t ional dera i ls, came under subtle prt·ss u re irom .\'l eri wether, who w o u l d periodica l l v grou se, '' Eric has got to fi nd a wa 1· to make some monev, " as i f r u n n i ng t h e firm wasn't enough. The arbi trageur-; were b l i nd to the v a l ue o f contri butions that d i d n 't d ro p st r<1ighr to the bottom l i ne; only fi n a n c i a l points counted. Perhaps this 11 a s one reason they were so intent, well �1 fter they had <1 111 ' need, on m a , i mizing their perso n a l ncr worths. They simply wouldn't g1vc u p on Scholes\ w�Hrant idea, the main p o i n t of which was to leverage thei r pcr<,o n a l for t unes. And the warrant became an obsession with them . .Just as the p�1 rtncrs had hrm1 hc < l lt'll \Inn I I , Hea r, a n d C h
1

':1':14, when the fund

was r a k i n g o ff. A l ittle later, J- .'v l . a n d Hagh a n i had gone u l l ing aga i n , hoping to e n l i st U BS for bond a n d swap tra di n g . But UBS ieared the leverage i n such tr�1 des a n d once aga i n decl i n e d . l lowever, Long-Term con t i n ued to press t h e Zurich- ba sed han k . What's m ore, t h e hedge fu nd h a d a k e y a l l y w i th i n U BS, a Brook l y n native �1n d former S a I om on <;,1 lcsma n na med R o n Ta n ncn ba u m . A f­ fa hle a n d rugged- look i ng, · L l l m c n h,w m h,1d jomcd Salomon in :\ew York
had been a sort of local d i s t ri bution <1gc J J t lor the A r bitrage C ro u p . Then he h a d transferred t o L o n d o n , w h nc he had seen < 1 lot oi .'\ l eri­ wcrher. A t fi rst, Tmnen ha um h,1d been mti nmlated hy J - .'vl . a n d pro b a b l y ,1 wed by J- M . \ traders. 1-\ u t o v e r the years, Tan n e n ba u m he­ came the group\ friend and stead Ll st <1d m i rer. At U BS, Tan nenbaum covncd hedge funds. l ie kept urging h i s bosses to give t h e boys from C reenwich �� chance. M e a n w h i le, the hank was going through u nsettl ing changes. Long the premier han k

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W H E N G E N I U S FAI L E D

in Swiw:rland, UBS had epitomized the country's tradition-hound banking esta bl ishment. Steeped in Swiss culture, it recru ited gnome­ like bankers from the national army rather than from \t iT and offered each v ice president a choice of three polished woods­ ma hogany, walnut, or pine-to panel his office with . ; ; The compla­ cent hank had been startled to discover that i nternational fi na nce no longer moved a t such a leisurely, Alpine pace. l r had been shocked when Swis� Ban k , a rival much q uicker to modern in· and, in partic­ ular, to em brace derivati ve!>, had overtaken U BS. By the mid- J <;) <;)OS, UBS had begun to fight hack, h i ri ng a slew of aggressive tr.1ders. Mathis Cahiall a verra, a debonair pri nce of Swiss banking who had risen to chief e xecutive, gave h is gunsli nger traders free rein in a des­ perate bid to rega in U BS\ perch at the rop. With the bank eager to grow, in Septem ber I <;)<;) ) , Ta nnenbaum persu;lded the board to ap­ prove Long-Term as a counrerpa ny. The bank a l so h i red a :Yialaysian-horn trader from Merri l l , T. .J. Lim, and gave h i m march­ ing orders to gin up its derivative business. Thus, hy 1 <;)<;)6, the stage wa' set for Long-Term to fi nally gain a foothold in the A l ps. Overnight, the hedge fund became l l BS\ biggest account, netting the bank $ 1 s m i l l ion in revenue in its first year. " But a' a l way' with Long-Term, the business was low margi n-typica l l y h a l f of 1 percenr. On one trade invol ving Ja panese equ ities, Long-Term shaved the mar­ gin ro 2 2. . 5 basis points, less than one q uarter of a percent. Ramy Goldstein, UBS's freewheeling head of equity deri vatives, rook the low­ margin trade under protest. " R onn i e, they're not customef';, they're competitors ! , " Goldstein, a siker-h a i red former Israeli paratrooper with a doctorate from Ya le lJni ver�ity, exclaimed to Ta nnenbaum. " Lose my number, " he added. " I don't want to do more I TC :M dea l s ! " B u t l lBS's LTC : \1 deals h a d only begu n . With control-; at C BS growing ever looser, the hank began to swing for the fences. In fact, the charismatic Goldstein, who had a cowboy's thirst for ;Jdvent ure, led the way, pursuing a raft of risky stock -option trade!> . .\1ea nwhile, 1�umenhaum began to think a bout elev;Hing the Long-Term relation­ ship to high er-margin products. l l BS sta rred assisting Long-Term on tax-related proposals, which reu n i ted "Lmnenhaum v.:irh a good friend from h i s Salomon Jays: M yron Scholes. With Long-Term showing such sexv profits, l l BS was regretting irs earlier fail ure to in vest. "' God, that\ the biggest m istake we ever made," moaned I Ians-Peter Bauer, head of fixed-income, cu rrency, and derivati ves, who had rejected Long-Term before. Long-Term had

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stopped rak i ng new money, so the w indow for investors apparently was closed. Indeed, wealthy Swiss were paying I o percent premiums to buy out old investors. But i n July I 9911, knowing that Twncn­ baum was tight with the boys from Greenwich. Bauer asked the sales­ man to sec if his friends m ight, perchance, let the ban k i nvest. Long-Term was now getting t'ery interested in U BS, and turned the charm on in i ts eager sa lesma n . The fund broke with irs no-new­ money stance and offered Tannenbaum a slice of the fund for him­ self, persona l l y, though U BS wou ldn't let him accept it. A t the time, Long-Term was thinking of forming a splinter fund-LfC'VI - X , it was d u bbed-to invest in especia l l y h igh risk trades and also to focus on Latin A merica. The frustrated Scholes saw I TC::vt - X as a way to get out from u nder l l i l i brand's control, which he increasingly re­ sented. With I TC:Vl - X in mind, the firm offered a partnersh ip to Roberto ,\;lendoza, a Harvard-educated vice chairman at .J . P. Mor­ gan and the son of a former C u ban ambassador to Great Brita in. With these plans percolating along, Scholes dangled before Ta nnen­ baum the prospect of working for I TCM-X-presu m a b l y part of an effort to ingratiate Long-Term with Tannenbaum\ employer. In Oc­ tober, Scholes offered the ultimate ca rrot, telling Tannenbaum that the fund would agree to l et l i BS make a Llrge investment 1 11 the fund-i/ the bank also agreed to write a warram on the fund for the Long-Term pa rtncrs. In the fa l l , C:abiallaverra, the bank chairman, and Goldstein paid a call on the partners in Greenwich. By now, the U BS brass, though eager to cement the tie to Long-Term, had started to worry that Tan­ nenbaum m ight be getting a link· too close to his account. " We aren't sure if Ronnie is our man or yours, " one of them said. J . M . brushed off their concern, sayi ng, " Ron's a good ma n . " T h e pa rtners treated C :ahiallavctta like a long-lost cousin. A lmoq all the partners attended the meeting, L"'\cept for :Vlerto n , vvh o was at l larvard, and Haghani, who, though in from London, was da�hing in and out of J . M .'s office to h;Jndk some emergency. When Cabi­ al lavetta asked a bout the outlook tor European m onetary integra­ tion, .J . M . had M u l lins give a link· lecture, which i m pressed the Swiss. Only Long-Term had a resllknt ccmral ban ker. Little was said at the meeting about the warrant, but Tan nenbaum spent :--J o vcmber writ­ ing a proposal to show to his superiors. The basic pitch was right out of the Black-Scholes model . The key determinant i n the option­ pricing formula is volati l i ty. And Long-Term had been exceptionally

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W H E N G E N I U S FA I L E D

steady. I n fact, 1 9 9 6 had been its steadiest year yet. Thus, a Black­ Scholes trader would he willing to write a call option on the fund for a relatively small premium. Sportingly, Scholes had offered a pre­ mium that was somewhat higher. In other words, under the assump­ tion that rmzg-7£'rm 's results would remain steady. UBS could hook an immediate $ 2 5 mill ion profit. Goldstein was aghast. " Ronnie, we could lose mu ltiples of that ! " he protested. The dea l hi nged on the Achil les' heel of Black-Scholcs: the a ssumption that volati lity is a con­ stant. If Long-Term should encou nter a skittish patch over the war­ ran t's seven -year life, l JF\S could face a ma<;sive loss. Tmnenhaum wrote a con vinci ng sales report. He portrayed the benefits of the wa rrant largely in relational terms, citing what U BS would gain from being Long-Term's partner, from seeing its trading flow, and so forth. "The Principals of LTC:.\1 will help accel­ erate UBS' lea rn i ng process in portfolio management, risk manage­ ment, a n d d y n a m i c capit;l l a l location, " the salesman w rote. Pre!ouming 'Llnnenbaum believed that, he was the only one left on Wa l l Street who did. But then, he had nourished a wish to he parr of the I .ong-Term gang for a decade. l i e was sti ll fond of recalling how he had starred out with l l i l i brand, "the biggest brain in the busi­ ness." Of cou rse, Tannenbaum was only a salesman and scarcely had authority to a pprove m a j or dea ls. Salesmen often become close to the cl ients they cover; that is why u ltimate responsibility rests with h igher-ups. But by year-end, although n oth ing had been signed, Sc­ holes's warrant was getting a hearing from L:Bs senior tr;lders and managers. The fund earned 57 percent in I 9 9 6 (4 I percent a fter the partners' fees) thanks to leveraged spread trades on Ja panese convertibles, j unk bonds, interest rate swaps, a nd-again-Ita l ian bonds. Also, when French bonds began to trade a bove German bonds ( im p l y i ng, curi­ ously, that France bore less inflation risk than Germa ny), the pa rtners cleverly, and successfu l l y, bet on Germany ro make a relative come­ hack. Their total profits in I 9 9 6 were an astounding $ 2 . 1 b i l l ion . ' ' To put this nu m ber i nto perspective, this small band of traders, ana­ lysts, and researchers, unknown to the general public and employed in the most a rcane and esoteric of businesses, earned more that year than McDonald 's did sel ling hamburgers a l l over the world, more than Merri l l Lynch, Disney, Xerox , American E xpress, Scars, ]\.' ike, Lucent, or Gillette-among the best-run companies and best-known brands in A merican business.

T U G - O f - WA R

•

'I �

And they had done i t with s tu nningly little volatil ity. N ot once 1 1 1 To l l i l i ­ hrand, l lagha n i , and l lawkins, t h e results proved conv i ncingly that diversi fica tion worked. The fund\ d i verse trades were blending with symphon ic perfection, like the independent d ice or the random cards from a model hy ."v1crton . ' " We can't get the risk [ read: volati I ity [ high enough , " the t r
•·

··

A NOBEL PRIZE Des{Jite its scientific pretensions. economi,·s still remains more of


art th,m

<1

science.

- R< liii R I K l 'T I !' F R

llFTIII. K L o '.: c -T r K \1 wanted t o admit i t or not, t h e secret of a l most every in­ W hond a rbitrage was out. By the late 1 'J ')OS,

vestment hank on Wal l Street had, to some degree, gotten into the game. �lost had separate �lrhitrage desks, with traders specific1 l l y as­ signed to look for opportunitie� in every nook and cra n n y of the husi­ nes�. Lured hy the scent of the fa ntastic profits being earned in C reen wich,' other banks were reaching for the same nickels a s Long­ Term. Inevita b l y, they whittled away the very spreads that had at­ tracted them; thus do free markets punish succe�s. Long-Term had always heen dogged by im itators, but now the i m i tators were piling on faster than ever. No sooner did a spread open up than rival traders pl ugged it. " Everyone else was catch ing up to us," Rosen feld com­ plai ned. " We'd go to put on a trade, hut when we started to n i bble, the opportu nity would vani�h . " ' Characteristica lly, �icriwether encou r�lged the fi rm to explore new territory. Even at Salomon, the troops h�1d always sought to extend their turf. l ladn 't they moved from swap spreads to mortgage-hacked <.ecurities ? Hadn't they branched i nto j un k bonds and European debt? In retrospect, such moves had been baby steps, not bold new

A NOBEL PRIZE

• 9 '/

departures. B u t the partners' experience-to them, at least-seemed to belie the a dage that it is d angerous to try to transport success to u n fa m i l i a r ground. Trusting their models, they s i m p l y rebooted their computers i n v i rgin terra i n . B y ! ':) ':) 7 , t h e plans for t h e h igh-risk splinter com p a n y, l .TC\1 - X , h of broe­ c ur itie-, busi ness was i t'> i n herent acces , i b i l ity. A n y body c o u l d b u v

.1

bond or m i m i c someone who d i d . The partners' rec l w, i v e s t y l e i l l fitted t h e rough democracy of m a rkets. They were i ncrea.,ingly i n trigued with the idea of m a k i ng less liquid, more perm;l nellt i n ­ vestment'> in fi n a n c i a l bu,i ne'>Se'>, beyond r h e reach of h a t e d u>pyc.ns. \lnton wa'> explori ng a j o i n t vell t u re w i t h Banca ::\ ;1 /.ion;l l c del

La voro, a n l ra l i. The i dea was to com b i ne B ::\ L's i n s t i t u t i o n a l clout w i t h Long-Term's academic ped igree a n d offer a product t o rhe everyday sig11urc. \1erton, with h i , IU i H· bel i e f in perfect m a rkets, w a s p u s h i n g r h e notion ot " op t i m u m port to! i o '> .. for the l i tt l e m a n . c ;iovan n i m , l .o n g-Tn m \ re-,ident lt.1 l i a n , w a -. dep­ urized to coordi nate rhe effort,
ro

to

work o u t deta i l '>

w i t h B ::\ 1 .. .\lea n while, .J. P. \!organ w a '> u rging Long-Term to d i ver­ s i fy further. \1organ executives felr rhat rhe partners s h o u l d " l ever­ age " their i nt e l l ect-in effect, apply their brains and methodology

to

husines-,es o u tside the normal scope of hedge funds. Q u ietly, t h e part­ ners began to explore setting up an i n s ur a nce operation . W h i l e s uch gra n d vemu res were progres'>ing slowly, l .o ng-·Term was under i m mediate pressure

to

park irs capital �< IIIICil 'IJcrc. B�

1 ':) ':) 7 , it h a d m o re than s5 b i l l ion in e q u it \ . If Long l i:rm wa'> to SU'>­

tain i rs -,plendid rate of retum , t ha r c.1pir.Ji would knT

to

he i nve'>ted.

But Long-Term's computers were fa d m g t o l m d opport u n i ties. I n one new foray, Long-Term bold l y c ra -.hnl the m a rket for 'oec u rities backed by commcrci,i/ mortgages- w h o l l y d i fferent from the m a rket for lOs and POs, which, of cou r�e. were hacked hy fam i l i a r home mortgages. Long-Term's a ppet ite W
98

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no pretense of h a ving expertise in commercial real estate; predict ably, he felt the firm could find an edge i n financing. "They could earn the carry [ the sprea d [ with very l i ttle risk," a mortgage banker recal led. "The spre3d was thin, but Long-Term had 3 lmJ!e abil ity to leverage." This wa� the firm's standard formula; the partners were determ ined to drag their cookie cutter wherever they could. Bur commercia l mortgages were relatively small potatoes. Equi­ ties-th at is, traded stocks-loomed a s a far larger a n d more tanta­ lizing new frontier. I t was an open fro n tier because most traders with Long-Term 's mathematical bent had natura l l y left eq uities alone. Al­ though pricing a bond can largel y be reduced to math, valu ing a '>tock is far more subjective. Wa l l Street (and academe ) had devised many a formula to forecast the market, but none, no matter how es­ oteric or rigorous, had worked. O ver the short run, stocks are sub­ ject to the whim of oftt:n emotional traders. Over the long run, they vary with business performance, which is subject to great uncerta inty ,md i' notoriously hard to forecast. It req u i res j udgment-not merely math-of the sort that no computer has ever m;btercd . A s the enm­ omist Burton :Vla lkicl once observed, " God Almighty docs not know the proper price-ea rn ing m ultiple for a common stock . " -' But Long­ Term Capital did k now-or at lea'>t, it boldly reckoned that ir could transport its m odels to equities. I Iaghani had been resea rching equ ities, particubrl y in F u rope, and he thought the field w3s ripe for a fi rm with the neces.,ary q u a ntita­ tive skills bur-i mportantly-without rhe need to get enmeshed in t he mes'>y deta i ls of specific-stock analysis. Rosenfeld, too, had been think ing about equ ity arbitrage si nce his days at Salomon. One at­ tractive point was that equity a rbitrage would ( he supposed ) he wz­ currelatcd with bond arbitrage. Ever Merton's di sciple, Rosenfeld wanted rLindom i nvestment dice, and it was hard to i magine that the �pread-, between stocks would widen at the same m oment as the spread' between m ortgages or the spreads between European bonds. ' Fqu ities seemed of a d i fferent wor l d . By defin ition, this would nor be a small extension of the business hut a rad ical, risky e xperiment. I l aghani focused his re.,earch on so-ca lled paired shares. Various European stocks were doubly li sted. Vol kswagen, for in stance, l isted an ordinary share and a "preference" share, the latter with superior voting rights. B M W was another. Haghani a lso looked at pairs of stocks with related ( hut not identica l ) assets, such as Telecom lta l i a,

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the I t a l i a n phone company, and Telecom ltalia Mobile, i t s subsidiary, or Louis Vuitton and Dior. For various reasons, one side of a given pair often traded at a di�counr to its partner. Hence, Haghani spotted the potential for arbitrage. David M odest, yet a nother M IT-trained economist, did the modeling on equi ty trades. But l laghani ran the show. " M odest did what Victor told him," one insider n oted. " Victor said, 'Go short this,' and :vtodest would work out how to do i t . " The paired-share trades weren't perfect arbitrages, beca use r h e t wo sides of each trade were never precisely equiva lent. A preference share of Vol kswagen was U'orth a premium over an ord i n a ry share, especially as, in Germany and elsewhere in Europe, managements did not feel the same obligation as in the United States to treat all stock­ holders fairly. No one could s;ly precisely what the " right" prem i u m was, only t h a t t h e 40 percent premium in VW\ case, for example, seemed e xcessive. Bur rhe spread could persist or even w iden-the models he d a m ned. Given such uncertai nties, most players l i mited paired-sha re trades to moderate size. But with its coffers b u rgeoning, Long-Term was developing a sense of proportion a l l i ts own; l i ke a man who pays for dinner with h u ndred-dol lar hills a n d never asks for change, it had lost the habit of moderation. H agha n i and :vt odest found a bout fi fteen paired-;hare trades, and Haghani her on them in staggering si ze. His favorite was Royal Dutch/Shel l, the h uge Anglo-Dutch oil consortium. Royal D utch/ Shell was owned by two listed compa nies, Royal Dutch Petroleum of the Netherlands and Shell Transport of England. A lthough Royal Dutch and Shell got their income from the same sou rce-that is, from dividends on Royal Dutch/Shell-the English finn had h istorica l l y traded at a n H percent o r s o discount t o its Dutch c o u s i n . T h e stocks were owned by distinct pool., of investors, and t he I hitch '>tock was typical l y more liquid. But there W;ls n o good re;Json tor t h e price clif­ ferentia l . With Europe becoming a -.mgk ec onom i c u n i t , 1--Llghani reckoned that na tional di fferences would mattn less and less, and the spread between Roya l Dutch and Shell would contract. This was a popular view. But the size of H aghani\ position was -,running. Long-Term bet $ 1. . _1 b i l lion-h a l f of it long on Shel l, the other h a l f short on Royal Dutch-without, of course, any assu rance that the spread would con· tract. I n practical terms, a position that la rge was tota l l y i l liq u id .

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Contrary to common su pposition, there is nothing wrong with being i l l iq uid-un less you are v u l nerable to being forced to sell i n a h u rry. But Long-Term, being h ighly leveraged, was i n that very spot-for, as we have seen, leveraged i n vestors can acc u m u la te losses with terrify i ng speed. Ignoring this o ft - proven verity, l l agh a n i struck a gargantuan trade with borrowed m oney. l i e was u nder stress due to the i l l health of h i s father, who died later that year, a n d he felt pres­ sure due to t h e deteriorating lan dsc<tpc in bond arbi trage. Sti l l , there i' no expla i n i ng the size of the Royal D utch/Shell trade, other than to accept that Hagha n i W
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that merger arbitrage-particu l a r l y on such a scalc-wa� e x n·-.. , 1 \T h· risky for the obvious reason that Long-Term was p l a y i ng in a field in which i t had a bsolutely no e xpertise . .\1criwether and h i s trader'> knew the bond world inside out. In merger arbitrage, j . .\1 . had no edge; indeed, i t was Long-Term's rivals who had the advantage. Within Long-Term, the debate over merger arbit rage was fierce . .\leriwcthcr ran the debate like a seminar, tolerating a l l point s of view. In a sen se, this was a mistake: J . i"vl . never put h i s foot down . A fter such a l ong and fruitful partnership, he was d isinclined to in­ tervene aga i n st h i '> two enfa n t terrible trader�, H i l i bra nd and l lagha n i . J . .\1 . 's pcr'ional loya I tics weighed on portfolio considera­ tions, a serious flaw in a risk manager. "This trade was by far the most controvcr�ial in our partnership," Eric Rosenfeld adm itted. " A lot of people felt we �houldn't be i n the risk arb busi ness beca usc it i'> so i n formation sensitive a n d we weren't trying to trade in an i n formation-sensitive way. " ' The firm would most l ikely have steered clear o f risk a rbitr;tge had the genera l l y pop u l a r Rosenfeld opposed the trade ( .\1 eri wethcr, i n particul a r, r a rely made a decision without con sulting h i s trusted pro­ tege ) . l lowever, Rosenfeld, too, tended to side with l l i l i br;md and Haghani, and the others fi n a l l y went a long. Veteran a rbs quickly rea lized that somebody new h;t d entered the game and that the somehody was both very big and indiscrimin ate­ or, as Rosenfeld put i t , not " i n forma tion sensitive. " By b u y ing in such volume, Long-Term was boosting deal stock<. across the board, squeezing spreads ro unprofitable levels. As usual, Long-Term was content to earn relatively tiny �preads because it i n tended to m u l tiply its returns with leverage. Sti ll, one m a rvels at Long-Term's audacity, sauntering into a corner of Wa ll St reet-one in which '>.tv v\· vetnans had been working for \T;l fs-;t nd rew rit 1 ng the l'Conomic-.. of the field overnight. Long-Term was the gori lla that .t n J J O U IKC'> the ru les wher­ ever it goes. One n ight, l l i l i brand, J . .\1 . , and \1 u l l lll, ILHI d i n ner with Daniel Tisch, a prominen t risk a rbitrageur. Ti-,ch , -,on of the i n vestor Larry Tisch, had the i m pression that Long-Term wa� t h i n k i ng a bout the busi ness solely i n mathematical tcnm. Indeed, H i l i hran d expressed every fi nancial puzzle in terms of ;1 spread. In risk arh, spread'> were rough ly 4 percent to 1 o percent , m uch greater than bond spreads. "Our business looks very attractive next to their business, where they

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trade t o m a k e a couple of h a sis point s , " Tisch noted. " The on l y tro u ­ h l c i s , i f you 're wrong o n a government boml t h e spread m a y cha nge by a h a l f a poi n t . I f vou're wrong on risk arh, you can lose h a l f your position . " In 'horr, the reason that deal spreads were so much wider than bond 'preads was that you could lose a lot more money on merger a rb i t rage. Tisch left feel i ng that Long-Term d i d n 't know what it was doing. lr was both i nexperienced a n d high l y leVL·raged-a po­ tentially explosive combination . Terence Sull ivan, the Long-Term i n ­ vestor from Shaker Heigh ts, hea rd of its ri,k-arb i n volvement through the gra pevine and was shocked that the fund w�1s stra ying so far from irs ken. Apart from CBS, Long-Term's biggest position wa' .\lC : I Commu­ n ications, which in 1 99 6
Readers may be excused for wonderi ng how Long-Term could bor­ row so m uc h toward the purchase of stocks. The Federal Reserve Board, under a statutory provision k n own as " Regu lation ·1�" sets a limit on broker loans for stocks, also k n own as " m a rgin . " For the past twenty-five years, the Fed has set the maximum m a rgin loan at so percent of the total investment. When Long-Term purchased stocks, it of course w;ls s ubject to Reg T. Bur for the most parr, Long-Term built its equity pos i tions without buying actual securities. R ather, the fund e ntered i nt o deriv­ a tive contracts that mimicked the hch<�l'ior of stocks. I f, for i n stance, Long-Term w anted to earn the return on S 1 oo m i l lion of CBS stock over a three-year period, it wou l d stri ke a " swap" contr;lCt with, say, Swi's Ban k . Long-Term would agree to make a fi xed a n n ua l pay­ ment, calcu l a ted as a n interest rate on $ 1 oo m i l l io n . And Swiss Bank

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would agrt:e to pay Long-Term whatever profit would have been earned had Long-Term actu a l l y pu rchased the stoc k . ( If the stock ft: l l, Long-Tt:rm would pay Swiss Ba n k . ) .\1ost likely, Swiss B a n k would hedge its risk by buying actual shares. But that was n o concern of Long-Tt:rm 's. What m attt:red to J . M . and company was that they could m a kt: a h uge i n vt:stment I ll CBS with 110 money down and without having to make a l l of the usual disdmure�. A n d despite Rt:g ' [ � it was perfectly legal . The Fed, a fter a l l , merely restricted loan� toward the tmrchase of .;rock-;. Long-Term wasn't purchasing a n y th i ng; it was m a k ing side bets on the direction of stocks-which amounted to the same t h i ng. The Street had het:n using eq uity swaps to get around Reg T for a bout a dt:cadt:, hut in recent years the sca le of the b u s iness had so�1red . .VI oreover, ban k s had bt:comt: i ncreasingl y b l u nt a bout help­ ing fi rms s k i rr the margin rules. Deri vati vt:s had n ot sta rted out thi� way; i n fact, the premi�e beh ind them had been i n n ocuous. l nvt:st­ ment ban k ers i n the late 1 ') 70S a n d early I ') Xos had had the idea that simple agret:ments-contracts, derivati ves, call them what you l i ke­ would bt: a m or t: t:fficit:nt way of transferring risk than actua l l y b u y ­ ing and sel l i n g asseh. F o r ex�1mple, in r h e prederivarive e r a , most fa milies were stuck with fi xed - ra re mortgages. Fven a homeowner who would h a vt: prt:ferred to roll the d ice ( i .e., assume a l i nk risk on future rate s ) had no practical way to act on his sen t i ments. The hank offered h i m , and everyone el se, the s�Hne con vem ional fi xed -rare loa n . That w�1s u nderstandable, as the mortgage bank was also pay­ ing a fixed rate for irs money. But by using derivatives (a favori te ex­ a m ple o f \1 erton 's ) the bank could con vert a fi xed-rate loan into a floating-rate one. The gen i u > beh i nd the idea is that, for every cus­ tomer, there is a l ways some other pa rry with the opposite need. Per­ haps a comp a n y plan ned to make a nn u a l borrowings for m a n y yt:ars and would p refer tht: predicta b i lity of a fixt:d rat e. It o n l y �1 fa m i l y that h a d a fi xed-rate mortgage, a n d t h e com p;l n y, which w a s facing varying borrowing costs, could swap lo;m-,! Tlu n b to derivatives, they could. ( l\:or that they k new i r; b,m k s, natllra l l y, acted as i nter­ mediaries . ) The fi rst modern swap w a s engineered in 1 9 8 1 . I B M h a d bonds denom i n a ted in Swiss franc� and ( ;erman marks and wa nted to con­ vert this debt to dollars. David Swt:nsen, a Yale P h . D . newly a rrived at Salomon, suggested that pt:rhaps some other borrower could be

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persuaded to issue debt that, aside from being denomi n ated i n dol­ lars, was identical to I BM's. One obvious choice was the World Bank, which had a n a ppetite for holding debt i n a variety of c urrencies. As a n ind ucement to borrow, Salomon gave the han k a slightly lower­ than-ma rket i nterest rate. Then the two borrowers switched-I B M w i n d i n g u p w i t h dollar debt, t h e World B a n k with t h e foreign stu ff­ and voi l;1 ! the world of swaps was b o rn . The busi ness grew--at first slowly, then exponen t i a l l y. Soon, banks were swapping obligations for c u rrencies, i nterest rate pay­ ments, equ irie�, any future stream of cash that could he traded for an­ other. In 1 9 90, there were $2 tri l l ion worth of i nterest rare swaps ( j ust one type of derivati ve) o utstan d i ng. By 1 9 97, the total had soared to $ 2 2 tri l l ion., One offshoot-la rgely u n i nt e n ded-of this tremendous growth was that banks' fi nancial statements became in­ crea singly obscure. Derivatives weren't disclosed i n a n y way that was mea n ingfu l to outsiders. And as the volume of deals e x ploded, the banks" balance sheets revealed less a n d less of the i r tota l o b ligations. By the mid- 1 9 90s, the fin a nci a l statements of even m a n y midsized hanks were wrapped in an i m penetra ble haze. The b a nkers were too busy m a k i ng money to bother a bout the risks or the shoddy disclosure in this fast-growi ng b usiness. The few who did voice c a ution, such as Henry K a u fman, a noted economist who worked at Salomon i n the 1 9 S os, were ignored . K a u fman re­ called: I still remember when .\1eriwether\ group carne in and we started doing i n terest-rate swaps. There was a l ways a q uestion of what type of li mits we would set. It j u st kept mounting and mounting. A fter we had a b i l l ion it went to two b i l l i o n . Then it went to fi ve b i l l ion. There was never a n analytical framework for sa ying how far we should go. By 1 9 9 5, when Meriwether's traders were happ i l y ensconced at Long-Term, the group had a total derivative hook worth $ 6 5 0 bil­ lion. With i n two years, the tota l doubled, to a n asto u n d i ng $ 1 .2 5 tril­ lion. G i ven the opaq ue nature of Long-Term's ( a nd everyone else's) disclosures, i t was im possi ble to p i n point the fund's derivative risks accordi n g to spec i fic trades. And si nce many of its contracts were hedges that tended to cancel each other out, it was i mpossi ble to cal­ culate Long-Term's true economic e xposure. One could say only that

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it a ppeared to he growing very q u ick ly-as were exposures u p and down Wal l Street. A lmost i m percept i b l y, the Street h a d bought i nto a massive fai th game, in which each ban k had become k n itted to its neighbor t h ro ugh a web of con tractual obligations req u i ring li ttle or no down payment. Regul ators became increasingly worried. By the m i d - 1 9 90S, Wa l l Street h a d become accustomed to o n e or two deri vative " shock s " a year. Ba n k s or i nstitutions considered healthy one day would go up i n smoke the next due to h idden derivative ex posures. One hy one, Orange Count y, Ban kers Trust, Bari ngs Bank, .'vletal lgesellschaft, Sumitomo Corporation, and others revealed sudden a n d massive losses. As the list oi individual tra u ma s grew, regula to r s began to fret about the possi b i l i ty of a shock to the entire system: p u l l on the right thread, and the entire hal l of string would unravel, they fea red. But was there such a t h read, a fi rm so i n tertwined with Wa ll Street that i ts fai l u re could undo the syste m ? Such fears m a y h a v e been un­ focused, h u t they were not u n reasonable. In the words of \licholas Brady, the former Treasury secreta ry, " Every time there's been a fire, these guys I derivative traders I have been a round i t . " " As earl y a s t h e spring o f 1 9 94, j ust when Long-Term was starting to trade, the 1\:ew York red W;\S becom ing U Tl l\lS)' a hout hedge funds' easy access to credit, i ncluding deri vative credit. In A pril, in a letter to the CEOs of every hank in the 1\:cw York region, Chester Feld berg, executive v ice president of the l\:ew York Fed, a d m o n ished the hankers not to eschew their h i storic duty to prudence. " C redit l i m its for customers a rc a n essential tool for cred it risk management," Feld­ berg warned . · Following up such concerns, Fed regulato r s met with man,1gers at several large 0:ew York ba nks in r 997 to d iscuss the banks' relationships with hedge funds.' The Fed e x ,l m iners u rged the hanks to step u p thei r monitoring of hedge fu nd acl·ou ms h ut, sur­ prisingly, reported that the h a n k s were a l readv 1 111pro v i n g their su­ JX'f\'ISion . With regard to derivatives, the pol icy m a k mg ,mn of the Fed took a laissez-fa i re a pproach-starting w i t h ( ; l"l"l"ll';pan. who was enam­ ored with the seam less a rtistry of the new lin,lncial tools. I n p u b l ic debates, G reenspan repeated ly joi ned torces with private b a nkers, led by C : i ticorp's john Reed, who wne lighting woth and n a i l to hc,ld off proposa ls for t ougher disclosure req u i rements. Fven as hedge funds increasingly u sed swaps to dodge the Fed\ own m a rgin r ules,

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GnTn'ipan cast <1n a pprov ing eye. I n c redibly, rather than trying to ex­ tend some form of margin rule to the derivative world, Greenspan proposed to elimi nate the margin ru les ent i rely. ! l is I l) l) 5 testimony to Congress read like a banker's brief. r\t its heart was a begu il ingly sim ple idea: that more trad ing ( a n d hence more lending) was alwavs and in herently good beca use it holstered "' liquid irv. " Removal of these financing con-,tr.1 i nr-, would promote the safety and sou ndne.,s of broker-dea lers hy permitting more fi ­ nancing alternati ves and hence more effccti ve l i q u i d in· m<1 nage­ ment. . . . In the case of b ro k e r-dea ler'>, rhe federal Re.,erve Board sees no pu blic pol icy pu rpose i n i t being in vohed in m-er­ seeing rheir Sl'C u ritie., credi t. ' ' r\ hit of l iq u idity greases the wheel., of m.uket'>: w h a t G reenspan overlooked i s that with too much l i q u idi ty, the Ill<1 rkcr is a pt to skid off the tra c k s . " Too much rr,1ding encou rages speni btion, and no marker, no matter how liquid, can accommmLne all poten tial seller., when the day of reckoning come'>. Bur G reenspan was hardly rhe first ro he seduced hy the notion t h a t if onlv we had a l i rril· more "' l iq u id­ i t\', .. we could prevent col lapses forever. Save for rhe Fed, the on l v ones who could restr<1 i n derivative lend­ ing were the hanks. But Wa ll Street ne,·er polices itsel f in good times. The ha nks' own bala nce <>heets were stead i l y ballooni ng; hv the !arc I l) ';)Os. Wa l l Street was leveraged 2. 5 ro 1 . ' 1\wash with liq uidit\ i i not q u ite d rowning in i t , t h e b a n k s /;,zd ro fi nd an outlet for rheir cap­ ira ! . The most tempting targets were hedge fu nds. "' People were look­ ing at the good side of the world , " noted Steve F reidheim, a trader and hedge fund ma nJgcr ar Ban kers Trust. "' I could borrow a n v amoun t I wanted, a n d t h e rates kept c o m i n g dow n . I 'd g e t calls from banks sayi ng, ' Hey, we got a n other fifrv m i l l ion for you-we got a hundred m i l lion ! ' ,. As ban ks relentlessly chased the fund business, rhey silently rela xed their -,ra ndards, marking down the risk of possi­ ble nega t i ve news. By I 9 9 6, Wa l l St reet was trading $ )OO b i l l ion in repos and $ 2.00 b i ll ion in c u rrency and i n terest rate swaps every day. ' · :\'o borrower had to account for its total exposu re: no lender asked. Each b a n k knew the extent of its otl'/1 exposure to a n indi vid­ ual cl ient. i n particular to Long-Term. ]\;one bothered to t h i n k a hour whether the hedge fund m ight be s i m i l a r l y exposed to a dozen other

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hanks. " Yo u 'd be doing big c h u n k s o f busi ne's with them," recal led Sicil iano, the m a n ager at Swiss B a n k . " You'd assume you were their n u m ber one provider, hut real l y you were n u m ber ten . You couldn't bel ieve they were doing that m uch volume." Swiss Ba n k had a s u btle bur powerful impact on Long-Term. Too 'ophi sticated i n derivatives to be easi l y impressed bv the s u perstars i n C rcenwich, it� h i story h a d paral leled Long-Term's. I n 1 <) 7 7 , when commodity traders had begun to a pply the options formula th;l t :V1 er­ ton and Scholes had in vented, Edwa rd and Wi l l i a m O'Connor, tvvo brother' who traded soybeans, had fou nded a new fi rm to i nvest i n option,. O'Connor & Associate' became o n e of t h e savviest of the new derivatives fi rms. I n 1 9 X 6, the firm hired David Solo, a terse, precise-spoken electrical engineer from M IT and a bri l l i a n t q ua nt ita­ tive trader. A fter the 1 9lh stock m arket crash, when options traders ,u ffered massive lo,,e,, O'Connor rea lized it needed deeper pockets. Citicorp, Bank er, Trust, and l J BS a l l had a ch;mce to acqu i re O'Con nor h u t passed. Fin a lly, i n 1 9 9 1 , Swiss B a n k bought it. This W ; l S a hold move. Swiss ba n k s were cloi stered hurea ucracie' in w h ic h on ly S w i " n a tionals could hope for employment and pro motion . Of Switzerla n d 's big th ree hanb, Swiss Bank was rhe most tradition a l . \ L1 rccl Chpel, t h e head of Swis'> Ba n k 's intern;Hional di vision, meant to change thi,. Though he had started a' a s i x t een- year-old a ppren ­ tice, splitting h i s time between b a n k i ng and school, Ospel had done a sti nt at :V1crri l l Lynch and rea l ized that Switzerla n d 's b a n k s would h;l Ve to modern ize or go the way of the cuckoo cloc k . l ie u sed O'Con nor to shake up the paroc h i a l cu lture in Basel, i n j ecting Yan­ kee idea' '>uch as a n incenti ve system that rewarded trader'> for long­ term performance. In 1 9 9 5 , C hpel engineered the p u rchase of S. C . \'V'arbu rg, B rita i n \ la rgest investment h a n k , a n d Swis'> Bank was doi'>tcred n o more. Too late, C :a bi a l l a vetta, Ospel's counterpart ;lt t h t· riv;l l l i BS, rea l­ ized that Swiss Bank was building a powerhou'>c 1 1 1 dni v;Hin·s that outclassed h i s o w n . Charismatic a n d loud whne ( hpel was q u iet and shy, C :a h i a l l a vetta panicked a n d hecamc dt''>PL'Lltc to overtake the up­ start. I lc w a s especially keen on b u i l d i ng the relations h i p with Long­ Term, which he ideal ized as the perfect partner i n derivati ves. The best way to d o that, he decided, was to ;lpprove .\1yron Scholes\ war­ rant . At Swiss Ha nk, the warrant had been tlnl y rejected, b u t at U BS, it had percolated toward the h ighest echelons of the ha n k . L i m , the

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trader, a nd Bauer, the derivative� ho��, who still regretted nor h a ving made a n in vestment i n Long-Term, had horh e mbraced the warrant. Steven Sch u l m a n , the risk man ager at t : BS, h,ld given i t a fa vorable nod. So had Werner Bonadu rer, who oversaw trading. That left it to Ca hiallavetta . I n J u n e I <J <J � , a h u ngry l J BS agreed to �el l Long-Term it'i long·�ought wa rrant. In a companion parr of the agreement, lJ BS, as�uming a mas�ive risk, beca m e the single biggest i n vestor in the fu nd. The terms called for a gro u p of the partner� to pay U BS a premium of S2Xy m i l lion. I n return, l J BS promi sed to pay t h e partners am profiro; ( m ore or less) that a n m vestor with S X oo m i l lion worth of Long-Term would make over the next seven �Tar�. A� a hedge again�t this obligation, UBS bought a n S X oo m i llion interest i n the fu nd. Fi­ nallv, as a sweetener, the bank was permi tted to in vest a n addition a l S 2 () (, m i l l ion in Long-Term. T h a t w a s the " ha�ic idea , " according to Ta nnenbaum, t h e sale'iman: " I f we wrote them calls on their own stock, they would let us in vest a third again as much in the equity of the fund. " ·Lmnen b a u m 's superiors regarded the warra nt as a coup. UBS\ managers were so ecstatic that they fought over which d i v i sion of the hank should hook the transaction. Bonadurcr claimed it for the fi xed­ income division-an odd choice, except that Bonadurer and Cahi­ a l lavetta were close iriends. Then, part of the deal was shi fted to the bank\ treasury depa rtment, which paid a ') percent pre m i u m . " l J BS's managers fig u red that event ua l l y rhev could repackage thei r Long­ Term i nvestment and sell it to wealthy �·l icnts; in the meanti me, they chortled a bout their new strategic relationsh ip to :\tcri wethcr. Cabi­ allavetta toasted their
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o n e t o t h e possi b i lity of fa i l u re. At the very t i m e w h e n t h e o utlet> for their n a rrow s k i l l s were dosing, the partners tossed off their i n nate caution, w h ic h had served them so well, l i ke an old suit. �1a n y put their ent i re net worth i nto the fund. :\1 u l l i ns, the former Fed offic i a l , was a n e xception; he stuck to his characteristic ban ker\ p rudence and opted out of the warra nt . ' · Otherwise, Sici l i a n o n oted, "These guys bel ieved in what they were doing with every o unce of their being. " The partners a lso forged a similar, though s m a l ler, war­ rant deal with Cred it Sui sse, a nother Swi" in vestment b a n k . B u r even t h a t w a s n or enough. To leverage even further, I TC 'vl , the partners' m a n a gement company, borrowed a total o f $ 1 oo m i llion from a trio o f han k s-Chase, fleet Bank, and Credit Lyon n a i > of France-wh ich money the partners plowed right back i nto the fund . "' Their h unger to turn m i l lions i nto b i l lions knew no bounds, nor did it recognize any risks. for men who prided themselves o n being dis­ ci ples of reason, their d ri ve to l i ve on the edge seemed inexplica ble, un less they bclicvt·d that beco m i ng the richc•;t would cert i fy them as a lso being the smartest. A> i f to tempt the fates, H i l i brand per-;ona l l v horrowl'd $ :q m i l ­ l ion more from Credit l .yonnai,, w h i c h ' c t up a program to l e t the partnl'rs borrow again>t their l ntL'rL'St\ 1 11 the fu nd. I t a n s l l u fschrnid, who >pecial izl'd in c u rrency t rades, borrowed S 1 5 m i l l ion, and two other partners borrowed lc,ser a m o unts. ' In addition, some of the partners had levl'ragcd personally with Rea r Stearm, their broker. Considning that the fund itself w;ls so heavily leveraged, thl' pa rt­ ners, l l i l i hrand in particular, were dangerously adding leveragl' to leverage, as if coati ng a fla m ma b l e tinderbox with kerosene. As op­ posed to a poor man who bets the l i m i t on a single horse, the a l ready rich l li l i brand had l i ttle to win a n d everything to lose. The l J B S wa rrant raised $ 1 b i l l i o n of cquitv for Long-Tl' rm at the worst pos>ihle rnoml'IH-wlll'n the fund wa\ s t r u gg l i n g to find p lacl's to in vl'st thl' money it a l ready had a n d when it wa' fighting off more and more competitor> in arbitrage. In the fir-;t h,, l f of 1 'J 'J 7 , it earned only I -, percent before fees-sti l l i m p rcsm'l', though well below its prior a verage. I ts leverage ( aga i n , not counting derivatives) fell from 30 to 1 to 20 to 1 , evidence that opportu nities had grown sca rce. A group of skeptical partners, including Scholes, were gro w i n g i n creas­ ingly u n co m fortable with the fund\ portfolio. One bright spot was Japan, where Long-Term was extremely prof-

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W H E N G E N I U S FAILED

itable, thanks i n part to David .Vlodest, a grayi ng, forty-th ree-year­ old former scholar. Modest, Rosenfeld, and a young trader na med C :arl l l uttenlocher devised a series of eq u i ty a rbitrages to exploit the Japa nese lack of fa m iliarity with, and mispricing of, options. Long­ Term's models made this an '' obvious" and, i ndeed, highly l ucrative trade. Modest, a d ro l l theoretician from Berkeley, and a handful of others would work the graveyard shift, staying until I .-\ . \ 1 . , when the next day's Tokyo rna rket fin a II y closed. Short I y a fter, w h i l e C reen­ wich slept, a skeleton crew would a rrive in time for the open ing in London, where J a panese wa rrants traded. " We had a couple of traders l i k e D a v i d l .\1odestl j u st k i ll i ng themselves," Rosenfeld re­ cal led. In J une I ') ') 7 , the traders were able to revert to normal hou rs, as Long-Term opened a Tokyo office. It was run by C h i-hi H u a ng, a prized .\1 1T mathematician and expert in model ing whom Long-Term snatched away from (;oldman Sachs, and Arjun Krishnamachar, a former swa ps trader at Salomon. j . !\1 . , who had been travel i ng to Japan for years, l iked having an institutional presence there. For a Western hedge fund i n ' li>kyo, Long-Term had remarkable cachet. M u l l i ns, who had i n form a l l y ad­ vised Japanese government officia l s when he had worked a t the Fed, contin ued to do so at Long-Ter m . W herever it operated, the fund's tentacles penetrated to the highest reaches. The pa rtners' ci rcle of conract'i was a maJor asset . Fven i n J a pan, the partners p u rsued a controversial trade. I n I ') ') 7 , J a pan's long bond w;ls y ielding only 2 percent, seem i ngly rock hot­ tom. Long-Term placed a na ked, unhedged her that this rare would rise-a so-ca l led di rectional trade in that i t W;lS betting on a single rate as di stinct from a spread. M a n y of the partners had doubts a bout the trade, which for Long-Term was un usually spec u l a tive. But ! !i i i ­ brand and Haghani were increasingly running the fi rm i rn:spective o f t h e wea ker p;l rtners' wishes. W i t h t h e resu l ts 'i O good, i t was easy to dismiss the na ysayers a s worrywa rts . •

At Long-'lcrm's I ') 9 7 annual meeting, in J u l y, the pa rtners admi tted they were concerned a bout the shrinking spreads in bond arbitrage. The meeting had to be held outside the United Stares, so as nor to jeopa rdize l .ong-' l crm\ legal status as an offshore fund. It was hosted i n a hotel by the Toronto a irport so that the p
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and out i n a day. Only four of them ( Leahy, ,\lu l l ins, Rosen feld, and Scholes) a n d about twenty-five i nvestors attended. The mood was downbeat: spreads had converged more quickly than the p a rtners had expected, sq ueezing potential profi ts. Though typical l y taciturn, Rosenfeld did reveal that Long-Term was getting i nvol ved i n eq u i ty trades. The s m a l l crowd of in vestors sudden ly l ivened. One i nvestor demanded, " We hear you're the biggest player in risk arbitrage. Are you ? " Rosen feld responded evasively. The i n vestors sensed that Long-Term was a pproaching a denouement. " D o you have a n y plan to return t h e money ? " a n i nvestor asked. Aga i n , Rosenfeld w a s vague. " We l l , whatever you d o , d o n ' t ret urn mine," t h e i nvestor s a i d . •

Coincident with the dour outlook for arbitrage, two prominent fi­ nance professors p u b l ished a paper a rguing that arbitrage was far riskier than its adherents claimed-the first shot at Long-Term's model fired from within academe. Writing in the prestigious Journ,zl of Fillullcc, A n d rei Shleifer of l la rvard and Robert W. Vishny of Ch icago presciently wa rned that a n arbitr.1ge fi rm of Long -Term's type could he overwhelmed i f " n oise tr.1der�" ( me;l n i n g u n i n formed specul ators) p ushed prices away irom true \·a lue. With u n ca n n y fore­ 'iight, rhey predicted that, in 'iuch a case, a rbitrageurs would "expe­ rience an a d verse price shock " a n d he forced to l i q uidate at m arket lows. " ,\1erron read an early version prior to publ ication but was nor con v inced; at a conference of scholars in Cam bridge, h e pooh­ poohed the notion that ma rkets could ever be overwhelmed. ' '' Then, in J uly, j mr weeks a fter the warra nt dea l , i nternational m a r­ kets were b a d l y shaken. Thailand, beset by financial defa u lts, al­ lowed irs c urrency to float. It prompt l v fell 2.0 perce n t . The wea k ness spread to c u rrencies Ill the Ph i l i ppi ne-,, \L llav'ii
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W H E N G E N I U S FAI L E D

blamed " rogue specu lator�" from overseas, speci fica l l y George Soros, for selling the Tigers out. :'vl ahathir had some of the right cul prits hut the wrong cri me. For­ eigners cou l d h a rd l y he blamed for deserting a listing s h i p; thei r sin was having provided the too-easy short-term credi t t h a t had l a unched the ship at fla n k speed. Comforted lw Treasury Secretary Roherr Rubin's ba ilout of .VIexico, Western hanks and investors had shoveled money at i\ s i a , fueling speculative in vestmen t s and u nderwriting the region's corrupt behavior. Rubin h a d pa ved the way h y u rging Asian governments t o l i ft controls on capital ;md th u s to a l low the money to pour i n-despite the area's appa l l i ng lack oi corporate d i sclosure and regu lato ry oversight. "The simple fact is that very sophisticated hanks loa ned to Indonesian companies, without a n y real knowledge of their fi nancial cond i tion," noted .fa mes Wol fensohn, president of the World Ba n k . ' Though Western i n vestors h a d repeatedly made the same m is­ take-to d a y romanticizing the developing world, tomorrow coming to rue their na·J·vete-the ban kers never learned. I n 1 ':) ':) 6 , S ':i ) billion of foreign capital had flooded I n donesia, M a laysia, the P h i l ippines, South Korea, and Thailand even a s thei r economics were slowing. \:ow that same money was dra i n i n g out, unnerving m a rkers a round the world. From Long-Term\ point o f view, both A s i a 's uphill and down h i l l sl opes were instructive. Easv cred it, which hedge funds a lso enjoyed, had led to i l l -advi sed and excessive inve•;tmenrs. Then, when the tables had turned, Greenspan\ much-vau nted l i q u idity was no­ where to be found, and the damage spread almost a t random. Once a typhoon brea ks loose in m a rkets, there i s no tel l i ng where i t w i l l go . •

I n late summer, the fund received a bit of had news: the !vi C ! merger was renegot ia ted at a lower price. M C Ts stock price colla psed, and Long-Term l ost $ 1 50 mill ion overnight-the first sign that it had been fishing in dangerous waters. I n Asia, where Long-Term's i nvest­ ment'> were primari l y in Japan, the fund was wea thering the storm . September, i n fact, was one oi l .ong-Term 's best months: i t earned $ ) oo mil lion. But the firm's prospects were steadi l y dimmi ng. When the pa rtners returned from their ann ual golfing party in Watervi l l e w i t h Merri ll Lynch, they a n n ou nced a shocki ng diktat: outside i nvestors in Long-

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T�:rm would hav�: to tak�: hack a bout h a l f of th�:ir money, j ust thl' investor at the a n n u a l meeting h
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W H E N GENIUS FAILED

seem i ro n ic, a n d the forced redemption of their money would come to seem a godsend. It wa� the pa rtners who would su ffer the most. But without the benefi t of hi ndsight, the partners' o bsessive p ursuit of wea lth carried more than a w h i ff o f greed. l\:ow that they had the scale to operate worldwide, they had n o i n terest in m a n aging money for others and l a rgely froze them out. They added a n u n u s u a l l y self­ serving touch, racking on fees, for the first time, to the bon w, money invested b y some of their own employees! The partners J LI'. t it ied the forced redemption as a sensi blc response to dimin ished prospech . .\1 y ro n Scholes said it was i ro n i c t h a t Long­ Term was gi ving m oney back at the Sseb, wh ich weren't, in fact, s h r i n k i ng at a l l . I ndeed, a t a t i m e w h e n opportun ities were dry ing u p a n d t h e portfo­ l i o was bloated with 7 ,6oo positions, the fund was defiantly and ill­ advisedly lever;lging itself fu rther, like a n Icarus chasing the s u n . ' ' .\1oreover, hv forcing outsiders to sel l, the partners were, once again, i ncreasing their personal leverage in the fund. The personal debt, on top o f the leverage in the management company a n d the debt in the fu nd itsel f, made for three levels of debt preca riouslv pyra­ m ided one a to p the other. •

Six days a fter :Vleriwether i n formed imT'>tor., that they would have to take money hack, the fi rm's cradle, Salomon Bro t hers, dropped a bombshell of irs own . Salomon had never fully rega i ned its footing a fter the .\1ozer sca ndal, the e x i t o f Meriwether, and the defections of Rosenfeld, l bghani, Hawkins, a n d H i l i brand. I t h as Long-Term was. Earlier in the year, its executi ves had agreed that Salomon would need a sig­ n i fica n t i n fusion o f capital or risk becom ing a second-class fi rm. Warren B u ffett, who, through Berksh ire l la thaway, was Salomon\ biggest sha rehol der, was constitutiona l l y opposed to i n vesting more money in fa i l i ng enterprises, which time and aga i n he had equated with throwing good money a fter had. Deryck \ b ughan, t h e chief ex­ ecutive o f Salomon, made i t clear that the only other option was to

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sel l the company. " Wa rren wa nted to >el l �o badly, " a d irector o f the compa n y > a i d . B u t to whom? �1aughan sounded our C :hase, b u t t h e h a n k rebu ffed him. Then he had l unch w i t h San ford I . Wei l l, chairman of Tra velers, the insurer . The -;on of a Brook l y n d ress

n1<1 n u facrurer, \Vei l ! had founded a humble four-man brokerage firm and, via mergers, stitched tog et h er the giant Shear-;on Leh ma n . Even­ tua l l y, he h ,ul sold

to

Americ1n F x p ress, lmr out in a power <,truggle

.md resigned. Then, in the late 1 ') Xo-; and eark '9os, he had done it .1ga i n . get t i n g control of <1 o,nu l l cred i t comp;mv and using it

to take

over Smith Barney and o Tr.l iTln,. I k di,Jiknl treet\ soci.1l h i n a rc h v. Pe rhaps S m i t h Barney ;md Salomon could pur their two >econd-class h a nb

toget h e r,

\X/ci l l proposed.

After the l u n c h with �h ugh a n , Wei l l cal led hack to i nsist that he w o u l d have to be in charge if Tra vel ers and Salomon m e rged. B u ffett

didn't c a re w h o ran the new compa n y, he j ust wanted to sel l the o l d one-at a good price, natura l l y. We i l l offered $9 b i l l i o n i n stock , h a i l ­ ing t h e O m a ha sage our of o n e of h i -, moo,t troubled i m est m e n t s . Ever d i plomatic, Buffett prnl We i l l <1'> .1 "gcn l u .,

..

. 11 h u d d m g -,h a re­

holder ,-,l i m· . " \X'e i l l \ u n d c r l mg-, 1\'L'fl' .1ghast th;l t h e had paid '>O m uch for a second-r a rbi trage, w h i c h the chairman detested. One hou>e jester s n i ckered, " Sandy spent nine b i l lion d o l l a rs to get a p i ece o f paper from Wa rren Bu fferr tor he was. He

was r u n n i n g a r o u n d showing i t to people l i ke a kid in a c a n d y store . " I t is i n teresting t o contrast Long--l (:rrn a n d its mother fi rm as each crossed a t h reshold. :\kriwerher had succe
billion in i f!, l ast fu l l year, compared w ith $')oO m i l lion for the i n vest­ ment ban k . S a l omon sti l l had a profitable arbitrage unit, but its at­ tempt to b u i l d a broad hank had fa iled. Long-Term, w h i le toying w i th the idea of d iversifying, had rem a i ned focused, a smart decision thus iar. But as both firms well k new, a r b itrage was entering a t ougher pe­ riod. Thei r responses were I Xo degrees apart. By merging Salomon with a more d iversified partner, B u ffett had d i luted the Salomon share-

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WHEN GENIUS FAILED

holders' interests in arbitrage and in the rest of Salomon's business. Now they would own pieces of a m uch larger Travelers. Long-Term's partners had made the exact opposite decision: to a great extent, they had bought out their partners, thus redoubling their bets on a rbitrage. The irony was that Buffett had converted a chronic loser into $':1 bil­ lion while Long-Term's partners had converted a consistent wmner into a giant-and still un rea lized-bet on the future. •

In October, the fund got a pw.i tive jolt: .\Ienon and Scholes won the Nobel Memorial Prize in Economic Science. :-.1erron, who was teach­ ing a class at l larvard, got a three-minute ovation from his students. He humbly warned, however, " It's a wrong perception to believe that you can elim inate risk j ust because you can measure it. "·' • Scholes, sitting for a celebrity profile with his hometown Othlll'u Citi::.en. was brusquely reminded of how skeptical the outside world was of derivatives. The Citizen had the temerity to inquire, "I low responsible do you feel for the I ')ll7 stock market crash ? " The stlmncd Nobcl la urcarc sputtered, " Nor at all. Nor really at all. It's the same as asking I Al fred l Nobel if he is responsi ble for the First World Wa r because he invented dyna­ mite." Pressed, Scholes adm itted that people trading on his theory­ meaning dynamically hedging, or -;elling on the way down-had exacerbated the crash, though he blamed a lack of " l iquidity," the fa­ miliar scapegoat. Always good at reducing high finance to everyday English, Scholes described Long-'l i._· rm in rl:'freshingly plain terms: "What we do is look around the world for in vestments that we think arc, beca use of our models, underval ued or overval ued. And then we hedge out the risk of something we don 'r know, like a marker factor. " ' From their col leagues in academe, Merton a n d Scholes got effusive praise; the rule that six economists h a \·c seven opinions on every sub­ jeer did nor apply to the Black-Scholcs theorem, which was h a i led as a towering contri bution to theory a-. well as practice. ( ; regg Ja rrell, a Chicago School economist at the l ! nivcr'oity of Rochestcr, e<1l led it "one of the most elegant and precise models that a n y of us has ever sccn. '"' But was real ity so precise? :'\!o ma tter. The fconomist in­ toncd, "What M r. �lerton and �1 r. Scholes did, back in I ':17 ), was to put a price on ri s k . " -"' A writer in The Wall Strect foum,li found proof in the award of the newspaper's most cherished belief, succinctly opining, "The Royal Swedish Academy of Sciences has made a dear ' l . i l < ' l ll<'Jl l : l\1 ;ukcrs work. " '"

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It was a n odd time to express one's faith. A l l across Asia, ni rrcnc·v and stock ma rkets were imploding. One Jay the epicenter was Thai land, the next Malaysia, then Indonesi a . On a single day, October 1 , Indonesi a 's rupiah plunged 6 . 5 percent, the Malaysian ringgit fell 4 · 5 percent, the P h i l i ppine peso 2 . 2 percent. Two days later, the rupiah plu nged X . 5 percent more. Though Asians had sown the seeds of their own cri-.is, no one was prepared for the market"s bruta l i t y or for the random way in which the contagion 'pread. Fven Latin A merican markets were pounded. I n the age of the I nternet, markets seemed connected by an invisible pla-.ma lin king the fate of bou rses oceans apart. By l ate October, com panies acros-. Asia were defa u lting, rais­ ing the specter of recession. Speculato rs then turned thei r guns on the Hong Kong dol l ar. The government, still under the British Crown, re­ ta l iated, rai-.ing overnight i nterest rates to a staggering _:; oo percent. The island\ stock marker gave up 2 3 percent in a wee k . By now, U .S. investors, fea ring t h a t Asia's agony w o u l d trigger a global slowdown, were in fu l l retreat. The Dow, which had reached a high of X , _:; oo during the summer, had fa l len through m ost of Oc­ tober. On the Friday before l lal lowcen, it fell more than 1 oo points, to 7 ,7 1 5 . Then on .vl ombv, O c ro lw r 2 - - vt·t .nwthn I l l "l' L l h k �1onday-Asia's fl u t i n .1 l h landnl .1 1 A mcnc.1\ d oor. I ht· d . 1 v \ losst's beg l.un, :-\ 1 ck Brady bla med the leverage i m plicit in derivative markch tor m n·-;en ing the damage: I have heard all the argu me n t s ;lhout h o w derivati ves and dy­ namic hedging decreases tran-;;lct ion Ul�t' and increases the depth of m arkets. Bur cert a i n l y ca rried to extremes they a rc not worth what they cost. . . . Excess lnerage\ part in last week's sell-off is well worth a lor of t h ought. ·

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WHEN GENIUS FAILED

Long-Term Capital dodged the hu ller again. The fu nd broke even in October and :--J o vcmher, q uite an accompl ishment. I ndeed, for Long-Term, Asia wa> an opportuni ty. With markets whi pped up ( more "volatile," as traders would say), Long-Term began to place hefty deri vative bets that stock trading would settle down-or that the volatility of stocks would fa l l . This was risky stuff. Salomon had made t h i s bet before October and had lost S r r o million. But short­ ing volatil ity w;p; the mmt natural of bet s for Long-Term. I n a sense, every one of it> spread tr;Jdes wa� a het on les�encd volatility. When markets a rc j u mpy, the prem ium for safety is greater; when ma rkers settle down, spreads tend to contract. "A lot oi our trades were 'vol' trades," Rosen feld noted. '·' In one form or another, the fund was a l ­ ways betting on calmer o r more convergent markers. U BS, Long-Term\ new hig investor, a l so had gambled on equity volatil i ty, and that and other exotic trades were turning i n to a disas­ ter for the hank. R umors were ci rcu lating of massive l osses in the de­ rivatives u n i t, run ( with total a u tonom y ) by c ;oldstein, who had pocketed an $ 1 1 . 5 mil lion bon us for I l) 9 6 . ' ' When toted up, U BS's losse> in 1 9 9 7 would reach $644 m i l l ion. Among other had trades, l J BS lost heav i l y on Japane>e convert i bles, which Long-Term had un­ derstood better. C:ahial lavetta, the han k 's chief executi ve, had long protected Goldstei n. Now he fi na l l y rea l ized that his pet trader was destroying the bank. I n :\ovem ber, C :ahial la vetta iorced Goldstein to resign . Then, in December, CJ hial lavetta admi tted that h is hank was hercit of leadership and humbly struck <1 merger with the a rchrival Swi>s Bank. Although Ca hiallavetta would qay as chairman and the bank would keep the U BS name, Swiss Bank was clearly the win ner. Basel fil led most of the important j obs and impo>cd its more conser­ vative culture on the gunslingers in Zurich. I ronica l l y, by merging with its fla m boyant rival, Swiss Bank had become a parry to the Long-Term warrant that it previ ously had spurned . •

In Stock holm, ,\;Ienon and Scholes put up at the Grand, a sumptuous hotel with a curving stai rcase, overlooking the old city. At the Nobel banquet, a black-tie affair for 1 , 200, the la ureates sat with a few friends and fam i l y members, the king and queen, various pri nces, and the quecn's mother. Waiters and waitresses who had a ud i tioned from

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all over Sweden served smoked fish on silver platter;. The la ureate; were in a bubbly mood. \lerton, as if to reassure h imse l f that he was rea lly there, k ept inqu iring of hi; gue�b, " A rc you having a good rime ? " l ie g;J ve a brief roast, ex pres;ing gratitude and a lso regret that Fischer Black hadn't l ived to ;hare the award . .\ Ienon\ lecture to the academy focused on the a pphcations <;pawned hv h is option rhn>r}, ranging from adjustable-rate m ort­ gages to student loan guaran tees to fle x i ble health care plans. " 'Option - like' struct ure., were �oon seen to be l ur k i ng everyw here, " .\-lerton a sserted, though it seem� unlikely that cause and effect were so direct. H i s own principal comriburion, .\1 erton noted-this being two months after the Dow\ 5 5 4 -point one -chy spill-- -had been to
•

Despite the festi ve mood, both l a ureates were deeply concerned about Long-Term\ future. Though Scholes confidently told Eugene Fama, his old adviser, that Long-Term Capital was safely mak ing a thousand s m a l l bets, Scholes decided nor to invest h i s h a l f of the m i l lion-dollar 0-'obel bounrv I ll the fund. · l rmuca l l y, the i v o r v - tower academics had a keener �ense o t t lw nsh th;m the 'e;J .,onnl traders did. Scholes and ;\ Ienon wne both leading the good life. Sclwles drove a wh i te B M W; .\-lerton, the car hu ff, sported a dark Jaguar. Scholes had rented a spacious home overlooking the water in C reen­ wich . .'vlerron had dyed hi; hair red, left his wiie, and m oved into a ;nazzy pad in Boston . Hut their fortunes were relatively small, and neither felt a s i n v u lnerable as their m u ltimill ionaire partners did. A� outsiders, n or trader;, thev had a perspective not shared hy l l ili­ hrand. The la ureates cou l d �ee th,l l t h e lund w.1 � moving ;J way from its sphere of expert ise and adding n,k .lt t lH· wor't po.,.,i h lc moment. \1oreover, .\ lerton was h igh ly agita tc·d ,Jhottt the fund\ compema­ tion structure, which was t o p - we t g h t nl to w,J rd f l i l i brand and Hagha n i . A s a n options expert, he knew t lu r the �en ior pa rtncrs had an added incentive to shoot for the moon - ;1 " mora l haza rd, " as econom ists say. The hunger the tradn., h.1d �hown a t Salomon to make as much as possible, no mat ter what the scale, was sti l l a l i ve and stil l disfiguring their relatiom with their partners. Krasker, the cautious modeler, was worried, too; he took money out of the fund

120

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WHEN GENIUS FAILED

ar the end of I ':1':17. Randy H i ller, who had hecn part of rhe gro u p at Salomon, ominously told a friend that he thought Long-Term was an accident waiting to happen . At year-end, when l .ong-Tcrm retu rned $ 2 . 7 bill ion to in vestors, ih leverage ratio skyrocketed from I S to I to 2S to 1 ( a s a lways, not including deri vati ves ). Thu-;, th ough the fi rm \ prospects looked ble a ker th,ln ever, the partners had raised their leverage hack to the level prev a i l i ng during the business's salad day,. With deri vati ves, it may have been even higher. l .ong-Term managed to earn 2 .') percent ( I 7 percent after fees ) in I y�n-its worst year yet hut sti l l a remarkable achievement, given the deteriorating marker. The original in vestors got $ I . S 2 hack ior each $ I they had put into the fund and sti l l had their original dollar in. Tha nks to their exorbitant ices
THE FALL OF LONG-TERM CAPITAL MANAGEMEN

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cows ;l n d spotted cows ;t nd q u iet t r, J d un� d.J \ � ,md m a rket cr;J s h e -, . F o r Long-Te r m \ professors, w i t h t il l ' i r � I I )'ITme L1 i t h i n m a rk e h , t h i s was w r i tten i n sto ne. I t flowed from t h l' i r \ k rton i ;m v i e w o f m a rk ers as e ff i c i e n t m ;l c h i ne'> t h a t -.p i t o u t IlL'\\' prices w i t h ;1 1 1 t h e r a n dom l ogic o f h e a r m o l e c u l e s d i -.pn-, i n g t h ro ugh a c l o u d . :\ n d w h e n the model-. told t h e m that t h e m;l rk e h \\'LTC m i �pri c i n g e q u i t v \·ol, thcv were w i l l i n g to het the firm on i t .

1 24

•

WHEN GENIUS FAILED

•

There is no stock or !>ecurity kn own as "equ i ty vol," no d i rect way of mak ing a wager on it. But there is an indirect way. Remember that, according to the Black -Scholes form ula, the key clement in pricing an option is the expected volatility of the underlying asset. As the asset gets j u mpi er, the price of the option ri!>e'>. Therefore, i f you knew the price of a n option, you could infer the level of vol a t i l i ty the ma rket wa-, expecting. An ana logy may he helpfu l . There i., no direct way to bet on the weather in Florida-but in certain seasons, the price of orange j uice futures fluctu a tes according to the likel ihood of a frost. I ndeed, an experienced trader could infer, i f the price of j uice was un usually high, that the market was expecting a chilly winter and rhus a scarcity of oranges. And if the trader believed that the ma rket's weather forecast was wrong, he could try to profit on h i s opinion by shorting orange j uice. In a similar manner, Long-Term deduced that the options mar­ ket was antici pating vola tility in the stock market of roughly 2.0 percent. Long-Term viewed thi' a-, i ncorrect, because actual vola­ tilitv was only a bout r 5 percen t. Thus, it figured that option prices would sooner or later fa l l . So Long-Term began to short options­ specifica l l y, options on the Standard & Poor's 5 00 stock i ndex and on the equiva lent indices on the m a j or exchanges in F urope. In their own argot, the professors were "selling volatility. " The people on the other side of the option t r;l ck may not have re­ aliLed it, but they, in turn, were buying volatil itv. Let's t h i n k about them for a moment. Typica l l y, the bu yer-, of optiom were equity in­ \TStors who wanted imurance aga inst a ma rker decline. They were wil ling to pay a small premium againq the risk of a crash . Long­ Term, on the other side, col lected the prem ium hut was committed to paying out if the market swooned . In Lll· t , it sold ins urance ( options) both way-;-aga inst a -;ha rp downru m .1 nd <1g<1 i n st a sharp rise. The buyers, not being till in tur­ moil and with stocks at nosebleed levels, in vestors were undersra nd­ ;J hlv j i ttery. One could scarcely pick up the paper hut that !>omc

B A N K OF V O L A T I L I T Y

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125

pundit was predicting the crash to end a l l crashes. So i t was hardly surprising that people were paying more for protection, driving up the price of options. Institutions i n Europe were capitalizing on peo­ ple's fea rs by ma rketing equity products with downside protection­ that is, eq u ities that "couldn't" go down! To protect themselves in case stocks did fa ll, these institutions, roo, were buying insurance, which in Long-Term's view was a rtificially inflating option prices. If Long-Term was right-if the price of options was roo h igh­ then in effect it was charging a premium price for insura nce, and over the l i fe of irs option contracts, which was five years, it should expect to come out a head . .\ll a ny other hedge fu nds were doing the same trade. These fi nancial firms were providing market insurance to or­ dinary in vestors. This was not neccss,ui ly stupid. The fu nds were say­ ing, "If people a re will ing to pay foolish prices for insurance, why shouldn't we sell it to them ? " B u t the trades were quite risky nonetheless. For one, forecasting the market\ \ olatil iry is notoriously dicey-unless you be/ieuc that the past is a rc/i,lhlc fJredictor ol the {uturc. Who could predict when a crisis in Asia m ight develop-or how j i ttery ma rkers would become if one d i d ? Who could say how volatile the marker " sh o u l d " he? It was like forecasting a frost in Florida. What's more, Long-Term could still lme nlom·y on the equity vol trade, even if it later tu rned our that ib j u dgment a bout volatility had been correct. Si nce long-dated options don't t rade on exchanges, Long-Term had to tailor private options contracts, which it sold to big hanks such as J. P. �1organ, Salomon Brothers, M organ Stanley, and Bankers Trusr. The ma rket for such a rcane contracts was thin, with only a handful of pla yers who traded on a " by a ppointment" basis. And the ma rket was inherently imbalanced. Banb such as ,'vlorgan were eager to " buy" voLni lity from Long-Term, beca use the hanks, in turn, were selling insur.1 ncc to rera il investors. In short, there was a n a tural pool of people ell or i f equity i nvestors suddenl y became more desperate for insurance, the price of volatil ity could go even higher. And Long-Term wou ld have to settle up-paying or receiving monies accord ing to how option prices moved-euery d<�y. It m ight

1 26

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W H E N G E N I U S FAILED

he right on equity vol in the long run, hut onlv i f it could stand the pain in the sh ort run. And over five yea rs, the pain suffered on such a large trade could be considera ble. On a gi ven day, it was possible that 1w unc would want to sel l, in which Ct 'ie Morgan could mark up the a\ser to wh atever higher price it decided was reasonable. There­ fore, Long-Term wasn't betting only on the extent of u l timate rea l­ Ized \·olari l ity, it was bett ing on da y-hy-dav inf('rrcd volatility, as determined by what other im-c-;tors would pay for optiom. I n effect, it was betting that these other, and presumablv le-;s r.ttional, investors wou ldn't hid up prices further. This w,t-;-so unl ike the partners' credo-ran k speculation. By pu rri ng themsel ves at the mercy of short-term fl uctuations, the pa rtners had abandoned whatever ad­ vantage lay in their precise mathematical models. Long-Term sh orted optiom a t prices that i mplied a ma rker volatil­ ity of I l) percent a year ( t raders refer to this a-; " se l l i ng volatility at I l) percent" ) . As option prices rose, Long Term cont i n ued to sel l. Other firms sold 1 1 1 tinv amoums. \lot Long-Term. I t j u st kept selli ng. K.osenfeld, l l ili bra nd, and Modest worked the trade in ( ;reen wich; I Iaghani and H u fschmid did it in Lon don. Fventually, they had a staggering S4o m i l l ion riding on each percentage poi n t change in eq­ uitv vola til ity in the L;n ited States and an equivalent a mount in Europe-perhaps a fourth of the overall ma rker. �1orga n Sta n ley coined a nickname for the fu nd: the Central Bank of Vola ti l i ty. Indeed, eq uity vol was Long-Term's ,uchcry p,t l trade. I n many of its spread trades, the firm was indirectly e x pressing 'l ll opinion on volatility. The pa rtners believed that, over time, in vestors would be­ come more rational, more steady, more etficient-rnore l i ke they were-a nd rhus that credit spreads would na rrow. " We've a lways had rhar belief, " Rosenfeld noted. The equ ity vol trade was an ex­ plicit a rticubtion of this doctrine; i t underscored the central role that volatility played i n Long-Term's Mcrton i,tn universe. "The M IT types al way-; want to short volatil ity, " noted An drew I ! a l l , an oil trader who had worked at Sa lomon 1 11 the t l) XO\. " Academics have embed­ ded in their m i nds the Black-Schole-> models that assume the normal distributions. They think these models a rc the Holy ( ; ra i l . " •

In the first months of I ':J ':J X , ma rkets were smooth. The I n ternational :\1 onetary Fund worked our a bailout of South Korea, capping a sta-

B A N K O F V O L AT I L I T Y

•

1 2 '/

bil izing trend in Asia. In Eu rope, where the launch of the curo w;l ' less than a year away, investors were bathing in a �pirir of optimism. In the U n i ted States, the Dow broke into record territory. As i nvestors rega ined confidence, bond !>prcads narrowed. At the st;lrt of 1 9 9 X , A-rated bond' ( those issued b y �trong corporations, s u c h a s Ford \1otor) yielded 7 5 basis points m ore than Trcasurys; by Februa ry, the spread had na rrowed to 70 poi nts. Such balmy cu rrents, though a pparently unrelated, reflected a gen ­ eralized feeling that the cri 'i' of the previous fa l l had passed even though a certai n cdginc�s l ingered. In October 1 9 9 7 , after the deba­ cle in Asia, �lerri l l Lynch had ordered i ts bond traders to downsize their posi tions. They had in bet pulled hack, but by the beginning of 1 9 9 X they were reverting to business as usua l . The world had gotten past so many crises; it had seen the U nited Stares ;md the ltv1 F rescue !'v1 cxico, Tha i l and, Korea . " l\o one bel ieved that Asia would spread," noted Dan Napoli, i'vl crri l l \ risk manager, referring to the traders who put the firm's c1pital on the l ine. As such sanguine atti­ tudes percol ated up from the trading desk of bank a fter bank, credit spreads inevitably na rrowed. The mood at Long-Term Wt nHHlth, t hey had lost a mere 2.9 percent.) I ndeed, the figure' I l l i p i inl t kl l it would ra ke a so-cal led ten-sigma event-that is, ;l s t .l t �'> l l l'.ll frea k occurring one i n every ten to t h e twenty-fourth power t l l nl·-,-lor the fi rm t o lose a l l o f irs capital within one yea r. ' I f the pa rtners were anxious, it w.l'> not about losing; i t was that they wouldn't fi nd enough investim'lll'> whnc t hey could w i n . As the pressure to find suitable trades moun ted, t hey i ncreasingly strayed into more e xotic tundra, such as Brazilian and R ussian bonds and

1 28

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W H E N G E N I U S FAI L E D

Danish mortgages. Martin Siegel, who handled Brazil a n d other emerging ma rkets, was a misfit a t Long-Term. An old-time trader, he knew nothing a hout models. Siegel had made money for Meri wether at Salomon hy in vesting in the Mexican telephone company, anJ J . M., typica lly, had given him a joh at Long-Term out o f loyal ty. Long-Term a l so hegan to make more directiona l hers, a ha ndoning ( for a fraction of its portfolio) the cautious hedging strategy that had been its trademark. Scholes was deeply u pset by such trades, partic­ u larly its big position in :\orwegia n kroner. l ie argued that Long­ Term should stick to its models; it did not have any " i n formationa l e trades, bur Haghani, invariably, was the architect. A n a ssociate was stunned to find that Modest had even shorted big-company stocks-reportedly inc luding M icrosoft, Dell, and General Electric­ seemingly on l la ghani\ whim. M odc�t expla ined to the associate, "Victor blew into town, he liked this trade and told me to do it." .'vlml­ est added, unnecessarily. "Victor is Victor-what am I going to do?" By now Long-Term was succumbing to the fatal temptation to pur its money someplace. I n a clear specu lation, ir bet on the lJ.S. stock ma rker to decl ine, via options. ' Then, a young, statistica l l y m i nded eq uity resea rcher na med Alain Sunier proposed buying stocks that, according to a model, were l i k ely to be added to the S & P index (when a stock is added to the index, m.llly portfolios a rc compelled to buy i t ) . H i li brand got very i nterested in this trade. l ie ignored Sun ier's model, discarding �unier's u Hnpanics and adding new ones. And l l i l i hrand insisted on buying hefty stakes in every one of them. Long-Term's notion a l investment in the trade soared to an a stronom­ ical $2 hillion. A colleague asked what had happened . Sunicr threw up his arms and rep lied: " l ie I H i l i bra nd l tu rned off a l l my stock s." H i l i hrand a lso shorted Berkshire Hathaway, the holding company

B A N K OF V O L AT I L I T Y

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129

run by Warren Bu ffett, believing that Berkshire was overpriced rela rive to its individual parts. But since many of Berks h i re's a ssets were private, H i l i hrand couldn't buy the parts, making it a poorly con­ ceived arbitrage. Though usua l l y coldly calculati ng, H i li brand was being a bit too clever-try ing to profit at the bill iona i re's expense­ and dangerously moving the fund afield of irs expertise. This was plainly un wise. Even on wel l-conceived trades, the pa rtners had lost all sense of scale. In one trade that would lose them money, Long­ Term bought < 1 h uge 1 <; percent share, worth S4Xo m i ll i on, of a j unk­ bond i-;sue from Starwood f l orels & Resorts, a rea l estate operator that itself had a tendency to overreac h . Though t h e i r trades wanted for scrutiny more tha n ever, t h e part­ ners' weekly risk meetings became increasingly scripted. They no longer had the patience to research and ana lyze trades q uite a s they had done with Italy. Though their debates were heated, the results seemed preordained. Scholes protested about the size o f the fi rm\ various positions. After a l l , the firm had had trouble e x i ting from some of its la rge trades-an obvious red flag.'' :V1crton, :Yt ul lins, ami !\kFntee made protc'>t'>, roo. But the di-;senters '>lopped short of threatening to quit, the one -; rep th.l l might han· prompted j . \1 . ;1 1 1 d Rosenfeld t o confront their t wo top t r. 1 d cr.. . r\ nd H i l i bra nd ;l nd I L1 g h . 1 n i 11 cre n 't rl'.l i l v h '> l l' l l t l l g . Younger col leagues e-,pied an impulsive '>tre;l k , not '>O '>urprising in l l aghani, per­ haps, but tota l l v h,1ffl ing in the c1se of l l i l i hrand. The i ntel lectua lly curious ;\l odcst was deeply resentful of having to be, a s a col league teased h i m , .. La rry\ execution slave . " The rare Long-Term man with Rena issa nce in terests. \lode-,r, who was raised Ill Bosto n , loved the t in fi nance was more academ ic· than enrrepreneuri;l l ; lw h;ld never li ked the sc· n t o r part nns' a u to ­ CLltic reign a n d control o1·n hi-, t i m e .1nd h.HI heen t h i n k ing of bolt­ ing unti l t l) l) il , w hen he had hecn made .1 l l l l l i o r p.1 rt ner. When he '> a w his part ners dep.1 rri ng from their t r.Hk t n ;n k prudence, the firm lost all ih mea n i ng for h i m . ' f ( >Ll l l v d o m i n;1ted hv the two sen1or tr;lckrs, Long - Tnm had hccome .1 lop,ided firm; it was a partnnship on l v in na me. \X'a ll Street knew noth tng of thc'>l' 1 1 1 l l'rtl.l l tcn.,ions; in deed. the hanb comin ucd to gi1e the fund ;1 free mk . .\1 crri ll Lynch happily fi­ t l a nced the fund in BL1 1 i l-;1 ri,b lll
1 30

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W H E N G E N I U S FAILED

Robert McDonough, the .\1erri l l credit officer responsible for hedge fund�, about Long-Term\ expos u re in emerging m a rk ets. :vlc Don­ ough j ust l a ughed. "We're in bed with these guys, " he noted. " I f they go down, we go down ! " Few possibil ities could have seemed more remote. I ndeed, so strong was \krri l l 's confidence in G reenwich that on April I , I 2 .'1 starry-eyed M erri l l executi ves p u rc ha�ed ( in i n d i v i d u a l , separate sta kes) most of Merri l l \ in vestment in Long-Term for the e xecutives' personal deferred compensation plan'>. 1<-:oma nsky, who had suc­ ceeded Tu l l y as Merri l l 's chairman, put in S X oo,ooo; i n tota l , the ex­ ecutives i n vested $22. m i l l ion . I ronica l l y, :vlerri l l , Long-Term's midwife, got our closer to the top than anyone else, leaving its own executi ves to take the down h i l l ride. Merr i l l 's w i l li ngness to fin ance its clien t was part of a pervasive cli­ mate of fin a ncial laxity, palpable in Wa l l Street\ eagerness to u nder­ write emerging m arkets. Russia was com mon l y tou ted as the next capital i st n i rv a n a . ''People were saying 'Asia was isolated, let's move on.' The amount of money pur�uing these areas was tremendous," noted Merri l l 's Rich ard Dunn, then head of debt markets in Europe and the U n i ted Kingdom. At such time�, i t took uncom m on cou rage to refuse to lend, for it would h a ve mea n t squandering b usiness to the competition. " We misread the h a i rcuts that we needed to he pro­ tected," D u n n admitted. " It wasn't a mi stake we made s i ngly for Long-Term. The whole market was pressuring us. To su ffer the orga­ nization tel l ing you that you a rc losing business-it rakes a tremen­ dous amount !of courage ! to -,ra nd u p and sJy, ' I ' m not going to do it.' The Street a l l got that collectively wrong. " I n April, Sandy Wei l l , sti l l trying to d igest his i l l-considered acq ui­ sition of Salomon, announced the b iggest financia l merger i n hi�rory: Tra velers a nd C:iticorp. The deal wa� emblematic of the Street's Pan­ glo"ian mood. T h i rty-year Treasury \ ields had di pped below (, per­ cent, rem i n iscent of the su blc ,1 11d in nocent bond ma rkets of .\1eriweth er\ vout h . The lwlid in
B A N K O F V O L AT I L I T Y

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I J I

rnately, was t h e low point for spreads, the h igh point for con fidence, and the h igh point for Long-Term Capital, which hoa�ted $ 1 3 4 bil lion i n assets. In j ust over four years, an investment i n the fund had q uadru pled, before accounting for the partners' fees. A fter deducting this tithe, the v a l ue of a single dollar i n vested at the start had ri sen to $ 2 . R s-a phenomenal I R 5 percent profit i n barely fifty months. Far from resti ng on their l a urels, the partners, l ed hy Dick Leahy, set up a Bermuda- based reinsura nce s u bsidiary, c h ristened Osprey Re. Osprey, which was capita l ized with $ wo m i l l ion, reflected Long­ Term\ self- i mage as an insurer of financial risks. \Jow the partners were planning to reimure tangi ble risk'i, such as losses from severe storms, earthqua kes, h u rricanes, a nd the l i ke. Their mutual fund ven­ ture with B l\: L , the Italian bank, h,!d been tabled b y the Italians and dropped. But the partners were exploring another new front: private equity ventures. Would nothing ever shake them? In the m a n ner of markets, the fi rst h ints of trouble were scattered, sma l l , and seemingly u nrelated. J o h n Succo, who ran the equity de­ rivati ves desk a t Lehman Brothers, was among those who felt that the Street was p l a y i ng with fire, spec i fica lly with the u nseen leverage in deri vati ves. At the end of Apri l, Succo w.1 '> s p ea k 1 n g .l t an i n v estors' conference spon sored b y t h e nL1n-rick m·wo.;k-rrn p u h h .,hcr J<1mes Grant. In response to '' q uest ion, Succo declared th
132

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W H E N G E N I U S FAI L E D

feet i n no time. B u t what f reidheim saw in A'>ia shook him: " a lot of big pla yers" were raking money off rhe table. D u r i ng a l u nch at a pri­ vate club in I l ong Kong. a major b,mkcr sudden l y changed the term'> of a deal to reduce the hanker\ e x po'>ure to ,\ -,ia. l'reidheim returned to the Uni ted State'> in a pessimi stic mood. " We began to ,hort the market a fter that, " he recalled. C redit '>pread-.; at home had never been tigh ter. There wa'> only one Wimilar concl usion-. . B,m b ;l nd -.ecuritic-, firm'> began ro cur hack their i n vento ries o f risk ier, less l i q uid bonds-wh ich. o f cou r;;e, were rhe very types of bonds in Long-Term\ port folio.' The sel l i ng was nor coordin ated, but the effect was much as if it had been, for the \·ari­ OL l'• trading desks genera lly owned rhe same securities. :vt eriwerher may have felt a ,b udder of dou bt, for i n a visit with Sici l i a no, the Swiss B a n k manager, J . .\ 1 . said he was looking for w a y '> ro invest rhe partner'>' capital outside the fund, pcrhap-. in stocks o r rea l estate. They were roo concentrated, J . .\1 . added, a '> i f forgett ing that hi, part­ ners had recentl y passed up rhe chance ro rake hack '>ome of thei r cnpiral. By far, the firm where unease lay heavie'>t wa'> Tran· ler'>. The fi rm\ bosses had been shocked ro learn rhar rhe fi xed-income a rbi trageurs at Salomon Brothers, their newlv acq u i red ;;uhsicli.Hy, routinely rook home yen r-end bon uses of S 1 o m i l l ion ;md more. Wei l l and his top lieutenant, J a m i e Dimon, were hostile to the star '>)''item pioneered lw H i l i brand, under which trader'> at Salomon ( now Salomon Smith Bar­ ney ) rook home a perc�.:ntage of thei r p ro fit '> . Since rhe tr;lders were nor pena l i zed for l osses, they had a penTrse i ncentive ro bet ;h m uch of rhe com pa n y 's money a -; they could. Essenti ;d l y. Wei l l a n d D imon viewed arbitrage as a d ressed-up form of gambling. \Jot su rprisinglv. they took a d i m view of Long-Term, a m a j or Salomon client. Shortly a fter the m erger, Di mon asked Long-Term for more i n formation . .vteriwether refle x i vely replied that -;uch i n formation w;lS private. Dimon, who had no a l legiance to ( ;reenwiCh, threatened to cur Long­ Term off, a n d J . M . meekl y compl ied with Dimon's req uest. ' A new breeze was blowing. Robert Stav is, the co-head o f arbitrage at Salomon , was trying to branch i n to equity trades, j ust as Long-Term was doi ng, but Sta vis's new bosses, pa rticu l a rl y Steven Black, head of global equ ities at Sa-

BANK OF VOLATILITY

•

1 33

lomon Smith Harney, blocked h i m . Sta vis was eager to get bigger in L·q uity vol, hut Black pur his foot down . A lways Long-Term's a l ter L'go, the Arbitrage Group at Salomon was turning into the more pru­ dent fi rm that Long-Term might have been had J M . steered it with a ti rrner hand. By April, Salomon\ group was down $ 2oo m i l lion, pro m pting se­ rious discussions a bout ib future. Sta vis told Weill that he should he prepared for further losses, which was not what Wei l l , who knew t h at Wa ll Street focused on ... hort-term ea rnings and wa'i h i msel f ob­ .,e�sed with Travelers' stock price, want ed to hear. Aware that spread' had diminished, the Travelers executives made <1 logica l deci�ion­ but one that had somehow el uded \'lcri wethcr--to sc1 le the bminess hack. The o n l y good news at Salomon was that Tra velers' pending merger w i t h Citicorp made Arbitrage seem less i m portant. I n di'­ cussing the pmsibility of trading losses, Weill was fond of sayi ng, '' I ' d l i k e to b e b i g enough s o that w h e n we get these explosions t h e y w i l l fed like pin pricks. " As part of Citicorp, he would b e . Sti l l , a s a check, a Salomon official put in a call to Long-Term to find out how m uch capital the hedge fund was using in its trades. Irs a nswer: " A l most n one. " Salomon, which hadn't anal yzed its arbi trage busi ness quire so intently, was unnerved. It was obvious that bot h firms h a d been re­ ly ing too m uch on leverage, and s,1l omon Smith Barney, at least, began to cut back . In M a y, contrary to the forecasts of Long-Term's models, arbitrage spreads began to w iden. Bond a rbi trageurs su ffered losses, setting off a modest but h ard-to-break cycle of sel li ng. Firms such as Salomon, which had less capital as a result of the losses, now were in v iolation of their own computer-determi ned guidelines rega rding the proper ratio of capital to assets. Thus, they sold a hit more. " As people liq­ uidated, volatility moved up , " < 1 s,1 lomon trader I ll London reca l le d . "That forced more people to liquida t e " It w a s sti l l j ust a pinprick, hut there wne more p 1 1 1 s than Weill had reckoned on. One of them punctu red the mon gagL' market, where the bond ma rket tro u ble of r 9 9 4 had started, too . .\lortgage-hacked se­ cu rities dec l i ned, prompting hedge fu nds to pare other exposures, such as in emerging markets . ' ' Suddenlv, Asta was not so calm. In I n ­ donesia, t h e b iggest of the A s i a n Tigers, the I M F bailout r a n into snags. Then, i n May, street rioting forced President S u h a rto to resign a fter thirty-two years in power. The real revolutionaries had been the

1 34

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W H E N G E N I U S FAI L E D

currency traders, who had forced a currency deva luation and ex­ posed a corrupt autocrat's nepotistic program as a fa i l u re. Everyone k new the specu lators' next target; ominously, it was Rus­ sia. Sergei Duhinin, chairman of the R ussian central hank, said the ruble was safe. I l oping to have the definitive word, he a dded, ''There will be no deval uation of the ruble . " " By the end of :\1 a y, he had tripled interest rates to halt the fl ight of capita l . Russia's financial sy-;­ tem, a l ready teetering, was now on the verge of colla pse. In the United States, meanwhile, the economv was slowing-a l ways bull ish for bond prices. Yields on Trea., urys tel l, and rhus the 'pread between Treasurys and other types of bonds, such as corporate issues, began to widen. This trend being the opposite of what Long-Term was bet­ ting on, the fund had its worst m onth ever, losing 6. 7 percent. Though Swiss Bank, which would be Long-Term's biggest investor after merging with U BS, knew noth ing of the losses, it was getting nervous. A fter reviewing the w a rrant package, Ti m Fredrickson, the head of deri vatives at Swiss Ban k , ca l led the bank's Siciliano and warned him, "This thing isn't too pretty. " The basic problem was that the investment was unhedgea ble: Swiss Bank was completely ex­ posed on the downside. " At that point , " Siciliano recal led, "it was like a benign rumor. If things were to go had we'd have a problem, hut they had never had a problem . " •

I n June, Ron ' Llnnenbaum, the U BS sa lesman who had pitched the warrant, left the han k-a footnote in the unfolding drama. Of greater import, credi t spreads continued to widen. :\1 ore frightening sti l l , they widened i n euery market in w h i c h Long-Term was active. The trouble wasn't specific to any security; it was a general pull ing hack of credit, a pervasive sense that ma rkers had been undercharging for risk. I n vestors wanted safety; now they would pay a n y a mount to buy a Treasury ( meaning that they would accept any lower yield, as long as they got out of riskier bond s ) . Jim McEntee, .] . .\1 . 's friend :md t h e o n e partner w h o rel ied on his nose, as distinct from a computer, sensed the trade-winds cha ngi ng. l ie repeatedly urged his partners to lower the firm's risks, hut McEn­ tee was ignored a s a nonscientific, old-fash ioned ga mbler. Since mov­ ing to Connecticut, the partners, who n o longer had to j ostle with t h e throngs on Wa l l Street every day, had become even more isolated

B A N K O F V O L AT I L I T Y

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I J !,

from the a necdotal, hut occasion a l l y mcfu l , gossip that traders pass around. They found it easy to brush off McEntee's a l a ru m s, particu­ larly since the Sheik 's own trades had been losing m oney. I ncreasingly frustrated, M c Entee met James R ickards, Long-Term's general coun­ sel, a fter work one n ight at the l lorseneck Ta vern in G reenw ich. Ricka rds was leaving the next morning on an expedition to c l i m b Mount :vic K i n ley i n Alaska. " By t h e t i m e y o u get hack, the world will have completely changed," McEntee predicted darkly. A l l over Wa l l Street, McEntee's fel low traders were now speaking of a " fl ight to q u a l i ty "-that is, to Trea sury bonds. By m id-J une, the yield on the t h i rty-year Trea�ury had fal len ro 5 . 5 8 percent, the low­ est since the government had started issuing thi rty-year bonds i n 1 9 7 7 . " Everyone i n the ! Treasury ! market i s a fraid t o g o h ome short," Matthew Alexy, a strategist w i th Credit Suisse F i rst Boston, told The \XIa/1 Street .fozm�cd. ' ·' Except for Long-Term Capita l, which went home short o n Treasurys every day. Treasurys were the basic bond that the fund sold short to hedge the riskier bonds it owned. And as Treasurys ral lied, spreads between them and other bonds widened. M ortgage-hacked secu ri ties j u m ped from 9 6 basis points over Treasurys to 1 1 -� poi ms. Corpor;HL' hond.s ro'>c ! rom ')') t o 1 0 5 , and j u n k issues rose fro m 2. . q t o .!(>1>. F vcn 1 h osc s.dv 'l'l' l l l l l lg o t t ­ the- run Treasurys c h m l lL'd ! rom r , po l n h on-r l o X po1 1 1 1 ' o\Tr. I n every market, t h e prenuum dem�1 n ded lor risk ier honds inLTL';lsL'll . In every nu rkct, Long-Term was lo�ing money. Why this a l l -consuming fear of risk ? Once again, Asia was the spark. I n Japan, the yen was p l ummeting, accentuating the country\ a l ready deep recession. Ja panese bond yields were p l u m meting­ exactly the opposite of Long-Term's bet. And Japan was the corner­ stone of the East Asian economy. With Japanese i mporters sca l ing back their p u rchases, there wa'> talk of a regional depression. I n In­ donesi a, the rupiah had lmt X 5 percent of its prccrisis \·a l ue. In South Korea, stock s pl unged 8 percent i n a si ngle d ay. The fear was pen·a­ sive, hut every day, it emerged in a d i ffcrcm place. The drumbeat from R ussia grew steadily louder. In J une, Goldman Sachs managed to sel l S 1 . 2 5 hill ion in five-year Eurobond notes for the R ussian government at a modest ( for R ussia ) 1 2 percent i nterest rate. Goldman's issue, tru l y a tri u m ph of salesmanship, briefly per­ suaded i nvestors that R u ssia's problems were abating. But Goldman's motives may have been a tri fle impure. :\latura l l y, the h a n k pocketed

1 36

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W H E N G E N I U S FAILED

tens oi m i lliom of dolla rs i n fees . .VI o reover, Goldman had $ 2. 5 0 mil­ lion in R ussian loans outsta nd ing; the new bonds enabled R u ssia to pay Goldm a n back at a most convenient time. The century-old i n ­ vestment ba n k was preparing to sell stock t o t h e public, and it pre­ ferred to have the R ussian loan off i rs books. And Goldman, which was hoping

ro

go public in rhe fa l l , did nor wait long

to

see if the op­

timism i r had generated i n R ussia l i ngered. lr q u ick l y u n loaded i rs in­ ventory of Russian bonds so a s nor

to

be stuck with the pa per i r had

floated to i n vestors. '·' Bv the end of J u ne, thanks to bonds issued by

Goldman as well ;!'; J. 1'. .\1organ and l kut..,che Ran k , foreign ma rkets were begi n n i ng to choke on Russian paper. I nterest rates on one-year R ussia n b i l l s s k y rocketed to yo percent. Even in A merica, t here were h i nts o f a slowdown . The stock m a r­ ket was sudden l y volatile, and option prices j u mped. Of di rect sig­ n i ficance

to

Long-Term, impl ied v o l a t i l i t y rose to 2. 7 percent. Having

shorted equity vol a t far lower levels, Long-Term was showing a sub­ stantial lo�s. Overa l l , in J u ne, the fund lost 1 0 percent, by far its worst month ever. Long-Term was now down 1 4 percent for the first h a l f of 1 y y il-its first sustained losing streak . Salomon Smith Barney's Arbi t rage Group h a d l osses, too . Wei l l h a d promised he w o u l d b e a b l e to l i ve w i t h volatile trading resu lts, bur he co uldn 't. Rdore June was out, he decided to close the firm's U.S. bond arbitrage operation, a business he had never l i ked. One might well ask why Weill had acq u i red Salomon, since A rbitrage had been its chief moneymaker. I n any case, Salomon began

to

l i q u idate

assets i n ea rnest. Of course, there was a s u bstant i a l overlap between Salomon's positions and Long-Term's trades. Thus, Salomon's sel ling helped to tip Long-Term's portfo l i o i nto negative territory; a rguably, it triggered t h e fund\ dow n h i l l spiral. Meriwether h a d o u t l a sted h is creator, b u t it would haunt h i m from the grave. Like Salomon, Long-Term had s horted a simple swap spread, a n u m ber that is derived from the i n terest rate on a standard, widely used trade. The swap rate is, a t any gi ven moment, the fi xed rate that banks, i n s u rers, and other i nvestors demand to be paid in exchange for agreeing

to

pay the L IB O R rate, a short-term b a n k rate. The twist

is that rhe L I B O R rate floats; n o one knows where it w i l l go i n the future. Typica l l y, swap rates i n each cou ntry trade a t a slight spread a bove the i n terest rate on the c o u n try's government debt. Th u s, this swap spread i s a basic barometer o f credit ma rket a n xiety; i r is the

B A N K O F V O L AT I L I T Y

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1 37

prem ium that investors demand for tak ing the ri�k of being e xposed 1o rate fluctu;Hions in rhe future. In rhe l in ired States, in April I 9 ';) X , rhe �wap spread was 4 X basis points. In recent historical terms, this number was high ( i t had been he low ) 5 points for most of the 1 ';) lJO>. although, during the last re­ ,·ess i o n , in I ';)')O, ir had briefl y spurted to X 4 ) . Long-Term, >eeing no rece�sion on rhe horizon, had bet on this spread to na rrow. In F.u rope, Long-Term's position wa> more nuanced . The swap spread 11 <1 ., 4 5 point> in England and onlv 20 in ( ;crmany, an u n u s u a l l y wide gap. There was .1 11 economJt' rea.,on for this disparitv, but it seemed ' to he a tempora ry, un natural q u i rk . ' . Th us, in Furope, Long-Term bet rlut the sp re.ul {Jetu•ci'll the lzl'u spredds would n;I rrow. Both of Long-Term's swap trade-, were intell igent convergence plays, though nor, as h i>tory had shown, sure thmgs. The swap mar­ ker was deep and had a hi ston· rhar was very >uitablc for model ing. But as had been rhe ca>e in so many other trades, the size of Long­ Term's swap position> wa> u nreasonably large. And a s Salomon began to liq ui date irs ( q uire similar) swap positions, Long-Term began ro lose both ways. The spread in rhe Uni ted State> wi dened­ to 56 points-and >o did rhe gap between the l lnitnl K i ngdom\ ;Jnd ( ;crmany "s. What was worse, in .I ul v, word of '. ;J i o m o n \ e x it t rom l J .S. a rbi­ rrage beca m e public. A memo from the bra,.,, lea ked to The \)('.z/1 \t ree/ .founZ has les">ened owr rime while t h e risks and volati l i ty have grown . " · · \:awra l l y, trader-. a t di vt'r'>e fi rms began to unload i nterest rare swaps a> well as other arbitrage trades, for fear of being trampled by Sa­ lomon 's stea mroller. The I .ong-Tcrm p;lrtncr-, hadlv undere-.u m;ltnl t il l' -.t-riou-.ne-.s of rhc >econd bigge.,r p l a ver 111 t h t·Jr h u -. i nc-,., t·.J I I i n g i1 q u i h . Thev ex peered other arbitrageurs ro till t h e v 01d . Wht'll .1 ! l l l l io r t r.Jtkr voiced concern to Eric Rosen feld, the l a t t e r hru-.hl'll ! 1 1 1 1 1 off, U l '> J ,ting that the partner' were on top of the sit u;l t J o l l . I n i u ly, ;Jfter Sw1ss Bank and UBS merged, Siciliano vi sired :\1 niwet hn, who stun ned Siciliano with the news of Long-Term's recent lo-.st''>. But _1 . :\1 . , too, seemed ''. I n Engl a n d , the governmem h.td donl' l i 1 1 k borrowing, l e a d i n g

to

lower gov­

ernment ratt'' ;md wider ;prea
1 38

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W H E N G E N I U S FA I L E D

confident-a l m ost rel ieved. F i n a l l y, the o n e or t w o had months h e h a d l o n g been expecting had c o m e . The only d i sconcerting note w a s t h a t Long-Term had l o s t money on all of i ts trades, something J . :\1 . hadn't expected. B u t h e cool l y added that n o w t h e fund would take advantage o f l ower prices and l oad u p on �omc fa vorite trtory was, they had gone back a n d retested all their m odels a n d come to the concl u s i on that .J une was an e xpected a berra t i o n . That was the parry l i ne. " .J . v1. was c a reful to per-,ona l l y notify A l l ison at .Vlc r r i l l Lynch and .

other of t h e fund's big partners about the losses. l ie general l y sounded rel a xed. Writing t o i n vestors, J . .VI . reported t h a t " future e x ­ pected returns a rc good . " '' M eri wether w a '> h i s old s e l f on t h e golf course, too; the losses hadn't dam ped his spi rits. A golfing friend said he seemed " •l t peace with h im�cl f. " The s u rest sign of long-Term\ contin ued con fidence wa-, that t h e fund contin ued t o recruit n e w people. A l ways i n f
a

pea k of l l) O .

Long-Term d id pare hack it'> a ssets, imending to bring them into line with its now-depleted reserves. But the total sel l i ng was <;)ighr. Wh i le Long-Term sold some d i rectional trades, the partners were keen on holding on to thei r big convergence pmitions, such as equity vol, swaps, a nd Royal Dutch/Shell; they a lso added to some posi­ tions . ' Ovem l l , their assets decl i ned only

to

S 1 2. X b i l l i on from $ 1 H

b i l l i on , a n d their leverage acl lw l l y rose, to t h i rty-one t i mes. Accord­ i ng to the fund's models, Long-Term had reduced the a m o u n t it was l i kely to l ose on a typical trading day, from $4 ) m i l l ion to SH m i l ­ l i on . " B u t t h i -; was a h ighly mec h a n i stic way of eval u a t i ng risk. It re­ l ied on past volat i l i t ies as a ga uge of the future: as u s u a l , the pa rtners driving Long-Term had their eyes on the rcarview m i rror. In . J u lv, the m a rkets cont i n ued to he edgy. I n Russia, where fears of

B A N K OF V O L AT I L I T Y

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I 39

dev a l u a tion h a d not been p u t to bed, yields on short-term bonds �oared to a d izzying 1 20 percent a n n ua l rare. l lowever, the a ttitude of global i n v estors-the plugged - i n trader� who were forever check­ ing C : N f\ o r Bloom berg and who seemed never to sleep-w a s that Russia was a problem, bur a cont;l i ned one. A� one R ussia h a n d non­ L·halanrly observed, the centr a l bank could easi l y shut the d o l l a r win­ dow a n d h a l t the flight of money. " People won"r care," h e a dded. "Just some hedge funds will get h osed ! " ' '

I f people d i d not care, i t was bec a u se rhe monetary pol icemen had been so q u ic k to patch any sign of t ro u ble. I n J ul y, at Secretary R u b i n \ u rging, the I M F and various nations worked out a $ 2 2 . 6 bil­ lion Russian bailout, seemingly dcmon�trating that there wa� no fi­ nancial problem that they couldn't fi x . C'vluch of the b a i l o u t money would be stolen by R ussian oliga rchs and si phoned out of the coun­ try. ) Then ( ;o l d m a n Sachs i n duced i n vestors to swap t h e i r s hort-term R ussian notes for twenty-year bonds-as i f the next twenty week s i n R ussia were clear, m uch less the next twenty years. B u t i nvestors h a d stopped a n a l y z i ng R ussia a s a c r e d i t ; t h e y were fa l l i ng back o n a cliche: " l\:uclear powers don't defa u l t . " I t 'ieemed an echo of Wa lter Wristo n , rhe C:iribank chairman who h a d made lo;In� t o I .l l i n A nwr­ ica i n the 1 ') 7 0S and early I l) Xo�, pr< >L·L11 mi ng t h a t <,O\'lTl' Ign n;Jtions didn't dda ulr. To thei r credi t , Travelers' Wei l l a n d Di mon smelled a rat i n R u ssia when oth e rs d id n 'r. "Sandy h ated Russia," according to one of his London trader�. " He said it was l a w less . " An L\1F offic i a l met with Salomon i n J u n e and u rged rhe bank to back �loscow, w hose leader­ ship he pra ise d . The I \1 F m ission chid in :Vloscow tried a d i fferent rack, ass u ring Salomon rhar the Un ited Stares would never let a n u ­ clear power dda ult. B u r Wei l l a n d D i mon were uncom forta ble with being ex posed to surpri se'>, a n d they sensed t hat R u ss i a would bring nothing bur. Tho ugh fa-,cinated by geopolitics and R us�w i n particu­ l a r, \XIei l l thought it wa-, a poor a rena for an in vestment hank to be l a y 1ng bets i n . The order went o u t to sel l . Once aga i n , Long-Term a n d Salomon were o n opposite sides of a t rade. l la g h a n i a n d l la w k i n s were taken by the idea t h a t R u ssia cou l d n 't-and �imply wuuldn "t-ler it'i c urrency fa i l . ( Economists were trooping from hedge fund to hedge fund, incl u d i ng Long-Term, pedd l i ng t h i s very notion . ) Long-Term k new, of course, t h a t a debult was concei v a b l e . But rhe professors h a d a model that, they lwi i l'Vnl,

1 40

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WHEN G E N I U S FAILED

forecast what would occur if �1oscow did default.'" To Haghani, this was a l together reasonable. "What we did is r<:ly on e xperience, " he noted later of the portfol io in genera l . " I f you're not w i l l i ng to draw any conclusions from experience, you might as well sit on your hands and do noth i n g . '" ' Rut could a " model " truly antici pate a countrv­ not mere l y i ts ma rkets but i ts pol i ticians, i ts legi slators, i t s passions, too ? Russia was a singularly poor la borator� for Long-Term\ type of trading. Less than a decade removed from com m u n i s m and strug­ gling to become a democratic society, Russia was al most in heren tly unpredictable. Haghani\ knowledge of h istory should h�1ve told him that. ( Ch u rc h i l l had declared i n ' 9 .) l) , "I cannot forecast to you the action of Russia. I t i s a riddle wrapped in a m ystery i n side an enigma . " ) I n T l) l) H , too, Russia was beyond the rea l m of economet­ rics, even of the computers in Greenwich. The Fed was well aware of the da nger of hanks basing predictions too much on the past. I n an open letter to banks, the Fed's top bank­ ing supervi�or wa rned, " Banb should resi�t any tendency to assume . . . that the tm usuallv fa vorable econ omic env ironment of the last ,. few years will continue indefi n i tely. Tho ugh the letter dealt with commercial loam r�lther than capital ma rkcts, i t underscored the need to t h i n k a bout '' alternative scenario'·· such as ba nk ru ptcie" and defaults, rather than assume that the fut u re would be a seamless ex­ tension of the present. " In contrast to th1s well-founded caution, Fed chief Green span wa<, sti ll singing t h e pra i '>es of unfettered derivative markets. On July -; o, testif� ing before the Senate Comm ittee on Agri ­ cu lture, \lutrition, �l l l ll Forestry, Crecnsp.tn dccLtrnl t h a t deriLi tive trader� " have m�t naged cred it risks q u i te effecti \'l:ly thro ugh careful evaluation of coun terpart ies . " The words c.nt only mL·an th;lt, i n ( ; reenspa n\ vinv, a .\krri ll or a :-. torgan w a s carefully scrutini;.ing clients such �1s Long-Term-a \·icw that would �oon become demon­ stra hlv fa be. · In the second h;t ! f of J u l \ , l .ong-· krm\ pcrtormancc ta i led off. I t ended t h e month flat. Stocks i n Furo pc ;l l l ll . \ rnniu swooned. lh e;trly :\ugtl',t, Russian bonds \\Trc s in kin g ;tga i n . Rumor-, �w1rled of <,el ling by Wa ll Street hanks and hedge funds. And the �ell ing spread to eastnn rurope, Latin America, ;t nd Asi;t . :'\ow, Rus-,ia was n ot �o cont;t ined. Dunng the second week ot :\ ugu'>t, R us-,i a 's rn�trkcb <,na pped. On \ u gtl\t 1 ; , \V ith do!Ltrs fln·ing the coun tn·, its rc-,enTs d w i n d l i ng,

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•

I 4 I

irs budget overta pped, and the price o f o i l , its chief commodity, down ' -' percent, the government i mposed controb on the ruble. The b a n k ­ ing system froze for l a c k of reliable a n d solvent banks. The :vioscow -,rock m a rk e t briefly h a l ted trading. It ended thc day down 6 perccnt-and down 7 5 perccnt for thc year. Short-term i nterest rates surged to a l most 2.00 pcrcenr. Long-term Russian bonds fel l to h a l f their price o f o n l y t w o months earlier, w h e n Goldman h a d h a p p i l y floated t h e m . As t h e w o r l d w a i ted for a ruble deval uation, w h ich the govern­ ment still insisted would not occu r, the Com m u nist-domi n a ted Duma, the l ower house of Parl i amcnt, rejected reform measures urged on i t b y the I M E Then rhc membcrs wcnt on vacat i o n . When rhe government bcgged the D u m a to reconvcne, rhe membcrs refuscd-but by rhcn many govern ment lcaders, including Pre'iidcnt Boris Ycltsin, were a lso at scaside dachas, !caving the country to sort out i ts m isery. It was a hard thing to model. In rhc U n i rcd States and E uropc, markers shuddered from a swelling l ist of ncgatives: thc crisis i n R ussia, weakness i n A s i a , I r a q 's refusal to permit full weapons i n s pcctions, the poss i b i l i ty of China dcvaluing its currcncy, and Prcsidcnt Cl inton's tc'>t imony a bo u t h i s relationsh i p with a W h i t c 1-lou-,e inrern, Mon ica l .ewimky. :\ <; global investors bailed out of Rus-;ia a n d A-.ia, rhcy fu nou'>l� pi led i n to Trcasurys, a b u lwark of safety when no one wanted risk. T h i rty-year bond y ields touched another new low: � . 5 6 percent. �atural ly, credit spreads kept wideni ng. Since April, the h igh point for bond a rbitragc, A-rated bonds had moved from 6o points over Treasurys to 9 0 points. U.S. swap spreads were rising, too. At every Wal l Street h a n k , a rbitrage desks werc c u tting hack; capital was flee­ i ng from bond a rbitrage j ust a-. it had fled from A si�l . The Fed, a t first, had been fa vorably disposed row�1rd t he t rend. <., prca d s h a d

been tight, cred i t t o o easy. B u t now, I ll t lw ' "ntc\ t o f R u ss i a 's melt­ down, the Fed's nerves were on edge . •

Long-Term w a s l osing money i n A ugtht -d i-,turhingly, for the th ird month in fou r. The partners could n o longn he -;o standoffish toward Wa ll Street. Real izing that Salomon, w h ich was con t i n ui n g

ro

liqui­

d a te, w a s a m a j or headache, I-lagh a n i o ffered to b u y t h e h a n k 's w hole position, worth about $2 h i l l ion-j u;t to freeze i t . Salomon's people

I PETALING J�'f� ·�R PU '31AK!\.,'.:! V.O MU NIT

142

•

W H E N G E N I U S FAILED

thought he was joking-Long-Term no longer had the capital to hack such hold ta l k-hut Salomon\ traders enj oyed the t u rn a b o u t i n their respective fortunes: Long-Term wasn't calling the shots a nymore. Robert Sh ustak, Long-Term's chief fin a ncial officer, was h a v i ng to field c a l l � every day from a worried Bea r Stearns. J. P. .\1o rgan heard rumors that Long-Term was l i q u idating positions-or at least trying to. Lehman Brothers heard the rumors, too. Though Long-Term had once s n u b bed the sma l lish i n vestment ha nk, now i t w a s m a k i ng nice with Lehma n . " They were coming to us to do more business, " Jeffrey Vanderbee k , head of fixed income at Lehman, reca lled. " I remember thinking that their l i q u idity might he drying up. They wanted more financi ng. " As repo loans were rolling over, Wa l l Street han ks, Leh man among them, were fin a l l y asking the professors for margi n . Suddenly a n x ious a bout their personal well-being, t h e pa rtners made h u rried calls to their advisers and attorneys. H a n s l l u fschmid, a London partner who was ma rried to a Ca l i forn i a n , was about to hid on a house in M a l i b u . Hut l l u bc h mid, who had borrowed heav­ i l y to in vest i n Long-Term, got a case o f nerves. On a h u nch, he de­ cided n ot to buy the house. M yron Scholes did buy a four-story home in San Francisco, where his fiancee l ived. It was a fan tastic home on R ussia n l li l l , with h igh cei li ngs and a terrace overlooking Fisher­ man's Wha rf. I t cost $ 6 . 5 m i l l io n . ' ' But then, Scholes had money out­ side the fu nd. And the fund's losses so far had hardly been severe. Meriwether confidently went a head with a trip to C h i n a in the middle of A ugust. The partners thought they had reason

to

he opti­

mistic; spreads had widened so much, they felt, th
THE FALL /he questirm . . . is ll 'hcther the 1 :1 ( .'lvl dis.zster ll 'ds mere/\' ,z zmiqut' ,md zsolc�tcd L'l'CIIt, c1 had dr,ul'illg (rom lhllllrc 's um; or 1/'hether su,·h disc�sters c�rc the 1//Cl'itc�b/c colzscqucncc of the Blc�ck Scholes fimmt!a itself and the illusion it IIhZ')' git•e tihll ,zl/ l l lclr k ct fhlrtu ·ifhlllt.< <'clll hedge .111'<1')'

,z// th,·ir risk .11 the same time . .\\ I I{ I 0� I I . .\ \ 1 1 1

I H,

� 0 1\ L I .

1.\ l ' R L\

IT

been I IROUCdl of A ugmt, l .ong-Tnm C1 p i t <1 l T having a had year, hut o n l y .1 had \'l\1 r '>uch as a m fu n d , or a n y Ti l l

.\ l l l l l l l l

had

capital istic enterprise, mu't sooner or l ater stdfer. l h reputation, l i ke its cap i t a l , remai ned i ntact. Its overa l l record sparkled, a n d its name, <1mong the members of the fin a n c i a l cognoscenti w h o t r u l y knew the fi rm, often gave r i se to the very term "gen i u s . '' Long-Term was u n ­ known to t h e general p u b lic, h u t t h a t is h o w \1criwether a n d h i s boys wanted it, a n d that, of course, i s how they ex pected the f u n d t o rem a i n . T h e y could hardly h I t c h e\'ellt' w o u l d u n ­ fol d . In l a te s u m mer, as Wa l l Streetn'> '>l'll rrinl for the 1-I a m ptons, t h e partners were a mong America\ nw'>t pro s JXTous, m o s t successful , and most h ig h l y esteemed i n vestors. Their fund h a d $ 3 . 6 b i l l io n i n capita l , o f w h i c h two fifths wa' pcrsorJ
1 44

•

W H E N G E N I U S FA I L E D

On Monday, A ugust 1 7 , R u�sia dec l a red a d e b t morato r i u m . The government s i m p l y decided i t w o u l d rather use i ts ru bles to pay R us­ sian workers than Western bondholder�. Nor would it attempt to mainta i n the v a l ue of those ru ble� in foreign markets. I n short, it was a deva l u ation and, on at least �ome of its borrowings, a defa u l t from a government that had prom ised that it would do neither. En igmatic to the end, R ussia said its moraro r i u m would a p p l y to $ 1 ) . 'i b i l l ion of local ( ru b l e ) debt-break i ng the rule, honored even in the depths of the Larin American dehr crisis, that a government h on o rs i ts own com . The reaction in ma rkets was m uted, at least at fi rst. M e x ican and Brazi l i a n bonds fel l , and stocks i n .Japan and various emerging mar­ kers wea kened. B u t rhe Dow rose nea r l y

1

so points. A merican banks,

honoring a tradition that extended back to 1 <;) 29 , q u i c k l y decla red that they e xpected ro weather the storm with l ittle i l l effect. Robert Strong, chief credit officer a t C :h,l se Nlan harran, whose srock price was

to

fa l l 5 0 percent within s i x weeks, confidently procl a i med to

Wa ll Street security ana lysts, " I do nor view R ussia as a major issue" for Chase or for other U.S. banks.' I n terms of it� total in debtedness, R us�ia was no big dea l, barely a nother Venezuela. Except that R ussia was not Venezuela. Supposed l y, n uclear powers did nor defa u lt. And when R ussia d i d , something in the ma rkers died. The comforting not ion rhar the g l o lx1l financial cops would always be there to p u r matters right was now exposed as a fa ! l acy. This time, there was no rescue by the 1 .'\1 1·� n o h u r ried bailout b y R obert R u bin or rhe Group o f Seven Western powers. "The fu nd a n d the G 7 fin a l l y managed to say n o , " remarked Nl orri'i Goldstein, a former sen ior L\l f officia l . ' The implications o f this truth c h i l led global ma rkets like a Siberian gale. The defa u l t shattered the lazy but conven ient as­ sumptions o f in vestors that the s a fety net would
THE FALL

•

1 4 '>

Germany's stock market fell 2 percent, as i f the Russian me1uce could actu a l l v t ra m p across the eastern front. I nvestors n o w were run n i ng n o t j ust from emerging m a rkets, hut trom i n vestment risk wherever i t l u rked. The panic proved that the Asian storm had never truly been forgotten. Swap spreads-those basic thernwmeters of cred i t m a rkets-rose l i k e a dangerous fever. The British b a n k Barclay� ordered its traders to u n load short posi­ tions in U . K . swaps, even though its t raders, like those a r Long-Term, thought swaps were u n reason a b l y high. Barclays' decision to aban­ '' don the trade merely pushed them h igher. · Barc l ays' m a nagenlt'nt didn't care. The bank wanted out. I r w:ls done with t a k i n g r i s k . T h e next d a y, Friday, A ugust 2 1 , traders everywhere w a nt ed o u t . Stock markers i n Asia and i n Eu rope pl unged. T h e Dow fell 2 X o points before n oo n , then recouped m o s t of ib losse�. T h i s p a l pa ble �urge in volati l i ty cost Long-Term several tens of m i l l i on s o f d o l l a rs. The d a mage to credi t markers was far worse. Treasurys ra l l ied, hut i r was a r a l l y d riven by panic, for i nvestors bought Treasurys

ro

get

our of i n ferior credits. A few months before, they h a d not d isti n ­ guished o n e r i s k from t h e next. N o w i t w a s a l l t h e y t h o ught o f . A rose-colored world had sudden l y gone dark, d i scol ored by R ussia, Japan, even the C : l i nron - Lewinsky sca ndal. I n

cverv

m :1 r k et , in vestors

wa nted o n l y the S, i t h:1d

to

he the

t h i rty-year Trea sury; in Germany, the ten -year B u m! . All over the world, people were buying safer ( l ower-yielding) bonds and sel l i ng riskier ( h igher-yielding) ones, pushing the spread.., between such bond pairs ever w i der. ,'v1 in u re by m i n ute, Long-Term was losing m i l lions . •

In Greenwich, on that golden !a rc - A ugust Friday, Long-Term's office was l a rgel y deserted . .\ 1 < l';t of t h e -,,·nior p:t rtiHT'> wcre on vacl l ion; it was a s u l t ry morni ng, and t h e -,ctft w . t '> 11101 111g -,l o w h. _l 1 111 \ k Fntee,

rhe colorful " 'ih e i k " who'>l' dolefu l w.t rl l l l tg'> h.td hn·n 1gnored, \\" m i nding rhe store. Bi l l K r;l'>ker, t h e p.t rt l tn \\· ho h.td constructed many of the fi nn's models, was :I I D . I < H I'> I \· l t to n i to r i ng m arker�, cl iL· k ­ ing trom one p h osph orescent p;tge t o t h e n n t . I' Ll'>kcr c l i c k ed trom govern ments to mortgage� to foreign ckht . t he enti re a r i a s of credit . .:- · f l , ,.., ; t . 1 , h o rt P ' " i t ion. hul\i,h.

:1

t r.tdn

l l l l " ' h 1 1 v h.tck h i ' t r:Hk; t h u,, r h c effect ; ,

1 46

•

WHEN GENIUS FAILED

When he saw the q uotation for U.S. swap spreads, h e stared at hi� screen i n d isbelief. On an active d a y, K rasker k new, U . S . swap spre<Jds m ight change by a s much a s a point. But o n this morning, swap spreads were wildly osc i l lating over a range of

20

poinrs. They

ended an a stonish i ng ') poi nts h igher, at 76, up from 4X in A p r i l . In Brita in it was the same story: SW
a nd

Br,J z i l i a n bonds

that it had sold short as the hedge� that were .,u ppo�ed to h
CITil

when i t had crept

to

within

2) ccms of the
merger was postponed and Ciena sro�·k plu m meted $2 'i. ) O, to

S i 1 . 2 5 a �h<1 rc . long-Term lost S 1 'iO

m il lion.

Yc<1 rs e;H i i e r, Rose n feld

h.1d been w<Jrncd that risk <1 rbi1 ragc 11 as like pick ing up n i �·h· l s 1 11 front of oncoming hul ldo�:ers. Ont' h;Jd fi n a l h · ni pped h i m .

The lo..ses ..: a m e fro m

n e r v c o r n er.

The\' were <,o .,w i ft, s o cncy-

T H E FALL

•

1 4 "1

clopedic i n thei r breadth, so utterly u ne xpected that the pa rtners kit a ba ndoned. They had suddenly lost control, as though the gods of science h a d been dislodged a n d some u n seen diabolical power had taken hold o f their fates. I n G reen wich, the skeleton crew frant i ca l l y cal led a ro u n d t h e globe to reac h the other partners. Victor Haghani w;1s i n Italy; he h urried back to London. Eric Rosen feld had j u st ar­ rived in S u n Va lley, Ida ho, for a two-week vacation w i t h h i s fa m i l >·· l ie got a red-eye back to �cw York . Meri wether was in C h i n a . H i s partners tracked h i m down a t a d i n ner i n Beij ing, a n d rhe b o s s took the next flight home. Before h e left, .J . M . cal led Jon Corzine, rhe chief executive o f Goldman Sachs, a m a j o r Long-Term trading pa rtner, at Corzine's home. " We've had a serious markdown," M e r i wether ad­ v i -;ed h i m , " bu t everythi ng i s fin e with us. " ' B u r everyt h i n g was not fi ne. Long-Term, which h a d calcu bred with suc h m a thematical cnra inty that i t was u n li k e l y to lose more than Sn m i l l ion on anv -,ingle d a y, had just dropped $ � 5 ; m i l l ion1 5 percent of its capital-on that one Friday in A ugust. It had started

the year with S 4 . 6 7 b i l l i o n . Suddenly, i t was down to $ 2 . ') hi/lion. Since the end o f April, it had lost m o re than a t h i rd o f i t -. eq u i t v. Worried by s uch serious losses

to

;1 major c l i e n t , :\ 1 1 k e A I J:-, , t he

Bear Stea rns executive w h o m o n i t o red crn l i t n s b , h ur r i c· d h c·.1 l l n l Robert Sh u s ta k , Long-Term\ L·lnd t i n;I nu.d otticn. "> inJsLik p ; ! l l e n t h went over t h e fi rm\ l i q tn d i t y. A h x w.1-. .1 m ;1 1.ed by '>h usra k \ calm,

.1

thought t h a t wa-. to come to A l i x often in the week s a head a b o u t S h u s t a k a n d <1 hour t h e other partners. T h e y were t r u e p o k e r p Lly e r s , :\l i x thought."

Two d a ys a fter the debacle, on Sunday, A ugust 2 ), t h e pa rtner-. as­

>emblcd i n the con ferenn: room a t 7 . \ . \ 1 . Outside the glass-and­ gra n i te headqua rters, a fou n ta i n -.pewed jets of w a t l' l' o v e r < 1 -.nd prure

of <1 c o p p er osprey. :\, i f stricken hv <1 pn·mon i t i o n , .\ kri werher had s u m moned Jim R i c L1 rd-., rlw ge m· r;1 l c o u n -.e l , to .1 d v i se th e gro u p <1 n d .I lso keep a record of r h e proceedi ng-.. I L\1 ing been h l i n d si ded by the .\lo1.cr sca n d a l , j. :\ 1 . k new from hitter ex perience t h a t o n c e -, uch mat­ ter'> became p u b l ic, i t was too l a t e to -.eek advice. From rh;l! Sundav on, whenever t h e parrnero, met, R ic k a rds, a lawyer w i th degree., from Pen n , J o h m l lo p k i n s, <1 n d �ew York l Jn i vcr-.i tv, W<1 '> a lmost .1 l w ;1 1· s in a ttendance. J . .\ 1 . h,1 d each t rader re p o rt 0 1 1 h i -. ;lrt'a of e x pertl'ie: l l i l i hrand 011 r i -. k a rb, Hawkim on Brazi l, .\l o d c q on cq uiues, l l agkm i i lw phone

1 48

•

W H E N G E N I U S FAILED

from Londo n ) on U . K . swaps and Royal Dutch/Shell. D isturbingly, the trader<; said there was no demand for Long-Term's trades, despite their seem ing soundness. The Tok y o partners reported a similar story: there simply weren't any buyers. - In such a climate, there was no way Long-Term could get out of i ts humongous trades without moving the m arkers even more. The partner� had assumed that other arbi trageurs would recogni ze the values that they saw; thei r fai l u re to step iorw;Hd mysriiied them .' \low, l i ke genera ls who overcomm i t to a distant war, thev iound the road out blocked. l mtincti vely, Meriwether and the other sen ior pa rtners gra vitated roward the same strategy: they would raise iresh capital to gi ve the iirm a cushion and wait unt i l its trades turned a ro u n d . They were cer­ tain that spreads would cvcntu a l l y convergc, j ust as rhcy had when a young J. \1 . had daringly hai led out Eckstci n. His carly hcroics had been an a l most fa ultless guidc to .J . M . 's carccr: Sprc<1ds ahu<�ys come hack.

But owing to its loss of capital, Long-Term\ leverage had become dangcrously h igh-dangerous because losses accum u l atc fastcr as leverage incrcases. Thercfore, to rcducc thcir risk, thc pa rtners would havc to scll something. But what? l n vcstors wantcd only the least risky bonds, and Long-Tcrm didn't own any. Onc candidatc was mcrger a rbitragc. Long-Term's dca I portfolio had mushroomed to a stunning $ 5 bill ion worth of rnergcr position s,'' including Citi­ corpfrravclers and \1CI/WorldCorn ( the latter a successor to MCTs never-consummated union with British Telccomrn unications ) . The partners thought most oi these ma rriages would go thro ugh ( as, in­ deed, they d i d ) . But they were h a rd l y central to the iund's portfolio. And i f all of them did col lapse, as the C :iena merger had, Long-Term calculated that it could lose more than h a l i a billion dolla rs-now an intolcra ble risk. That samc Sunday night, Rosenfcld cal led Wa rren Bu ffctt, rcach­ ing him at h is home in Oma ha. Rosenield had won Bu fictt's admira­ tion in 1 ') ') 1 a iter the \1 ozer sca ndal, when he had worked dil igenth to get Salomon past the crisi!>, helping also to restore its name. 1\:mv Rmenfeld figu red there was no one better to oifer Long-Term's mcrger portfolio to than Buffett. The bil lionaire li ked to deal in sizc. l ie had donc risk a rbi trage hciore. And thanks to widcning dcal sprt'
THE FALL

•

1 49

hecn invol ved in merger arbitrage in a while and wasn't up to speed. No sale. G raciously, he asked if there was anything else he could do. Rosenfeld couldn't think of anything. " The next day, A ugust 24, the partners started d i a l i ng for dollars. With their gilt-edged roster of contacts, their brilliant record, their l ustrous reputations, no modern Croesus was beyond their reach. Creg H a w k i n s tapped a friend in George Soros's fu nd and set up a breakfast for M eri wether, Soros, and Stanley Drucken m i l ler, rhe bil­ liona ire's top srrategi�t. Soros, a w i l y refugee from Commun ist Hun­ gary, and Meriwether were as di fferen t as could he. Soros's Eastern European origins oozed from h i s every pon·. Formal and sti ff, he had a tendency ro launch into phi losophical disquisitions. I k looked l i ke a graying owL .VIeriwether was informal, un prerentiow,, m idwestern; he could h a ve been t he Stare Farm agent down rhe street. They rep­ resented u n l i ke styles in investing, roo. Long-Term envisioned mar­ kets as stable systems in which prices moved about a central point of rational eq u i l ibrium. " I had a d i fferent view," Soros noted. · The '>peculator saw ma rkers as organ ic and unpredicrahlc. l ie felt they in­ teracted with, and were reflective of, ongoing events. They were hardly sterile or a bstract systems. As he explai ned ir, "The idea that you have a bell-shape curve is fa lse. You have ourlving phenomena rhar you can't a nticipate on the h,t s i 'i of prev tous e x pnience . " R us­ sia, where Soros\ funds h
\1eriwether argued, ca lmly bur persuasively, that Long-Term\ mar­ kers would snap back; for those with deep pockets, the opportunities were great. Soros listened im passi vely, hut Drucken m i ller peppered J.:'vl . with q uestions. l ie snwllcd <1 cha nce to reco up Soros's Russian losses in a h u rry. Then, Soros boldly said he would be w i lling ro in­ vest $ 5 00 m i l lion at the end of Aug u s t that is, a week later-pro­ vided that Long-Term could restore i h capital by raising another $ s oo m i l lion in addition. :\"ow Rosen feld called J. P. \! orga n, a firm that long had thirsted for closer ties ro G reenwich. The b,mk sent two reams-one versed in bonds, the other in equities-to comb through Long-Term\ books. From then on, M organ people and Long-Term people were tal king - -

1 50

•

WHEN GENIUS FAILED

al mo�t consta ntly a bout how to sal vage various of Long-Term's posi­ tions. ' · N a tural ly, Long-Term turned for help to R oberto :'vtendoza, the �1organ vice chairman to whom it had offered a pa rtnership. Though clo�e to the partner'>, espec i a l l y Merton , .Vt ull im, and Rosen­ feld, .\1endoz;l had had no idea that Long-Term was in serious trou­ ble. Rosenfeld told him, "' We need beginning to crack. Personal bank ruptcy was not o u t of the lJUes­ tion. The possib ility that he had been so wrong was deva stati ng. But this time, J . .V1 . insisted: Hili bra nd would have to disclose a lit­ tle '>Omething. The arbitrageur grudgingly compl ied . .\tendoza, the partners" friend, loya l l y promised that \1organ ( or its clients ) would be good for $ 2.00 mi llion . Now Long-Term needed S � oo mil l ion more: it did not seem so much. Rickard�. the house I a wver, drafted papers for an i m m inent closing. On Tue�day, August 2. 'i, �1eriwether made two more calls. One \\ as to l l erh A l l ison, the Merri ll president. Ordinari l y, the two would h;n e been chatting about the upcoming trip to Wa tervi l le, but this �eptemher there would he no gol f weekend . .J . .V1 . disclosed that the fund's capital had fa llen to S 2.. ..., /Jillirm. l ie stressed that Long-Term had plenty of l i 4 u idity and, indeed, that liq uidi tv wa'>n"t an issue-;ln assertion that, even if sincere, was n a i \Tiy at odds with the fu nd's es­ calating leverage . .J . M . stil l believed in the models, a n d the models were still flas h i ng bullish signa ls. :'\Jonetheless, .J . M . noted, Long- I"erm would h a ve to report its losses to in vestors at the end of the momh; he would feel better if he could show them that new money was coming in. Smoot h l y switch­ ing gears, he emphasized the splendid opportunity for an yone who invested now. Playing his trump card, he implied that a big in vestor­ All ison guessed he meant Soros-was a lready in. Perh aps \1erri ll would l i k e to join him and commit, say, S � oo m i l lion to $ 5 00 m i l l ion before the end o f August? Though fond of Meriwether, All ison thought it was a curious in vitation. It was a lot of money to be want­ ing in a week . .

THE FALL

•

151

.J . M . \ other ca l l that day was to Jamie Dimon at Traveler;, the parent of Salomon Smith Barney. I n stead of the two fi rms peck ing each other to death by liquidating arbitrage trades, he suggested, why not un ite Long-Term's portfolio with what was left of Salomon\ A r­ bitrage Group and manage them together? ( ;oing hack to the mother firm, in a sense. A couple of J . M . 's partners cal led Salomon, too, so­ l iciting their old friends for capita l . They said that the fund needed $ 1 billion hut was well on the way toward getting ir. But Long-Term was losing ground, not gaining it. :\Lukers were steadily t u rn i ng on the fund. i\lortgage spreads j umped an additional 4 points that M onday, (, more on Tuesday, and ) more on Wednes­ day, A ugust 26. High-yield spreads blew out ,J nothcr 2 ) points. With each tick, more of Long-Term's once abundant capi u l drai ned away-the fi rm was losing money faster than it could ra ise ir. Stun ned by the unceasing losses and hel pless to do an ything about them, its t raders were becoming dazed, l i ke infantry i n a sla ughter. " I t was bizarre," one of them sai d . " Day after d a y w e had massive losses, and they d idn't sto p . " The firm was hemorrhaging. Long-Term k new it had to reduce its positions, but it couldn't­ not with markets under stress. Despite the ba lly hooed growth in de­ rivatives, there was no liquidity in cred it markeh. There never is when everyone wants out at the s;Ullc t i me. This is what the models had m issed. When losses mount , leveraged i nvestors such as Long­ Term are frJrccd to sell , lest their losses overwhelm them. W hen a firm has to sell in a ma rket without buyers, prices run to the extremes be­ yond the hell c urve. To take j ust one example, yields on News Cor­ poration bonds, which had recently been trading at 1 I o points over Treasurys, biza rrely soared to I So over, even though the company's prospects had not changed one i ota. In the long run, such a ;pread might seem a bsurd. But long-term t h i nk ing is a l u x u ry n ot a lways available to the h ighly leveraged; they m;ly not survive that l ong. The end o f A ugust is always a slow time in markets, hut this Au­ gust, trading i n bond markets all hut vanished. The market for new bond issues simply dried up. Schedu led new offerings were a bruptly withdrawn, which was j ust as wel l, because there was no one to b u y them. The lesser investors, t h e copycats, t h e fashionable hedge funds, the newcomers to arbitrage, and the smaller, European-based traders were q uitting the spread-trading b u siness or withdrawing their capi­ tal from it i n droves. ' '

152

•

W H E N G E N I U S FA I L E D

Wary of their cl ients' mounting losses, hanks were fin a l l y tighten­ i ng their credi t l ines to hedge funds. Steve Frcidheim, the hedge fund manager at Bankers Trust, was getting margin ca lls. H i s loan brokers had changed their tunc. Once they had shoveled money at h i m ; now they were demanding more margin. frcid heim watched in horror a-; the value of h i s bonds sank beneat h the value of the loans against them. Si nce many of his bonds were unsalable, Frcidheim sold other credits-Brazil, Turkey, Tha i L1 ml, U . S . mortgage securities, h igh­ yield bonds. It didn't matter what he sold; the point was, he had to sell somethilzK. At such a ti me, capital natu rally flows from riskier as­ <;ets to less risky ones, irrespective o f their underlying v a lue. To a tiny degree, Frcidhcim's own actions made i t do so. M ultiplied by a thou­ !>and other Frcid heims all over Wa l l Street, the crisis o f fea r became a self-fu l fi l ling prophecy, j ust as :vterton's father, who had coined the phrase, had theorized . As prices fel l , banks backed away from hedge funds. And as banks backed away, h edge funds had to keep sel l i ng. Sandy Weil l , far from wanting to partner with Long-Term or any­ one ebc in arbitrage, was tel l i ng his troops to lower their e xposure to hedge fu nds. Even as its own traders were liq uidating a ssets, Salomon was reeling from losses in bond arbitrage as wel l a s in Russia. Wei l l i s said t o have ordered h i s minions t o reduce the n u m ber o f hedge funds doing business with Salomon from five hundred to twenty! Weill's buddy Warren Bu ffett was monitoring his people, demanding to hear, in very detai led terms, about Berkshire l l athaway's exposure to hedge funds. Bu ffett, who instinctivel y tigh tened h i ' grip on his company's cash when times got tough, wanted to know i f a Berkshire insurance s u bsidiary was holding adequate collateral on swap trades . " Goldman Sachs w a s nervous a bout i t s exposure t o swaps, pa rticu­ larly with Long-Term. When Corzine, who had been j arred by J . .\1 .'s call from China, called Meriwether back , he warned h i m , " We aren't getting adeq uate feedback. It could h urt your credit standing. " Gold­ man was tryi ng to pry information l oose from the always tight-lipped hedge fund, but Long-lcrm was sti ll rel uctant to s h a re i n formation. It was trying to operate on a business-as-usual basis. But the firm no longer had the capital to dictate terms w i l ly-n i l l y. Under pressure from Goldma n and other ban ks, knowledge of Long-Term's positiom was slowly leaking out. ).low it was Wednesday, A ugust 26, and Merrill's All ison called to

THE FALL

.. n 111

•

153

n o d icl'. Sti l l i n thl' dark, A l l i so n a ddl'd, "John, I ' m n o t s u re it's

1 o u r i n terl'st to raise the money. I t m i g h t look l i k e y o u 're h a v i ng a

l ' ro h l e m ! " '>oro�\ d ea d l i ne was fi ve d a y ' off, a n d the market new., con t i n ued 1" he h a d . Fq u i ty volati l i t y notched u p two more poi n t�, to 2 ';1 per­ '

,·nr . Bon d s in Lari n Amer ica wea kened. O m i n o u .,!y, Wl'stern hanks

' l .l rted a d m i tt i n g to losses o f t h e i r own i n the former Soviet U n ion. < red i t S u i sse Fi rst Boston to r in r u b l e debt, the a ppropriatel y n a med I I igh Risk O pportu n ities F u n d , r u n by I l l Offshore A d v i sors o f West l '.dm Bea c h , F l o r i d a , was w i ped out. W i l l i a m McDonough, pres ident ot the :-Jew York Fed, h u r r ied l y canccll'll h i , trip to J;1cbon l l olc, \X'vo m i ng, w h e re the Fed was h o l d i n g its a n n u a l l a te-<, u m m e r rl'treat. With hears o n the prowl , :Vk Dono ugh h a d no t i me for moose. I ncrea s i n g l y desperate, .\ l eriwerher a n d Rosenfe l d p laced a nother c .J I I to B u ffl' t t .

·

Some of the partners had never forgi ven Hu fktt for,

1 11 t he i r eyl's, r i d i n g :\ l eriwl'th n o u t of S;domon. They rl'Sl'ntl'd thl' folks1· h i l l i o n a i rl''s tl'ndency to preach, particu l a r l y s i nce hl' l i kl'd

10

heap d i s d a i n on acadl'mic modl'ls. w h ich hl' esdll'Wl'd i n fa vor of h i s s i mpk b u y - a n d - h o l d .1pproach t o common sroch.

,.\.,

1\T

h a v e o,n· n ,

I ong-Tc r m \ p a rtnns had e v e n o; h o rt nl lkrk s h i rc, a n ;J r h i t ragl' o n ll' hich t h e v h a d l o .. r ;J hout

S 1 )O

m i l l i o n . B u t B u ifett a n d t h e part ners

�ri l l fL''>pccted each ot her a -. t a l e n t ed i n n·-.tor'>, a l lw i r from d i fferent .,chook A n d now Long-Term n eeded mon ey, a n d n o one i n A m erica 'o
Bu ffett agreed to -.ee l l i l i h r a n d , who flew our to O m a h a on T h u r.,­ LL l y. :\ ugu-.t

27.

Bv now, the fi r m \ capital

11'<1S

down to

S2. )

/Jil/iun.

!'he m o rn i ng\ Nell' Y" r/.: '1 //1/c:; i nr oned, "The m a r k L·t t u rmoi l i ... being U l m p a re d

to

t h e 111o'>! p.t t n fu l fi n . l l !l l .d d 1 "1 �tn� i n mc m orv. "

lh· the t i m e H i l i h rand

1\',1'

had f.1 l l en ; pcrce nr, to .1 t 1n·h·,·

not

·

.u r h o n ll·, h ,· k n ,·w t h . l t s rod<., i n ' ] ( > k y o 1 e. 1 r

l o w. " lhL· most basic thmg

i'

to p. 1 1 1 i c , " K i i d1 1 .\ l i v;l / a w . l , j . 1 p. 1 1 1 \ l l l l l l l s t c r of fi n a nce, o h ­

�L'riTd . ' T h a t d a y. R u s'.l
, 1 L· oo l

iL-1

stod.

p n c·,., ll' < > l t l d Ld l 1 7 pcrce nr, lea \ ­

pcrccm hL·Iow t h ,· l r l n c l . l t t h e

., ta r t

o f the vear.

I n Llcr. n t a r k ct'> a ro u n d the w o r l d \\ l'l't' p l u n g 1 ng : London fel l ; per cent, Spa111

6

perccm. Bra ; i l

1 o pnc·l' t l t .

.\ m e r i c·;l \ m <J rk ct-. fe l l l l1 " n c \I' l l h t l w 1\' o r l d \ . The Dow d ropped ; 'i"' po i ll t'>, or 4 pnce n t . Commod i t v p n c l''>, ., JHi d d e r i n g from fear of

! 54

•

WHEN G E N I U S FAILED

a world recession, touched a twenty-one-year low. The next day's Wall Street Journal would call it a " global margin c a l l . " ' Everyone wanted his money back . Burned hy foolish speculation in R us�ia, in­ vestors were rejecting risk in any guise, even reason able risk. Yields on long-term Treasurys fell ro 5. _:; 5 percent, the lowest since Lyndon .Johnson was president. Yields on �i ngle-A credi ts-i ssued hy the blue-ch ip Ford \1 otors of the worl d-soared to 1 1 5 over Treasurys, though Ford was no less safe a credit rhan in April, when it had traded at a spread of onlv 6o. l m·e-,tor'> wa nted <;afety; moreover, they wanted the peace of mind that safer bonds deli vered, no matter the pnce. Bu ffett met H i l i hrand at the a i rport that Thursday and escorted him back to h i s office, a modest suite in a pale h igh-rise across the street from a pizzeria . l l i l i hrand was his usual methodical self. l ie was candid about Long-Term's l osse'i hut totally controlled. l ie did not strike B u ffett a s desperate. The arbitrageur went over his battered portfolio in deta i l . H i l i brand stressed that he saw great potential going forward-given his peNmal debts, he had l ittle choice. Bur l .ong-Term was in a h ur ry to ra i 'ie money, l li l i brand said, and thtl'; he offered to cut the fund's usual fee in h a l f. This was hardly enough for B u ffett. I n his opinion, Long- l l:nn 's fees had been too h igh as they were . ' ' In any case, he had l ittle inter­ est . at lea<;t for now. Buffett said thanks, hut no thanks. When H i l i brand left and called Greenwich, the nc\\''> wa-. even worse. The fund had lost $ 277 mil lion Thursdav-its second worst dav ever. I ts capital was down to S 2 . 2 {Jillion. For four Yl'
T H E FALL

•

155

' \ L'l l l of defa u l t a n d that, therefore, the hanks were entitled to de­ J l l.lnd n:payment. But the m a nagement company d i d n 't have the , . l , h ·-mo�t of the money had been poured i nto the fun d to heighten 1 he partners' i n vestment. Effecti vely, the management com pany was , lo-.e to being i nsol vent. If that fact hecltne public, both the firm and J i lt' fu nd could face a debi l itating spira l . '>
ried a b o u t h i s pero;on al debt, thought I TC\1 should s i m p l y sell some of i ts 'ta ke in the fund and pay off the hanks. But R i c k a rds, the

l .l \v y e r, properly w a rned that i f i n sider-; rook out money n ow, when 1 hc ouhide i n ve�tors had no ,ud1 opt u m , it could l oo k very had later. \ lcriwcthcr, who did not wam a 'L'Con d ccn,urc from rhc S FC, .1grced. M o reover, he re;l l i zed th;H he could su rcc l y .�!>k other-; for new i mT!>tment if the partners were ca,hing our. h1r hcttn or worse, r h c partners' money would h a ve to st;ly in the fund.

r\nd the fund ( a s distinct from I TC :\1 ) had cash flow worries, too. ;\s r\ ugu't trick led away, the part ners were feeling pressure from Bear '.tcarns, the fund\ clearing broker, w h ic h was nervously eyeing the drop in Long-Term\ equity. Tha n k s to l l il i bran d 's h a rd h a l l negotiat­ l llg tact ic,, the fund and Bea r had never signed a n agreement, mea n ­ ing t h
.1

li,l hd i ty (the problem

of pairing trades wouldn't h
or her

traders had gotten away with helllg 'L'cn· t i VL' .md even a r rogant when the fund was o n top, but now t h L· J r 'mug ;upcriority w a � coming back to lu u n t them . Long-Term w a -, h.l\ ing to plead for len iency to the very b a n k s that it had offendl'd . And the partners were tortured by the memory of having rerurnl'd-dl''ipite the S h e i k \ stren uous objcctio n s- $ 2. . 7 b i l l ion to i n vc'
1 56

•

W H E N G E N I U S FAILED

vestor-, to take it! That monev would have <,olvc:d their problem-,, bur oi course, the investors were no longer enamored of Long-Term, nor were they begging to reinvest. What's more, manv o f the han k -, were them-,elves under stress. This is a timek·;,;, i ron)·: when you need mom·y most, the most likelv sources of it ( i n Long-Term's Cl '>e, other operators suL·h as Soros, as well as in ve;,tment ha n k s and i n;,titutions) are likelv to he h urting as wel l. The partners began to '>ense th;H thev might not make it. Their e x ­ qu i;,itelv wrought expcrJ meJll in risk management, to -;ay nothing o f their fa bulous profits, w a ;, in da nger of unra \Ti ing. " We were de;,­ perate at the end of Augu;,t," Rosen feld adm itted. Their tone cha nged to di;, helid and bi tterness ar ha\·ing left themselves ex posed to ;, uch needless h u m i l iation. They were m uch too rich to h;l ve gorten into so much trou ble . ."vlodest, the newest partner, lamen ted that h i', part­ nersh ip was v i rtually worthless. In another sign of their growing desperation, rhe pa rtners ;,cram­ bled to keep their personal assets from being conra m i n a ted hv Long­ Term\ troubles. H i l i hrand, once worth half a b i l l i o n d o l l a rs, \\'pecter of credi tors. l i e signed mTr his only real e;,tate p roperty-a twentv-acre l or in tony Pebble Beach, Ca l i forni a-to his w i fe ( h i'> Westc hester estate w;l '> a l ready in ."v1 imi\ n
THE FALL

•

157

\ Lntone

smiled sadly. "When you're down h y h a l f, people figure L;ln go down a l l the way. They're going to push the marker · "�-l lllst vou. They' re nor going to roll I refina nce ! your trades. You're ' •

111

' l l ll:'·h!'d. "

\:ot long a fter .'vbrrone\ visit, .\ leri werher and \.lcFntee went for d r i n k at a local inn favored hy J. \1 . and other rranspb nted Wa ll '-t rcetns. Sipping h is trademark gin and tonic, \.leriwether looked at l m pal and said in a voice that was completely fla t , " You were right. " I Ill' Sheik l ooked at him. " I should have listened to you, " J. .VI . said . 1

•

( lutsiders would Lncr com menr on how t h e gro u p held together, hut was their only palarahle choice. Tlw dccpn their fi x, t h e less the p.1rrners wanted ro he with anyone ebc and the more thq closed r.1 n h . They su ppressed, for the momem, their resentments and hitter di-,li keo;; they a voided recriminations and blame. Grim and derer­ lni ned, they got ro rhe oifice , seducing new ones, fending off han kers. Rosenfeld and Iea hy tried to keep up mora le. They told rhe sta ff, " We're going to he fi ne. We h a ve a lot of l iqtlldit y. We're r.1 ising new m oney. We j ust have to he smaller-we have too much risk . " The pa rtners conrinu­ ;J I I y retreated to the conference room, always with the curta i n s drawn to block out prying eyes, to hash out their problems in secret. Their meetings seemed endless. When they ex ited, a sta ffer might plead for .1 bit of news. B u t the partners barely responded, not even to their own employees. The tighrly wound H i l i brand would brush right bv as though he didn't hear. 11

• Hy the fin a l weekend in August, long-Term was further than ever from meeting Soros's terms, and most every body on Wa l l Street who had the power to write a check w;ls our of town for the end of sum­ mer. Long-Term had lost scores of m i l l i ons or h u ndreds of m i l lions of dolla rs day a fter day, every single day for weeks-until, fi nal ly, it had enjoyed that single up day on Friday. Sti ll hoping against hope, Meri­ wether made yet another round of calls. One was to Merrill's Dan 1\'apoli, to ask when Napoli thought the

! 58

•

WHEN GENIUS FAILED

bleeding would stop-as i f :\'apoli or a nyone else could kn ow. Then J . M . called Siciliano, reaching the U B S manager in Tokyo. " Does anyone i n your hank want to in vest? " !'vleriwether q ueried. "These trades a re m ispriced. We think we have a tremendous oppor­ tlmity. " Keeping his composure, J . M . added that I ong-Term bel ieved it had up to $ 1 bill ion in other new m oney virtua l l y sewed up. U BS, though, was alre;ldy Long-Term\ higge�t in vestor. " You must be down twenty-five percent , " Siciliano said . .J . :V1 . replied coo l l y, " :VI ore like fort v-five percent." Sici liano wa� stunned. He won dered who would want to risk putting in the first b i l lion. He k new it wouldn't be he. On Saturday, August 29, Meriwether called Edson M i tchell, the Merrill Lynch banker who had spea rheaded Long-Term \ ma iden fu nd-raising effort in 1 9 9 .� · M itchell had since moved to London to launch a global bond business for Deutsche Bank. Could :vt itchell and Deutsche raise capital for Long-Term now ? M itchell said i t was u n l ikely. Meriwether was running our of friends. When you need money, Wa ll Street is a heartless place. On Monday, A ugust .> 1 , as the month ran o ur, the I long Kong .\lonetary A u t hority, wh ich had been buying shares of local stocks, �uddenly stopped supporting the market. Yet another safety net had been exposed as porous. The local bourse tumbled 7 percent, trig­ gering a run on Wa l l Street. The Dow crashed 5 1 2 poin ts, a (, percent plunge that took the a verage down to 7 , 'i '\ <) . It had fa llen 1 9 percent since mid-J u l y. Secretary Rubin, hack from �almon fi shing in Alaska, tried to calm mark ets hy declaring that the l i S economy was "soun d . " This merely deepened the m ystery of the cra sh, for no one piece of news was responsible. The \Vall Street Joumal cited a "dis­ appointing Chicago purchasing managers index," ;l ll a l most comi­ ca l l y tri v i a l expla nation. The paper was closer to the tru t h when it noted, "On the margin, there is no increment a l buyer. " · ' The .\1 ain Street economy was sound, hut financial ma rkets were overleveraged and overe x tended. The entire Street had lost its nerve. The cool, un­ emotional traders of Merton's models no longer e x isted, i f they ever had. N ow they were in full-fledged panic. The damage in Long-Term's m a rkets was acute. Equity volatility broke a bove 3 0 percent. Yields on Treasurys dropped, widening credit spreads ever more. Spreads on investment-grade bonds ex-

T H E FALL

•

1 59

ploded u pward-on that one day-from 1 :; :; points to I 6 2 ! I n truth, such spreads had to be i n ferred, beca use almost nothing i n bond mar­ kers traded that day. The bond ma rket had effectively dosed; no one undd trade out of a nythi ng, or not without suffering horrendous losses. It was a s i f a bomb had h i t ; traders looked at their screens, and the screens stared blankly back . B uyers were simply nowhere to be found. " A ugust thi rty-first was a un ique day, " said C u rtis Sham­ baugh, the bond strategist at Credit Suisse First Bosto n . " So few is­ �Ul'S tradl.'d, you had to guess w here thl'y were . " ror a fund that had to l ighten i rs load, the month had ended with the most n ightmarish kind of bond m arket imaginable : no bond nw rkl.'t a t a l l . •

:\ugust was thl' worst month ever rec o r d e d 1 1 1 c re d i t ' p re;Id,. · I n t h e past, s u c h ballooning spreads h a d presagl.'d a n econ o m i c u 1 l l a pse. But this time, no depression threarenl.'d Main Street; perhaps a slow­ down, but nothing more. The bond market collapse was caused by a panic not in the ma instrea m economy but on Wa ll Street i tself, where roo much optimism ( a nd too much leveragl') had suddenly come un­ donl'. Threl' q u a rters of all hedge funds lost money in A ugust, and Long­ lerm did the worst of any of them . In one drl'adful month, ,\leri­ wether's gang lost S 1 . 9 hill ion, or 4 5 percent of its capital, l e a v i n g it with only $ 2 . 2 S hi/lion. The Soros opportunity was gone-hopelessly gone. And Long-Term's portfo l i o sti l l was dangerou s l y bloated. The fund had $ I 2 5 b i l lion in assets-') X percent of its prior total and an extraor d i n a ry fifty-fivl.' times i rs now-shrunken eq u ity-in addition to the massive leverage in its derivarivl.' bl.'ts, such as l'q u i ry volatility . 1nd swap sprl.'ads. This lcvnagl' was simply untenahll'. If its assets L·ont i n ued to fal l , i b losses would eat thro ugh that $ 2 . 2 H b i l l ion sliver of l'q uity in a n eye b l i n k . Yet that leverage could not he reduced-not gi ven the size of the trades and the utter loss of liquidity. The partners were in an unfa mi l i a r place, a territory the modelers hadn 't explored. Sravis fel t the pa rtners had gotten to "a kind of volati l ity they d i d n 't understa nd. " Theoretica l l y, the odds agai nst a loss such as A ugust's had been prohi bitive; such a debacle was, ac L·ord ing to the mathematicians, a n event so freak ish a s to he unli kclv t o occur even once over the entire life of the Uni verse and even ovn n umerous repetitions of the U n iverse.''· Bur it had hap pe n e d t o I o i l ) ',

1 60

•

W H E N G E N I U S FAILED

Term not q uire four years a fter .'v1eri werher had wri tten to the firm's investors, nmfidenrly endorsing \1erton and Scholes's so finely tuned assumptions a bout the fund's risks. A las, in the partners' lingo, the "correlations [ a mong the trades ] h
THE HUMAN FACTOR

I 1 1 1 1 1\ l ( ; t :-.; :-.; 1:\ ( , 01

September, !'v1criwet hcr h;ld to tell h i -, i n ­ ;uHI h i -; letter did n or

A Vl''>tor' a h o u r t h e fu nd\ horren dou., lo-,-,e-,, m ince words:

As you a rc ;1 1 1 roo aware, events surrounding the collap'>e in R ussia caused l a rge and dramatica l l y increasing volatilitv i n global m a rkers throughout A ugust. . . . U n fortunately, Long­ Term Capita l Portfolio has a lso experienced a s harp dec line in net a sset value . . . it is down 44 percent for the month of Au­ gust, and 52 percent for the year-to-d;HL'. l .o:-.scs of this magn i ­ tude a rc a shock t o U '> ;h they <;urcl y ;lrc to y o u , especially 1 11 l ight of the h i s torical volatility of the fund. ' l lowever, .J . M .'s letter was guarded l y optimi stic a bout the fund\ future. No doubt this rosy v iew reflected his honest a ssessment, but by now the partners' view of their prospects had seriously diverged from that of the outside world. According to the letter, the seeds of Long-Term\ disaster had been sown earlier i n 1 9 9 X , when credit spreads had widened. Long-Term had bet on spreads to narrow aga i n , but i n vestors had fled from i lliquid securities, p u s h i ng 'prcad-,

162

•

W H E N G E N I U S FA I L E D

wider sti l l . Owing to this " fl ight to liquid ity," as J.M. phrased it, "our losses across strategies were correlated a fter the facr"-a tor­ tured construction intended to mean rhar Long-Term had done every­ thing it could to a void �uch correl ations " before rhe fact . " I lis analysis w a s devoid of a n y suggestion that a nyone a t Long­ Term had made a mistake-for instance, by nor trimm ing rhe balance sheet at the end of 1 ':1 ';1 7 , when opportuni ties had been so sc;Jrce. By implication, J . \1 . fa ulted not h 1 -. t r.Jdcr-, but the ma rkers that had moved again'>t them. M eriwether assured the In vestors that " steps have been taken to reduce risks now, commensu rate w i th our level of capita l . " But this was a rather m isleading comment, gi ven that Long-Term had done little in the way of sel ling and that its leverage had bolted to 5 5 ro 1 -a fact that .\1criwether om itted. The ki ndest explanation 1s that :'vh:ri wether, under the strong i n fl uence of l lili brand and l l aghani, did nor comidcr the core trades to be all that risky. " \X'e see great op­ portunities in a nu mber of o u r he>t strategies, " he noted. In the meanti me, .J .!vl. asserted, the fund was "q uire liquid "-a point that was true hut that fa i led to address the serious ca�h flow problems de­ veloping Jt I TCM, the parrners' mJnJgement company. Long-Term fa xed the confidemia l letter on September 2, but one of the in vestors lea ked it to B l oom berg, the financial new� service, which published it even before the last in vestor had gotten h i s copy. This dollop of un wanted publ icity h i t the p; utners l i k e a splash of icc water. The Wall Street Juun�cd gave top hilling to Long-Term\ losses in
T H E H U M A N FA C T O R

•

1 63

1 1 1 e v it a b l y, the banks tightened credit in Bra z i l . l lcrb A l l ison, Mer­ ' r l l \ prc,idcnt, called a meeting for September 4, the Friday before I

. r hor D a y, to go over Merri l l 's repo exposures in emerging ma rkets .

. \ l h son, once so s u pportive of the relationship with Long-Term, de­

l l r.tnded to know why �1erril l was fi nancing the fund's Brazi l i a n l l .tde,. '' W h a t do y o u mean, H e rb ? " o n e of Al lison's u nderlings re­ t < �rted, a l l uding to his boss's former fondness for Long-Term. " It's he­ ' .wse of y o u ! " Al l ison la ughed and told his staff not to let it h a p pen .rgam. The hanks were agitated not j u st about hedge funds h u t about t hei r own m ou nting los,es. Goldman, Morga n , Salomon Smith B a r­ n e v,

Merri l l , a n d the rest owned h uge portfolio' of bonds th at, in d i f­

krent configurations, were genera l l y si m i L l r

to

Long-Term\. The

hanks, too, had hedged their portfolim hy , h oning l i .S . Treasu rys, .t nd they were exposed to the same merciless w iden ing o f credit -.preads. M o reover, the hanks' s h a re prices had t u mbled. Goldman, which h a d s uffered the biggest l osses, was espec i a l l y nervous lest the hea r m a rket ruin its public offering, p l a n ned for the fol lo w i n g month. Salomon w a s nervous, too. Sandy Wei l l was terri fied that the losses trom A r bi t rage m ight jeopardize his pending merger with C :iticorp, .t lso slated for October. Under Wei l l 's steely orders, Salomon conti n ­ ued to l i q u i d a te . T h e mercurial �bghani h a d been so u pset t h a t he wanted to buy what remained o f Salomon's portfo l i o , j ust to stop its '>el l i ng. I {is p a rtners thought Haghani wa' d a ft-Long-Term wasn't 111

a position to /my anything. They a l l hut -,uspected t h a t the nervy

Haghani was not doing h is a l l to u n load a''ets, a l most a s though he -,ecrerly e n j oyed the thrill of h a v i ng everything a t stake. W hen i n Lon­ don, he continued to pedal to work, as i f noth ing was wrong. But the pa rtners noticed a n ominou-; patte rn : their t rades were fa l l i n g more than others'. There was a ral l y in j u n k bonds, for i n ­ stance, h u t t h e specific issues that Long-Term o w n e d stayed de­ pressed . ' S i m i l a rly, swap spreads were widening i n England much more t h a n i n Germany-the ex act opposite of w h a t Long-Term had bet on-w i t h o u t a n y apparent economic rationale. I n the United K i ngdom, swap spreads soared to X2 points, w h i le i n Germa n y thev l i ngered a t 4 5 · " It didn't make sense," a Long-Term trader fumed. I f Fngland w a s s u ffering from a fl ight t o q u a l i t y, i t s h o u l d logica l l y have .;truck i n Cerman y, too. But logica l l y or ot herwise, Wal l Street tradn, were r u n n i n g from Long-Term's trades like rats from a sinking , J n p .

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This was n o longer purely coincidence. As it scavenged for capital, Long-'l crm had been forced to revea l bits and pieces and even the genera l outline of its portfolio. I ro n ica lly, rhe secrecy-obsessed hedge fund had become an open hook . M arkers, as Vinny M arrone m ight say, conspire against the wea k . And thanks to !\:1 eri wether's letter, a l l Wa l l Street knew a bout Long-Term's troubles. Rival fi rms began to sell in advance of what they feared would he an aval anche of liqui­ dating by Long-Term. "As people smel led trouble, they started get­ ring our," Costas k:aplani., , then a t rader at Salomon, rern;�rked. "\:or to attack I TC�1-to '>ave themsel ves. " As rhey h a mmered ;nvay ar Long-Term's trades, Lea h y felt <,ick, as though the fi rm's competitors were liquidating Long-Term's own positiom for ir. ' l lili­ hrand had not been wrong: when you hare vour secrets, you're left n;! ked . •

Meriwether may have felt the fund was l iq u id, hut Be;H Stea rns was not so sure. Long-Term's assets " i n the hox "-tha t is, the cash and '>ecuritie., it kept on call ar Bear-were dropping by the day. Bea r wa<, increasingly uncomfortable a hour clearing for the fu nd. M a king mat­ ters worse, Robert Sh usra k, who updated Bear on the fund's results n'Cr)' in rhe box wenr below $ 5 00 m i llion, Bea r would stop cbHing for the fu nd. Un­ derlining Bea r's stare of <�gila, 1\ l i x ordered Long-T(:rrn to find new fi ­ nancing for -;omc fut ure-, contr.lch it ILHI fi n.mn·d wirh Bea r. The prudent Bear wanted no L' XU_'" L'Xpo-,ure to the hedge fu nd. The pressure from Bea r pur .\l ike Reisman, l .ong - Term\ rcpo man, in a '>tate of <�gil<� as wel l . Reism;l n wa-, Long-Term's m onev guv, the one who fo und rhe financing . bonds. ! lc was al .,o the L-lose<,t that Long-Term had to .1 g.:n uine dlt.l lld-up

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165

, < lill ie who o wned a piece o f the Gotham Comedy C l u b i n ;\1a nhat­ t .m. If a nyone kept the office l ight, i t was Reisma n . B u t i n early Sep­ r ,·mber, the repo guy was in no mood for comedy. Reisman, who r nore than anyone else had h i s finger on the fund\ pu l se, told a col ­ league that i f Long-Term didn't ra ise new money h y the end of the monrh, the fund would lose its repo l i nes, without which it couldn't 'urvrve. The staff had a personal reason for feeling anxious. They had their own capital i n t he fu nd, yet they remained in the dark about what the p;lrtners were doing to save it. The employees were q u iet heroes, working long days even as thei r future became increasingly cloudy. l\atura l l y, they resented the pa rtners, who worked a longside them hut never shared their secrets. When the hosseo, shut the door for meetings, the sta ffers would wait with clenched teeth . When t h e part­ ners exited, a sta ffer would say, " I Icy, guys, what's goi ng on ? " The t �'pica l response: " We're working on it." As a substitute for solid mfo, employees mockingly developed a " necktie index " : the more partners w h o wore a tie, the employees kidded, the m ore big meet­ ings and thus the deeper the fi rm's trouble! The partners were, in fact, worried that the empl oyees would holt. fhe issue could not he ignored, because I TC : M , wh ich paid the em­ ployees' sala ries, was anything hut l iquid. In the first wc:ek of Sep­ tember, Fleet Bank cal led its loans to I TC:: \1 . This meant that lTC\1 was liv ing on a t h read; Fleet could put it into ban k ru ptcy at any time. Presumably, i f that happened, Long-Term's trading counterparties wou l d then c l a i m a default on their swap agreements and tip the fund itsel f i nto bankruptcy. Facing their worst crisis yet, the partners moved $ ; R m i l li on out of the portfo l i o a nd into I TC \1 ( which they per'>ona l l y owned ) in the form of a loan. This dubious trans;Jction prov ided the cash to pay -,a I aries t h rough the end of I ') l) X , buying I TC : \-1 some time w i t h the employees. The fund's outside d i rectors approved the loan, reasoning that if I TC M fai led, the fund itself could topple. But the loan, even though contractua l l y permissible, was shot through with confl icts of interest. The partners were with d ra w ing-or, technically, borrowing against-their own investment in the fund without giving the same opportu n ity to the outside investors for w hom they were trusted fidu­ ciaries. It was a sign of rank desperation. Even this fancy footwork was not enough . Sti l l facing a threat

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WHEN GENIUS FAILED

from Fleet, LTCY! persuaded David Pflug, the Chase .Vlanhatran banker, to a ssume Fleet's loans, which totaled rough l y $46 m i l l ion, and to agree not to ca l l the $62 m i l lion loan a lready outstanding from Chase. Rosenfeld was deeply grateful for Chase's " i ncredi ble move. But now LTC: . \1 was i n hock to Chase for S 1 0X mil l ion, ro Credit L)'Ormais for S 5 o million, to L loyds for $7 m i l l i on-and to its own fund for $ ) X mil lion. Seek ing capital vet again, Meri wether o i led a t ri o o f Merri ll exec­ utiVl·s September h, rhe Sunday before Labor Day. D u l y alarmed, Merri ll's Richard Dunn spent the holiday sifting through the bank's exposures to Long-Term. :\lcrri l l was now worried a bout more than its own d i rect exposure. Dunn was th i n k ing about what would hap­ pen to ma rkets i f a collapse by Long-Term sparked a run for the exits: Could the entire Street fir through the same door at once ? Merri l l was so concerned that it deputized D u n leavy, the salesman, and Bob �lcDonough, the credit manager, to get some facts in Greenwich. Dunleavy, who was on frien d l y terms with the partners, a sked them point-bla n k , " Arc you guys O K ? " The partners, putting their usual posi tive spin on matters, said that the firm, despite its problems, was liquid. D u n leavy later told colleagues that the partners had lied to him. But J . YI . and company truly bel ieved that with spreads so wide, a golden vindication lay a round the corner. "We d reamed of the day when we'd have opportunities l i k e this," Rosenfeld said.' What they lacked was the mea ns to exploit them. J . :Vl. was now in Eckstein's po­ sition, facing the prospect of ha ving to let some new J .M . make the k i l l i ng. J ust to be on the safe -,ide, Meriwether told B i l l M cDonough, the New York Fed president, that Long-Term was h a v ing to look for new money. J . :\1 . and other Salomon executives had once been criti­ cized for not h a v i ng advised the Fed of a problem early enough; J. M . would n o t make t h a t mistake aga i n . "•·

•

Throughout the end of August a n d i nto September, the pa rtners' mood gyrated with their prospects for fresh investment. They side­ stepped the delicate issue of lTC M 's cash problems and dwelled on the supposedly bright prospects for a n yone who in vested now. M or­ gan's Mendoza was still prom ising $ 200 m i ll ion. He breezi l y dropped the names of bl ue-chip investors on h is l ist, including Jack Welch, the

THE HUMAN FACTOR

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chairman o f General Electric. l lowever, �1endoza w a � often dis­ tracted from I TC M hy other a ffa i rs. l ie wa<> gl'llu i ncly fond of the firm, hut the partners were divided on whether �1endoza was their m ost effective ally or simply a sympathetic \·m cu r. In any ca se, the partners had plenty of tony na mes in thetr own Rolodexes. :Y1 yron Scholes contacted �ichael Dell, the per�on al-computer magnate, who sen t a rea m ro i nspect the fund\ boob. The Basses, the Texas fi ­ na nciers, a n d a h ost of others followed. Superficial ly, the blitz resem­ bled Long-Term's first campa ign of 1 9 9 .> · But though they seemed n or to rea lize it, the pa rtners had lost the a u ra of i nvincibil ity that had opened doors for them before. They had the flashy resu mes hut nor rhe magic-.tnd without ir, thev were jw.r .t nother fun d . Hoping to land rhe /itt hrot hn� , rhe puhl i'ihing moguls, Meri wether offered to cut Long Term\ uncommon ! � high fcc for-ami only for-the first th ree year-,. Perh aps such a teaser might have worked once, hut now J. ,\1 . \ offer of o n l y a temporary discount struck the /i ffs as arrog the ephemeral gl itter of Wa ll Street: i nvestor� will k n ock down the door of a high-priced manager and then abandon h i m when he cuts h i s rare. A group o f the partners a l so visited .J ulian Robertson, the head of Tiger .'\!Ltn a gemenr, a hig hedge fund operato r. Robertson, w h o wa� about to disclose a $ 2. billton loso, on a mispLtccd yen hct, mav not have been in a speculating mood. In anv case, Robertson, a o,h rewd o,outherner, was not impressed; he saw lirrle to con vince h i m rhar Long-Term had any superior expertise. Once again, the partners c·ame up empty. Rarely had such heady credentials and �uch a gaudy li st mer with such dim results. Even Long-Term's existing i n vestors were beginning ro see the fu nd i n a harsher light. Marlon Pea'ie, the di rector o f fi n a nce of the l J n i ­ \ ersiry of Pittsburgh, flew t o Green wich t o sec ,\1erron and Scholes, who had v i rtu a l hero 'itarus i n academia. The professors were close­ mouthed about their recent losses but tal ked up the fund\ potentia l . Scholes, e ver t h e salesman, e xpressed con fidence t h a t Long-Term would raise a b i l l ion dol l a rs in September and another b i l l ion by year-end. But Pease declined to contribute more.'' " We had been lulled into this d rea m l i ke state," said W i l l iam Sharpe, a Sta n ford professor w h o advised one of the fun d 's i n vestors. But now Sharpe snapped out of it. When Scholes, h i s former col­ league a t Stan ford, cal led to raise more money, Sha rpe was wary. I I i�

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client, a wealthy Chinese American, was ready to invest $ _3 0 m i l l ion; the professor said it was too risky. They agreed that the client would invest $ 1 0 m i llion now and another $ 1 0 m i l lion i f Long-Term could corral a m a j or investor. They were re;ldy to wire the money to a n es­ crow account, hut Scholes delayed the clo�ing. Long-Term knew i t would h e pointless t o col lect m oney in small amounts. For the big money, :Vleriwether contin ued to angle with Herb Al­ lison at Merri l l , Edson .\1itchell at Deutsche Bank, Donald Layton, a vice cha i rman of Chase, and Gary Brinson, who ran ;ln asset man­ agement unit for UBS. Among them, these Wal l Street lions easil y had enough resources. But could the lions he rou�ed from their den ? The partners' glowing forecasts n otwithstanding, the bankers had a nose for trouble. And with Long-Term increasingly desperate, the ban kers cou ld a fford to be patient. Every day that passed, the " rare opportu­ nity" merely got cheaper. I mproha ble as it seemed, Long-Term's markets kept sink ing. Risk­ arb spreads opened to their w idest �ince the I 9!l7 crash . '' Public stock offerings ground to a halt, �t:nding a shudder through the bankers a t Goldman Sachs." Y;clds on B-rated bonds c l i m hed to 5 70 basis points a bove the yields on blue chips-up from 200 points a year before. The price of short-term stock ma rket insurance (equity volati lity) douhled. ' ' " I t's l i k e a hlanket of fear has descended over the market , " an options trader told '/he Wall Street Journal. " Over­ seas, prices reflected sheer pa nic. I n terest rates on an index of emergi ng-m;lrket deht �oared to I ,700 points a hove U.S. Trea sury-;­ up from ; oo points a year before! ' Alan Greempan ominousl y warned that the Un ited States could not t:xpect to ht: an oasis of pros­ perity in such a trouhled world . ' ' It was a hear market in risk no mat­ ter what the asset. And Long-Term had bet on risk a l l over the world. I n every arbi­ trage, it owned the riskier asset; in every country, the least �afc hond. I t had made that ont: same bet hundreds of times, and now that her was losi ng. Thursday, September 1 o, was a very had day. Swa p spreads j umped another 7 points; other spreads widened, too. In a spot of bad l uck-or was it a portent?-a rocket ferrying a dozen Gloha lstar satellites fell our of the sky and e x ploded. Long-Term, as it happened, owned G l o ba lstar bonds. The partners al most laughed: even the heavens were against them. I n the risk-management meeting, the traders went around the ta hle, each reporting his res u l ts . When it he-

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, .llllt: clear that t:very trader had lost, Mullins demanded sarcastically, ' ( an't we ever make money-j ust for one day ? " So far i n September, l h L·v hadn't, nor onct:. Ma rkers were simply on strikt:. Everyone was ,,·!ling now-except for Long-Term . The fu nd was immobil i led by irs sheer mass. Tht: s m a l ler fish . 1 round i t were liq uidating every bond in sight, hut Long-Term was h t·lpless, a hloart:d whale surrounded by deadly pira n h a s . The fright­ ! ul size of irs positions pur the pa rtners in a terrible h i n d . If they sold ,·1-en a tiny fraction of a big position-say, of swa ps-it would st:nd 1 h t: price p l u m meting and reduce the v a l ue of a l l the rest. Ever since his Salomon d ays, l laghani had pushed his col leagues to double and ,·vt:n q uadruple thei r pmitions. Now ht: '>aw rhat -;izc t:xtracrs a prict:. By late a fternoon on the tenth, the p'1rtner' k new they had crossed .1 debi l itating psychological barrier: their capita l had fa llen below $2. billion. l r was la tt: that day when Meriwether got the call he had dreaded-from Warren Spector, t:xecutive vice president of Bear Stearns. Long-Term's assets i n the box had dipped below $ 5 00 mil­ lion, though they were restored by day's end. Apparently, J . M . ex­ plai ned, some of Long-Term's trading partners had started to rake rheir time sending in monies due. N o ont: wants to pay a prospective bankrupt. Bur Spector was past rht: poi nt oi explanations. Ht: curtly told .J . :vl . that Bear would he sending a team to look a t Long-Term's hooks on Sunday. Otherwise, ir wouldn't clear Long-Term's t rades on 'vlonday. The next day, September 1 1 , Meriwerht:r called Corzine. The Goldm best beh a v ior. Sudden l y a model client, it opt:ned its books and set our a spread of sandwiches. Past the point of mising a fuss, l li l i brand patienrlv took rhe visitors through t:very trade. 'vlcrivv-erher and Rosen fcld a ttended rhe entire brit:iing, showing that l .ong-Term was taking Bear's th reat seriously. A l i x was impressed by the performance bur di stu rbed by rhe sile of Long-Term's tradt:s. The nexr day, a fter Hear\ executive committee mer, A l i x reiterated to S h u '>Ll k t iL l l lk.n

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truly regarded t he $ 5 00 m i llion threshold as in violate. I f Long-Term pierced it again, the game would be over. U BS, Long-Term's biggest i nvestor, was feeling even worse than Bea r. David Solo, a derivati ves w h iz from the old Swiss Ba nk, real ­ ized-too Ll l e--t h a t t h e newly merged U BS w a s in for h orrendou� lo,ses. A s Solo a n a i V!.ed the warrant package, U BS had taken a h uge risk for a potential return of only X percent-which now, of course, it would never rea li te. " A l l thi\ discm�ion of option hedging, volatil­ i ty and prem ium' is ridicu lom," he ta pped in a n u rgent September 1 4 e -m a i l ro �b rc el O sp e l , formerly head of Swis-; Bank and now C :FO of UBS. I n a dig at thei r merger partners, Solo added conspi ratorially, "This trade was a pproved by the U BS group executive board and by many people sitting a round your table." Mea n w hile, that Monday, �1eriwethcr, Rosenfeld, and Lea h y called on L e h m a n Brothers. Jeff Vanderbeck, who r a n t h e bond side of Lehm a n , i m media t e l y asked if the ru mors he was hc
Long-Term did have one c sc .1 pe hatc h : the re v o l v i ng credit it had ob­ tai ned in I l) ') 6 from the ha nk s y n di c a te led by Cha ,c . The $yoo mi l ­ lion revolver ( raised from $ ;; oo mi ll ion init i a l l y ) W
THE HUMAN FAC T O R

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r i ll' ha nks were on the hook. Thanks to Chase's sloppy drafting, the would h a ve ro knd $yoo m i l l ion to a n insolvent company. Hut the pa rtners were badly split on whether they should borrow. \ I J J I I ins thought they shouldn't. I f the fund went down, w h y take the l •. 1 1 1 k s with them ? An additional loan would on l y compl icate matters. 1 .\ 1 . , l l awk ins, M odest, and the l\ohelish agreed. H i l i brand, I I .Jghani, Leah y, and Rosenfeld a rgued strongly for drawing on the r n olver. How else, t hey asked, could they hope to replenish their , . 1 piral at Bea r ? Krasker, McEntee, and Sh usra k were for fundi ng, I < H l . Rickards, the lawyer, pointed out that l .ong-Term might be I L1 hle to its own investors if it d i d n 't pu rsue every optio n . " We don't 1 1 . 1 \'l' to decide at this j uncture," _ 1 . .\1 . fi nallv '>;l id, cutting off the de­ i >. l t l' . They didn 't need the money quite ITt . The pa rtners sti l l had Goldman Sachs and Cort.i nc, w h o n ow, in r r 1 r d-Septe m bcr. emerged as Long-Term\ one heo,t hope. Tal l and 1 >,-.1rded, Corzine had alwa�·s seemed an unlikely financier. Born in a l . l l'lnhouse in southern I l l inois, he h a d played basketball i n col lege . r r1d ma rried a girl from his k indergarten class. "· In 1 ') 7 ) , a year a fter \ J eri wether had been hired by Salomon, Corzine had joi ned the bond .kpartment at Goldman. He had developed into a talented trader. r h ough less celebrated than Meri wether, whom he fra n k l y admired 1 r 1 d whose a rbi trage unit he 1·invcd ;1 '> .1 model for h i -. own tirm . .\s ( ort.ine c l i m bed the ranb at Coldm;l l l , he remai ned una ffected and , . . 1 \ \ going, k nown for fuuy patched swearers in a w orld of three · t•rece suits. ( ;oldman, Wal l Street's last private ful l-service i n vestment hank, ·,lu red certa in tra its with l .ong-Term. l h partners 1vcre secretive and, t or many decades, had been unusua lly close. The Goldman culture .,,.,1 '> exceptionally discreet ( t hne is no indicat ron of Goldman\ pres­ , nee in the lohb�· of irs he.ldqturtLT'> ;It S :; Bro.1d '->trcct ). Unt i l recent 1 1 mes, Coldrnan had bet·n known for the care that it Ln i a nd even eschewed trading for its own .lc· c·ount, on the noble premise that trading could pur the hank into , onflict w i t h its customt·rs. ' But in the 1 ySoo, and carh· 'yos, o.;uch ,Ira wing room niceties were c1st ;l';ide. The leadero,hip duo o f Stephen I riedman and Robert Rubin, later of Treasurv fame, con fiden tly ex­ p.ulded int o trading, ;lTld a -. Goldman\ hankers removed their wh itt· gloves, conflicts with Cll';tomers beume com mon. When the hond l •. 1 1 1 k s

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marker cracked i n I ';) ';)4, Goldman-which, like Long-Term, had set risk lim its according to statistical models of volati lity-s u ffered enor­ mou� and destabilizing losses. ( ;oldman discovered that irs leveraged position-, were well known to other traders, and it could not get our of them without s u t k·ring heavy losses. ' Partners defected en masse, saddling the un pretentiou' Corzine, who rook over in the fa ll of I ';) ';) 4 , with the j o b of rebu i lding the p:t rtnership as well as the business. The firm bou nced b,Kk, hut ( ;oldman\ partners--aga i n l i k e Long­ Term\-rca lized th;ll they needed more C;t pital, which was the reason for their pla n ned stock offenng. :VIean w h i le, Corzine further empha­ sized the l ucrative business of trading for the ban k 's account. Corzine had been intrigued with the idea of joining forces with ;vleri­ wether before, and now he coul d deal with his rival from a position of strength. He agreed to provide investment capital, but at a price: he de­ manded half of the partners' management company, full access to Long­ Term's strategies, and the right to set a limit on the fund's exposures. The congenial financier was proposing nothing short of a ta keover. l lowcver, Corzine was offering Si 1 billion of Goldman's a nd its cl ients' money, as wel l as a promise to help l .ong-Term raise a second billion. And merely informing the world that Goldman was i n Long-Term's corner might stop the bleeding. �1criwether could not say no. The two fi rms q u ickly struck a tentative dea l, conditional on Gold­ man's raising the money and on Long-Term's passing an i nspection, a customary process. Goldman had to move fast, before any more of Long-Term \ capital wa' i
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,omt: of the very same positions. At the end of one day, when the fund's positions were worth a good deal less, some Goldman traders in Long­ ICrm's offices sauntered up to the trading dt:sk a nd offered to buy them. ' " Brazenly playing both sides of the street, Cold man represented investment banking at its mercenary ugl iest. To J . M . and his partners, ( ;oldman was raping Long-Term in front of their vcrv eyes. On Mon day, the day the Go ldman invasion was l a u nc hed, equity volatility c l i m bed to an asto ni s h i ng 3 2 percent! On Tuesday it h it n percent-each point cost the fund $40 m i llion. Thro ughout the fund's portfo l i o it was a similar story. Long-Term's trades-its trades in particular-were mercilessly ba ttered, from Danish m ortgages to Vol kswagen shares to j u n k bond, of '-,r;1 1 ion C :asino'i a n d Sta rwood. '-.hel l Transport, which Long-' l i:rrn had purdu..;nl ,lt ;t i l X percent dis­ d>Unt to Royal Dutch, disastrously widened to a 'pread of 1 4 per · cent. Even the reliable trade in Ita lian bonds, which had made m oney during most of 1 9 9 X , now fel l hack, too. In every c la ss o f asset and a l l over the world, the m arket moved .tga inst the hedge fund in Greenwich. Rickards, the h ouse attorney, described it to col leagues as the " I TCM death trade." The correLt­ tions had gone to one; every rol l was turning up snake eyes. The mathematicians had not foreseen this. Random markets, they had t hought, would lead to standard distrihutiom-ro a norm a l pattern of black sheep and wh ite sheep, head'> and tails, a n d jacks and deuces, not to staggering losses in every tr;tde, day after day a fter day. The professors had ignored the truism-of which they were well ;t warc-that in markets, the tails a rc a lways far. Stuck in their glass­ w a l led pa lace far from New York's teeming trading floors, they had forgotten that traders arc not random molecu les, or even mechan ica l l ogicians such as l l i l i brand, but people moved hy greed a n d fea r, ca­ pable of the e xtreme behavior and swi ngs of mood so o ften observed in crowds. And in the late summer i>f 1 9 9 X , the bond-tra d i ng crowd was extremely fea rfu l, especia l ly o f risky credits. The pro fessors hadn't modeled this. They had programmed the market for a cold predictab i l i ty that it had never had; they had forgotten the predatory, acquisitive, a n d overwhel mingly protective instincts that govern rea l­ l i ic traders. They had forgotten the h uman factor. •

.'vleriwether bitterly com plained to the fed's Peter Fisher tha t ( ;old man, a mong others, was " front-running,'' meaning trading ;tg. I I I I ' I 1 1

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on the basi> of inside knowledge. Goldm a n , indeed, was a n extremely active trader in mid-September, a n d rumors that Goldman was sell­ ing Long-Term's positions in swa ps a n d j u n k bond> were all over Wa ll Street. In fact, its high-yield traders were said to be bragging about ir. Goldman officials denied >uch charges: in a n v case accmarions were hardly l i m i ted to ir. K nowledge of Long-Term 's portfolio was, hy now, common place. S,t lomon w;ts, ,md had been, pounding the fund's posi tiom for months. Deutsche Ba n k was ha i l i n g out of swap trade>, and A merican I nternation a l Gro u p, which hadn't shown a n v i nt erest 1 11 eq uity volati lity before, was suddenly b i d d i n g for it. Why this sudden i nterest, if not to exploit Long-Term's distress? �1organ and UBS were buying volatil ity, roo. Some of this activity was clearly predatory. The game, as old as Wa ll Street itself, was simple: if Long­ Term could be m,1de to feel enough p,1 i n-could he " sq ueezed "-the fund would crv uncle and buv hack its .,hort'>. Then, a n yone who owned those positions would make a bundle. Yet the extent o f pred,nory tra d i ng wa> les> than one m ight sup­ pose, and certa i n l y less than was later asserted i n certa i n paranoid theories in Greenwich . The p,urners' bunkered view of the world made them highly su>ceptihle to conspiracy rheorie>, particularly si nce >uch explanations shifted the blame for their losses to others. Being so self-a bsorbed, the ;t rbirrageurs naturally assumed rhar the hanks were obsessed wirh Green wich, roo. Bur the simple fact is rhar by rnid· 'wpremher, the Wa ll Street ba nb were not principa l l y worried about Long-Term Capital-they were worried a bout themscl ve>. G I \'Cn rhar every ha n k had m a n y of the same trades as Long-Term, exiting from their positions was a matter of self-preserva tio n . Goldman in particular was >teeped in lo>ing trades and, with irs stock offering j ust weeks awav, was desperate to cut its losses. But it bears repeat i n g that hy mid-Septem ber, the our­ lines of Long-Term's portfolio were wel l k nown on Wa ll Street, n or j ust by fi rms such as Goldman that had '.l'Cn Long Term\ hooks, and the selling by ba n k s was sinnlarly widespre.t d. I t made no d i fference whether the han k s were consciously trying to profit at Long-Term's expense or merely protecting themselves from the tidal wave of sel ling that they a nticipated irom G reen w ich. Either motiuation would haue produced the slime hehauior-a wholesa le flight from Long-Term's trades. One Long-Term trader saw his best friend, a fel low former academic now a t Deu tsche Ban k ,

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dumping Long-Term's positions. The othn traders knew that if Long­ Term coll a psed, the ground would trem ble. " I f vou think a gori l l a has to sel l, t hen you sure want to sell fi rst," noted a Goldman trader in London. " We a re very clear on where the line i\; that\ not i l lega l . " With t h e exception of 'itocks i n A merica, which ,1re speci fica l l y '> uhject to i n s ider trading l a w s t h a t a rc en forced a � now hne else, t rading on private i n formation goes on a l l the rime. l n vestmcllt han ks that a lso operate proprietary bond-trading desks, �uch a� Salomon and Gold m a n , p u blicly boasted of e x ploiting their knowledge of the "customer flow. " Translated, this meant that when a Salomon or a Goldman got w i n d of which way its cu stomers were running, it often ran there too-an d iast. Thi� w;l., w h v C ;oldman\ previous .,tewa rds had refused to get i nvol ved in proprieLl fl t r,Hi i ng; th L· pos., i hil irv of conflicts of i nterest wa., j ust roo gn·;J t . Hut h1· l l) l) X , C .old nun w;l., known as a n aggressive, hare-kn uck led trader that had long since a bandoned a n y pretense of being a gentleman hanker. Of course, i f Goldman or a nyone else took adva ntage of i n forma­ tion it obtai ned pri vately from Long-Term it could, theoretica l l y, he lia ble under fra ud statutes. Corzine, for his part, did not deny that Goldman traders "did th ings in markets that might have ended up h u rting I T C : M . We had to protect our own positions. That p a rr I'm not apologetic for. " Corzine did deny t h a t Gold man t raded a n y differently as a result of its access to Long-Term than it otherwise would have. G i ven the kind of q u a rter i t was having, he added wry l y, it was strange to hear that Goldman w a s accused of m a k i ng u n toward profits. ' • •

Long-Term was completely at s uch rivals' tender mercy beca use irs trades were so a rcane and special ized. For instance, o n l y a h a n d fu l of dealers-Morgan , Salomon, UBS, Societe Cenerale, Ba n kers Trust, and Morgan Stan ley-traded eq u i t y volatility. They k new that Long­ Term was massively short, and t hey knew that sooner or l a ter the fund would have to buy its way out o f the trade. So, the dealers re­ fused ro sel l . In desperation, Long-Term cal led Societe Gencrale, seek­ ing a bid for irs position, hut the French hank q uoted a ridiculously lofty price: 1 o percentage poin ts a bove the market ! A bs u rd a s i t was, there were n o other potential b u yers of eq u i ty volatility. l n e v i ra hlv, the price ballooned. Norm a l l y, a free m arker cures such b u bbles on irs own. I n 1 q X • • .

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for i nstance, the H unt brothers had tried to corner the s i l ver market, briefly tak i n g the price to $ 5 0 an ounce. But then people began to sift through attics for stowed-away sil ver, and scrap dealers a l l over the world started melting it down. When a l l that meta l reached the mar­ ket, the price went back to $ 5 an ounce, and the l l un ts fi led for bank­ ruptcy. But equity volati lity was a rare bird. No one had stored volatility in h i s attic, there was no surplus source of supply. " Eq uity volati lity was the ultimate short sq ueeze," said a k nowledgea ble Long-Term employee. "There were only four or fi ve dealers. And they refused to sel l . " •

As the firm's los�es mounted, the latent divide between the inner group of partners and the others fermented into sour w ine. I nevitably, the lesser partners blamed H i l ibrand and Haghani for blowing so much wealth. Hawk ins and l l i l i brand, never the best o f friend�, be­ came hitter toward �·ach other, and Scholes and l l i l i brand were barely speak i ng. The unhappy pa rtners resented not j ust H i l ibrand's and I l agha n i 's i nvestment call� bur their domineering, i nsensitive style. Sch oles felt that the secretive l l i l i brand hadn 't rea l l y been a partner; La rry hadn't trusted the others. Ironical l y, it was the same complaint that the ba n ks had been m a k i ng all along. McEntee, mean­ whi le, was i ncreasingly absent from the fi rm. l ie was i mmobil ized by an aching hack, a symbolic expression of the partners' despa ir, and increasingly bitter that Meriwether hadn't heeded hi> w a rn i ngs. C iven their frayed nerves and their enorrnou� lo,ses, it was only human for the partners to show some ten sion. They were losing not only their fortunes but also their reputations. Meriwether wa> facing the unbeara ble indignity of a second disaster in a once shining career. And his traders, no matter what they m ight accomplish later, would always be k nown for their role in Long-Term's stupendous rise and fal l . Rosenfeld, the most emotional of the group and the most de­ voted to the fi rm, was touchingly a ffected. At le;l st he was not a fraid to scream when the anguish overcame h i m . Merton, h i s teacher, w a � upset, too; h e w a s distra ught and not h imself. Worrying that Long-Term's collapse would u ndermine the standing of modern fi nance-a l l he had really worked for-Merton repeatedly broke i n to tears. The professor was wonderfu l l y human, a fter a l l . Scholes, too, k new that i f the firm fai led, many would

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consider their Nobel Prizes tarnished. Coin c i d e nta l l y, as the fund plummeted, Scholes made a long- sc he d u le d visit to his h ometown, l la m ilton, Ontario, where he was honored as a local hoy t urned Nobel l a u reate. ! lis a udience had no idea of the t ro u b l e at Lon g­ Term, a n d the tension on the guest of honor rnu'it have been u n bea r­ a ble. A fter fond l y reca l l ing his youth there, Schole� n e a r l y broke down . ' ' Mullins's prospects h a d darkened, as well. The natty ha nker had once i magined that he m ight be a su cce '> sor to Alan G reenspa n . Now that would n eve r h appen . Yet a m i d t h i s u n ce a s i n g . A lth o u g h deeply d istressed a bout the lw,.,e-., he ' a week, gave way to a sense o f the .1 b s ur d . One n ight, around 2. . \ . \ 1 . , J . :V1 . wa.'> si tti ng with Lea hy, Rosenfeld, a n d Rickards. E x h a ustion had made them giddy, a n d the group started to ta l k ll fl· ive. J . .\1 . said w rv k, I g u e., ., WL' u Hdd call ou rselve'> ' \i o ­ l lai rcut Capita l :V I a n a ge m e nt . "' Th ,n brok e u p t he group; J . .\ 1 . \ h u mor al w a y s cheered them. Then , ,1., i f to makl' l ight of t h e i r brutal handiwor k , \leri wethcr whi-.t led and added, "Oh, we took the Swiss down big. " l ie meant U BS, the big S\\ i-.-. i n ve'otor. J . \1 . j o ke d, " We'll never be a ble to 'L't foot i n Switzerland .1gain-the v ' l l .t rre s t m the moment we get off the p l
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( ;oldman\ hanker'> looked tor money, the y discovned a fact t h . 1 1 .\ l eri wether h a d n 't disclo'ied : the best prospects o n ( ; o l d m . t n \ J J ., I , . \s

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such as Buffett, Soros, Michael Dell, and Saudi Prince A l waleed hin "Lt l a l bin Abdulaziz a i-Saud, had a l ready been called by Long-Term­ and had a l ready rejected the fund. Corzine was more than a little piq ued; with the situation so desperate, it was no rime for Long-Term to be playing coy. Long-Term was sti ll losing scores of m i l lions oi dollars each day. It was desperately trying to pair irs trade�, hut it� progres' was slow. It was j uggl i ng positions to �ray a bove its minimum a t Bear, but its mounting losses, compounded lw unfavora ble marks ( prices ), moved it ever closer to the edge. The fi rm tried to dump positions on irs banks, hut the Merrills and the Goldmans had no i nt erest: they were overinvested in the same trades . •

By mid-Septem ber, the partners were pra ying for three strokes of l uck to turn markets: for Congress to approve more aid to the 1 .\1 1·� for the I M F to a pprove a ba ilout of Brazil, and for Greenspa n to lower in­ terest rates. Of the three, Greenspan was the most cru c i a l and the least predictable. The Fed was deeply concerned a bout the widening of credit spreads, and the New York branch had repeated l y been advised of Long-Term's p l ight. Also, on September I I , Representative R ichard Baker, a Louisiana Republican, alerted Greenspan to the fact that hedge funds were aggravating the condition of publicly traded han b . In a perceptive letter, Representative Baker, who was getting inside dope from a :'vlorgan graduate on hi., stecrct dea lings with l .ong-Term. The fol l owing da\·, �wptember I <1 , Crcenspan went before rhe same panel . He dashed the marker's hopes, tel l i ng Congress that a rare cut was out of the q uestion. Incred i b l y, he aga in downpla yed the risks posed by rogue in vestors such as hedge funds. The chairman\ credu lity seemed to know no bounds: " H edge fund., are strongly reg-

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ulatcd hy those w h o lend t h e money, " G reenspan asserted. G i ven that Long-Term's lenders had bankro lled the runaway hedge fund, it is hard not to concl ude that Greenspa n was either woefu l l y out o f touch or willfully dea f to what he had heard . Secretary Rubin, a t least, ac­ knowledged t h a t the hull market had inevitably du lled m a n y han kers' sense of prudence. " Where you've had five, six, seven years of good results, " he told the panel, " people who extend cred it tend to get a I i ttle less ca refu l . " 22 •

Finance is often poetica lly j u '>t; it punishes the reck less with special fervor. Long-Term\ creditor' were di ,L overing t hat their p;l St k· niency had made the current cri-,i' wor,t·. Whrn·.h when a typical cl ient defa ulted, a rc,erve would exist in t he fonn of 111.1 rgin money held hy lenders, Long-Tnm could theoretically drop a l l the way to zero. The hanks' w i l l i ngness to fina nce Long-Term without a n y h a i r­ cuts had enabled the fund to operate right up to the edge. Now, if it defaulted, nothing would be left. ::\ot surprisingl y, the lenders were horri fied by what they had wrought. " We h a d no idea they would have trou ble-these people were known for risk ma nagement. They had t;1 llght it; they dcsiRncd it," reflected D a n �apoli, the Merri ll ri'k ma nager who had so en­ joyed gol fing with the partners in I reland. "God knows, we were deal ing with Nobel Prize winners ! " I ronically, on ly a very intell igent gang could have put Wal l Street in such peri l . Lesser men wouldn't have gotten the financing or a ttracted the fol lowing that resulted in such a bubble. In a sure sign that the credit ncr a round the fund was tighten ing, General Rc, a n insumnce comp
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derivative panic' from seizi ng collatera l . I f Long-Term fi led, it could expect to find its fa x machi ne h u m ming with claims from each of its fifty or so counrerparties. I n bet, if Long-Term defa u l ted on
',alomon Smith Barney-Long-Terrn \ progen itor-had staved aloof from the rescue efforts. Bur on Wednesdav, ',eptember I 6, Sal omon jumped i n to the action. The h a n k sent K.oh Adrian, Salomon\ head of risk management for eq uit ies, A nd v Consta n, who ran derivatives trading for rhe fi rm, and \Lire Wcill-Salllh \ son-to C remwich . They ex pected to join ( ;oldman a n d others of the b;J n b in a wide­ ranging meeting. l lowever, by the t i me the Salomon group arri1·ed, ju-,r a fter 4 1 '. \ 1 . , the meeting wa-, oi'Cr. Adrian n ot iced an eerie qu iet; door'> were closed, and the trad i ng floor W;ls deserted . Haghani took them to an office and blunt ly a n nounced that o n l v one topic re­ mained on the agemLI . " \Ve need mone1 , " he noted .' l laghani offered to show them the hooks, which IHTC now an open secret, bur Wei l l , knowing of his LL!d\ antipathy ro a rbitrage, didn't want to compromise Salomon hv seeing too m uc h . So the group d rove h ome. The next day, Sa lomon sent a more sen ior rea m : Steve Black, Thomas \1a heras, and Peter l l i rsch. Bv now Hagha n i seemed to he in shock . O ver rhe last fi ve trading day-,, Long-Term had lost S s _:; o million. The losses seemed even worse for having been so relentless. On Th u rsday, September I o, the firm had lost $ q 5 mil lion; on Fri­ day, $ I 20 m i l lion. The next week it hadn't stopped : on \1onday, Long-Term dropped $ 5 5 mi l l ion; on Tuesda y, S X 7 m i l l i o n . Wednes­ day, September I 6, was especia l l y had: S I 2 2 million. Like a biblical plague, the losses gave no respite. H aghan i went over rhe losses with ;J clinical a i r, a s i f they had ha ppened to someone else. He cou ldn't .

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get over the fact that Long-Term's diversification hadn't worked. The August losses he under,tood, bur Seprem ber's-when the m a rkets should have recovered-baffled h i m . U . S. swap 'pread, had c l i m bed to an asro n i , h i ng x , points; U . K . swaps, incredi bly, were a t X X ! Long-Term's massive positions i n t hese two trades alone could bank­ rupt it. Haghani b i tterly bla med Wa l l Street, especia l l y Coldman, for ganging up on the friendle" fund. ' ' Though iurious ar Coldman, t h e partners were, q u i xotica lly, coun ting on the hank as a savior. Rosenfeld and others were calling ( ;oldman thro ugh out the week, with growing desperation. Despite ( ;oldman\ i n i t i a l optimism, ir h a d n 't vet raised the money, and Long­ Term now figured that it n cnl l d not t wo hut four bill ion dollars­ quire a sum . .\1eriwether, l l i l i hra n d , Rmcnkld, ;Jnd .\l nron went to press their case with Coldman o n Thu r-,day morni ng, 'wptcm hcr 1 7 . Corzine and John Thain, the narrow-set, angu la r chid fi nancial offi­ cer, ushered t h e m i n . Rosenfeld s a i d , in s o m a n y words, " You're our l ast chance." Later rhar Thursday, \;l eri wethcr advised B i l l .\kD onough of Long-Term's pl ight. Iron ica lly, the fund made money that d a y, its fi rst profit all month . But the profit was a pittance, S6 m i l lion-fa r roo lit­ ric and too l a te. Long-Term's eq u i t y was down to S 1 . ) hi/lion. I t was aston ishing t o think that only a month had passed since Russia's de­ ia ult. I n that one month, Long-Term had lost six tenth 'i of its capital, one of Wal l Street's epic colh pses. On Friday, Long-Term heard from Goldman. Tha i n noted that very few people could invest in the a mounts that Long-Term needed. Bu ffett might he good for a chunk, and Soros might, bur Long-Term had already cal led them, as well as v i rt ua l l y everyone else on Gold­ man's l ist. Peter K raus, a Goldman in vestmen t hanker, had tal ked ro Bu ffett that very morning. Bu ffett had reiterated t h a t , as he had told Hili brand, he wasn't i nterested. The others had refused, too. There­ fore, Tha i n didn't think it was possible. Thain didn't bother to say what he was t h i n k i ng privately: to a l l a ppearances, Long-Term was going under. '

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But Goldman didn't stop trying. Kraus and Buffett spoke severa l more t i mes that day. The biggest stumbl ing block for B uffett was t h ;l l h e d i d n ' t l i ke Long-Term's compl icated partnership structure. l ie h.HI

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no i nterest in its various feeder funds and certa i n l y none in the tan­ gled detai l s of ITCM. Buffett had folded his own pa rtnership decades ago, partly for such reasons; he had no usc for somebody else's. But i f it was j ust a matter of buying Long-Term's portfolio-which now was pretty beaten down-without keeping Meriwether, h i s sta ff, or his company, that might work, B u ffett told Kraus. Refi ni ng this thought, the two began to talk about Berkshire and Goldman j ointly bidding for Long-Term\ a�sets, pcrha ps along with AI G , t h e insurer. Meanwhi le, Kraus reported rhi� slight progress to Corzine. Through­ out rhe day, Goldman k icked a ro u n d the notion of a Berk shire­ Goldman hid as well as other ways of saving the fund. At Long-Term, the situation was becoming dire. The fi rm got a let­ ter from Bear fl atly staring its intention to stop clearing below $ 5 00 million-dearly the final step before cutting it off. �ow it was time to talk to Chase. Though Long-Term felt that lega l l y it could draw on its loan facility anytime, the partners wanted to hear C ha se say so, too. :'v1 u llins, the house banker, called David Pflug. Pflug had a l ready stuck his neck out for Long-Term by assuming Fleet's loan. Would he do it aga i n ? Pfl ug, a ban ker's banker, knew t h a t if Chase a n d t h e other syndi­ cate members did fund, they m ight not get the money hack. But i f Chase didn't fund, it could b e lia ble. Moreover, Pfl ug w a s a fraid that if Long-Term collapsed, it might reverberate all over Wa l l Street. And Wal l Street was a major client. Calling Walter Shipley, Chase's chair­ man, Pflug said, " I don't think we have any choice . " .\1eanwhile, Long-Term's ma rker� were tumbling aga i n . Incredibly, equity volatility j u mped to .> 5 perccnt. l i .S. �waps w idened to X4/,. And on it went. Mortgage spreads widened by 7 points, j u n k bonds by 5 . The Dow fell 2 I X points; J a pa nese stocks fell to levels not seen since I 9 H 6 . Friday evening, Rosenfeld called :'vi organ's Peter l la ncock, who lived in Mamaroneck, the same town as Rosenfeld, a n d who�e chil­ dren attended the same school a � Rosenfeld's. The usually collected arbitrageur was highly agitated; he was petrified that Bear would pull the plug and confided that Long-Term m ight not survive the fol low­ ing week. Long-Term was losing its credit l ines, and its woes were being e xacerbated by rumors ( ma n y of them false or w i ldly exagger­ ated ) about its positions. On a w h i m , Rosenfeld suggested that the Morgan hanker call

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Thain a t Goldman. A s far a s is known, that was the first time a nyone had asked the hanks to coordinate their efforts. l la ncock and Thain '>poke that night. Kra us, the h a n ker spearheading the Goldman effort, had taken his wife and a c lient to a Beethoven concert in Newark on Friday. At in­ termission, Kraus ducked out to a pay phone and dialed Omaha . He .llld Buffett penciled out some n u m ber� for a dea l . Buffett said some­ thing about going on a trip, and Kraus went back to Beeth oven, say­ i ng nothing to his wife or the client. Then Buffett cal led Joseph Hrandon of General Re, Berkshire's soon-to-he insurance acq u isition. "There a re fol k s that arc in meltdown. They may not m a ke it," the billiona ire warned. " Accept no e x ntse'> for an yone who doesn't post col latera l or make a margin ct l l . i\c<"i'fil 11" <'X<"IISI'S . " Then he hopped a plane for Seattle to m e e t a Bill ( ;,lte>-kd gro u p that w,ts planning a t wo-week holiday in Alaska and �omc of the western na·· tiona! parks.'' :'-low the d ream was alive that B u ffett would rescue Long-Term­ as he had, coincidenta l l y, Salomon seven years earlier. l\:onetheless, Corzine thought the Fed should he brought into the loop. l ie cal led \tcDonough, who also spoke with the heads of other big banks. To a man, the hankers said that Long-Term's troubles were depressing markets. :V1oreover, they were worried that tf Long-Term fa i led it L·ould have a seriously destabilizing effect. With such fears in mind, Corzine offered to have Goldman brief the Fed on Long-Term's portfolio. :V1eriwether agreed that the Fed should he briefed hut natura l l y preferred to have Long-Term do ir di­ rectly. Thus, on Saturday, M u l l ins, a former centra l han ker, cal led \1cDonough a n d invited the Fed to C reen wich. McDonough , of course, had been thin king about Long-Term for a while. He had known that event u a l l y he might have to step i n ; he a l so knew that doing so would expose the Fed to criticism . A regu lator is part protector, part godfather. He d i s l i kes a public spectacle; he is most effective w hen he can wield h i s power discreetly, by merely threaten ing to act or by cajoling others to do his bidding. Most ideal, in McDonough's mind, would he for some private Wal l Street leader to orchestrate a solution. He and John Whitehead, the c h a i rman of the New York Fed, t a l ked about who could do it. Once, Walter Wri,­ ton of Citiha n k or Gus Levy of Goldman could have ral l ied w,, l l Street. A centu ry ago, of course, J . P. Morgan, Sr., had played th e p.t rt

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to perfection. But who could play rhe parr today? McDonough and Whitehead agreed on the a nswer: no one. Wa l l Street had many hankers hut no J . P. ,\1orga n . ··· Therefore, a lthough the Fed was agreeing o n l y to he briefed, nor to p l a y ;HI active role, :\lcDonough was ready to take the first step. The meeting was scheduled for Sunday. Bur :\kDonougb was plan­ ning to fl y to London the night before. He decided not ro cancel­ it would u pset markers-a nd to send Peter Fisher, his deputy, to Long-Term i n stea d . Before .VI cDonough lcit, he briefed bot h Green span and Rubin and told them rhar Long-Term\ attempt to raise capital had fa iled.' But Goldman was sti l l on the case. Hy cha nce, David Solo, the Swiss-lx1sed derivati ves ma ven at U BS, was in New York for the wed­ ding of a friend. Corzine tracked h i m down and asked if UBS would want ro join a fund-ra ising effort for Long-Term. Solo s;l id, "' Fine, hut do you rea lize we're their biggest cq uitv in vestor? I don't think our interests a rc exactly a l igned . " Corzine, who hadn't known, rang off, obviously irritated. l ie was getting tired of trying to rescue a firm about which, apparently, he was
AT THE FED ,'\;l,n·kcts ll'<Jll!d . . . {iossi/J/y cease to jimctiu11. - Wi i l l \ \1

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wa'> created, in I <) I ) , for manv rh,a people no lon ge r trusted pn vare ha n kers ro -,hephcrd rhc fi n,mcial market'>. Pnor ro the Fed's founding, t h e government had had no e ffective weapon to temper the country's economic cvclc'>, nor was there much it ulldd do ro case the periodic cri-,c; that ,lfflicted \l(la ll Street. 'l(>o often, the government had had to go hat in hand to a p ri vate han ker for help. B y the Pro­ gressi\T Era, with its suspiL·ion of rru srs and its fa ith i n regulation, people wanted a hank that would represent the public i nt e rest. Ever ;i nce, the Fed has been a p u b l ic servant hut one that works in clo-;e proximity to pri vate hanks and to Wa ll Street. I t i; a delicate role, for the Fed is s u p posed to regulate ban k i n g hut not to shelter han kers. It must protect the functioning of m a rkets without a ppearing to he too cl ose-too protective-of t he banks it watches over. The side of the Fed most often seen in public is i ts governing hoa rd, in Washington, which has the high-profile job o f adj usting short-term interest rates. The chairman of this body is the countrv\ chief i n flation fighter and, in a larger sense, the steward o f i t s n·• 1 1 1 omy. A l a n G reenspan, w h o has been chairman since 1 9 i b , I '> p ro h . 1 ill

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bly the most respected of all those who have held the job, thanh to the economy\ stellar performance duri ng his ten u re. If Creenspan has perfected a convoluted, often i m penetrable style of public utter­ ances, this h a s only heightened h is image as the nation's economic or­ acle. More th;l n is commonly rea l ized, C reenspan relics on the Fed's in­ dividual branches, part icularly on the \Jew York Fed, w h ich,
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middle-class s u b u rb l ight-year> from Greenwich, h itched a ride with Dino Kos, one of h i s assi>tants, in Kos's Jeep. At Long-Term's offices, they rendezvoused with Gary (;enslcr, an assistant secretary of the Treasury and former partner of R ubin's at Coldman Sachs, a nd w ith another official from the Fed. Long-Term 's offices were q u iet. The Sun workstations were mostly unattended. \ll u l l i n s u>hered the visitors into the conference room with the other partners, passing by a room where, fisher noticed, Jacob Goldfield and his Goldman team were poring over Long­ Term's files. After some brief cordialities, H i li hrand showed the b urea ucrats a document so secret that even most of Long-Tnm \ employees had never seen it. The documem w;t� known , \ ., the " risk .tggregator. " Long-Term w a s h a rd for ouhider� to understand heL·;wse m a n y o f its positions consisted of m u ltiple t rade�. What\ more, its derivative, hook was a monstrosity of contracts each of which was offset hy other contracts. The risk aggregator simplified the portfo l i o by sum­ marizing Long-Term's exposure to each individual m a rket. Fisher studied the report l i ke a pathologist scanning a n X ray. As he l istened to the presentation, h e rea lized that the patient was in crit­ ical con dition. Each exposure in the risk aggregator was l i sted in a separate row, and the rows were grou ped into sepa rate boxes by cat­ egory. For instance, the fir�t box was Account .. l Too ) , " w h i c h dea l t with ·· u s n ( Fl/US ) , " o r U . S . d o l l a r fixed income. T h e first entry in the first box >aid: lJS[) Y-sh i fr . . . 2s- 1 os (ai 4 .'i

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- 2 . !l o . . . 5 y-sh .

.

. q.oo

This line gave Long-Term's exposure to a fla ttening of the y ield curve between two··year and ten-year Tn:a'iury bonds, for which the spread was then 4 5 has is poinh. For each movement of five basis points, Long-Term could make (or l o.,;e) S 2 . !l m i l l ion. The e xpecred Yolar i lity of rhe trade over one year w;ts five such j u m ps, mea ning that, according to irs models, Long-Term's yea rly expo>ure was no more than S 1 4 m i l l ion. The next entry, " USD_I:+D--,h ifr," showed Long-Term\ ex posure to a change in short-term interest rates. It wasn "t unt il the fifth line that Fisher >aw a truly a Lt rming n u m ber. Under " USD_Swap Spread," l .ong-Term showed an exposure of S 240 mill ion-bu t that was as· suming that >wap spread> stuck to their historic voLttility o f only 1 'I

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points a year. And given that swaps had a l ready moved in a 40-point range in 1 <;1 9 8 , that assumption had become l a ughable. There were twenty-five entries in all-on j ust the first page. And the risk aggrega­ tor went to fifteen pages. The sheer mass of it was numbi ng. Tu rning to the international trades, l l ili hrand showed Fisher rows of entries for bonds and swaps in Great Britain, mortgages in Den ­ mark, swap spreads in New Zealand, bond� in ! long K ong, and var­ ious exposu res in Sweden and Switzerland as well as in ( ;ermany, France, and Belgi um. Fisher saw bonds in Italy, Spa i n , and the Netherlands, too. And then Fisher saw more entries, now perta ining to the fund's po­ sitions in stocks. He was shocked by the massive entries for stock market volatil ity. Then came Long-Term\ exposu res in emerging ma rkets: Brazil, A rgentina, ;vtcxico, Venezuela, K orea , Poland, China, T1 iwan, Thailand, ;vta lavsia, and the Philippines. There were three entries for R ussia, including " Russia l iard Currency D i rec­ tion "-mea ning tlut the fu nd had gone directional, or specu lated outright. At first it seemed a-.ron ishing that so many trade� should have col ­ lapsed simultaneously. But gazing over the portfolio, Fisher had an epiphany: Long-Term's trades were l i nked-they had been correlated before t h e fact. "They had the s;l me spread trade everywhere in the world, " Fisher thought. Censler had a related though t : Du ring a cri­ si�, the corrclLZtions <�hu<�ys go tu o11e. When a quake h i ts, all markets trem ble. Wll\· wa<, Long-Term so surprised lw that? When the partners fi ni�hed with the ri-.k aggregaror, they went through another document , bre;l k i ng down Long-Term\ n:pmure ,1ccord ing to counterp;lrty. In theory, irs coull llTparties were pro­ tected by t heir co iLHera l. But in fact, if the fund sudden l y fa i led, e;1ch of irs cou nrerp;l rtie-, would attempt to -,ell-in uni son-,md the 1·alue of the colla rer.1l would nccessa ri ly plunge. \ lorem·cr, e;Kh of Long­ Term\ sw;lp coun terpart ie-, would be " n;l ked," or holding on to onlv one side of a cont ract for which the other side no longer exi-,red. Each counterpa rt y would ru-.h to J l eutr.ll lle ir-. one··,ided -,wap-,, over­ whelming ma rker' a� in '' hank ru n. If rl1 <1t h.1ppened, accord ing to Long -Term, irs -,evenreen biggest L·ounrcrpa rtie-;-h;l n b such as \kr­ ri ll, Goldman, \ ! organ, and S;l l omon-would sL1nd to l oo,e <1 total of SL-�l billion. Fisher evehal led the n u mber and t h ought, "That might he plau-.i-

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hie in a normal market. " Bur m arkets were a l ready sorely frayed; now they could go total l y haywire . Mentally, Fisher adj usted the po­ tential l osses to $3 billion to $5 b i l lion, and even that was a guess. I t wasn't j ust Long-Term t h a t w a s on t h e hook-it was a l l of Wall Street. Who knew when the losses would starr to stra i n the system? Who k new i f the system had a breaking point? The more Fi sher heard, the worse he felt. 'Tm not worried about ma rkets trading down," he confided. 'Tm worried that they won't trade a t a l l . " Once t h e visitors h a d a n overview, the gro u p began ro explore some solutions. In 1 990, Gensler noted, a bank ruptcy fi l i ng by Drexel B u rn h a m Lambert, the j u n k -bond ki ng, had actua l l y eased the panic in j u n k bonds. But i n this case, R icka rds explai ned, ha nk ruptn would not stop anythi ng; it would merely ring the hell for countcrparries to start going a fter their colla tera l . And the Drexel crisis had i n v o l ved only bonds, nor derivati ve�. Long-Term's case was far more complex. I t would h e h o peless t o try t o unravel a l l tho�e overlapping swaps, Fisher k new. Furthermore, finding a buyer for the fi nn was out of the q uestion. l\:obody would touch positions such as equity volatil ity. '' So this is a new paradigm, " Gensler said unhappi ly. The pa rtners were particularly agitated about the pressure from Bear Stea rns. W h a t Long-Term needed, h�her concluded, was brea t hing space. A fter some gi ve-an d-rake, the arbitrageurs a nd offi­ cials came u p with a plan. Supp<>';e the hanks were to visit fou r days hence, on T h u rsday, on the understanding that they would be shown the portfo l i o in the strictest confidence? After a q u ick study, the banks could hid for the assets a t a n a uction the following Sunday. When markets reopened Monday, Long-Term would effectively have disappeared . But there was one problem with the pla n: Long-Term had only $ 1 . 5 billion of eq u i ty left, RickarLb remi nded them. Ded ucting the cash locked u p a t Bear Stearns a n d the mon ies tied up in m a rgin ac­ counts and the l i k e left free cash of e xactly $4 70 m i l l io n . The com­ pany had been losing hundreds of m i llions of dollars a day. In a l l proba bility, Long-Term wouldn't m a k e it until Th ursday. And now it was 4 P. M . on Sunday, only hours from the open ing of the Tokyo m a rkets. They had spent six hours worki ng on the prob­ lem and solved nothing. The o ffici a l s went to a side room, and Censler called the Treasury. Midterm elections were six weeks o t t ;

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th us fa r, the economy had bc.:en the government's one bright spot. The last thing it wanted was a financia l meltdown. Rejoining the partners, Fisher told them, " You're composed and we're composed, hut Wash­ ington is going crazy. " Then he held out his hand to Meriwethc.:r. j. .\1 . -;aid that, come what may, he wanted to h�1ndlc the problem right. "Thanks," Fisher said. " You're the first one to tc.:ll us m ad­ vance. Sunda y a fternoon, Corzine u l ked to Bu ffett, who was sti l l on a tour of the t\ Ja,kan fjords and sti l l seemed uncerta in a bout a rescue of Long-Term . That night, the Goldman chief called Fisher and told him not to count on a private rescue. Fi sher had one thought: "I low do we get to a nother weekend ? " For the first ti me, he broached the idea of getting a group of banks together. Corzine, who was feeling pessimistic a bout the Bu ffett bid, encou raged him. · J. P. M organ was having s i mi l a r thoughts. Morgan anal ysts in Tokyo and London had 'pent the past twenty-four hours download­ ing files si m ilar to those that had bc.:en seen hy Goldman and hy the Fed. lnten:stingly, the ."v1organ anal ysts wc.:re >urpri ,ed that Long­ Tc.:rm \ trades hadn't been more e xotic. They were big but not un­ usua l . Sti l l , since Long-Term was known as a bond house, Morgan was surprised by the size of its c.:quitv hook. Morgan saw two options. One was to let the fund fa i l . Then every bank would seize col lateral for i tsel f; Morgan figured t h at would cost the bigger banks $ s oo m i llion to S 7oo mill ion a piece. Or, Morgan could buy big chunks of the portfolio itself. But that would po!>e an­ other pro b lc.:m. M organ knew that other hanb had sec.:n the portfo­ l io. If a n y une bank acquired it, it would be in the sa me.: 'pot as Long-Term-the whole Street would be ,hooting at it. So a l l the banks would have to be in. Corzine, who had been h a ving thoughts similar to M organ's, called Komansky, the Merril l Lynch chairman, Sunday a fternoon. Komansky, who is half Russian Orthodox Jewish, h a l f I rish Catholic, and r oo percent The Bronx, wa' preparing for Rosh l lashanah at sundown. " ITCM has some real pro blems. It loob like they're going bankrupt in a day or two, " Corzine told him. He mc.:ntioncd that Goldman's people had been in Greenwich-bur not that Goldman had gotten a n exclusive peck at Long-Term's books. :'\lor did he men­ tion that Goldman and Buffett were, at the moment, m u l l ing over a takeover bid.

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Koman s k y, citing the holiday, rang off and had l lcrb A l l ison, his trusted l i e u te n a nt a n d Merri l l 's president, pick up the ba l l . Corzine \\ as playing golf, hut a t 1 0: 1 0 that n ight, he and A l lison connected . Bit by hit, Wa l l Street's top hankers were ..,tarting to t a l k to one an­ other. Through their carelessness, thei r reckless tinancing, their vain attem pts to i ngratiate themselves with a seli-important L·l ient, the Wall Street h;l n k s had created this fiasco together. Their i mtincr had been to sa vage as m uch of the carcass of Long-Term a s possible, hut now they h a d begun to see th;lt doing so would risk bri nging them­ -;elws down a s well. One hy one, rhev were concl uding that they might have to do the verv thing that wa-; most ant ithetica l to thei r na­ rure: they might have ro work togethcr. .\1onday, September 2. 1 , w;IS yet . 1 1 1 0 t h n b.1d d.1v. l I . S . sw;1 p -.pread-. c l i m bed t o 1\7; U . K . -. w a p s ... oared to ') '\ . T h e sprL\ld between on -the-run and off-the-run Treasurys-both of them perfectly 'ia fe U.S. gmTrn ment credits-j u mped, i ncredibly, to 1 ') points. (J ust a month before, the spread had been the customary 6 poin t s . ) P rices had an a i r of u nrea l i ty, as though traders were selling .mything con­ nected, even b y the faintest rumor, to Long-Term. B a n k s were " hend­ mg the marks" against the fund, grabbing all the collatera l thn could while there still was something to gr;J b . Stl'\ c BL1ck, the Sa lomon Smith Barney e x ecuti ve, IH\1rd from hi, t roops in ' [ ( ) k vo rhar (;old­ man was " ba nging the s-- " out of Long · l erm's t rade-;, especi a l l y -.waps. Coldnun s a i d Salomon w a s doing t h e s;lme i n E u rope. ' :\ rou n d midday, equitv volati l i ty j erked up ' percentage points on one rather small trade-to ' X percent ! The opriom m a rket was now implying a catastrophic level o f volatil ity, maybe a crash every month. To Rosen feld, it was s i m p l y nomen..,ica l; ir fel t as though volatility was rising onlv beca use rradcr'i k new th;lt Long-Tnm was vu lnera ble-which at that poi nt wa-. prohahly true . ' The obvious ma­ n i pu l ation cost rhe fund $ 1 2.0 m i l l io n . As Vi nnv .\Ll ttone had proph­ esied, h u ngry traders were fin i s h i ng the job of k i l l i ng Long-Term that rhe crisis in R ussia had begun. Long-Term's tot a l loss on .\1onday was S s 5 ) m i l lion, coinciden­ ta l l y equal to its l oss of a month before. I n percentage terms, this :'vl onday's loss was far worse: it are th rough a t h i rd of Long-Term\ equity, lea v i n g i t with j ust u n der a b i l lion dollars. A n d the fund s t i l l had m o r e t h a n $ 1 oo b i l l ion i n a ssets. T h u s , even o m i t t i n g derivati ve..,, its leueraJ!.e was J!.reater than 1 o o to 1 -a fantastic figu re in thl' . 1 1 1

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nals of investment. i\iow, i f Long-Term lost even a mere 1 percent more, it would he wiped our. Though the magnitude of the loss wouldn't he known until a fter the ma rkets closed, the partners k new early in the day that Monday wa� high noon. Jim Rickards, the a ttorney, called Warren Spector, Bear's executive vice president, and threatened to sue i f Bear stopped clearing. The fund had nothing to l ose, and Rickards k new it. Then R ickards called Chase and demanded an immediate dispersa l of $ 5 00 million from the revolver. Minutes later, the �yndicate hanks, twenty-four in a l l , heg<m to squawk. R ickards and Bruce Wibon, the fund's controller, insisted that the hanks had no choice hut to lend the money. But would they own up to it before the client expired? The stalwart Pflug said that Chase would fund. What's more, he telexed the other hanks and rol d them that, in his opinion, they would h ave r o fund a s w e l l . Long­ Term got $4 7 5 m i l l ion, most within that day (only Credit Agricole held out). The loan did nothing for Long-Term's equity, hut it was money in the box at Bea r. It bought, perhaps, a few days' time. At the Fed, h sher was in touch by phone with Goldman's Corzine and Thain, :\1erri ll's Allison, and J. P. Morgan's chairman, Douglas Warner. The calls convinced Fisher that the private efforts to raise capital were fa i l ing-and, what's more, that ma rkets were on the brink of a d isaster. l ie had a growi ng sense that the three big banks should take some collective action. Allison and Corzine spoke thro ughout the day. Allison, nor as competitive as some of the traders, natur a l l y gravitated towa rd a joint approach. Corzi ne, stil l concea ling t h e Buffett card, did s o as wel l, b u t only a s a backstop. That M onday, Corzine contacted M a urice Greenberg, the chairman of AIG, the insurer, and convinced h i m to join the Bu ffett-Goldman bid. AIG had the neceS!>
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a team to C reenwich via helicopter i n the a fternoon to find out j ust how desperate his diem was. H i li brand and Rosenfeld, who were working thro ugh the Rosh l la s h a na h holiday, took the visitors through the portfolio-was there unyonc left who had not seen the hook s ? :VIcriwether rema ined rem a rkably calm, even gr.Kcfu l . " We misjudged the m arkets," he adm itted. But .J . .V1 . sti l l felt that Long-Term's trade� were sound-if it could j ust get past the temporary crisis, t h e momentary i m p l osion of liq­ uidi ty. J . .Vl . so m uch wanted t h e fund to li ve. l ie was l i ke a man about to embrace his lover, if only he can land his plane in a storm. But the m argin cal ls, the traders shooting at them, the r umormon­ gers, the mercen a ries at ( ;oldman . . . The \terri l l team was stunned by the huge dimen,iom of Long­ Term\ trades, especi ally in equi ties and European swap' ( w h ich were far kss l i q u i d than U.S. swaps ) . " Do you realize t hese a rc fairly suh­ shmtial position s ? " Merrill's R ic ha rd Dunn i n q u ired . ' The arbi­ trageurs seemed not to get it. The Merri l l people were p uzzled by the mysterious presence of Goldfield, the ubiquitous Goldman trader; he was bent over h i s laptop and didn't look the \1erri l l people i n the eye. •

Monday n ight in London-still a fternoon 1 1 1 ( ;nTnwich-Andy Sicil­ iano, the UBS man ager, decided he had to see the hedge fund first­ hand. He h opped the C :oncorde and humped into Victor Haghani on the il ight. Though both were jet-lagged by the time they a rrived, nei­ ther man had any i ntention of sleepi ng. They shared a l i mousine to Greenwich, where J . M . , Rosenfeld, and the laureates were holding court in the conference roo m . ( ;oldman was sti ll in the b u i l d i ng, l i ke an invading army that had established
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time, sizing up the prospects trade by trade. Siciliano, the only out­ sider, rea lized with a start that no one objected to h is presence. Long­ Term had no secrets now. In fact, Sicil i a no was strangely welcome. l lc was a bridge to the outside world the firm had s h u nned but now so desperately needed. The pa rtners i m plored Sici l i a no to help, to spread the word of their positions' inherent logic-a nyth ing for cap­ ital. They were sti ll sel ling. Bur a fa int odor of sel f-del usion colored their con fa b u l ati ons. The t heme of revenge bubbled beneath t h e sur­ face like the curd of 'our m i l k : if onlv Long-Term cou ld t h ro w fresh capital into the breach, price' would snap back and those nasty op­ port unists who had traded aga inst them would he begging for mercy. By Monday, market gossips were a ttributing every slight dip in prices to sel ling from Creenwich. B ur the general press had been stun­ ninglv silen t . Since the day a fter .\1 eri wether's September 2 letter, the press hadn't breathed a word on the runaway hedge fund. Wa ll Street pundit' were preoccupied with the e xpected rdea'e of a videot like a corpse. A fter talking with the banb, Fisher concl uded t h a t Wa ll St reet would be will ing to participate in a rescue, hut gi ven the ban kers' mutual distru't h ing Fisher to bring -;ome hanb together on neutral gro u n d . Seming t hat t i m e wa' running our, Fi sher invited the big th ree hanh to breakfa,r a t rhe Fed. Fisher maintained that neither he nor :VkDonough wa> worried about t h e loss to Long-Term, nor l'\Tn a bout the potenti a l loss to other fi rnh. If the e\1 i llle\Tnteen banks were correL·t, lo'>'>L'' of up to S ) OO m i l li on per fi rm were cer­ ta inly tolerable. h en if rhev were nut tolerable, these private Wa l l Street hanks h a d p ur their own ,hareholder'' monev at ri-;k; t hey had no ca ll for help from the Federa l Re-;enT. Fisher\ concern wa' the broader notion of "system ic ri,k ": i i I ong-Term fa i led, and i f i t > credi tor-; forced a hasty a n d di,orderly

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l iqu idation, he feared that it would harm the ent i re financial system, not j ust some of i ts big participants. Greenspan later used the phrase "a seizing u p of markets," con j u ring up the i mage of m arkets i n such disarray that they m ight cease to function-meaning that traders would cease to trade.' :V1cDonough evoked a parallel fear-that losses in so m a n y markets and to so m a n y players would spark a vi­ cious circle of l iq u i dations, e xtreme fl uctuations in interest rates, and then sti l l further losses: " .\1 a rkets would . . . possi bly cease to func­ tion for a period of one or more days and maybe longer. "" Since the G reat Depression, the U nited States has not experienced anything l i k e a rea l meltdown, t hough at times markets h a ve seemed to be spinning toward one. But t h e fear of a fi n:�ncial A rmageddon has inspired an i maginative l i terature th a t ;l t the extreme has its par­ a llel in natura l-d isa ster plots, mass-computLT- fa ilure -,agas, and the like. I n the abstract, no one can say whether �ystemic risk presents a real th reat-the very phrase is vague and i l l defined-but regulators n;Hura lly err toward ca ution. As fisher readied to meet h i s guests, Asia was a l ready in the throes of a recession if not a depression; R us­ sia was m ost cert a i n ly fa l ling into one; and South America was on the brink. I n the U n i ted States, the vast widen ing in cred it spreads sug­ ge-;red that lenders were rcfming to knd -;1 cl.1ssic -.ign of <1 cont L1C tion. The prev ious day, SL·premhn .!. 1 , I "rc.t s t t ry viL·lds l1.1d touched a low of ) . O ) perce n t . Acu )f(l ing t o ;1n L'COJ J o m i st quoted in The \V111l Street .fr!ltnhzl. "Trcas urys a rc purelv a mca-,ure of fear now "-fcar of holding a n y bon d that was not a Trca 'iu ry. Stocks had plunged everywhne from Switzerland to Brazil to Si ngapore. Stepping back from Wal l Street, Fisher would have noticed that A merica\ economy was sti l l q u i re vi brant ( un l i ke in the fa ll of 1 ') .!. ') , when, by the rime of the ( ;reat Cr.1 Sh on \Vall Street, it w a -, ,,lreadv in recession ) . I n ­ deed, most Americans were un;1 w a re rlut the financial crisis-which Secretary R u bin said \\'a'< the worq in h,,!f a ccnturv-cven existed . ' B u r it ccrta i n l v exi sted i n the m i n d of the Fed . •

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Fi-,hcr\ gucsts--Koma nsk y and A l l i son from :Vlnrill, Corzine a nd Tha i n from Goldm;m, and \lcn do;a from J. P. :Vlorga n-arrivnl . 1 1 ; : _) o that morning. If an exec u t i ve\ m ood lll
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!vi organ's was off by more than 40 percenr. Gold m a n had not yet gone publ ic-which meant that Corzine\ mood was probably the worst of a nyone's. In such a marker, Goldman could have no hope of sel ling stoc k . Fi sher s a i d he h a d spent Sunday at Long-Term and was worried about system ic risk. The bankers were sympathetic. :\1erri ll Lynch was in something close to shock-nor over Long-Term hut over its own spira ling losses in bonds . .\1erri ll, which had pu rposely sh ied away from a rbitrage-type opera tions, h,Hl never dreamt that it could be �o vu lnerable. J\·l orga n, though in better shape, h
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third gro u p, led hy A ll ison, would retreat to :vterril l Lynch to study the consort i u m idea. A lso, t hey agreed to i n v ite U BS, Long-Term's biggest in vestor, to join them. :vt eriwether greeted the han kers with aplomb, hut l l i l i hrand looked hagga rd and nervous; the losses had taken a tol l on the mas­ ter trader, who was also so personally leveraged. By n ow, meetings between Long-Term and inquiring hankers had a staged, too-familiar air. The pa rtners were wea ry of reluctant suitors; what's more, mar­ kets were moving so fast that the han kers had no way of knowing what the portfolio was worth. Conservatively valu ing the portfolio at a discount, the hanker� arrived '1 r. Big" would surface, either. That left ir to All ison. Alli �on, a fifty-five-year-old in vestment hanker, was a rarity among top executives at Merri l l , most of w hom had been p lucked from the firm's legion of stockbrokers. The prototypical Merri l l man was Ko­ mansky, a persona ble, heavyset former broker who had never gotten a col lege di ploma but had starred in sale�. A l l ison, a philosophy major at Ya le with an M . B . A . from Sta nford, was fa r more bookish. Wispy, balding, and bespectacled, he was more a deta i l man than a ra inmaker and-despite h i � a m bi tion-a consummate n um ber two. Unden iably smart, he had a talent for deconstructing a deal and fit­ ring the parts into working order. Tuesday ;tfrernoon, h ol ed up in a conference room overlooking the Statue of Li berty, A l l ison and a sma l l cadre o f bankers ha mmered away at a plan. By 4 P. vl . , when the four banks and Fisher hooked u p in a conference ca l l , A l l ison h.td worked up a succinct outline, on th ree quarters of a page, for ;t L< > l l sorti u rn . .

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For A ll ison\ plan to have a n y cha nce, i r wou l d need the su pport of most of the ba n k s on Wal l Street. :VI oreover, he expla i ned to Fisher, the on l v w a y ro get rhe ban k s together was for the Fed to c a l l rhem and offer to hold a meeting. ' ' Fisher agreed. While i n s i sting that the Fed was nor backing any partic u l a r a pproach, the reg u l a to r -;wung i nto action beh i n d the :'v1 erri l l p l a n . A round 6 1' . .\ 1 . , Fi sher and some a i des cal led rhe dmen ban k s that-along with :V1 erri l l , ;\! organ , Goldman, a n d l J BS-were Long-Term\ biggest counrerparries and announced a n emngencv meet i ng ;lt the Fed at eight that nTn i ng. :'\1cDonough , who had been spea k i ng to i n ternational reg u l a to rs in London about the da ngers of denvati ves, was in touch b y phone. Bv n ightfa l l i n London, McDonough was jetting hack to :\ e w Yor k . Bankers from t h e Big Fou r hanks m e r w i th F i s h e r a t seven . A l l i ­ son's plan cal led for t h e si xteen hanks t o i n vest S 2. 5 0 m i l l ion each. Tha i n had i n si sted 0 1 1 the s4 b i l l ion total-an yth i n g less, and the porrfoho would come under arra c k . But the ban kcrs d i sagreed on everyt h i n g else. Shou ld the package he e q u i t y or-as the more gun­ shy bankers proposed-a temporary loa n ? Sho u l d the Long-Term partners he a l lowed to stay, or -;hould rhev be fired ? If rhey did stay, who would control the fun d ? Corzine strongly a rgued that rhe Long­ Term pa rtners should forfeit con t ro l . At H : 2.o, the four lead ba nks were still debati ng. :'\'l eanwhi le, the chid executi ves of the other big hanks had begun to arrive :1 nd wen: coo l i ng their heels outside the boa rd room . Fisher cal led a h a ir, opened the massive wooden doors, a n d i m· i ted the others i n . It was an awc'>< Hllt' g.nhni ng, the i.Ti.\l lll of Wa l l Street. Fi -;hcr spied Deryck .vl a ughan, co-c h i d executive of Salomon Smith Barney; Thomas La brecque, president of Chase; J i m m v Cayne, rhe CEO of Bear Stearns; A l len Wheat, c h i d executi ve of Credit S u i sse Fi rst Boston; Ph i l i p P u rcel l , chairman of !\!organ Stanley Dean Wir­ rcr; and sen ior executives from Lehman Brothers a n d Bardays of Brita i n . From the Big Four, Fisher saw Komansky, A l lison, Corzi ne, Thain, Warner, Mendoza, Rose, :1 nd David Solo. Twelve ba n k s had sent twenty-fi ve hankers-a ll men, a l l m i dd lc - :1ged . Even these thick­ necked bankers, though fam t l i a r to one .l!wthcr, were u naccustomed ro seeing so m a n y of their brethren on such short n ot ice and in such a place, sq ueezed i nto soft, leather-hacked cha1rs under the q uiet gaze of the gold - framed oil port raits t h a t rimmed the boardroom . .\1or­ gans's Sa ndy Warner broke the ice, j o v i a l l y declaring, " Boys, we're going ro a picn i c a n d the t ickets cost $250 m i l l ion . "

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Fisher, though a bureaucrat who earned a pittance o f what his guests did, commanded their a ttention because he ;l lone cou ld repre­ 'erlt the " p u b l ic interest" that now seemed 'o imperiled. Fisher spoke for j u't a few min utes. He said the Fed was interested in seeing whether the private sector could find a solution that would avoid a chaotic liquidation-one that would spa re the sv,tem. Otherwise he adopted a neutral stance, i ntention a l l y sta y i ng aloof from the par­ ticulars. A l l i son said, " I t was like he had rented out a h a l l . " Of course, Fisher had done more than that. The Fed does not inv ite the heads of Wa l l Street to its boardroom every day, and the executives knew it. Gazi ng a bout the room, Thomas Ru -.,o's first thought wa\ awe­ a fleeting satisfaction at being part of such a group. As the debate got under way, Russo, the chief lega l officer for Leh m a n , became con­ 'cious of a n i rony. " When you get to a h igh level. how m uch do you rea lly understand about the deta ils under you ? " he wondered. They had a l l been trained to exercise due d i ligence, hut none had been trai ned for an emergency like this. All ison summarized his plan, a n d each of the lead banks spoke in favor. Komansky said, " It's not my first choice of what to do with the money, but I think it's the right th ing. " K omansky didn't bother to add that he was scared that if l .ong-Tnm colhp-;ed, Merri l l \ aston­ ishing trading l osses would spi r;l l out of contro l . The other hankers were worried, too. But Leh man objected that it shouldn't he a sked for the same contri bution as the bigger banks-why shou ldn't each hank in vest according to its e xposure? Thain retorted that that was roo complicated-there wasn't time. Each bank now began to j ockey for its parti c u l a r interest. Chase's Labrecque fired a shot at Bea r for preci pitating the crisis. Bea r sti l l held the trigger, he k new. Cayne, whose fi rm had ea rned S :; o m i ll i o n a yea r clearing for Long-Term, and who was personally an investor in the fund, was notab l y silent. Then the hankers vented their ire at Long-Term. They had taken all they wan ted to from the gang in Greenwich. For fou r years, tht· partners had held themselves a l oof, picking off the best trades fron r each of the hanks and not even trying to h ide their smug s u pt: ri or r l 1 Now the pa rtners had the look o f fal se prophets. The han kn, l t - l r taken-they had been so credu l ous. Several said the p;� rt nn' , J r . . r r l . l b e fired. W h y give them the money? A l lison a n d Corr. I I H" r q lt'.r l o ·. l h broke away from t h e talks t o g i v e Meriwether u pd . r r t · , ( . r l 1 . . . r ·. r ' " ' ' banks were i n on every phone c a l l , to ; l vord r h t· l'"'··. r h r l r t l . . 1 · · · ' " '

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dea ling ) . Meriwether sounded morti fied to hear of the a nger d i rected at him. " Look, I ' l l help however I can," he m urmured . Goldman 's Thain, who had the most intimate knowledge of Long­ Term, described the portfolio risks. The group agreed that any invest­ ment shou ld he in the form of equity, hut no one beyond the four lead firms was ready to commit. Most of the hanks thought they would lose less than $2 5 0 m i l l ion if Long-Term fai led; why thro w good money a fter had? Al l ison said that the fa llout could he truly scary, even worse than a fter Russia. Long-Term had S 1 00 b i l l i on of assets and S 1 trillion in notional derivative exposu re, he rem inded the group. Moreover, its equity positions were spooky. Some in vestors would not he in stocks were it not for the insurance policy provided by op­ tions, and Long-Term was easil y the biggest supplier. Without Long­ Term, it was possible that i n vestors would hack away from stocks. None of the hankers wanted to sec the stock ma rket t u mble further. Pflug felt a pervasive fear in the room . Then he had the depressing thought that it was his birthday and he was spending it locked in a conference room. A round I I P . .\1 . , Fisher suggested they break until ten the next morning. A ll ison and a Merril l colleague, T ()m Davis, returned to the office to redraft the terms. Now and then, to rewl ve a fine point, they cal led Meriwether, who was keeping vigil in Greenwich. Around I A . \1 . , A l li son updated Corzine and Mendoza; All ison wanted no surprises on Wednesday. At ) c\ . � 1 . , when the business day in Paris began, A l l ison faxed the new terms to Long-l(.'rm 's French counter­ parties. Then he went home. The next day, he would need each of the ban ks to commit. He wondered if it could he done. ' No one had ever raised $4 b i l l ion in a day before. Merrill had real i zed it would also need some l awyers in a h u rry. Philip Harris, a pa rtner at Skadden, A rps, Slate, Meagher & Hom, !v1erril l 's outside law firm, had worked on Long-'I crm during its ini­ tial fund-raising, hut Harris, who specialized in investment funds, wanted a workout specialist, too. At 2: )O A . \t . , Harris c a lled a Skad­ den partner n a med J. c ; regory M i l m oe, waking h 1 1n at h i s home in Scarsdale. M i l moe, a fifty-year-old soft-spoken attorney with wh ite hair and gold-ri mmed glasses, special ized in bankruptcy. A former piano player, M i l moe had gotten a job in Sbdden's m a i l room and l a ter gone to law school. "Something has come up," H a rris said. " We need you . "

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:vt i l m oe prom ised he'd he i n first thing i n the morning. " :-..J o , " H a rris explained. " We need you to come i n now. " M i lmoe showered, dressed, a n d hopped into his Volvo. l ie cruised into M a n h a tt a n at the city's q u i etest hour. By _> : ) o, he rc.:ached the glea ming black skyscraper where Sk adden had its headq u a rters and went to work . •

�1cDon ough, who had j ust a rri ved from London, got to the Fed early Wednesda y. Pushc.uts were jostling for street space with stretch l i m ­ ousi nes, which m oved ;H ;1 pondcrou.'- pace through the na rrow a l ­ leyway,. T h e Fede r a I Re">nn· b u i l d ing l oomed .1 hove, i t " high o u t n w a l l rising t o a vacut t h;1 kony, <1 '- i t t h e ;1 rchitect h a d w;uttnl to con vey horh the ceremony of a palace and the implaca b i l i t y o f a fortress. :\kDonough c a l led his peer'> at E uropc.:an central b a n k s, notifying them of the crisis. Fisher, his col league, rook a ca l l from J i m m v C:ayne at Bea r Stea rn s . C :a yne, whose fi rm had l ittle exposure, said Bear would 110/ contri bute to any rescue. Fisher pleaded with C :;1 yne to keep .1 n open m i nd. C :ayne said dark lv, " Don't go a l p h a he t ica l l v i f y o u want this t o work . " A t 1 o .\ . \ I . , the banker' ret u rned. Wednesday\ g;Hhering was la rger, about fort\ - five in .t i l . The group w'" ;1 who's who o f \X'a ll Street power broker!>: Sandy Wei l l , i(om,msky, ( :ouine, Chase\ Labrecque, :\1 orga n's Wa rner, Credit Su isse Fi rst Bost o n \ \XIhe. The cur­ uins were d r<1\\' n . The elegant, b LK k -trimmed mahoga n y t<1 hle w.ts roo 'mall to accom modate -,uch a crowd; ;1 la rger cover h,ld been ha-,t i l \ , l u ng over i t . ' ' The ho,1 rdroom ir-;elf w a s a n add-on, the Fed h a v i ng ;lc q u i red i t i n 1 tock m a rker cr,t .,h t o get h o l d o f the '>pace. T h e 1 o k t · ' . 1 1 1 1 < ·, 1 .

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a sting, si nce the red's failur e to curb stock specu lation on margin debt early in I 92') has ever si nce been v iewed
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been worth $ 4 . 7 billion a t the start o f rhe year. B y d a y \ end, Long­ Term, which was suffering yet a nother down day in ma rkets, would he worth only $ 5 5 5 million. But even next ro this sta rtl ingly reduced net worth, B uffett's offer was decidedly cheap. The partners-worth hundreds of m i l lions apiece only weeks earlier-would he w iped out. What's m ore, they would he fi red. A lso, j w-.t to make sure rhat Meri­ wether w o u ld nor shop his offer a round, Bu ffett issued a deadline of I 2 : 3 0 1' . \1., nor q u ire an hour away. .\1eriwet her h anded the fa x to Rickards. " What do we do with i t ? " J.M. asked. To Meri wether, rhe proposal mmt have been a n especia l l y hitter pill. J . M . was furious at ( ;oldman and A I ( ; for trad i n g ;lgai nst the fund-i ndeed, for helping to knock it down before trying ro buy it on the cheap . .\1oreover, rhe pro posal would reenact rhe central tra uma of J . M .'s career: losing his company, and his j ob, ro Warren B u ffett. Nonetheless, the partners studied ir with care. U BS's Sicili ano, who was with the pa rtners again that day, was i mpressed by their mood of ea rne�tnes�. Their first concern, Siciliano believed, was to fashion a clean solution that would avoid a general ized catastrophe. Bu ffett's hid, ar least, could provide one. Unfortunately, Rickards saw problems with the hid. I t was m istak­ enly worded a s an offer to buy the a ssets of I TC :M-the management comp;m y-which Bu ffett did not want. ' John Mead, Goldman's counsel at S u l l i van & Cromwell, expla ined to Ricka rd� that Bu ffett was rea l l y a fter the fund\ portfolio. The portfolio 's assets-the stocks, bonds, and so forth-could of cou rse he sold ar a n y time. :\'or so irs deri vative con tracts, because the pa rties on the other side would have to approve. �1oreover, one of B uffett's conditions was that the port­ folio's financing remain in place. As Ricka rds read it, B uffett would have to b u y the portfolio 0>111/hlll}'-that is, Long-Term Capita l Port­ folio, the Cayman I slands partners h i p. But I TCP was merely the h u h in t h e original, compl icated feeder structure. T h e h u h was owned b y eight sepa rate spokes and by i t s genera l partner and, according t o Rickards, was a bsol utely unsalable w ithout a change in t h e pa rtner­ ship agreement, which would need the consent of the in vestors in each of the spokes. In short, Rickards said, the hid was a nonsta rter. However, he thought it would work in a di fferent form-i f rhc Berksh ire gro u p simply in vested in the fund as it was c ur rently srrm· rured. And B u ffett, as the biggest in vestor, would sti l l he free to I l l <' rhe partners. .

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Bur �1ead did not have a u thority to <:h ange the hid, a n d H u fferr was bizarrely u nrea<:hahle. I ndeed, one wonder� how badly he wanted Long-Term. I n the past, Bu fferr's . .\ l ore­ over, Krau'>, the in vestment hanker, who might have set Bu ffett '>traight, had h i mself been inexpl i<:,1 hh- u n fa m i l i a r with l .ong-Term\ stru<:ture and had sorely mi.,lu ndled the h i d . Mead, C o l d m a n \ our..ide lawyer, was left w i t h l irrle <:hoi<:e. A t 1 2. : 20, M ead told R i<:kards t h e hid w a s withdrawn, a n d Ricka rds wa lked hack to J . M . \ office and sa1d, ··The Buffett hid is off the ta ble . " �1eri wether i mmediately cal led .\ k [ )onough-t r u l y hi., Ll.,t hope:. O K �1cDonough said, 'Ti l <:a ll the hanb, hut I don't k now if thev're coming ha<:k or nor." J. .\ 1 . W Lner said to han· deli her;ncly '><:ot<:hed the B u lferr hid, figu ring t h a t he could do herrer with .\1cDonough . Thi., version, though, cred its _ 1 . .\1 . with a rather fu l l understa nding o f a <:onfu sed and quicklv moving d rama. It is true that .\ lcriwether did n or attempt to rL''>olve the legal problems, and such complications a re often worked our later on, a fter an agreement in principle ha., been signed. But H u ffett Wt dctcrred _1 . .\1 . from pu rsu ing B u ffett fur­ ther, hut what J . M . did know wa'> that for the comorti u m effort to have a n y cha nce, it had to rel l!rn to the Fed-a nd qui<:klv. The ha n kers came hack at one, i n a sullen mood . Coldman\ m i n uet had reminded them oi how l i ttle they rru-,ted one another. They didn't want to be there; they had no stake in Long-Term. Pur­ <:ell, chairman o f M organ Stanley, saw l i rrle risk to his hank i f the fund <:o l la psed. Sandy Weill had j u st sh ut down his own arbitrage u n i t-wh y save someone el.,e\? Wei l l hadn't even retumed ( he was represented hy Derv<:k .\1 a ughan a n d .fanl!e Dimon ) . Credit Suisse F i rst Boston was skeptica l, too. Labrecq ue o f Chase said he would go in o n l y if the han k synd icate's loan were repa id. A l l ison and K omansky were still i n favor o f a de;l l , hut now t he y doubted it W
,"

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The han kers debated the likelihood o f systemic collapse but got nowhere. I t was a parlor topic, not someth ing the bankers wanted to spend S 2. 5 0 m i l lion on. Lehman Brothers simply couldn't a fford it. Lehman\ own sta b i l ity was the � u b j ecr of whi-.pcrs i n the Street, and its fu nding costs had been soa ring. Dick Fuld, Leh m a n \ chairman, hlunr l v a sked Corzine ii ( ;oldman\ h u ver had hacked awav on ac­ count of price-a nd if so, w h v should the consorti u m offer more? Corzine said there had been lega l i �sues. The CEOs l i stened sourly; who knew what to believe? McDonough was mostly silent. It was A l l ison\ meeting now. The number-; man decided to ra ke a pol l . Ban kers Trmt said ir w;1s in . . . . B;lrcbys was i n . A l l eyes da rted t o the hu lking Cl \ I H'. sl oud1 ing next to '--, p ector, his colleague. The Bea r CEO S
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were expendable. " We don't need these guys; they created this mess," Corzine said. No one exactly sympathized with \1eriwcther, hut A llen Wheat of Credit Suisse first Boston said it would he a m i stake to fire h i m . If the Street invested a l l this money in t h e fund, they would need someone to run ir. And the guys in Greenwich obviously knew it better than a nyone. Corzine, though, insisted that the consortium at least had to get full control, including the right to fire .J. \1 . and the other partners. I t wou ld need cont racts locking the partners in a n d strict s u pervision over trading l i m its. Corzine wen t from one extreme to the other­ now wanting J . M . as his partner, now wanting h i m in shackles. But he understood the flaws in Long-Term better than anyone else. The firm had no controls, no one above the level of trader. I nsisting that ( ;oldman would never invest without accountabil ity, Corzine cal led ;\1eriwerher to make sure he would swallow the terms; otherwise, Goldman was our. The others could sense that Corzine was under a speci a l strai n . Thain, his lieutenant, w a s getting c a l l s on his cell phone right in the Fed room. 1'\o one could hear what Thain was saying, hut they could sec anguish written on his iace. Goldman's losses were big; it> IPO was on the rocks, irs partners were u n h appy. Corzine h a d the l ook of a man caught between two arm ies. Aside from Corzine, others of the ban kers contin ually left rhe room . The E uropeans cal led home; the Americans checked their of­ fices. Perha ps, some of the hankers cal led their traders. Deta il-; of the meeting leaked. At Long-Term there was rad io si lence. Its markets were t u m bli ng, especially its eq u i ty volatility trade. The latest quote was 4 1 percent ! I t a lmost didn't matter now. The firm had come to a hair. Trading had ceased, the p hones were finally q uiet. There was no one to call; the people the partners had been talking to all these weeb were in the Fed roo m . The partners waited toget her in the glas-;-walkd conference room. Every so often, A l l ison or Corzine would call J . M . with �l q uestion, and the pa rtners would infer a hit of progress. Outside, a gro u p of the nonpartners stood hy a television monitor, hoping for a glimpse of the story that h a d been u n folding for weeks on t h e other side of rhe gl ass. Around 3 P.:VI . , CNBC revealed what was going on at rhe Fed, in surprising detai l . Haghani came our, and Reisman, the repo

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man, said, "They're going to bail you out. " Hagh a n i thanked him and walked off. In the Fed room, the issue came down to money. A l l ison had fig­ ured on si xteen banks at $ 2. 5 0 m i l l ion a piece. But the French hanks wouldn't go a bove $ r 2.5 m i l lion each. Lehman was stuck on $ 1 00 mil lion. Bear was a zero. All ison had counted Salomon S m i th Barney and Citicorp a s two banks, but Citi, reckoning that i t was a bout ro merge w ith Salomon, hadn't shown . Pflug said C:iti should be there, but Dcryck M a ughan told h i m to m i n d his own b usiness. By 4 P . M . , the cha nce was slipping away. They weren't even dose to $4 billion. A l lison, seeing no other option, hi ked the ante to $ 3 00 million. This was emba rrassing tor Cortine, who had to call his Goldman partners for consent. Peter Karche� of Morgan Stanley sneered, " What do you mea n ? You're the ho�s ! " The ban kers >US­ peered Cor z i n e of looking for a n out, but Corzine fu l l y accepted that Wal l Street's leaders should do their bit. I l is partners, who had a le�ser sense of h istory, did not. They were loath to i nvest w hen Gold­ man itself was seeking capital, and they were distracted by the fac­ tional riva lries tea ring at Goldman's fabric. To All ison, Corzine cut a tortured figure-angry at I TC: M for its irrespon sibility, w hich had put h i m into this d i fficult spot, a n d under intense pressure from his partners but sti l l trying to do the right thing. l i e and Thain were eye­ ing each other warily. At one point, Thain got off t h e phone and whispered into his car. Corzine plaint i vely turned to the gro u p and said, " :V1 y pa rtners re<11ly don't want to do this. " Despite h i s shaky support, Corzine went ahead. 1\:ow, with eleven banks at $ wo m i ll ion, plus the French and Lehm a n , $ _; . 6 5 b i l lion had been raised. Counting Long-Term's sti l l remaining sli ver of eq­ uity, it would have S4 billion of ct tor. The bankers wanted their money hack quickly, hut if t h e U lll>ortiurn were perceived a s transitory, other traders would sL1rt shooting a t i t . To b e cred i ble, the consort i u m needed staying pown. The hankers agreed on a three­ part agenda: reduce the fund\ risk level, return capital to the new in­ vestors, a nd-la st-try to rea l ize a profit. To a m a n , the hankers would be happy j ust to get out whole.

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At 5 : 1 s 1'. \1 . , A l l i son called �1eri wether with the terms. Long-Term would be getting $ ) . 6 5 billion from a new " spoke" representing fourteen banks. In exchange, the ba nks would receive ') O percent of the equity of the fund. Long-Term's e x i sting investors would reta in a 1 o percent interest, worth about $400 m i l lion. But the pa rtners' share of the latter would he tota lly s u bsumed by the debts against them­ selves and LTC� . In short, their in ve�tment in Long-Term-once worth $ 1 .') billion-was tota lly gone, most of it lost in a mere five weeks. The deta i l s of the new a rra ngemenr had yet to be ironed out, though it wa� clear that, at least for the next three years ( the consor­ tium's expected l i fe), the partners' fees would be cut and their man­ agement and operating freedom would be severely curta iled. Komansky thought the rival banks had done noble work, though of cou rse they had saved their own h ides and not j ust Meri wether's. What the ban kers had done was choose a cerh1in risk of S -, oo mi llion over the mere possibility of a loss whose magnitude was un knowable. It signified that the bankers had-fi n a l ly-lost their appetite for gam­ bl ing. Shortly a fter seven, they handed a press relea'ie to a mob of re­ porters. The release would affect events in an unexpected way, for it commun icated to the world a level of final ity that this complex deal did not yet possess. The press natura l l y focused on the role of the Federal Reserve Sys­ tem in orchestrating the bai lout.' ' Accord ing to the next day's New York Times, the Fed had stretched the doctrine of "too big to fai l " to a pply to a h igh-risk, speculative hedge fund. The Times story, which buried the fact that no public money was involved, i m mediately put the Fed on the defensive. The implication that the Fed was even tac­ itly assu ming responsibi lity for private, u n regulated funds was h igh l y disturbing. As a former Treasury o fficial noted elsewhere, "What if George Soros has a problem ? " " The Wall Street Journal editorialized that the rescue contin ued a decade-long pattern of shielding private investors from the effects of their m ista kes-each instance of w hich emboldened investors to make sti l l further mista kes." By the day a fter the rescue, there was a l ready a clamor for a gov­ ernment investigation, both into Long-Term and into hedge funds in genera l . ' ; As i f to underscore the damage that hedge funds could cause, UBS h u m bly a nnounced that it was writing off i ts entire in­ vestment in Long-Term. The "strategic relationsh i p " that Mathis

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Ca hiallavetta had hoped would revital ize l i BS h a d ended up costing the bank S7oo m i l l ion. Com menta tor; took wicked delight in the fa l l oi the h igh and mighty Long-Term, with its superrich traders, its esoteric mathemat­ ics, and i rs acclai med laureate'i. The hnunci£11 Times of London ob­ served, " I f [ Da v i d [ ,\ l ullins enj oyed fi xing LTises �o much, he nlu'it be a very h;l ppy man . " ' ' The gener;1 1 , and understanda ble, reaction was one oi h orror that the Fed was coming to the rescue of the hero of Li,zr 's /'rJker. For M eriwether, it was a h or ro r of a di fferent sort. Everything he had done since the sca ndal at Salomon had been, at least in his m i nd, aimed a t restoring his reput;1tion ;md CJrL'l'f. �ow it had a l l come crashing down. The mo'>t imv;Jrd of mt·n, .\ k n w e t h n h.1 d become .1 public figure identified with the a rrogance, greed, and spec u l a t i \ L' follv o f Wa l l Street taken to staggering excess. He and h is devoted a r­ bi trageurs were the authors of a h i storic colla pse, one that had threat­ ened the e nt i re sy-,tem. Camera crews descended on ( ;rce n w ich, and television helicopters buzzed the firm's formerly tranquil ofiices. ,\-leri wether wa-, at least spared the suggestion of personal d i shonor, but otherwise late September was for him the worst k i nd of night­ marc. l ie reta i ned h1s unc1 n n \' calm, though one wondered 1f it ma sked a certain detach ment irom h1s tragnh . l l 1s onh p u hl1c utter­ ance was a one-sentence renu rk, rek'cd through his pre'>'i ;!gent, in which he bL1 1 1 d l y ex prc-,-,ed a pprec1;1tion for the consorti u m 's capita l . In fact, t h e consortium deal was an ything b u t assured, a s t h e hanks first had to resolve a host of '>ticky issues. One set related to ,1 . .\1 . and his partners a n d how rightly the hanks could control them. A nother revolved around the fund's sha k y fi nances: the consortium condi­ tioned the d ea I on getting W<1 i vcrs from L' Vl'f\' one ot Long-Tcrm \ nu­ merous lender'>. The ha 1 1 h w nt· pern t i nl t lu t t'\ L'n .1 ttn the in fu-,ion of new capital, a single ddault would t n ggn . 1 L·hain reaction and topple the fu nd. Al so, each of the banks had to n.amme-a nd come to un der­ stand-the fund well enough to pL-rsuade irs own hoa rd to go ahead with the dea l . When this wa'i done, they would need a contract. And it all had to happen by \londay, September 2.S, the schedu led closing d ate-only five days a w a y. 1\;orma l l y, the process rakes months, but Long-Term was sti ll ha nging by a threa d . " It was a mad rush," said Tom Bel l , the outs1de counsel from S i m pson Thacher &

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Bartlett, " to see whether we would c lose the deal or run o u t of money first." Skadden, A rps, Merril l 's law fi rm, was naturally h i red to represent the consort i u m . Merril l offered to make S u l l i van & Cromwell, Gold­ man's law fi rm, co-counsel, hut the cagey Goldman d id n't want its at­ torneys working for anyone else. Nonetheless, Goldma n insisted that Sulli van's John !\1ead he present for the negotiations. Thi� set up an interesting dynamic. While M i lmoe, the pleasant-mannered Skadden partner, had to mediate for the ent i re consorti um, :vtead negotiated strictly for Goldman. A gra yi ng, forty-six-year-old l i tigator, Mead had a soft oval face and double c h i n that masked a bruta l l y tough style. R ight from the start he took a hard l ine, pushing M ilmoe to make sure rhar the contract restricted rhe Long-Term partners as much as possible and otherwise protected the consort i u m 's interests. This was fortunate for the hanks, because the pa rtners were hoping to win hack thro ugh negotiations what they had l ost in the ma rket­ place. l ncredihly, Meriwether and h i s cohorts were a l ready plotting a new hedge fund-the partners' only cha nce of resurrection-as if Long-Term cou l d he pur behind them like a had trade. Meanwhile, a tempest was brewing on the fund's trading floor. Staffers, who h
Skaddcn sta rted the negotiations Friday, three days before the dead­ line. Seventy lawyers from the various banb piled into .'v1erri ll's boardroom . The lawyers discovered rhar the agreement they had come to negotiate actual l y didn't e xist; too many issues d ivided them. As the l a wyers tal ked, the ma rkets tumbled aga i n, knocking Long­ Term's capital down to S4oo m i l l i on-9 I percent below its level of January I . .'v1ead's notes of the meeting show that the hanks were highly con-

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ClTnt:d that the partners' ( and l T C : M 's ) debts would capsi1:c the bailout: " Long-Term needs cash of a pproximately $ 1 22 m i l lion to enable certain Principals to repay personal loans and to enable the .\ bnagt:ment Company to rt:pay, a mong other things, a S 3 X m i l l ion loan to l'artnt:rship." Also, Mead noted, the banks rema i ned ex­ tremely nt:rvous about investing . .J . P. Morgan wanted a guarantee that the banks could redeem their investment a fter th ree years. Chase insisted t h a t the $ ; oo m i l l ion revolver be repaid rhe d a y a fter the closing. Bankers Tru�t and Deutsche Bank demanded scat� on the " Oversight Comm ittee" that would run rhc fund. M organ Stanlt:y and Goldman Sachs wanted j oint indemnification i f any one of the banks were sued, and so on. Thi� was a tall order by M on d a y. What M t:ad\ notes didn't say was that Mead was raising more is­ sues than all rht: other lawyers combined. The Goldman la wyer de­ rna ndt:d t h a t .J . �L and hi� pa rtners be stripped of d ay-to-day cont rol; rhar rhey l ose their indemnity from investor lawsuits; t h a t they be stuck w i t h fu l l liability. Moreover, he insisted that the rescuers be sh ielded from l i a bi lity even for acts that the banks might commit in the future. Sacking the a ncien regime was nor enough; Mead wanted to trundle o u r tht: guil lotine. By Friday evening, the cooler .\1 i l moe, who had barely slept over the past two nights, had managed to piece together some basic terms. The consorti um, to he du bbt:d " Ovt:rsight Partner I," would invest its money for r hrce years. The partners' it:es would he cut, and half of the management compan y would be transferred to the consortium for a $ r fee . .\leriwether and his partners would still run rhe fund day to d a y, bur they would report to the O versight Comm ittee, made up of han kers w h o would work fu ll-t i m e in Greenwich
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prcciativc " ; by Saturday, the gang was refusing ro sign. There was nothing in it for them. Th is show of petulance carried a serious thrcar. The consortium could not invest w ithout the partners' signatures. And the consortium was now publicly committed to doing the dea l . By contrast, the part­ ners had l ittle left to lose. They could al ways, they intimated, let the fund blow up, seck cover in personal bank ruptcy, and go get seven­ figure j obs on Wal l Street. Rickards m anaged to cool the pa rtners off, promi sing that the fin;ll version of the contract would be better. Then a group of them left for Skaddcn, A rps. The prestigious ,\lidtown law fi rm had set out two big conference rooms and a series of private suites on the th irtv-third floor to accommodate an e xpected onsla ught of lawyers and ban ker�. By Saturday morning, 1 40 lawyers were scurrying back and forth in ncar pandemonium, trying to get a handle on the hedge fund's numbingly complex assets, its dchts, it� structure, its management companv. The Skaddcn a ttorneys rook q uestions from the hank la wyers in the first conference room, a cavern ous space with twenty - foot-high , cei l ings that was quickly du bbed "the l a wyer�' room. . !'VI i l m oc, who ra n the mecring, said, "Throw your issues at me," and the lawyers let him have it. \li lmoe was in a tcrrihk hind . .\'l erri l l-thc consorti um's de facto kader-fclt it hLZd to close. a poor position from which to negotiate. Trving to craft a contract that would he accepta ble to fou rteen hank� c�nJ each of the pa rtner'> ,1 1 1 within st"\l"ntl -two hou r'>, \ l i l moe natu­ r;l lly had ro fa shion compro m ise'>. A-, the day wore on, the hank lawyers heg;ln to feel that .\li lmoe was conceding too m uch to Grecn­ \\"lch. At one poi nt, stri ving for ; 1 con'icnsus, the congenial ;Htornev 'aid, '" I'd I ike to represent !TC:.\1 \ demands. " .\ IL",ld sna pped, " How can they have demands? They're going ba nkrupt on .\1 onda y ! " Though the irritating .\ lead made \1 il moc\ work more d i fficult, he worked to t he c on,ort i u m \ ;llh ;mugc by strengthen ing \-l il moe"s negot i ati n g h;J n d . \1cri wethcr, f laghani, Rosen feld, l .e;lhv. <;hu,t;l k , and Ricka rds showed up at Skadden at noon. The pa rtner,, who had ro walk past a gaunt let of incensed han kers in the ha ll w;l � , 11·cre respectful and contrite, m ur m uring ex pressions of gratitude. I n ; l tel ling reversal, the iormcrly nonchalant arbitrageurs had donned -;pi fh· suits while the

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hankers a n d lawyers were wearing ch inos. The h u m bled partners were escorted to the second conference room-the due d i ligence room-where the hankers peppered them with q uestions. It was mostly fact-fin d i ng: the hanks wouldn't mmmit u n t i l they u nder­ stood the fun d better. The once-so-secretive partner> were u n usually helpful, as if eager to dig up treasure they had long ago b u ried. They left in late a fternoon. By now time was really running short, and most of the big issues had yet to be resolved. Mead was demanding that the Long-Term partners perso n a l l y guarantee their representations, and he wanted the new money (the hanks' money ) shielded from lawsuits. Also, :V1ead did not l i ke the look of the p
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heard. "This is the first time that one case could fuck u p o u r relations with three quarters of our clients," Flom noted. "So don't screw it up." The lawyers, including twenty-five assigned to the case by Skad­ den, gradua l l y drifted to nearby h otels, leaving beh ind the hal f-eaten sandwiches, paper cups, and sta le coffee that ever adorn these legal Wood�tocks. \ll i l moe kept drafting. l ie penciled in rev isions as a dwindling band of lawyers stood at h i s shoulder, mum bling suggested change�, and the prin ter hu mmed like a sleeple�s cat. Sometime after 4 A . \1 . , his mind sti ll ringing with F l om 's admonition not to let the dea l fa ll through, M ilmoe tum bled on to the gray fa bric couch in his office and slept. •

Sunday morning, All ison hustled over to Skadden. l ie set up shop in the small room between the two big conference rooms-this became "the ban kers' room . " By midmorn ing, banker� stood shoulder to shoulder around the cl uttered sq uare table where A l lison was hoping to save the rescue yet again. The partners came back, too. \ll eri wether and some of the others were sitting together in one of the conference rooms. But H i l i brand was off to the side with his personal lawyer. l li l i brand, who was hopelessly in debt, was wondering if he should quit the rescue, fi le for bankruptcy, and put his debts behind h i m . Of course, that would take the fund down, roo. Apres moi . . . I lil ibrand's antics reminded the bank ers of how l ittle they wanted to be there. They were loath to help the partners person a l l y. Only fea r kept them in the deal. A l l ison thought it would he worse for the markets-m uch worse-if Long-Term fai led now, a fter a deal had been announced. Moreover, Merri l l's reputation was on the line. And Long-Term's lawyers knew how bad l y A l l ison wanted the dea l; they played the game of chicken masterfu l l y. "The consort i u m said, ' You have no a l ternative but us,' " recounted Bell, the Long-Term lawyer. " And we said, ' You have no alternative but 11s.' " Though it is seldom realized, a creditor is also beholden to hi� debtor. •

For much of Sunday, the hankers-led by William H a rrison, a vice chairman of C hase, who had driven down from Connecticut with

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Pflug-tried to line up nece�sary wai vers. The stickiest problems re­ lated to 1\om ura, Republic Bank, and the foreign excha nge office of Italy, each of w h ich had loans to Long-Term . The bank ers insisted they wouldn't go a head until each of the th ree agreed to waive their rights to i m mediate repa yment. Then there was C :r�dit l .yon nais, which was calling i rs S 5 o mil lion loan to I TC :Vt . .\t erri l l 's Richard Dunn called a senior executive of the bank in Pa ris, where it was a l ready nighttime Sunday, and made suc had been fe�tering all weekend w i th many of the hankers-who, typica l l y, were h a ppy to let Goldman play the hea vy. Once aga i n , Pflug was dumbfounded-and tired of al ways being the noble one. Even the other ban kers, though sympathetic to Gold­ man\ pu rpose, were stunned that it would risk the enti re deal over such a point. Russo, the Lehman lawyer, turned to Katz and said, " You 're bl uffing. " Katz merely smiled. The Chase ream made it clear that they would walk. At that point, Katz reflected la ter, "There was no dea l . " J t was 7 1' . \ 1 . Corzine, who was returning from a weekend a t his ma jestic beach ­ front h o m e i n the H amptons, called the meeting room from his cell phone. When Corzine reiterated that Goldman would not i n vest un less Chase left its money in, Pflug, who had stea d i l y been losing p.1 tience, ex ploded. "Jon, " he said, " t here is no polite way t o ,, I \ this-Go l d m a n c a n g o fuck t hemselves ! " Corzine, w h o w;ls 'I l l< k 1 1 1 traffic on t h e Long Island Fxpressway, let it pass; h e W;l s u ,ed l c • ,.,,. 1 .

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ring heat from his bickering partners, who were bac k i n g away from the consort i u m agai n . After ta l k ing t o Corzine, Katz sa id resignedl y, " We c a n ' t get an a n ­ swer tonight . " S o Goldman w a s o ut, roo. K atz said Goldman's exec­ utive committee would meet .'vlonday morning at 6 : _3 0 and decide then. Now it was the turn of Steve Black, the Salomon Smith Barney executive, to erupt. All Goldman really wanted, he fumed, was twelve hours' time to trade in Japan before it made up its m i n d . "No way! " Ironica l l y, the consorti um's most intracta ble problems l a y not with Long-Term but among themselves. Frank Newman , chairman of Bankers Trust, had a bandoned the meeting, fur i o u s t h a t Goldman, Merrill, and Chase were excluding him from their various sidebar chats. And the ugly i �suc of front-running, which had never gone away, reared its head at the worst moment. Sandy Wei l l cal led Alli­ son; the Travelers cha irman was seeth ing over reports that ( ;oldman's traders were at it aga in. A l lison pulled K a tz aside and then spoke pri­ vately to Corzine on the telephone. Both of the Goldman executives denied the reports. A l lison told K a tz, " I f one of us leaves, it a l l fa lls apart. Do you rea l l y want the dea l to fa l l apart over th i s ? " All ison d i d not think Corzine was bluffing; Corzine's partners were j ust obstinate enough to w a l k . But with two banks holding our, All ison intui t i vely sensed the basis of a dea l : Goldman would reenter the ring if only Chase would agree to i rs condition, A l l i�on suggested. One always had to indulge the bad boys at Goldman. H arrison and Pflug saw no way our, and Chase consented; the fund could hang on to the $ 5 00 m i l l ion. Corzine pol led a few of his partners and decided-perhaps too quickly-that he had thei r support. Around ') 1' \l., Goldman rej oined the consorti um. The bankers still needed waivers from Chase's twenty-three syndi­ cate partners, in addition to Nomura, Republic, and the I ta l ians. Otherwise they wouldn't proceed. A lso, the French bank Pari bas, an i nvestor in the consortium, hadn't gi ven < l final assent. A l l ison went a round the room, polling the banker' to sec who had contacts at which banks. Then they began to ca ll wh;Hevcr time zone people were awake i n . All ison left a l ittle before midn ight. I n Greenwich, Ricka rds was frenetica lly negotiating by phone with Skadden. At one point, Haghani darted out of the conference room and blurted out, as if under a delusion, " Remember one thing-we gotta buy this baby back ! " Buy it back with what? R ickards may wel l •.

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have wondered . Sometime a fter midn ight, the a ttorney got the con­ sorti u m to agree to bon uses for the partners. At t h ree, h e left for home. Despite a l l the loose ends, the la wyers expected to dose the deal a t 1 0 A . :VI . Monday. But F leet, Republic, and Bank � ova Scotia had refused to sign the wa ivers. W i l l i a m Rhodes, vice chairman of C :itiba n k , who was friendly with some of the holdouts, and Ha rrison spent .\1onday morning polling the banks. ! I a rrison was vehement: they h,ld to close on .\1onday. At Skadden, the ban kers had staked out one conference room and the pa rtners were camped in the other, whcre ; t guard stood vigil at the door. A l l ison shutrled between the two, pcriod ica l ly going off with Meriwether to check on the status of his partners. Haghani humped into Black of Salomon Smith Barney in the h a l l w a y, and said, "I can't believe this has h appened . " l laghani felt their trades would soar-and now it wou ld a l l belong to the banks, not to the partners. Black felt sorry for h i m .. Around eleven, j . .\1 . sent a n emissary to convey to A l l ison that the partners wan ted to apologize for the trouble they had ca used and wanted to help the consort i u m . But they were still d i v i ded.' - A ma­ j ority wanted to sign; they were d ra i ned and wanted the tra uma over. Hili hrand was holding out. And the fund was losing money aga i n . The ha nkers kept watching Bear, wondering i f Long-Term would make it through M onday. Amid this nerve-rack i ng vigil, Goldman Sachs bowed to the inevitable and canceled its planned public offering. This was doubly ominous for Corzine, w h o had pledged to invest $ 3 00 m i l l i on in Long-Term and yet had fa i led to raise capital for his own firm. Then Fra nk �cwman, the chairman of Bankers Tru st, who had been pouting over his excl usion from the inncr circle of bankers, bolted. I ncred i b l y, the insecure hanker declared that h e was q u itting the consorti u m . I t was > 1'. :·..1 . on .\1onda y. Allison now got on the horn with �ewma n. l ie was running out of concessions but offered one more: a scat for Ba nkers Trust on the Oversight Committee. \lcwman swa llowed hard a nd rejoined the dea l . At 5 J > .\ 1 . , t h e consortium agreed t h a t t h e partners could ca ll o n " o l d mone y " t o satisfy potential lawsu its. A t s : .3 0, t h e consorl l l l l l l agreed t h a t a n y partners w h o were fired wouldn't lose t h e i r <''1 1 1 1 1 1 , . , ., ,,

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would those who q u it. Meriwether, not quite satisfied, said, "Our guys stil l won't sign until it says we can go out and do a new fund . " That w a s their goal now-to get free of Long-Term. All ison, who k new the banks would never invest $ 3 . 6 5 b i l lion i f the partners were plotting t o desert, pul led .J . M . aside a n d expla ined that he couldn't put it into writing. The partners would lhll'C to commit to th ree years each ; markets would have little faith in the new consortium un less it was seen as truly " long term . " But in time, A l l i ­ son ventured, t h e pMtner� might b e free t o leave. J. .'vl . heard t h i s a s a promise; h e had gotten a l l h e could. The waivers were in, and the Federal Reserve had been a lerted to keep its electronic payments wire open past i ts usual 6 : 3 0 closing time. The Fed was expecting w i res from fourteen banks totaling $ :; . 6 5 billion. The partners were ready to sign. They stood in a k not at the far end of the room, a cathedra l-sized space that seemed to dwarf the sma ll hand of dimi ni shed a rbi trageurs. l l ili hrand was reading the contract, which was hopelessly i l legi ble to a l l but the lawyers. The margim were ja mmed with penciled revisions and crossed-out sentences and a rrows up and down, as though the contract were a vi­ sual representation of the confusion of the last three days. Rickards and a couple of other attorneys were trymg to tell H i l i brand what it meant, but he didn't want to listen , he wanted to read it hi msel f, and he could ba rely see it through the tears that were strea ming down his face. He didn't W
Epilogue The

which fed upon itself driuing market po­ the lez·els incorporated in risk munagemozt und stress loss discipline. Conii dl'll ti,J I :\lcmora n d u m , J a n u a ry 1 9 9 9

result was a downward spiral

sitirms to unanticipated extremes well /Jeyond

-l.TC\1

.

Long-Term's debacle was a t ragedy for its partners. Moti vated by insatiable greed, they had forci b l y cashed out thei r outside in vestors only months before, leaving themselves to withstand, v i r tu a l l y alone, the b ru nt of t h e col lapse. The w izards of Wa l l Street person­ a l l y lost S 1 ·9 b i l l ion. Larry H i l i brand, the most coc k s u re of traders, who had previously been worth close to h a l f a b i l lion d o l l a rs, awoke to d i scover that he was broke. Forced to l i ve off the a ssets o f h i s w i fe, Debor a h , he h a d t o plead with Cred it Lyo n n a i s t o spare h i m the ignominy of personal bankrupt�·y while he tried to work off a crus h i ng S 24 m i l l ion debr. :'v1 ost of the other partners lost 9 0 per­ cent or more of their wealth-t h a t is, everything they h a d i n vested in the fun d . T h a n k s to the <;mooth takeover encouraged by the Fed­ eral Reserve a n d ma naged by l l crb A l l ison, most of the pa rtners re­ m a i ned far richer than ord i n ary Americans; high fi n a nce rewards sun:ess, but in the twi l ight yea rs of the twentieth century, it strangely protected fa i l u re as wel l . The partners ( i ncluding H i l i ­ bra n d ) kept t h e i r elegant h omes, even though their d a y s a mong the superrich were over. \lever conspicuous spenders, they su ffered more for the w a y their epoc h a l loss branded them as socia l l y i rrc-

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sponsible speculators i n t h e p u b l i c e y e and for t h e w a y i t r u ined their reputations among Wa l l Street colleagues. B u t n o moral sca n ­ d a l ensued . The money w a s lost, b u t honestly lost. Eric Rosenfeld, Long-Term's manager, auctioned off caseloads of the wine collection he had once so lovingly assembled-some of it

to

Merrill Lynch's Conrad Vol dstad, who, as a member of the Oversight Committee, had thus inherited Rosenfeld's portfo l i o a s well. Worse yet, Rosenfeld had to endure the k n owledge that relatives of h i s w i fe, who were by no means rich, had s uffered losses at his behest . But he seemed

to

take these setbacks in stride. When Bill Mcintosh , a former

colleague at Salomon Brothers, cal led to see i f there was a nything he cou ld do, Rosenfeld responded wryly, "Just send money. " Others of the partners became morose or desperate for v i n dica­ tion . Haghani, the master trader, was haunted by the fund's brief, brutal devastation, so much of i t caused by his repeated insistence on betting the house. "This is a persona l tragedy," a friend of the mer­ curial Haghani noted. " It's with him every day, and it's not going away." The fun d 's collapse got w i de coverage around the country, virtu­ ally none of i t sympathetic to the pa rtners. Time d u bbed them "The Brightest and the Brokest" and noted that "outrage was m i ngled with shock . " Headline writers had a field day with the fa i led gen iuse s . "We're So R ich, We C a n B e D u m b , " jeered t h e San Francisco Chron­

icle. Merton's hometown paper, The Boston Globe, ch imed in with " Fast ( a nd Suspect) Fix for a 'long-Term' Problem . " The press natu­ rally seized on the bald unfa i rness of the Fed's helping

to

bail out

Wa l l Street mogu ls. I n P h i l a delphia, the Inquirer pointedly de­ manded, " When a Hedge Fund Fai ls, All Investors S u ffer-Is That Fa i r ? " while The Miami Herald's "The Bolder They A re, the Softer They F a l l " ripped the arbitrageurs as pampered rich k i d s . ' Merton was more distraught over the stain that Long-Term's fa i l ­ u r e cast on modern finance and on h i s o w n prod igious academic oeu­ vre. Though tacitly conceding rhat the models had fa iled, he insisted that the solution was

ro

design ever-more ela borate a n d sophisticated

models.' The notion that relying on any formulaic model posed in­ escapable risks el uded him . Merton's fellow laureate, M y ro n Scholes, was rema rried, to a San Francisco l awyer, at the elegant P ierre Hotel in :"Jew York, a week after the bailout. Scholes could not escape signs of the catastrophe even at his wedding. Meriwether and Rosenfeld kept d a rting off to

EPILOGUE

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22 1

make telephone calls, and Merton M i l ler gave the groom a gentle roasting, observing that Scholes had now found out for h i mself j ust how dangerous it was to try to beat the market. ' At least the dashing Scholes m a inta ined his wit. Refusing to duck, the Nobel l a u reate dryly informed the revelers that rather than his wife, J a n , taking his name, he would take hers. As for J . M . , he never spoke publicly about his feel ings and didn't speak m uch a bout the "extreme event," as the fund referred to its col­ lapse. Eager to flee the limelight and horrified by the reporters who banged at his door;' the retiring trader reacted to his persona l tragedy like very few others in this overly public era: with utter silence. Surely, as he had said to Allison, he regretted it all. Perhaps he brooded over how, a fter a l i fetime of cJrefully playing the odds and a voiding the l imelight, he had become a noto rious symbol of speculative excess. But it would h a ve been more like .J . M . to banish the disaster from mind. Long-Term had been a bad trade; there would be others . •

The Federal Reserve reduced interest rates on Tuesday, September 29, the very day a fter the bailout. l lowever, the Fed's action did not bring any relief to Long-Term or its new owners. In the wake of the rescue, U.S. swap spreads widened to 9 6 '/, points and Brita i n 's soared to 1 20. The spread on Royal Dutch/Shell-S percent when Long-Term had entered the trade-ba llooned to 22 percent. The two classes of Volkswagen sha res-Long-Term had invested at a 4 0 percent di ffer­ ential-widened to more than 6o percent. And on it went. Recapital ized with a fresh $ 3 . 6 5 bill ion, Long-Term continued to plummet, l i ke a parachutist who yanks the rip cord but keeps fal ling anyway. In i ts first two weeks, the consortium lost $ 7 50 mi ll ion. I t was happening again-for the consortium, the sca riest o f a l l possi ble epilogues. By mid-October, all of Wa l l Street seemed to have caught Long­ Term's disease. One by one, Merrill Lynch, Bankers Trust, U BS, Credit Suisse F i rst Boston, Goldman Sachs, and Salomon Smith Barney-the linchpins of the new consortium-d i v ulged large losses that in sum matched those of Greenwich. The banks' stocks plum­ meted, sign a li ng a pervasive loss of confidence in the very institutions that had come to Long-Term's rescue. In the wake of the bai lout, in­ vestors became obsessed with Wal l Street's careless sponsorshi p of hedge funds. One a fter another, the banks dutifu l l y reduced their ex-

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posun: t o t h i s noxious class-a category t h a t so recently had been the envy of a l l Wa l l Street and now had become a pari a h . I n fact, t h e exposures, while b i g , were n o t as threaten ing as a larmists maintained; there was n o " second Long-Term " waiting in the wings. But Long-Term (and other hedge fun d s ) d i d have a corro­ sive effect on Wall Street all the same. The banks had not been able to resist the l u re o f the funds' fa b u l o u s-if fleeting-profits. Flush with capita l, they had rushed to set u p their own, s i m i l a r, trading desks and had m i m icked the hedge funds' d i verse strategies. I n the af­ termath o f Long-Term's collapse, the banks, too, had l o sses in bond arbitrage, in Russia, and in equ ity derivatives. fam i l i a rity had bred the desire to i mitate; that was the true price of the b a n k s ' " e xpo­ sure . " Merrill Lynch's stock price p l u mmeted b y two third s in a mere three months-not as severe, and certa i n l y not as enduring, as the 9 2 percent loss from top to bottom i n Long-Term's equity, but astonish­ ing nonetheless. Komansky and A l l i son had taken such pride in shielding Merri l l from proprietary tra d i ng, but Merrill's bond traders lost close to a bil l ion dollars all the same. Suddenly a n x i o u s that Mer­ ril l's own credit rating would come under pressure, Merri l l , led by Al­ l i son, aggressively cut costs and fired 3 , 5 00 people, l a rgely in the bond department. By mid-October, not only was Long-Term i m plod­ ing aga in, but its new owners, the leading banks on Wal l Street, were in deepening trouble. And now Alan Greenspan decided he had seen enough. On Octo­ ber

r

5, the Fed chief cut rates for a second ti me-a sign a l that he

would cut and keep cutting until l i q u i dity to the system was restored. Wal l Street ral lied, and bond spreads n a rrowed . ror the first time in months, bond arbitrageurs made a sustained profi t . In Greenwich, the portfo l i o turned around. After six months that had been by turns painful, then su rprising, then agonizing, and then utterly devastating, Long-Term Capital, which since April had lost the fa b u l o u s total of $5 billion, fin a l l y stopped losing. The storm had passed . '' • The fa llout from the bust fell broa d l y but-as is u s u a l l y the caseunevenly on various of Long-Term's i n vestors, employees, counter" In

2000,

in an echo of rhe hedge fund's debacle, Soros and Tiger :vtanage­

llll"nr ,uffered debiliraring losses, and Tiger was forced

ro

liquidate.

EPILOGUE

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223

parties, a n d Wa l l Street fri ends . Herb A l lison, who had done more than anyone to save the fund, was soon resented within :vlerril l Lynch for h is role i n Merri l l 's zea lous cost cutting. When the crisis passed and memories of the panic faded, A l l ison was blamed for overreact­ ing. I n formed that he was not in line to succeed Komansky, A l l i son resigned and went to work for Senator John McCa i n 's presidential campaign. D a n iel �apoli, Merri l l 's risk manager, took the fa l l for Ylerr i l l 's losses. Replaced, he went on long-term leave. Gold m a n 's Jon Corzine continued his hot-and-cold roma nce with Long-Term Capital for j u st a bit longer. Goldman let i t be k n own that-at the right price-Warren Bu ffett would sti l l be a n eager s u itor for Long-Term. Corzine also cal led Prince Alwaleed to gauge the Saudi's i n terest in joining yet another b u y o u t h i d . But hy the end of October, the fu n d had stabi lized and the consortium had no need of Goldman's peripatetic bankers. Goldman resu rrected its !PO and went public in May

r

9 9 9 · But

Corzine, who had staked his career on the earlier I P O attempt and had then staked it again on Meriwether, fell before the battle was won. I n Janua ry, i n a rare boardroom coup, his partners sacked h i m . Corzine made one final p a s s w i t h Meri wether, the m a n he h a d wanted as h i s p a rtner for so l o n g . I n t h e spring, t h e t w o teamed u p t o raise m o n e y to acquire Long-Term from its Wa ll Street owners, with the idea that Corzine and M e riwether would run it together. But the effort fizzled. Then Corzine, who had reaped S 2 3 0 m i l l ion in Goldman's I P O , q u i t Wa l l Street a n d began a vigorous campa ign for the Democratic senatorial nomi nation in :\"ew Jersey. A bundle of contradictions, Corzine was a decent man at the helm of a cutthroat firm, a banker with a sense of his place in the larger world in a soci­ ety that honored only profits, and a competitor who fe ll on his sword for Meriwether, a rival who d isa ppomted him but enchanted him a l l t h e same. UBS was left i n tatters, devastated by losses not only from its in­ vestment i n Long-Term but a l so from Ramy Goldstein's eq uity deriv­ atives u n i t . Yl a t h i s Cabialla vetta, the former prince of Swiss banking and the architect of UBS's d u bious strategy, resigne d . M a rcel Ospel, the chief executive formerly with the more prudent Swiss Bank, quickly cleaned h o use . An unlucky victim was Andre w Sicil i a n o, the partners' friend and the manager at UBS who had first exp ressed doubts about the dubious Long-Term wa rrant. For fa i l i n g to take his concerns to· the very top, Siciliano was fired .

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Bankers Trust suffered catastrophic losses in R u s s i a , where it had been a n aggressive buyer of ruble securities, as well a s in Brazil and other emerging markets. Apparently m a k ing a mockery o f the self­ important pretensions of its chairman, ha nk Newma n , the bank was forced to sell out to a German rival, Deutsche Bank. Though j udged a fa i l ure, Newman, who had nearly scorched the Long-Term rescue, secured a golden parachute for h i mself estimated at

$ r oo

m i l lion, in

the circu mstances, an enormous undeserved bounty. ' Sandy Wei l l came out on top, as he a l ways seemed to. Citicorp and Travelers/Sa lomon merged on sched u l e . Lehman Brothers, wh ich had been plagued by rumors, quickly recovered. Chase M a n hattan­ without whose repeated help Long-Term would h a ve surely failed­ had its loans repai d and came out whole. Indeed, thanks to the rescue, Long-Term met every m a rgin ca l l . All of its debts to creditors were repa id i n fu l l . • :Vtost of Long-Term's outside i n vestors came out ahead-saved, iron­ ical ly, by the forced repatriation o f their capital at the end o f I 9 9 7 · Some thirty-eight investors who had been l ucky eno ugh to invest a t the inception and t o have been mostly cashed out i n I 9 9 7 finished with an average return of I 8 percent a year-not q u i te a s high as the major stock averages over the same span but very good all the same. About a n equal n u mber of in vestors who had

fully cashed

out before

the catastrophic losses of I 9 9 8 d i d even better. Investors who had been granted the speci a l d i spensation of being allowed to keep more of their capital invested ultimately lost money. Ironical ly, Bea r's Jimmy Cayne, who nearly brought the fund down, was one such " favored " loser. Komansky, chairman of Merri l l , who invested at the top, was a loser, too . About a dozen big banks made only single-digit annual returns, and a dozen others-including, no­ tably, U BS, Credit Suisse F i rst Boston, and Dresdner-lost money. The m ixed results of the outside in vestors in n o way d i m i n ished the magn itude o f Long-Term's fa i l ure. Even with the headwind o f its first four highly successful years, Long-Term's fi n a l , c u m u lative loss was staggering. Through April I 9 9 8 , the value o f a d o l l a r invested in Long-Term q uadrupled to $ 4 . I I . By the time of the b a i lout, only five months later, precisely 3 3 cents o f that total remained. After deduct­ ing the p a rtners' fees, the results were even sorrier: each i nvested dol-

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225

lar, having gro w n to $ 2 . 8 5 , shrank to a meager 23 cents. I n net terms, the greatest fun d ever-surel y the one with the highest IQs-had lost 77 percent of its capital w h i le the ordinary stock market i n vestor had been more than doubling his money. •

The fund's employees, like those at most Wal l Street fi rms, h a d gotten most of their pay in the form of year-end bonus money. M ost of those bonuses had been invested in the fund and went down the d ra i n . " We a l l lost our money, " said a staffer who worked as an a n a l yst. " We ended up working for noth ing," said another, a bond trader. In October, employees staged a m i n i revolt, demanding that future bonus money he p laced in a trust where it could not he squandered. The staff a l so craved a measure of recognition, some admission that their bosses had been wrong to keep them in the dark. But the part­ ners' habit of secrecy was deeply i ngrained. At one meeting of part­ ners and sta ff, an employee demanded, " Explain to us why we should he sitting here and not looking for jobs." Replied a partner, " Th at's a valid q uestion . We' l l get hack to you . " The talented, dedicated workers never did win their bosses' trust. A month after the rescue, Long-Term laid off thi rty-three employ­ ees, almost a fifth of the staff:· After that, there was a steady stream of defections. The fund offered a small severance package, hut even this was a carrot for which J . M . & C :o. exacted a price. Departing staff members were cajoled into sign ing termination agreements in which they repeated a pledge never to say a word about the fund­ as if the partners feared the revelation of some secret shame . •

Once the fund stabilized, the partners found themselves in a n un­ happy l imbo. Though they sti l l presided over a huge fu nd, their hands were tied hy their new Wa l l Street lll
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of foot-dragging, had

to

dispatch s o m e of i t s members to London

to

make sure the uny ielding arbitrageur fell into line. The p a rtners' steely eleventh-hour negotiations had guara nteed them a generous bonus-on average,

$ s oo,ooo-in return for stay­

ing the yea r. Otherwise, they were treated l ike the h i red hands they were, forced to swallow a hitter helping of their own gruel. Dis­ agreements between them and the hanks were resolved i n favor of the consorti u m , which now held a l l the power. The consorti um, wanting no more emba rrassment from the free-swinging arbitrageurs, moni­ tored the fund's i mage, too. In a h u m i l i a ting reversal o f roles, they or­ dered the p a rtners to clear public statements with their new bosses, implying that now it was the pa rtners that couldn't be trusted. More d i stressing sti ll, espec i a l l y to a firm that had prided itself on its clever a voidance of taxes, the Internal Revenue Service la unched a global a udit of LTCM and its various affiliates. The a u d it, w h ich fo­ cuses on the years

1 99 6

and

1 9 97,

and which remained u n resolved

eighteen months a fter the fund's colla pse, exposed the p a rtners to the possibil ity, one day down the road, of being b i l led for massive back taxes owed. After the crisis, the group's extraordinary unity broke down. Sev­ eral of the p a rtners came to believe that for the good o f the firm, Hili­ brand a n d Haghani should go, not only for their p a rt in losing the money but for their control l i n g d i spositions, too. �either was suited to teamwork. Meriwether heard complaints about the two from Hawkins, M c Entee, Modest, and M u l l i n s . But he w a s s i ngularly un­ prepared to deal with them . J . M . held a few meetings and tried to placate the mutineers, but he was too deli berate, and too loyal to his longtime cohorts, to confront h i s two top traders. Hawkins finally searched out the boss and decl ared, i n effect, that i t was either H i l i ­ brand or h i m . J . M . , always spare with words, said, " Good l u c k

to

you . " Then he left the room . In t h e y e a r following t h e bai lout, unhappy partners gradually (and with the consortium's perm i ssion ) left the fi rm. Most were a ble to tap past connections and resume a normal working l i fe . :--J o stigma was attached; second acts on Wa l l Street are a > common as they are in politics. Perhaps one cycle, he it an election cycle o r a n economic cycle, is the extent of the public's memory. Scholes, who was hitter about the entire e x perience, returned with Jan to the Bay Area, where he took up writing and occasional lectur-

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227

ing at Stanford. He and Chi-fu H u a ng, the former head of Long­ Term's Tokyo office, were hired to manage money for the Basses, the Te xas tycoons. Merton continued to teach at Harvard. A yea r after the rescue, with the benefit of his hard-won firsthand know ledge, Merton was h i red as a consu ltant i n risk management by J.

P. M o rgan.

Modest, the i ntellectual modeler, became a managing d i rector in eq uities at M o rgan Stan ley. M u l l i n s, the central banker, decided on yet a third career change and became an adv iser to several start-up companies

that

prov ided

fi n a n c i a l

services

over

the

I n ternet.

Hawkins and M c Entee drew u p plans for an investment fu n d . With the exception o f the outspoken Scholes, who was never shy about of­ fering his thoughts-i ncluding on Long-Term, on which he had kept detailed notes-the depa rted partners contented ly disa ppeared from public view. Meriwether never doubted that he and his core group from Sa­ lomon would try to raise money and do it again. A l most a s soon as the i n k on the bailout agreement was dry, J.M. and his loyal ists began to chafe under the consortiu m's restrictions. They conti n u a l l y pestered their overseers to let them raise new money, and .J . M . began to m utter that A l l i son-who ins isted that the group should wait a bit-wasn't liv ing up to his promise, as if the group's rescuer was in debt to them. The partners went on the road in late

1 9 9 8 and early 1 9 9 9 to visit

their investors-osten sibly to explain the disaster but rea l l y to seed the ground for future fu nd-raising. A l li son was stunned to learn that J . M . was circulating a brief on the d i saster to investors in Europe-a prelude to m a rketing his next ventu re-and the consort i u m ordered him to stop. "Do these guys possibly think they can redeem themsel ves ? " one of the consorti u m ban kers wondere d . Clearly, they d i d . In their one public interview before they were gagged, the partners put forth a re­ deeming and i dealized view of themselves as a band of brilliant ultraratio n a l i sts who, most u n l uc k i l y, had been done i n by a n unrea­ soning and ven a l worl d . T h e p a rtners appeared t o accept responsibil ity; they said they d i d and apologized o n various occasions; but they never made c l e a r j ust what it was they were apologi zing for. J . M . & Co. genera l l y denied that either the leverage or the size o f their portfolio had been a sig­ n i ficant contri buting factor; they denied, even, that their basic strat­ egy had been fl awed : ' Rather, i n meeting after meeting, the partnn�

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blamed the irrationality and venality of other traders. They portrayed Long-Term as the victim of outside events, specifical l y, of a l iquidity shortage in August followed by hostile front-running in September. On the fi rst anniversary of the h i storic meeting at the Fed, .\1 yron Scholes cogently argued in a talk at l\:ew York's Windows on the World restaurant that spreads on l ower-rated bonds had widened to greater levels than could have been explained by mere default risk . Therefore, Scholes concl uded, the spreads must have been " l iquid­ ity spreads," representing the p rem ium that in vestors were willing to pay for more liquid pa per. There is a circular nature to such ar­ guments: when prices fal l , one m a y a lways blame the a bsence of buyers and hence of " l iquidity. " As Scholes himself pointed out, there were very real , underlying events that had scared the buyers away; to wit, investors had been counting on the I .\1 F to bail out de­ veloping regions, but the I M F had been incapable of protecting everyone at once: The example I like to give is that of a father with several sons. Each son thinks that the father will support h i m in his time of need. But, if one of his brothers nee&, support, the father then has fewer resources to support his activities and also those of his other brothers. The value of the support option is dimin ished in value. This, in part, is the cause of the fl ight to liquidity in Au­ gust. figuratively, another son, R ussia, could not he sufficiently supported, and as a result, all of the other sons, the underdevel­ oped countries, looked less credit worthy." Scholes lamented that academics and practitioners hadn't modeled this "stress-loss l iquidity component" and its implications for prices. But obviously, i l liquidity was merely the exp ression of the problem, not its cause. What was m issing from these self-serving sound bites was any suggestion that Long-Term had been at fault for exposing it­ self to such perils. A man driving a car at thirty miles an hour may blame the road if he skids on a patch of ice; a man driving at a h un­ dred miles an hour may not. Scholes averted the question of why " academics and practitioners" had ignored the long-established and basical l y self-evident l iquidity risks. Even after their historic l oss, the Long-Term partners admitted no essential mistake. They had been done in, they argued, by an un­ foreseeable event-a perfect storm such as strikes once in a hundred

EPILOGUE

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229

years. " I believe that," Rosenfeld explained after the crash. " I do think it was something that never happened before. " ' ' Of course, it had happened, not once in a h u ndred years hut many times-in Mex­ ico, on Wa l l Street, i n stocks, i n bonds, in silver, i n Thailand, i n R us­ sia, in Brazil. People caught in such fin ancial cataclysms typica l l y feel singularly u n l ucky, hut financial history is replete with e xamples of " fat tails"-unusual and extreme price swings that, based on a read­ ing of previous prices, would h a ve seemed implausible. Whatever they had learned from the trauma, the partners contin­ ued to insist, j ust as they had before the bailout, that spreads were too wide, that now was the time to invest, that opportun ities had never looked better. The models said so! On this they were proven wrong-or at least, a year after the bailout, they had yet to he proven right. Though Wa l l Street recovered, Long-Term's brand of arbitrage did nor. Under irs new owners, the fund enj oyed a good last q uarter in 1 99 8 and a good start to the new year; then it went into a tailspin. I n the summer of 1 9 99, U.S. swap spreads once aga i n b a llooned, to 1 1 2 points-wider, even, than at the astronomical height o f the pre­ vious year's panic. The once-in-a-century flood had struck twice in two years. On September 28, 1 9 99, exactly a year after the bailout, swap spreads rem a i ned a t 93 points and equity volatility was at 30 per­ cent-each far higher than when Long-Term had entered the respec­ tive trade. In the first year after the bai lout, the fund earned 1 0 percent-hardly a dramatic recovery. Then, in addition to this mod­ est profit, the fund redeemed the consortium's $3.65 bil lion i n capi­ tal. For practical p urposes, the fund had liquidated by early woo. So Long-Term's problem had not been j ust i l l iq u id ity. Perhaps the fund's enti re strategy had been wrong, and the world's ( an d Long­ Term's ) perception of credit in I ') ') 8 had been a l ittle too rosy. The evidence s uggests that both factors were at work: Long-Term mis­ j udged the ma rkets, and the effect of that misj udgment was sorely compounded i n September, when-to protect themselves against Long-Term's i m minent collapse-other traders went on strike and " l iquidity" d isappeared . •

Alan Greenspan freely admitted that by orchestrating a rescue o f Long-Term , the Fed had encouraged future risk takers and perh . l f "

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increased the odds of a future disaster. "To be sure, some moral haz­ ard, however slight, may have been created by the Federal Reserve's involvement, " " the Fed chief declared. H owever, he j u dged that such negatives were outweighed by the risk of "serious distortions to mar­ ket prices had Long-Term been pushed suddenly into bankruptcy. " If one looks at the Long-Term episode in isolation, one would tend to agree that the Fed was right to intervene, j ust as, if confronted with a suddenly mentally unstable patient, most doctors would willingly prescribe a tranquilizer. The risks of a breakdown a re immediate; those of addiction are long term. But the Long-Term Capital case must be seen for what it is: not an isolated instance but the latest in a series in w h ich an agency of the government (or the I M F ) has come to the rescue of private speculators. In one decade, this unfortunate roster has grown to include the savings and loans, big commercial banks that had overlent to real estate, investors in Mexico, Thailand, South Korea, and Russia (where a bailout was attempted), and now the various parties affiliated with Long-Term Capital. It is true that the Fed's involvement was limited and that no government money was used. But the banks would not have come together without the enormous power and influence of the Fed behind them, and without a joint effort, Long-Term surely would have collapsed. Presumably, the banks and others would h ave suffered more severe losses­ though not, one thinks, as great as some suggested. Long-Term's ex­ posure was h uge, but, spread over all of Wal l Street, it was hardly of apocalyptic proportions. At some point the selling would have stopped. At some point buyers would have returned and markets would h ave stabilized. Other banks could have fai led, though that was an outside chance at best. Permitting such losses to occur is what deters most other people and institutions from tak ing imprudent risks. �ow especia l l y, after a decade of prosperity and buoyant financial markets, a rem inder that foolishness carries a price woul d be no bad thing. W i l l investors in the next problem-child-to-be, h av ing been lulled b y the soft landing engineered for Long-Term, be counting on the Fed, too ? On balance, the Fed's decision to get involved-though understandable given the panicky conditions of September r 99 8-regrettably squandered a choice opportunity to send the markets a needed dose of discipline. McDonough always defended his actions, though he seemed dis­ pleased and perhaps embarrassed b y the fund's survival . A year after

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the bailout, i n a n impolitic burst o f candor, the fed president de­ clared, " LTCM is close to being o u t of business. I can assure you that is a result that pleases me considera bly. " " Greenspan's more serious and longer-running error h a s been to consistently shrug off the need for regu lation and better disclosure with regard to derivative products. Del uded as to the banks' ability to police themselves before the crisis, G reenspan called for a less bur­ densome regulatory regime barely s i x months after it. ' ' H i s ;-,reolithic opposition to enhanced disclos u re-which, because it a llows in­ vestors to be their own watchdogs, is ever the best friend of free cap­ ital markets-served to remind one of the early Greenspan who ( i n thrall t o Ayn R a n d ) once wrote, "The basis o f regul ation is a rmed force . " 1 4 In fact, it is in countries that lack transparency ( such as Rus­ sia) that markets need to be defended by soldiers. If the Long-Term episode proved anything, it is that the system of disclosure that has worked so well with regard to traditional securi­ ties has not been a ble to do the j o b with respect to derivative con­ tracts. To put i t plainly, investors have a pretty good idea a bout balance-sheet risks; they are completely befuddled with regard to de­ rivative risks. Some of the reporting standards a re being changed ( over rhe opposition of both Greenspan and the banks), b u t gaping holes remain. As the usc of derivatives grows, this deficiency will re­ turn to haunt us. Moreover, aside from improving reporting on derivatives, there is a strong a rg u ment to he made for restricting actual exposure. Regu­ lators limit the amount that Chase M a nhattan and Citibank can lend, so that their loans do not exceed a certain ratio of capita l . The regu­ lators do this for good reason: hanks have repeatedly shown that they will exceed the l imits of prudence if they can. W h y, then, does Greenspan endorse a system in which banks can rack up any amount of exposure that they choose-as long as that exposu re is in the form of derivatives ? The fed's two-headed policy-head in the sand before a crisis, in­ tervention a fter rhc fact-is more misguided when viewed as one single pol icy. The gouernment's emphasis should always be on pre­ vention, not on active interuention. It is a ltogether proper that the government set r u les in advance for regulated bodies such as banks; crisis intervention on behalf of u nregulated hedge funds is another matter.

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The White House formed a blue-ri bbon panel, the President's Working Group on Financial M arkets, a mu lriagency group ( includ­ ing the Fed ) to study the Long-Term debacle. Its report concluded, "The central public policy issue raised by the LTC M episode is how ro constra in excessive leverage more effectively. " :vtoreover, it recog­ nized the growing role of derivatives, noting, " Ba lance-sheet leverage by itself is not an adequate measure of risk . " , . However, the report was weaker when it came to proposing sol utions. It did ca l l for en­ hanced disclosure by hedge funds, better risk and credi t ma nagement policies by hanks, and tougher regulatory standards. But the cau­ tiously worded report, which was issued in April I 999, did not have the fire to provoke action from Congress, which in any case was rapidly losing interest in Long-Term. " Last Septem ber and October, it was a hot issue," David Runkel, a spokesman for the House Bank­ i ng Committee, noted the s u m mer a fter the crisis. "But not now. " "· The fur o r over hedge funds a lso d ied down-a nd a ppropriately so. The Long-Term crisis happened to i nvolve a hedge fund, hut the fa­ thers of the crisis were the big Wal l Street banks, w h ich let their stan­ dards grow lax as their pocketbooks grew fl ush. At the time of the hailour, the hanks were depicted as victims that had been kept i n the dark by Long-Term's patented secrecy. Such a v iew was enhanced by various hankers' assertions o f in nocence. ( K omansky, for one, called a friend upon leaving the Federal Reserve and decla red, " When I saw their position, my fucking k nee<; were shaking. " ) With time, such claims rang increasingly hollow. Each bank had k nown its own ex­ posure to Long-Term trade by trade; it did not take geni u s for them to infer that the fu nd was doing similar business elsewhere. Patrick Parkinson, a Fed official assigned to the President's Work­ ing G roup, told a Senate com m ittee a couple of months after the res­ cue: LTC::\1 appears to have received very generous credit terms, even though it took an exceptional degree of risk . . . . Counter­ parties obtained information from LTC::\1 that indicated that i t h a d securities and derivatives positions that were very large rel ­ ative to its capital. However, few, i f any, seem t o h a ve rea l l y u n ­ derstood LTC::vt's r i s k profile. ' So the q uestion becomes, why did the bankers lend? In a public symposi u m early in 1 9 9 9 , Walter Wei ner, the former chairman of Rc-

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publ ic, m a i nt a ined that the han k s had had n o choice-or at least, no choice other than the rare, courageous one of rejecting business: "To enter the c l u b, you had to play by lTCM 's rules. The terms were non­ negotiable-take it or leave it. " " The banks took it. They, too, were greedy, and they were awed by Long-Term's performance and dazzled by the pa rtners' reputations, degrees, and celebrity. " We may have been mesmeri zed by these supermen," Weiner acknowledged. Unique in Wal l Street h istory, the fund had blazed across the financial skies like a lumi nous rocket, a half-man, h a l f-mach ine that seemingly re­ duced an uncertain world to rigorous, cold-blooded odds. Like visi­ tors from a remote future, the professors seemed to have superseded the random luck and ill fare that had ever lurked in the shadows of markets . •

Long-Term's saga of riches to rags was replete with lessons for in­ vestors. Its asto nishing profits looked less impressive in the l ight of the losses that followed. As with a n insurer who collects heady pre­ miums hut gives them back when a big storm h its, Long-Term's prof­ its were not, in a sense, all "earned"; in part, they were borrowed against the d a y when the cycle would turn . :\'o investment-Internet wunderkinds included-can be j u dged on the basis of h a l f a cycle alone. I ndeed, Long-Term saw that the cycle was turning but inexplicably refused to prune its exposures. As spreads narrowed, i nevitably rais­ ing the risks i n the business, Long-Term increased i ts leverage, as if borrowi ng could turn an unattractive business i nto a better one rather than j ust a riskier one. Long-Term wouldn't have made this mistake but for a major managerial wea kness: the absence of any i ndependent check on the traders. In the end, every partner had sat through the risk-management meetings, and every one, u ltimately, had acquiesced in the trades. In that sense, every partner was to blame. Long-Term put supreme trust i n diversification-one of the shib­ boleths of modern i n vesting, but an overrated one. As Keynes noted, one bet soun d l y considered is preferable to many poorly u nderstood. The Long-Term episode proved that eggs in separate baskets can break simultaneously. Moreover, Long-Term fooled itself i n to think­ ing it had d iversified i n substance w hen, in fact, it had done so only in form. Basically, the fund made the same bet on l ower-rated bond\

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in every i maginable permutation . It is hardly a surprise that when the cycle turned and credit tightened-as, throughout recorded time, it periodically h as-Long-Term's trades fell in lockstep. It is interesting to compare Long-Term's losses from various cate­ gories of trades from January I, 1 9 9 8 , to the bailout : ' ' Russia a n d other emerging markets: $4 3 0 m i l lion D i rectional trades in developed countries (such as shorting Japanese bonds): $ 3 7 1 m i l l ion Equity pairs (such as Volkswagen and Shel l ) : $ 2 8 6 m i llion Yield-curve arbitrage: $ 2 1 5 m i l l ion Standard & Poor's 5 00 stocks: $ 20.� million High-yield ( j unk bond) arbitrage: $ I oo m i l l ion Merger arbitrage: Roughly even These seven categories accounted for $ 1 . 6 billion in losses-a cat­ astrophic result. However, Long-Term could have survived them. N ow consider the losses in its two biggest trades: Swaps: $ 1 . 6 billion Equity volatility: $ 1 . 3 b i l l i on It was these two trades that broke the firm. Long-Term got far too big in these markets-a cautionary error. It got so big that it distorted the very markets on whose efficiency the firm relied. This wouldn't have mattered but for the fact that Long-Term also leveraged its cap­ ital 30 to 1 -again, in addition to the huge leverage implicit i n its de­ rivatives book. One can be big ( and therefore i l liquid); one can ( with in prudent limits) be leveraged. But the investor who is highly leveraged and illiquid is playing R ussian roulette, for he must he right a bout the market not mere l y a t the end, hut every single day. ( O ne wrong day, and he is out of business . ) Long-Term was so self-certain as to believe that the markets would neuer-not even for a wild swing some August and September-stray so far from its predictions. Reared on Merton's and Scholes's teachings of efficient markets, the professors actually believed that prices would go and go directly where the models said they should. The professors' conceit was to think that models could forecast the limits of behavior. In fact, the models could tel l them what was reasonable or what was predictable based on the past. The professors overlooked the fact that people, traders included, are not always reasonable. This i s the true lesson of Long-Term's demise. No matter what the models say, traders are not

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machines gu ided by s i l icon chips; they are i mpressionable and i m i ta­ tive; they run i n flocks and retreat i n hordes. Even when traders get things " right," markets can hardly be ex­ pected to oscil late with the precision of sine waves. Prices and spreads vary with the uncertain progress of compan ies, governments, and even civil izations. They arc no more certain than the societies whose economic activity they reflect. D ice are predictable down to the dec­ imal point; Russia is not; how traders w i l l respond to Russia is less predictable sti l l . U n l i ke dice, m arkets are subject not merel y to risk, an arithmetic concept, but also to the broader uncertainty that shad­ ows the future general l y. Unfortunately, uncertainty, as opposed to risk, is an indefinite condition, one that does not conform to n u mer­ ical straitj ackets. The professors blurred this crucial d istinction; they sent their mathematical Frankenstein gamely i nto the world as if it cou l d tame the element of chance in l i fe itsel f. N o self-doubt tempered them; no sense of perspective checked them as they wagered s uch staggering sums. The supreme i rony is that the professors were trying to deconstruct and ultimately to mini mize risk, not-they believed-to speculate on overcoming it. In this, the fund was not unique. Long-Term was in fact the q u i n tessential fund of the late twentieth century-an ex­ periment in h a rnessing the markets to the twin new discip l i nes of financial econom ics and computer progra mming. The belief that to­ morrow's risks can be inferred from yesterday's prices and volatil ities prevai l s at v i rtually every investment bank and trading des k . This was Long-Term's basic mistake, and its stunni ng losses betrayed the flaw at the very heart-the very brain-of modern fin ance. None other than �lerri l l Lynch observed in its annual report for 1 99 8 , " Merr i l l Lynch uses mathematical risk models to help estimate its exposure to m a rket ris k . " In a phrase that suggested some s light dawni ng awareness of the dangers i n such models, the bank added that they " m a y provide a greater sense of security than warranted; therefore, rel i a nce on these models should be limited . " ·''' If Wal l Street is to learn j ust one lesson from the Long-Term debacle, it should be that. The next time a Merton proposes an elegant model to manage risks and foretell odds, the next time a computer with a perfect mem­ ory of the past is said to quan tify risks in the future, i nvestors should run-and quickly-the other way. On Wal l Street, though, few lessons remain learned. In f\: m·c1nhn

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I 999, J W M Partners-the principals were Meriwether, Haghani, Hilibrand, Leahy, Rosenfeld, and Arj un K rishnamachar-circulated an offering document for " Relative Value Opportunity Fund I I . " Ac­ cording to the circular, leverage in their new fund would be held to a relatively modest I 5 to I , discipline would be tighter, and the firm would make use of a " risk control system" that had been designed "to help ensure to the extent practicable that the Portfolio Company can withstand extreme events o f the type experienced in I 9 9 8 . " Whether any mathematical system designed with a previous crisis i n mind c a n ensure against future debacles is doubtful, but for �1eri­ wether, the successful launch of J W M was yet another astonishing comeback, the sort for which Wal l Street is justly famous. In Decem­ ber, fifteen months after he l ost $ 4 . 5 billion in an epic bust that seemed a bout to take down all of Wal l Street and more with him, Meriwether raised $ 2 50 m i l lion, m uch of it from former investors in the ill-fated Long-Term Capital, and he was off and runn ing again.

Notes

Epigraph: Henry T. C:. Hu, " M isunderstood Derivatives: The Ca uses of Informational failure and the Promise of Regulatory Incremental­ ism," The Yale l.aw Journal, I 0 2, no. 6 ( April 1 99 .> ) . 1 4 77.

1

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Meriwether

Author interview with Thomas E. Creevy. Gretchen Morgenson, "The !vtan Behind the Curtain," The New York Times, October 2, I 9 9 8 . 3 · Ibid. 4· !vtichael Lewis, Liar's Poker ( New York: Penguin, I 9 8 9 ), I 5 . 5 . Roger Lowenstein, Buffett: The Making of a n A merican Capitalist ( :\:ew York: Random House, 1 9 9 5 ) , 3 7 r , note. Lewis himself backed away from the talc in a subsequent New York Times Magazine piece, saying only that Meriwether had "supposedly" issued the challenge; see Michael Lewis, " How the Eggheads Cracked," The New York Times Magazine, January 2 4, r 9 9 9 · 6. Morgenson, "The M a n Behind the Curtain." 7· Author interviews with Mitchell Kapor and William Sahlman. I.

2.