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

* (#ulink_a67baa07-afe4-523f-97f5-5c0834620229) The Securities and Exchange Commission filed a civil complaint charging that Meriwether had failed to properly supervise Mozer. Without admitting or denying guilt, Meriwether settled the case, agreeing to a three-month suspension from the securities industry and a $50,000 fine.

2 HEDGE FUND (#ulink_2554231f-38a0-5444-9c0d-fe07e267f02c)

I love a hedge, sir. —HENRY FIELDING, 1736

Prophesy as much as you like, but always hedge. –OLIVER WENDELL HOLMES, 1861

BY THE EARLY 1990s, as Meriwether began to resuscitate his career, investing had entered a golden age. More Americans owned investments than ever before, and stock prices were rising to astonishing heights. Time and again, the market indexes soared past once unthinkable barriers. Time and again, new records were set and old standards eclipsed. Investors were giddy, but they were far from complacent. It was a golden age, but also a nervous one. Americans filled their empty moments by gazing anxiously at luminescent monitors that registered the market’s latest move. Stock screens were everywhere—in gyms, at airports, in singles bars. Pundits repeatedly prophesied a correction or a crash; though always wrong, they were hard to ignore. Investors were greedy but wary, too. People who had gotten rich beyond their wildest dreams wanted a place to reinvest, but one that would not unduly suffer if—or when—the stock market finally crashed.

And there were plenty of rich people about. Thanks in large part to the stock market boom, no fewer than 6 million people around the world counted themselves as dollar millionaires, with a total of $17 trillion in assets.

(#litres_trial_promo) For these lucky 6 million, at least, investing in hedge funds had a special allure.

As far as securities law is concerned, there is no such thing as a hedge fund. In practice, the term refers to a limited partnership, at least a small number of which have operated since the 1920s. Benjamin Graham, known as the father of value investing, ran what was perhaps the first. Unlike mutual funds, their more common cousins, these partnerships operate in Wall Street’s shadows; they are private and largely unregulated investment pools for the rich. They need not register with the Securities and Exchange Commission, though some must make limited filings to another Washington agency, the Commodity Futures Trading Commission. For the most part, they keep the contents of their portfolios hidden. They can borrow as much as they choose (or as much as their bankers will lend them—which often amounts to the same thing). And, unlike mutual funds, they can concentrate their portfolios with no thought to diversification. In fact, hedge funds are free to sample any or all of the more exotic species of investment flora, such as options, derivatives, short sales, extremely high leverage, and so forth.

In return for such freedom, hedge funds must limit access to a select few investors; indeed, they operate like private clubs. By law, funds can sign up no more than ninety-nine investors, people, or institutions each worth at least $1 million, or up to five hundred investors, assuming that each has a portfolio of at least $5 million. The implicit logic is that if a fund is open to only a small group of millionaires and institutions, agencies such as the SEC need not trouble to monitor it. Presumably, millionaires know what they are doing; if not, their losses are nobody’s business but their own.

Until recently, hedge fund managers were complete unknowns. But in the 1980s and ’90s, a few large operators gained notoriety, most notably the émigré currency speculator George Soros. In 1992, Soros’s Quantum Fund became celebrated for “breaking” the Bank of England and forcing it to devalue the pound (which he had relentlessly sold short), a coup that netted him a $1 billion profit. A few years later, Soros was blamed—perhaps unjustifiably—for forcing sharp devaluations in Southeast Asian currencies. Thanks to Soros and a few other high-profile managers, such as Julian Robertson and Michael Steinhardt, hedge fund operators acquired an image of daring buccaneers capable of roiling markets. Steinhardt bragged that he and his fellows were one of the few remaining bastions of frontier capitalism.

(#litres_trial_promo) The popular image was of swashbuckling risk takers who captured outsized profits or suffered horrendous losses; the 1998 Webster’s College Dictionary defined hedge funds as those that use “high-risk speculative methods.”

Despite their bravura image, however, most hedge funds are rather tame; indeed, that is their true appeal. The term “hedge fund” is a colloquialism derived from the expression “to hedge one’s bets,” meaning to limit the possibility of loss on a speculation by betting on the other side. This usage evolved from the notion of the common garden hedge as a boundary or limit and was used by Shakespeare (“England hedg’d in with the maine”

(#litres_trial_promo)). No one had thought to apply the term to an investment fund until Alfred Winslow Jones, the true predecessor of Meriwether, organized a partnership in 1949.

(#litres_trial_promo) Though such partnerships had long been in existence, Jones, an Australian-born Fortune writer, was the first to run a balanced, or hedged, portfolio. Fearing that his stocks would fall during general market slumps, Jones decided to neutralize the market factor by hedging—that is, by going both long and short. Like most investors, he bought stocks he deemed to be cheap, but he also sold short seemingly overpriced stocks. At least in theory, Jones’s portfolio was “market neutral.” Any event—war, impeachment, a change in the weather—that moved the market either up or down would simply elevate one half of Jones’s portfolio and depress the other half. His net return would depend only on his ability to single out the relative best and worst.

This is a conservative approach, likely to make less but also to lose less, which appealed to the nervous investor of the 1990s. Eschewing the daring of Soros, most modern hedge funds boasted of their steadiness as much as of their profits. Over time, they expected to make handsome returns but not to track the broader market blip for blip. Ideally, they would make as much as or more than generalized stock funds yet hold their own when the averages suffered.

At a time when Americans compared investment returns as obsessively as they once had soaring home prices, these hedge funds—though dimly understood—attained a mysterious cachet, for they had seemingly found a route to riches while circumventing the usual risks. People at barbecues talked of nothing but their mutual funds, but a mutual fund was so—common! For people of means, for people who summered in the Hamptons and decorated their homes with Warhols, for patrons of the arts and charity dinners, investing in a hedge fund denoted a certain status, an inclusion among Wall Street’s smartest and savviest. When the world was talking investments, what could be more thrilling than to demurely drop, at court-side, the name of a young, sophisticated hedge fund manager who, discreetly, shrewdly, and auspiciously, was handling one’s resources? Hedge funds became a symbol of the richest and the best. Paradoxically, the princely fees that hedge fund managers charged enhanced their allure, for who could get away with such gaudy fees except the exceptionally talented? Not only did hedge fund managers pocket a fat share of their investors’ profits, they greedily claimed a percentage of the assets.

For such reasons, the number of hedge funds in the United States exploded. In 1968, when the SEC went looking, it could find only 215 of them.

(#litres_trial_promo) By the 1990s there were perhaps 3,000 (no one knows the exact number), spread among many investing styles and asset types. Most were small; all told, they held perhaps $300 billion in capital, compared with $3.2 trillion in equity mutual funds.

(#litres_trial_promo) How-ever, investors were hungry for more. They were seeking an alternative to plain vanilla that was both bold and safe: not the riskiest investing style but the most certain; not the loudest, merely the smartest. This was exactly the sort of hedge fund Meriwether had in mind.

Emulating Alfred Jones, Meriwether envisioned that Long-Term Capital Management would concentrate on “relative value” trades in bond markets. Thus, Long-Term would buy some bonds and sell some others. It would bet on spreads between pairs of bonds to either widen or contract. If interest rates in Italy were significantly higher than in Germany, meaning that Italy’s bonds were cheaper than Germany’s, a trader who invested in Italy and shorted Germany would profit if, and as, this differential narrowed. This is a relatively low-risk strategy. Since bonds usually rise and fall in sync, spreads don’t move as much as the bonds themselves. As with Jones’s fund, Long-Term would in theory be unaffected if markets rose or fell, or even if they crashed.

But there was one significant difference: Meriwether planned from the very start that Long-Term would leverage its capital twenty to thirty times or even more. This was a necessary part of Long-Term’s strategy, because the gaps between the bonds it intended to buy and those it intended to sell were, most often, minuscule. To make a decent profit on such tiny spreads, Long-Term would have to multiply its bet many, many times by borrowing. The allure of this strategy is apparent to anyone who has visited a playground. Just as a seesaw enables a child to raise a much greater weight than he could on his own, financial leverage multiplies your “strength”—that is, your earning power—because it enables you to earn a return on the capital you have borrowed as well as on your own money. Of course, your power to lose is also multiplied. If for some reason Long-Term’s strategy ever failed, its losses would be vastly greater and accrue more quickly; indeed, they might be life-threatening—an eventuality that surely seemed remote.

Early in 1993, Meriwether paid a call on Daniel Tully, chairman of Merrill Lynch. Still anxious about the unfair tarnish on his name from the Mozer affair, J.M. immediately asked, “Am I damaged goods?” Tully said he wasn’t. Tully put Meriwether in touch with the Merrill Lynch people who raised capital for hedge funds, and shortly thereafter, Merrill agreed to take on the assignment of raising capital for Long-Term.

J.M.’s design was staggeringly ambitious. He wanted nothing less than to replicate the Arbitrage Group, with its global reach and ability to take huge positions, but without the backing of Salomon’s billions in capital, credit lines, information network, and seven thousand employees. Having done so much for Salomon, he was bitter about having been forced into exile under a cloud and eager to be vindicated, perhaps by creating something better.

And Meriwether wanted to raise a colossal sum, $2.5 billion. (The typical fund starts with perhaps 1 percent as much.) Indeed, everything about Long-Term was ambitious. Its fees would be considerably higher than average. J.M. and his partners would rake in 25 percent of the profits, in addition to a yearly 2 percent charge on assets. (Most funds took only 20 percent of profits and 1 percent on assets.) 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 investors commit for at least three years, an almost unheard-of lockup in the hedge fund world. The lockup made sense; if fickle markets turned against it, Long-Term would have a cushion of truly “long-term” capital; it would be the bank that could tell depositors, “Come back tomorrow.” Still, it was asking investors to show enormous trust—particularly since J.M. did not have a formal track record to show them. While it was known anecdotally that Arbitrage had accounted for most of Salomon’s recent earnings, the group’s profits hadn’t been disclosed. Even investors who had an inkling of what Arbitrage had earned had no understanding of how it had earned it. The nuts and bolts—the models, the spreads, the exotic derivatives—were too obscure. Moreover, people had serious qualms about investing with Meriwether so soon after he had been sanctioned by the SEC in the Mozer affair.

As Merrill began to chart a strategy for raising money, J.M.’s old team began to peel off from Salomon. Eric Rosenfeld left early in 1993. Victor Haghani, the Iranian Sephardi, was next; he got an ovation on Salomon’s trading floor when he broke the news. In July, Greg Hawkins quit. Although J.M. still lacked Hilibrand, who was ambivalent in the face of Salomon’s desperate pleas that he stay, Meriwether was now hatching plans with a nucleus of his top traders. He still felt a strong loyalty to his former colleagues, and he touchingly offered the job of nonexecutive chairman to Gutfreund, Salomon’s fallen chief—on the condition that Gutfreund give up an acrimonious fight that he was waging with Salomon for back pay. Though overlooked, Gutfreund had played a pivotal role in the Arbitrage Group’s success: he had been the brake on the traders’ occasional tendencies to overreach. But it was not to be. At Long-Term, J.M. would have to restrain his own disciples.

In any case, J.M. wanted more cachet than Gutfreund or even his talented but unheralded young arbitrageurs could deliver. He needed an edge—something to justify his bold plans with investors. He had to recast his group, to showcase them as not just a bunch of bond traders but as a grander experiment in finance. This time, it would not do to recruit an unknown assistant professor—not if he wanted to raise $2.5 billion. This time, Meriwether went to the very top of academia. Harvard’s Robert C. Merton was the leading scholar in finance, considered a genius by many in his field. He had trained several generations of Wall Street traders, including Eric Rosenfeld. In the 1980s, Rosenfeld had persuaded Merton to become a consultant to Salomon, so Merton was already friendly with the Arbitrage Group. More important, Merton’s was a name that would instantly open doors, not only in America but also in Europe and Asia.

Merton was the son of a prominent Columbia University social scientist, Robert K. Merton, who had studied the behavior of scientists. Shortly after his son was born, Merton père coined the idea of the “self-fulfilling prophecy,” a phenomenon, he suggested, that was illustrated by depositors who made a run on a bank out of fear of a default—for his son, a prophetic illustration.

(#litres_trial_promo) The younger Merton, who grew up in Hastings-on-Hudson, outside New York City, showed a knack for devising systematic approaches to whatever he tackled. A devotee of baseball and cars, he studiously memorized first the batting averages of players and then the engine specs of virtually every American automobile.

(#litres_trial_promo) Later, when he played poker, he would stare at a lightbulb to contract his pupils and throw off opponents. As if to emulate the scientists his father studied, he was already the person of whom a later writer would say that he “looked for order all around him.”

(#litres_trial_promo)

While he was an undergrad at Cal Tech, another interest, investing, blossomed. Merton often went to a local brokerage at 6:30 A.M., when the New York markets opened, to spend a few hours trading and watching the market. Providentially, he transferred to MIT to study economics. In the late 1960s, economists were just beginning to transform finance into a mathematical discipline. Merton, working under the wing of the famed Paul Samuelson, did nothing less than invent a new field. Up until then, economists had constructed models to describe how markets look—or in theory should look—at any point in time. Merton made a Newtonian leap, modeling prices in a series of infinitesimally tiny moments. He called this “continuous time finance.” Years later, Stan Jonas, a derivatives specialist with the French-owned Société Générale, would observe, “Most everything else in finance has been a footnote on what Merton did in the 1970s.” His mimeographed blue lecture notes became a keepsake.

In the early 1970s, Merton tackled a problem that had been partially solved by two other economists, Fischer Black and Myron S. Scholes: deriving a formula for the “correct” price of a stock option. Grasping the intimate relation between an option and the underlying stock, Merton completed the puzzle with an elegantly mathematical flourish. Then he graciously waited to publish until after his peers did; thus, the formula would ever be known as the Black-Scholes model. Few people would have cared, given that no active market for options existed. But coincidentally, a month before the formula appeared, the Chicago Board Options Exchange had begun to list stock options for trading. Soon, Texas Instruments was advertising in The Wall Street Journal, “Now you can find the Black-Scholes value using our … calculator.”

(#litres_trial_promo) This was the true beginning of the derivatives revolution. Never before had professors made such an impact on Wall Street.

In the 1980s, Meriwether and many other traders became accustomed to trading these newfangled instruments just as they did stocks and bonds. As opposed to actual securities, derivatives were simply contracts that derived (hence the name) their value from stocks, bonds, or other assets. For instance, the value of a stock option, the right to purchase a stock at a specific price and within a certain time period, varied with the price of the underlying shares.

Merton jumped at the opportunity to join Long-Term Capital because it seemed a chance to showcase his theories in the real world. Derivatives, he had recently been arguing, had blurred the lines between investment firms, banks, and other financial institutions. In the seamless world of derivatives, a world that Merton had helped to invent, anyone could assume the risk of loaning money, or of providing equity, simply by structuring an appropriate contract. It was function that mattered, not form. This had already been proved in the world of mortgages, once supplied exclusively by local banks and now largely funded by countless disparate investors who bought tiny pieces of securitized mortgage pools.

Indeed, Merton saw Long-Term Capital not as a “hedge fund,” a term that he and the other partners sneered at, but as a state-of-the-art financial intermediary that provided capital to markets just as banks did. The bank on the corner borrowed from depositors and lent to local residents and businesses. It matched its assets—that is, its loans—with liabilities, attempting to earn a tiny spread by charging borrowers a slightly higher interest rate than it paid to depositors. Similarly, Long-Term Capital would “borrow” by selling one group of bonds and lend by purchasing another—presumably bonds that were slightly less in demand and that therefore yielded slightly higher interest rates. Thus, the fund would earn a spread, just like a bank. Though this description is highly simplified, Long-Term, by investing in the riskier (meaning higher-yielding) bonds, would be in the business of “providing liquidity” to markets. And what did a bank do but provide liquidity? Thanks to Merton, the nascent hedge fund began to think of itself in grander terms.

Unfortunately, Merton was of little use in selling the fund. He was too serious-minded, and he was busy with classes at Harvard. But in the summer of 1993, J.M. recruited a second academic star: Myron Scholes. Though regarded as less of a heavyweight by other academics, Scholes was better known on Wall Street, thanks to the Black-Scholes formula. Scholes had also worked at Salomon, so he, too, was close to the Meriwether group. 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 Michael Jordan and Muhammad Ali on the same team. “This was mystique taken to a very high extreme,” said a money manager who ultimately invested in the fund.

In the fall of 1993, Merrill Lynch launched a madcap drive to recruit investors. Big-ticket clients were ferried by limousine to Merrill’s headquarters, at the lower tip of Manhattan, where they were shown a presentation on the fund, sworn to secrecy and then returned to their limos. Then, Merrill and various groups of partners took their show on the road, making stops in Boston, Philadelphia, Tallahassee, Atlanta, Chicago, St. Louis, Cincinnati, Madison, Kansas City, Dallas, Denver, Los Angeles, Amsterdam, London, Madrid, Paris, Brussels, Zurich, Rome, Sao Paulo, Buenos Aires, Tokyo, Hong Kong, Abu Dhabi, and Saudi Arabia. Long-Term set a minimum of $10 million per investor.

The road show started badly. J.M. was statesmanlike but reserved, as if afraid that anything he said would betray the group’s secrets. “People all wanted to see J.M., but J.M. never talked,” Merrill’s Dale Meyer griped. The understated Rosenfeld was too low-key; he struck one investor as nearly comatose. Greg Hawkins, a former pupil of Merton, was the worst—full of Greek letters denoting algebraic symbols. The partners didn’t know how to tell a story; they sounded like math professors. Even the fund’s name lacked pizzazz; only the earnest Merton liked it. Investors had any number of reasons to shy away. Many were put off by J.M.’s unwillingness to discuss his investment strategies. Some were frightened by the prospective leverage, which J.M. was careful to disclose. Institutions such as the Rockefeller Foundation and Loews Corporation balked at paying such high fees. Long-Term’s entire premise seemed untested, especially to the consultants who advise institutions and who decide where a lot of money gets invested.

Meriwether, who was continually angling to raise Long-Term’s pedigree, went to Omaha for a steak dinner with Buffett, knowing that if Buffett invested, others would, too. The jovial billionaire was his usual self—friendly, encouraging, and perfectly unwilling to write a check.

Rebuffed by the country’s richest investor, J.M. approached Jon Corzine, who had long envied Meriwether’s unit at Salomon and who was trying to build a rival business at Goldman Sachs. Corzine dangled the prospect of Goldman’s becoming a big investor or, perhaps, of its taking Meriwether’s new fund in-house. Ultimately, it did neither. Union Bank of Switzerland took a long look, but it passed, too. Not winning these big banks hurt. Despite his bravura, J.M. was worried about being cut out of the loop at Salomon. He badly wanted an institutional anchor.

Turning necessity to advantage, J.M. next pursued a handful of foreign banks to be Long-Term’s quasi partners, to give the fund an international gloss. Each partner—J.M. dubbed them “strategic investors”—would invest $100 million and share inside dope about its local market. In theory, at least, Long-Term would reciprocate. The plan was pure Meriwether, flattering potential investors by calling them “strategic.” Merton loved the idea; it seemed to validate his theory that the old institutional relationships could be overcome. It opened up a second track, with J.M. independently courting foreign banks while Merrill worked on recruiting its clients.

Merrill moved the fund-raising forward by devising an ingenious system of “feeders” that enabled Long-Term to solicit funds from investors in every imaginable tax and legal domain. One feeder was for ordinary U.S. investors; another for tax-free pensions; another for Japanese who wanted their profits hedged in yen; still another for European institutions, which could invest only in shares that were listed on an exchange (this feeder got a dummy listing on the Irish Stock Exchange).

The feeders didn’t keep the money; they were paper conduits that channeled the money to a central fund, known as Long-Term Capital Portfolio (LTCP), a Cayman Islands partnership. For all practical purposes, Long-Term Capital Portfolio was the fund: it was the entity that would buy and sell bonds and hold the assets. The vehicle that ran the fund was Long-Term Capital Management (LTCM), a Delaware partnership owned by J.M., his partners, and some of their spouses. Though such a complicated organization might have dissuaded others, it was welcome to the partners, who viewed their ability to structure complex trades as one of their advantages over other traders. Physically, of course, the partners were nowhere near either the Caymans or Delaware but in offices in Greenwich, Connecticut, and London.

The partners got a break just as they started the marketing. They were at the office of their lawyer, Thomas Bell, a partner at Simpson Thacher & Bartlett, when Rosenfeld excitedly jumped up and said, “Look at this! Do you see what Salomon did?” He threw down a piece of paper—Salomon’s earnings statement. The bank had finally decided to break out the earnings from Arbitrage, so Long-Term could now point to its partners’ prior record. Reading between the lines, it was clear that J.M.’s group had been responsible for most of Salomon’s previous profits—more than $500 million a year during his last five years at the firm. However, even this was not enough to persuade investors. And despite Merrill’s pleading, the partners remained far too tight-lipped about their strategies. Long-Term even refused to give examples of trades, so potential investors had little idea of what the partners were proposing. Bond arbitrage wasn’t widely understood, after all.

Edson Mitchell, the chain-smoking Merrill executive who oversaw the fund-raising, was desperate for J.M. to open up; it was as if J.M. had forgotten that he was the one asking for money. Even in private sessions with Mitchell, J.M. wouldn’t reveal the names of the banks he was calling; he treated every detail like a state secret. With such a guarded client, Mitchell couldn’t even sell the fund to his own bosses. Although Mitchell suggested that Merrill become a strategic partner, David Komansky, who oversaw capital markets for Merrill, warily refused. He agreed to invest Merrill’s fee, about $15 million, but balked at putting in more.

At one point during the road show, a group including Scholes, Hawkins, and some Merrill people took a grueling trip to Indianapolis to visit Conseco, a big insurance company. They arrived exhausted. Scholes started to talk about how Long-Term could make bundles even in relatively efficient markets. Suddenly, Andrew Chow, a cheeky thirty-year-old derivatives trader, blurted out, “There aren’t that many opportunities; there is no way you can make that kind of money in Treasury markets.” Chow, whose academic credentials consisted of merely a master’s in finance, seemed not at all awed by the famed Black-Scholes inventor. Furious, Scholes angled forward in his leather-backed chair and said, “You’re the reason—because of fools like you we can.”

(#litres_trial_promo) The Conseco people got huffy, and the meeting ended badly. Merrill demanded that Scholes apologize. Hawkins thought it was hilarious; he was holding his stomach laughing.

But in truth, Scholes was the fund’s best salesman. Investors at least had heard of Scholes; a couple had even taken his class. And Scholes was a natural raconteur, temperamental but extroverted. He used a vivid metaphor to pitch the fund. Long-Term, he explained, would be earning a tiny spread on each of thousands of trades, as if it were vacuuming up nickels that others couldn’t see. He would pluck a nickel seemingly from the sky as he spoke; a little show-manship never hurt. Even when it came to the fund’s often arcane details, Scholes could glibly waltz through the math, leaving most of his prospects feeling like humble students. “They used Myron to blow you away,” said Maxwell Bublitz, head of Conseco’s investment arm.