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

The son of an Ontario dentist, Scholes was an unlikely scholar. Relentlessly entrepreneurial, he and his brother had gotten involved in a string of business ventures, such as publishing, and selling satin sheets.

(#litres_trial_promo) After college, in 1962, the restless Scholes got a summer job as a computer programmer at the University of Chicago, despite knowing next to nothing about computers. The business school faculty had just awakened to the computer’s power, and was promoting data-based research, in particular studies based on stock market prices. Scholes’s computer work was so invaluable that the professors urged him to stick around and take up the study of markets himself.

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As it happened, Scholes had landed in a cauldron of neoconservative ferment. Scholars such as Eugene F. Fama and Merton H. Miller were developing what would become the central idea in modern finance: the Efficient Market Hypothesis. The premise of the hypothesis is that stock prices are always “right”; therefore, no one can divine the market’s future direction, which, in turn, must be “random.” For prices to be right, of course, the people who set them must be both rational and well informed. In effect, the hypothesis assumes that every trading floor and brokerage office around the world—or at least enough of them to determine prices—is staffed by a race of calm, collected Larry Hilibrands, who never pay more, never pay less than any security is “worth.” According to Victor Niederhoffer, who studied with Scholes at Chicago and would later blow up an investment firm of his own, Scholes was part of a “Random Walk Cosa Nostra,” one of the disciples who methodically rejected any suggestion that markets could err. Swarthy and voluble, Scholes once lectured a real estate agent who urged him to buy in Hyde Park, near the university, and who claimed that housing prices in the area were supposed to rise by 12 percent a year. If that were true, Scholes shot back, people would buy all the houses now. Despite his credo, Scholes was never fully convinced that he couldn’t beat the market. In the late 1960s, he put his salary into stocks and borrowed to pay his living expenses. When the market plummeted, he had to beg his banker for an extension to avoid being forced to sell at a heavy loss. Eventually, his stocks recovered—not the last time a Long-Term partner would learn the value of a friendly banker.

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While Merton was the consummate theoretician, Scholes was acclaimed for finding ingenious ways of testing theories. He was as argumentative as Merton was reserved, feverishly promoting one brainstorm after the next, most of which were unlikely to see the light of day but which often showed a creative spark. With his practical bent, he made a real contribution to Salomon, where he set up a derivative-trading subsidiary. And Scholes was a foremost expert on tax codes, both in the United States and overseas. He regarded taxes as a vast intellectual game: “No one actually pays taxes,” he once snapped disdainfully.

(#litres_trial_promo) Scholes could not believe there were people who would not go to extremes to avoid paying taxes, perhaps because they did not fit the Chicago School model of human beings as economic robots. At Long-Term, Scholes was the spearhead of a clever plan that let the partners defer their cut of the profits for up to ten years in order to put off paying taxes. He harangued the attorneys with details, but the partners tended to forgive his hot flashes. They were charmed by Scholes’s energy and joie de vivre. He was perpetually reinventing himself, taking up new sports such as skiing and—on account of Meriwether—golf, which he played with passion.

With Scholes on board, the marketing campaign gradually picked up steam. The fund dangled a tantalizing plum before investors, who were told that annual returns on the order of 30 percent (after the partners took their fees) would not be out of reach. Moreover, though the partners stated clearly that risk was involved, they stressed that they planned to diversify. With their portfolio spread around the globe, they felt that their eggs would be safely scattered. Thus, no one single market could pull the fund down.

The partners doggedly pursued the choicest investors, often inviting prospects back to their pristine headquarters on Steamboat Road, at the water’s edge in Greenwich. Some investors met with partners as many as seven or eight times. In their casual khakis and golf shirts, the partners looked supremely confident. The fact was, they had made a ton of money at Salomon, and investors warmed to the idea that they could do it again. In the face of such intellectual brilliance, investors—having little understanding of how Meriwether’s gang actually operated—gradually forgot that they were taking a leap of faith. “This was a constellation of people who knew how to make money,” Raymond Baer, a Swiss banker (and eventual investor), noted. By the end of 1993, commitments for money were starting to roll in, even though the fund had not yet opened and was well behind schedule. The partners’ morale got a big boost when Hilibrand finally defected from Salomon and joined them. Merton and Scholes might have added marketing luster, but Hilibrand was the guy who would make the cash register sing.

J.M. also offered partnerships to two of his longtime golfing cronies, Richard F. Leahy, an executive at Salomon, and James J. McEntee, a close friend who had founded a bond-dealing firm. Neither fit the mold of Long-Term’s nerdy traders. Leahy, an affable, easygoing salesman, would be expected to deal with Wall Street bankers—not the headstrong traders’ strong suit. McEntee’s role, though, was a puzzle. After selling his business, he had lived in high style, commuting via helicopter to a home in the Hamptons and jetting to an island in the Grenadines, which had earned him the sobriquet “the Sheik.” In contrast to the egghead arbitrageurs, the Bronx-born McEntee was a traditionalist who traded from his gut. But Meriwether liked having such friends around; bantering with these pals, he was relaxed and even gregarious. Not coincidentally, Leahy and McEntee were fellow Irish Americans, a group with whom J.M. always felt at home. Each was also a partner in the asset that was closest to J.M.’s heart—a remote, exquisitely manicured golf course, on the coast of southwestern Ireland, known as Waterville.

Early in 1994, J.M. bagged the most astonishing name of all: David W. Mullins, vice chairman of the U.S. Federal Reserve and second in the Fed’s hierarchy to Alan Greenspan, the Fed chairman. Mullins, too, was a former student of Merton’s at MIT who had gone on to teach at Harvard, where he and Rosenfeld had been friends. As a central banker, he gave Long-Term incomparable access to international banks. Moreover, Mullins had been the Fed’s point man on the Mozer case. The implication was that Meriwether now had a clean bill of health from Washington.

Mullins, like Meriwether a onetime teenage investor, was the son of a University of Arkansas president and an enormously popular lecturer at Harvard. Ironically, he had launched his career in government as an expert on financial crises; he was expected to be Long-Term’s disaster guru if markets came unstuck again. After the 1987 stock market crash, Mullins had helped write a blue-ribbon White House report, laying substantial blame on the new derivatives markets, where the snowball selling had gathered momentum. Then he had joined the Treasury, where he had helped draft the law to bail out the country’s bankrupt savings and loans. As a regulator, he was acutely aware that markets—far from being perfect pricing machines—periodically and dangerously overshoot. “Our financial system is fast-paced, enormously creative. It’s designed to have near misses with some frequency,” he remarked a year before jumping ship for Long-Term. With more omniscience regarding his future fund than he could have dreamed, Mullins argued that part of the Fed’s mission should be saving private institutions that were threatened by “liquidity problems.”

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Wry and soft-spoken, the intellectual Mullins dressed like a banker and was thought to be a potential successor to Greenspan. Nicholas Brady, his former boss at Treasury, wondered when Mullins joined Long-Term what he was doing with “those guys.” Investors, though, were soothed by the addition of the congenial Mullins, whose perspective on markets may have been much like their own. Indeed, by snaring a central banker, Long-Term gained unparalleled access for a private fund to the pots of money in quasi-governmental accounts around the world. Soon, Long-Term won commitments from the Hong Kong Land & Development Authority, the Government of Singapore Investment Corporation, the Bank of Taiwan, the Bank of Bangkok, and the Kuwaiti state-run pension fund. In a rare coup, Long-Term even enticed the foreign exchange office of Italy’s central bank to invest $100 million. Such entities simply do not invest in hedge funds. But Pierantonio Ciampicali, who oversaw investments for the Italian agency, thought of Long-Term not as a “hedge fund” but as an elite investing organization “with a solid reputation.”

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Private investors were similarly awed by a fund boasting the best minds in finance and a resident central banker, who plausibly would be a step ahead in the obsessive Wall Street game of trying to outguess Greenspan. The list was impressive. In Japan, Long-Term signed up Sumitomo Bank for $100 million. In Europe, it corralled the giant German Dresdner Bank, the Liechtenstein Global Trust, and Bank Julius Baer, a private Swiss bank that pitched the fund to its millionaire clientele, for sums ranging from $30 million to $100 million. Republic New York Corporation, a secretive organization run by international banker Edmond Safra, was mesmerized by Long-Term’s credentials and seduced by the possibility of winning business from the fund.

(#litres_trial_promo) It invested $65 million. Long-Term also snared Banco Garantia, Brazil’s biggest investment bank.

In the United States, Long-Term got money from a diverse group of hotshot celebrities and institutions. Michael Ovitz, the Hollywood agent, invested; so did Phil Knight, chief executive of Nike, the sneaker giant, as well as partners at the elite consulting firm McKinsey & Company and New York oil executive Robert Belfer. James Cayne, the chief executive of Bear Stearns, figured that Long-Term would make so much money that its fees wouldn’t matter. Like others, Cayne was comforted by the willingness of J.M. and his partners to invest $146 million of their own. (Rosenfeld and others put their kids’ money in, too.) Academe, where the professors’ brilliance was well known, was an easy sell: St. John’s University and Yeshiva University put in $10 million each; the University of Pittsburgh climbed aboard for half that. In Shaker Heights, Paragon Advisors put its wealthy clients into Long-Term. Terence Sullivan, president of Paragon, had read Merton and Scholes while getting a business degree; he felt the operation was low risk.

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In the corporate world, PaineWebber, thinking it would tap Long-Term for investing ideas, invested $100 million; Donald Marron, its chairman, added $10 million personally. Others included the Black & Decker Corporation pension fund, Continental Insurance of New York (later acquired by Loews), and Presidential Life Corporation.

Long-Term opened for business at the end of February 1994. Meriwether, Rosenfeld, Hawkins, and Leahy celebrated by purchasing a shipment of fine Burgundies ample enough to last for years. In addition to its eleven partners, the fund had about thirty traders and clerks and $10 million worth of SPARC workstations, the powerful Sun Microsystems machines favored by traders and engineers. Long-Term’s fund-raising blitz had netted $1.25 billion—well short of J.M.’s goal but still the largest start-up ever.

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3 ON THE RUN (#ulink_bfe79ce0-17c9-5f11-81ad-a0ee93f15424)

They [Long-Term] are in effect the best finance faculty in the world. –INSTITUTIONAL INVESTOR

THE GODS SMILED on Long-Term. Having raised capital during the best of times, it put its money to work just as clouds began to gather over Wall Street. Investors long for steady waters, but paradoxically, the opportunities are richest when markets turn turbulent. When prices are flat, trading is a dull sport. When prices begin to gyrate, it is as if little eddies and currents begin to bubble in a formerly placid river. This security is dragged with the current, that one is washed upstream. Two bonds that once journeyed happily in tow are now wrenched apart, and once predictable spreads are jolted out of sync. Suddenly, investors feel cast adrift. Those who are weak or insecure may panic or at any rate sell. If enough do so, a dangerous undertow may distort the entire market. For the few who have hung on to their capital and their wits, this is when opportunity beckons.

In 1994, as Meriwether was wrapping up the fund-raising, Greenspan started to worry that the U.S. economy might be overheating. Mullins, who was cleaning out his desk at the Fed and preparing to jump to Long-Term, urged the Fed chief to tighten credit.

(#litres_trial_promo) In February, just when interest rates were at their lowest—and, indeed, when investors were feeling their plummiest—Greenspan stunned Wall Street by raising short-term interest rates. It was the first such hike in five years. But if the oracular Fed chief had in mind calming markets, the move backfired. Bond prices tumbled (bond prices, of course, move in the opposite direction of interest rates). And given the modest nature of Greenspan’s quarter-point increase, bonds were falling more than they “should” have. Somebody was desperate to sell.

By May, barely two months after Long-Term’s debut, the thirty-year Treasury bond had plunged 16 percent from its recent peak—a huge move in the relatively tame world of fixed-income securities—rising in yield from 6.2 percent to 7.6 percent. Bonds in Europe were crashing, too. Diverse investors, including hedge funds—many of which were up to their necks in debt—were fleeing from bonds. Michael Steinhardt, one such leveraged operator, watched in horror. Steinhardt, who had bet on European bonds, was losing $7 million with every hundredth of a percentage point move in interest rates. The swashbuckling Steinhardt lost $800 million of his investors’ money in a mere four days. George Soros, who was jolted by a ricochet effect on international currencies, dropped $650 million for his clients in two days.

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For Meriwether, this tumult was the best of news. One morning during the heat of the selling, J.M. walked over to one of his traders. Glancing at the trader’s screen, J.M. marveled, “It’s wave after wave of guys throwing in the towel.” As J.M. knew, panicky investors wouldn’t be picky as they ran for the exits. In their eagerness to sell, they were pushing spreads wider, creating just the gaps that Meriwether was hoping to exploit. “The unusually high volatility in the bond markets … has generally been associated with a widening of spreads,” he chirped in a—for him—unusually revealing letter to investors. “This widening has created further opportunities to add to LTCP’s convergence and relative-value trading positions.”

(#litres_trial_promo) After two flat months, Long-Term rose 7 percent in May, beginning a stretch of heady profits. It would hardly have occurred to Meriwether that Long-Term would ever switch places with some of those panicked, overleveraged hedge funds. But the bond debacle of 1994, which unfolded during Long-Term’s very first months, merited Long-Term’s close attention.

Commentators began to see a new connectedness in international bond markets. The Wall Street Journal observed that “implosions in seemingly unrelated markets were reverberating in the U.S. Treasury bond market.”

(#litres_trial_promo) Such disparate developments as a slide in European bonds, news of trading losses at Bankers Trust, the collapse of Askin Capital Management, a hedge fund that had specialized in mortgage trades, and the assassination of Mexico’s leading presidential contender all accentuated the slide in U.S. Treasurys that had begun with Greenspan’s modest adjustment.

Suddenly markets were more closely linked—a development with pivotal significance for Long-Term. It meant that a trend in one market could spread to the next. An isolated slump could become a generalized rout. With derivatives, which could be custom-tailored to any market of one’s fancy, it was a snap for a speculator in New York to take a flier on Japan or for one in Amsterdam to gamble on Brazil—raising the prospect that trouble on one front would leach into the next. For traders tethered to electronic screens, the distinction between markets—say, between mortgages in America and government loans in France—almost ceased to exist. They were all points on a continuum of risk, stitched together by derivatives. With traders scrambling to pay back debts, Neal Soss, an economist at Credit Suisse First Boston, explained to the Journal, “You don’t sell what you should. You sell what you can.” By leveraging one security, investors had potentially given up control of all of their others. This verity is well worth remembering: the securities might be unrelated, but the same investors owned them, implicitly linking them in times of stress. And when armies of financial soldiers were involved in the same securities, borders shrank. The very concept of safety through diversification—the basis of Long-Term’s own security—would merit rethinking.

Steinhardt blamed his losses on a sudden evaporation of “liquidity,” a term that would be on Long-Term’s lips in years to come.

(#litres_trial_promo) But “liquidity” is a straw man. Whenever markets plunge, investors are stunned to find that there are not enough buyers to go around. As Keynes observed, there cannot be “liquidity” for the community as a whole.

(#litres_trial_promo) The mistake is in thinking that markets have a duty to stay liquid or that buyers will always be present to accommodate sellers. The real culprit in 1994 was leverage. If you aren’t in debt, you can’t go broke and can’t be made to sell, in which case “liquidity” is irrelevant. But a leveraged firm may be forced to sell, lest fast-accumulating losses put it out of business. Leverage always gives rise to this same brutal dynamic, and its dangers cannot be stressed too often.

Long-Term was doubly fortunate: spreads widened before it invested much of its capital, and once opportunities did arise, Long-Term was one of a very few firms in a position to exploit the general distress. And its trades were good trades. They weren’t risk-free; they weren’t so good that the fund could leverage indiscriminately. But by and large, they were intelligent and opportunistic. Long-Term started to make money on them almost immediately.

One of its first trades involved the same thirty-year Treasury bond. Treasurys (of all durations) are, of course, issued by the U.S. government to finance the federal budget. Some $170 billion of them trade each day, and they are considered the least risky investments in the world. But a funny thing happens to thirty-year Treasurys six months or so after they are issued: investors stuff them into safes and drawers for long-term keeping. With fewer left in circulation, the bonds become harder to trade. Meanwhile, the Treasury issues a new thirty-year bond, which now has its day in the sun. On Wall Street, the older bond, which has about 29½ years left to mature, is known as off the run; the shiny new model is on the run. Being less liquid, the off-the-run bond is considered less desirable. It begins to trade at a slight discount (that is, you can purchase it for a little less, or at what amounts to a slightly higher interest yield). As arbitrageurs would say, a spread opens.

In 1994, Long-Term noticed that this spread was unusually wide. The February 1993 issue was trading at a yield of 7.36 percent. The bond issued six months later, in August, was yielding only 7.24 percent, or 12 basis points, less. Every Tuesday, Long-Term’s partners held a risk-management meeting, and at one of the early meetings, several proposed that they bet on this 12-point gap to narrow. It wasn’t enough to say, “One bond is cheaper, one bond is dearer.” The professors needed to know why a spread existed, which might shed light on the paramount issue of whether it was likely to persist or even to widen. In this case, the spread seemed almost silly. After all, the U.S. government is no less likely to pay off a bond that matures in 29½ years than it is one that expires in thirty. But some institutions were so timid, so bureaucratic, that they refused to own anything but the most liquid paper. Long-Term believed that many opportunities arose from market distortions created by the sometimes arbitrary demands of institutions.

(#litres_trial_promo) The latter were willing to pay a premium for on-the-run paper, and Long-Term’s partners, who had often done this trade at Salomon, happily collected it. They called it a “snap trade,” because the two bonds usually snapped together after only a few months. In effect, Long-Term would be collecting a fee for its willingness to own a less liquid bond.

“A lot of our trades were liquidity-providing,” Rosenfeld noted. “We were buying the stuff that everyone wanted to sell.” It apparently did not occur to Rosenfeld that since Long-Term tended to buy the less liquid security in every market, its assets were not entirely independent of one another, the way one dice roll is independent of the next. Indeed, its assets would be susceptible to falling in unison if a time came when, literally, “everyone” wanted to sell.

Twelve basis points is a tiny spread; ordinarily, it wouldn’t be worth the trouble. The price difference was only $15.80 for each pair of $1,000 bonds. Even if the spread narrowed two thirds of the way, say in a few months’ time, Long-Term would earn only $10, or 1 percent, on those $1,000 bonds. But what if, using leverage, that tiny spread could be multiplied? What if, indeed! With such a strategy in mind, Long-Term bought $1 billion of the cheaper, off-the-run bonds. It also sold $1 billion of the more expensive, on-the-run Treasurys. This was a staggering sum. Right off the bat, the partners were risking all of Long-Term’s capital! To be sure, they weren’t likely to lose very much of it. Since they were buying one bond and selling another, they were betting only that the bonds would converge, and, as noted, bond spreads vary much less than bonds themselves do. The price of your home could crash, but if it does, the price of your neighbor’s house will likely crash as well. Of course, there was some risk that the spread could widen, at least for a brief period. If two bonds traded at a 12-point spread, who could say that the spread wouldn’t go to 14 points—or, in a time of extreme stress, to 20 points?

Long-Term, with trademark precision, calculated that owning one bond and shorting another was one twenty-fifth as risky as owning either bond outright.

(#litres_trial_promo) Thus, it reckoned that it could prudently leverage this long/short arbitrage twenty-five times. This multiplied its potential for profit but—as we have seen—also its potential for loss. In any case, borrow it did. It paid for the cheaper, off-the-run bonds with money that it borrowed from a Wall Street bank, or from several banks. And the other bonds, the ones it sold short, it obtained through a loan, as well.

Actually, the transaction was more involved, though it was among 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 Wall Street firm, which then wired cash to Long-Term as collateral. Then Long-Term turned around and used this cash as collateral on the bonds that it borrowed. On Wall Street, such short-term, collateralized loans are known as “repo financing.”

The beauty of the trade was that Long-Term’s cash transactions were in perfect balance. The money that Long-Term spent going long (buying) matched the money it collected going short (selling). The collateral it paid equaled the collateral it collected. In other words, Long-Term pulled off the entire $2 billion trade without using a dime of its own cash.* (#ulink_20f4c60a-16f5-5727-8475-34cb3aefb2cb)

Now, normally, when you borrow a bond from, say, Merrill Lynch, you have to post a little bit of extra collateral—maybe a total of $1,010 on a $1,000 Treasury and more on a riskier bond. That $10 initial margin, equivalent to 1 percent of the bond’s value, is called a haircut. It’s Merrill Lynch’s way of protecting itself in case the price of the bond rises.

The haircut naturally acts as a check on how much you can trade. But if you could avoid the haircut, well, the sky would be the limit. It would be like driving a car that didn’t burn gas: you could drive as far as you wished. What’s more, the rate of return would be substantially higher—if you didn’t have that extra margin tied up at Merrill Lynch.

And from the very start, it was Long-Term’s policy to refuse to pay the haircut or else to substantially reduce it. The policy surely flowed from Meriwether, who, for all his unassuming charm, was fiercely competitive at trading, golf, billiards, horses, and whatever else he touched. Rosenfeld and Leahy, two of the more congenial and laid-back partners, were usually the ones who met with banks, though Hilibrand also got involved. In any case, the partners would insist, politely but firmly, that the fund was so well heeled that it didn’t need to post an initial margin—and, what’s more, that it wouldn’t trade with anyone that saw matters differently. Merrill Lynch agreed to waive its usual haircut requirement and go along. So did Goldman Sachs, J. P. Morgan, Morgan Stanley, and just about everyone else. One firm that balked, PaineWebber, got virtually none of Long-Term’s business. “You had no choice if you were going to do business with them,” recalled Goldman Sachs’s Jon Corzine, J.M.’s admiring rival.