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

Although Long-Term’s trades could be insanely complex and ultimately numbered in the thousands, the fund had no more than a dozen or so major strategies.

(#litres_trial_promo) Some, such as the Treasury arbitrage, involved buying and selling tangible securities. The others, derivative trades, did not. They were simply bets that Long-Term made with banks and other counterparties that hinged on the fate of various market prices.

Imagine, by illustration, that a Red Sox fan and a Yankees fan agree before the season that each will pay the other $1,000 for every run scored by his rival’s team. Long-Term’s derivative contracts were not dissimilar, except that the payoffs were tied to movements in bonds, stocks, and so forth rather than balls and strikes. These derivative obligations did not appear on Long-Term’s balance sheet, nor were they “debt” in the formal sense. But if markets moved against the fund, the result would obviously be the same. And Long-Term generally was able to forgo paying initial margin on derivative deals; it made these bets without putting up any initial capital whatsoever.

Frequently, though not always, it got the same terms on repo financing of actual securities. Also, Long-Term often persuaded banks to lend to it for longer periods than the banks gave to other funds.

(#litres_trial_promo) Thus, Long-Term could be more patient. Even if the banks had wanted to call in Long-Term’s loans, they couldn’t have done so very quickly. “They had everyone over a barrel,” noted a senior executive at a top investment bank.

This was where Meriwether’s marketing strategy really paid dividends. If the banks had given it a moment’s thought, they would have realized that Long-Term was at their mercy. But the banks saw the fund not as a credit-hungry start-up but as a luminous firm of celebrated scholars and brilliant traders, something like that New Age “financial intermediary” conjured up by Merton. After all, it was generally believed that Long-Term had the benefit of superior, virtually fail-safe technology. And banks, like some of the press, casually assumed that it was so. Business Week gushed that the fund’s Ph.D.s would give rise to “a new computer age” on Wall Street. “Never has this much academic talent been given this much money to bet with,” the magazine observed in a cover story published during the fund’s first year.

(#litres_trial_promo) If a new age was coming, no one wanted to miss it. Long-Term was as fetching as a debutante on prom night, and all the banks wanted to dance.

The banks had no trouble rationalizing their easy credit terms. The banks did hold collateral, after all, and Long-Term generally settled up (in cash) at the end of each trading day, collecting on winners and paying on losers. And Long-Term was flush, so the risk of its failing seemed slight. Only if Long-Term lost money with unthinkable suddenness—only if, say, it was forced to dump the majority of its assets all at once and into an illiquid market—would the value of the bankers’ collateral be threatened and would the banks themselves be exposed to losses.

Also, many of the banks’ heads, such as Corzine and Merrill Lynch’s Tully, liked Meriwether personally, which tilted their organizations in Long-Term’s favor. But Long-Term’s real selling point was its connections to other powerful traders around the world. A firm that did business with Long-Term might gain valuable inside knowledge—totally legal in the bond world—about the flow of markets. “How do you get people to come to your party? You tell them that every cool person in town is coming,” said a banker in Zurich who financed Long-Term with a zero percent haircut. “So everyone said, ‘OK, I’ll do it, but if anyone else gets a haircut, I get one too.’” This was especially clever of Long-Term. The partners could say to each new bank, “If we give you a haircut, we have to give it to everyone.” So they ended up giving it to nobody. (On a small number of riskier trades they did agree to haircuts—but very skimpy ones.)

Since the banks, too, were doing arbitrage trading, Meriwether viewed them, not unjustly, as his main competitors.

(#litres_trial_promo) Long-Term resembled other hedge funds such as Soros’s Quantum Fund less than it did the proprietary desks of its banks, such as Goldman Sachs. The Street was slowly shifting from research and client services to the lucrative business of trading for its own account, fostering a wary rivalry between Long-Term and its lenders.

Having worked at a major Wall Street bank, J.M. felt that investment banks were rife with leaks and couldn’t be trusted not to swipe his trades for themselves. Indeed, most of them were plying similar strategies. Thus, as a precaution, Long-Term would place orders for each leg of a trade with a different broker. Morgan would see one leg, Merrill Lynch another, and Goldman yet another, but nobody would see them all. Even Long-Term’s lawyer was kept in the dark; he would hear the partners speak about “trading strategy three,” as though Long-Term were developing a nuclear arsenal.

Hilibrand, especially, refused to give the banks a peek at his strategies or to meet them halfway on terms. He would call a dealer, purchase $100 million in bonds, and be off the phone in seconds.

(#litres_trial_promo) “I’m just concerned about margin requirement, and I’m not putting up any margin,” he bluntly told Merrill Lynch. Kevin Dunleavy, a Merrill Lynch salesman, sometimes called Hilibrand two or three times a day, trying to pitch strategies he had devised with the clever Hilibrand in mind. But Dunleavy was repeatedly frustrated by Hilibrand’s obsessive secrecy, which made it nearly impossible to service the account. “Rarely could you take your ideas and implement them into LTCM’s strategy,” noted Dunleavy, an unaffected New Yorker with a military brush cut. “It was very unusual, not to take input from the Street. Larry would never talk about the strategy. He would just tell you what he wanted to do.”

The fund parceled out its business, choosing each bank for particular services and keeping a distance from all of them. Chary of becoming dependent on any one bank, Long-Term traded junk bonds with Goldman Sachs, government bonds and yen swaps with J. P. Morgan, mortgages with Lehman Brothers. Merrill Lynch was the fund’s biggest counterparty in derivatives, but it was far down the list in repo loans. To be sure, there was something shrewd about this divide-and-conquer strategy, for Long-Term did each set of trades with the bank that boasted the most specific expertise. But Long-Term thus forfeited the benefits of a closer, ongoing relationship. J. P. Morgan, for one, was extremely curious about Long-Term and eager to develop a closer working alliance, but it couldn’t get past the fund’s unwillingness to share confidences. “How can you propose ideas to them without knowing what their appetite is?” wondered the head of risk management at a major Wall Street firm. As arbitrageurs, the partners tended to see every encounter as a discrete exchange, with tallyable pluses and minuses. Every relationship was a “trade”—renegotiable or revocable if someone else had a better price. The partners’ only close ties were within Long-Term, mimicking the arrangement within their beloved group at Salomon.

They were a bred type—intellectual, introverted, detached, controlled. It didn’t work to try to play one off against the other; they were too much on the same wavelength. Andrew Siciliano, who ran the bond and currency departments at Swiss Bank Corporation, was stunned by their uncanny closeness. One time, Siciliano called Victor Haghani, the head of the London office, and followed up in Greenwich with J.M. and Eric Rosenfeld a month or two later. The American-based partners didn’t miss a beat; Siciliano had the eerie feeling that he was continuing the same conversation he’d had with Haghani.

Not that there weren’t tensions within the firm. A small group—J.M., Hilibrand, Rosenfeld, and Haghani—dominated the rest. As at Salomon, compensation was skewed toward the top, with the inner circle garnering more than half the rewards. This group also had voting control. Lesser partners such as Myron Scholes were forever angling for more money, as well as more authority. But the inner circle had been together for years; as in a family, their exclusive and inbred alliance had became second nature.

If the firm could have been distilled into a single person, it would have been Hilibrand. While veteran traders tend to be cynical and insecure, the result of years of wrong guesses and narrow escapes, Hilibrand was cool and maddeningly self-confident. An incredibly hard worker, he was the pure arbitrageur; he believed in the models, stuck to his prices, was untroubled by doubt. Rosenfeld hated to hedge by selling a falling asset, as theory prescribed; Hilibrand believed and simply followed the form. Hilibrand’s colleagues respected him immensely; inevitably, they turned to him when they needed a quick read. He was highly articulate, but his answers were like unrefined crystals, difficult for novices to comprehend. “You could refract the light with Larry’s mind,” said Deryck Maughan of Salomon Brothers. Like the other partners, but to a greater degree, Hilibrand saw every issue in black and white. He was trustworthy and quick to take offense at perceived wrongdoing but blind to concerns outside his narrow sphere. His Salomon colleagues used to joke that, according to the libertarian Hilibrand, if the street in front of your home had a pothole you ought to pave it yourself. But money probably meant less to him than to any of them. He found his passion in the intellectual challenge of trading. Aside from his family, he showed interest in little else. If anyone brought Hilibrand out of himself a bit, it was J.M. Hilibrand had a filial attachment to the chief, perhaps stemming from his close relationship to his own father. Rosenfeld had a similar devotion to Meriwether.

Outsiders couldn’t quite explain J.M.’s hold on the group. He was an unlikely star, too bashful for the limelight. He spoke in fragments and seemed uncomfortable making eye contact.

(#litres_trial_promo) He refused to talk about his personal life, even to close friends. After organizing Long-Term, J.M. and his wife moved out of Manhattan, to a $2.7 million, sixty-eight-acre estate in North Salem, in Westchester County—complete with a 15,000-square-foot heated indoor riding ring for Mimi.

(#litres_trial_promo) The estate was set back three quarters of a mile on a private drive that the Meriwethers shared with their only neighbor, the entertainer David Letterman. As if to make the property even more private, the Meriwethers did extensive remodeling, fortifying the house with stone. J.M. liked to control his private life, as if to shelter it, too, from unwanted volatility.

Though he attended a church near home and made several visits to Catholic shrines, J.M. didn’t speak about his faith, either. His self-control was implacable. Nor did he open up among his traders. At firm meetings he was mostly quiet. He welcomed frank debates among the partners, but he usually chimed in only at the very end or not at all.

The firm’s headquarters were the ground floor of a glassy four-story office complex, on a street that ran from the shop-lined center of affluent Greenwich past a parade of Victorian homes on Long Island Sound. Several dozen of Long-Term’s growing cadre of traders and strategists worked on the trading floor, where partners and nonpartners sat elbow to elbow, cramped around a sleek, semicircular desk loaded with computers and market screens. The office had an elaborate kitchen that had been put in by a previous tenant, but the partners lunched at their desks. Food meant little to them.

J.M., Merton, and Scholes (the latter two because they didn’t trade) had private offices, but J.M. was usually on the trading floor, a mahogany-paneled room that looked out through a full-length picture window to the water, resplendent and often speckled with sailboats. Aside from the natty Mullins, the partners dressed casually, in Top-Siders and chinos. The room hummed with trader talk, but it was a controlled hum, not like the chaos on the cavernous New York trading floors. Only occasionally did the partners revert to their past life for a few rounds of liar’s poker.

Besides the Tuesday risk meetings, which were for partners only, Long-Term had research seminars on Wednesday mornings that were open to associates and usually another meeting on Thursday afternoons, when partners would focus on a specific trade. Merton, usually in Cambridge, would join in by telephone. The shared close quarters fostered a firm togetherness, but the associates and even some of the partners knew they could never be part of the inner circle. One junior trader perpetually worried that his trades would be found out by the press, which he feared could cost him his job. Associates in Greenwich, even senior traders, were kept so much in the dark that some resorted to calling their London counterparts to find out what the firm was buying and selling. Associates were never invited back to the partners’ homes—there seemed to be an unwritten rule against partners and staff fraternizing. Leahy, a college hockey player, exchanged the normal office banter with the employees, but most of the partners treated the staff with cool formality. They were polite but interested only in one another and their work. The analysts and legal and accounting staffs were second-class citizens, shunted to a room in the back, where the pool table was.

Like everyone else on Wall Street, Long-Term’s employees made good money. The top staffers could make $1 million to $2 million a year. There was subtle pressure on the staff to invest their bonuses in the fund, but most of them were eager to do so anyway—ironically, it was considered a major perk of working at Long-Term. And so, the staff confidently reinvested most of their pay.

Just as predicted, Long-Term’s on-the-run and off-the-run bonds snapped back quickly. Long-Term made a magical $15 million—magical because it hadn’t used any capital. As Scholes had promised, Long-Term had scooped up a nickel and, with leverage, turned it into more. True, many other firms had done the same kind of trade. “But we could finance better,” an employee of Long-Term noted. “LTCM was really a financing house.”

Long-Term preferred to reap a sure nickel than to gamble on making an uncertain dollar, because it could leverage its tiny margins like a high-volume grocer, sucking up nickel after nickel and multiplying the process thousands of times. Of course, not even a nickel bet was absolutely sure. And as Steinhardt, the fund manager, had recently been reminded, the penalty for being wrong is infinitely greater when you are leveraged. But in 1994, Long-Term was almost never wrong. In fact, nearly every trade it touched turned to gold.

Long-Term dubbed its safest bets convergence trades, because the instruments matured at a specific date, meaning that convergence appeared to be a sure thing. Others were known as relative value trades, in which convergence was expected but not guaranteed.

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The bond market turmoil of 1994 seeded the ground for a huge relative value trade in home mortgage securities. Mortgage securities are pieces of paper backed by the cash flow on pools of mortgages. They sound boring, but they aren’t. Some $1 trillion of mortgage securities is outstanding at any given time. What makes them exciting is that clever investment bankers have separated the payments made by homeowners into two distinct pools: one for interest payments, the other for principal payments. If you think about it—and Long-Term did, quite a bit—the value of each pool (relative to the other) varies according to the rate at which homeowners pay off their loans ahead of schedule. If you refinance your mortgage, you pay it off in one lump sum—that is, in one giant payment of principal. Therefore, no further cash goes to the interest-only pool. But if you stand pat and keep writing those monthly checks, you keep making interest payments for up to thirty years. Therefore, if more people refinance, the interest-only securities, known as “IOs,” will fall; if fewer people prepay, they will rise. The converse is true for principal-only securities, or POs. And since the rate of refinancings can change quickly, betting on IOs or POs can make or lose you a good deal of money.

In 1993, when Long-Term was raising capital, America was experiencing a surge of refinancings. With mortgage rates dropping below 7 percent for the first time since the Vietnam War, baby boomers who had never given their mortgages a second thought were suddenly delirious with the prospect of cutting their payments by hundreds of dollars a month. Getting the lowest rate became a point of pride; roughly two in five Americans refinanced in that one year—in fact, some folks did it twice. Naturally, the prices of IOs plummeted. Actually, they fell too much. Unless you assumed that the entire country was going to refinance tomorrow, the price of IOs was simply too low. Indeed, Meriwether, Hilibrand, Rosenfeld, Haghani, and Hawkins bought buckets of IOs for their personal accounts.

In 1994, as Long-Term was beginning to trade, IOs remained cheap for fear there would be another wave of refinancings. Bill Krasker had designed a model to predict prepayments, and Hawkins—an outgoing, curly-haired mortgage trader with backwoods charm—continually checked the model against the record of actual prepayments. The IO price seemed so out of whack that Hawkins wondered, “Is there something wrong with the model, or is this just a good opportunity?” The methodical Krasker carefully retooled the model, and it all but screamed, “Buy!” So Long-Term—once again with massive leverage—started buying IOs by the truckload. It acquired a huge stake, estimated at $2 billion worth.

Now, when interest rates rise, people aren’t even going to think about refinancing. But when rates fall, they run to the mortgage broker. That means that IOs rise and fall in sync with interest rates—so betting on IOs is like betting on interest rates. But the partners didn’t want to forecast rates; such outright speculation made them jittery, even though they did it on occasion. Because interest rates depend on so many variables, they are essentially unpredictable. The partners’ forte was making highly specific relative bets that did not depend on broad unknowns.

In short, the partners merely felt that, given the present level of interest rates, IOs were cheap. So the partners shrewdly hedged their bet by purchasing Treasurys, the prices of which move in the opposite direction from interest rates. The net effect was to remove any element of rate forecasting. The partners excelled at identifying particular mispriced risks and hedging out all of the other risks. If Haifa oranges were cheap relative to Fuji apples, they would find a series of trades to isolate that particular arbitrage; they didn’t simply buy every orange and sell every apple.

In the spring, when interest rates soared, Long-Term’s IOs also soared, although its Treasury bonds, of course, fell. Thus, it was ahead on one leg of its trade and behind on the other. Then, in 1995, when interest rates receded, Long-Term’s Treasurys rose in price. But this time people did not rush to refinance, so Long-Term’s IOs held on to much of their former gains. Presumably, people who had gotten new mortgages in 1993 were not so eager to do it again. Long-Term made several hundred million dollars. It was off to a sizzling start.

Despite appearances, finding these “nickels” was anything but easy. Long-Term was searching for pairs of trades—or often, multiple pairs—that were “balanced” enough to be safe but unbalanced in one or two very particular aspects, so as to offer a potential for profit. Put differently, in any given strategy, Long-Term typically wanted exposure to one or two risk factors—but no more. In a common example—yield-curve trades—interest rates in a given country might be oddly out of line for a certain duration of debt. For instance, medium-term rates might be far higher than short-term rates and almost as high as long-term rates. Long-Term would concoct a series of arbitrages betting on this bulge to disappear.

The best place to look for such complex trades was in international bond markets. Markets in Europe, as well as in the Third World, were less efficient than America’s; they had yet to be picked clean by computer-wielding arbitrageurs (or professors). For Long-Term, these underexploited markets were a happy hunting ground with a welter of opportunities. In 1994, when the trouble in the U.S. bond market rippled across the Atlantic, the spreads between German, French, and British government debt and, respectively, the futures on each country’s bonds, widened to nonsensical levels. Long-Term plunged in and made a fast profit.

(#litres_trial_promo) It also sallied into Latin America, where spreads had widened as well.

(#litres_trial_promo) 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 Japanese stocks against options on the Tokyo index—one of Long-Term’s first excursions into equities.

By the mid-1990s, Europe had become a playground for international bond traders, who were hotly debating the outlook for monetary union. Its markets were increasingly unsettled by the prospect—still much in doubt—that France, Germany, Italy, and other age-old nation-states would really merge their currencies, abandoning their francs, marks, and lire for freshly minted euros. Every trader had a different view—just the sort of uncertain climate in which Long-Term thrived. Many investment banks were betting that bonds issued by the weaker countries, such as Italy and Spain, would strengthen relative to those of Germany, on the theory that if union did come about, it would force a convergence of interest rates all across Europe. Long-Term did some of these trades, but as usual, the partners were reluctant to risk too much on a broad economic theory. Long-Term’s expertise was in the details. When it came to forecasting geopolitical trends, it did not have any apparent edge. What’s more, the mostly American partners were Euro-skeptics. With Europe’s highly regulated economies perennially trailing America’s, the Continent seemed hopelessly rigid. A Swiss partner, Hans Hufschmid, tried to push the convergence theme, but the American partners, including Victor Haghani, the free-spirited London chief, resisted.

Haghani preferred to focus on strategies that were confined to single countries, where there would be fewer risk factors. For instance, he arbitraged two issues of gilts, the British equivalent of Treasurys, one of which was cheaper owing to an unfavorable tax treatment. When the U.K. government reversed its stance, Long-Term quickly made $200 million.

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Haghani frequently traded the yield curve of a country against itself. Thus, he might go long on Germany’s ten-year bonds and sell its five-year paper, a subtle trade that required command of the math along with a keen appreciation for local economic trends. But at least it did not require comparing the trends in Germany with, say, the trends in Spain.

Newspaper accounts of Long-Term generally overlooked Haghani, who was intensely private. The press played up Meriwether’s leadership and Merton’s and Scholes’s “models.” But in fact Haghani was a critical player. While J.M. presided over the firm and Rosenfeld ran it from day to day, Haghani and the slightly senior Hilibrand had the most influence on trading. Similarly brilliant and mathematically adept, they spoke in a code that outsiders found impenetrable.

Although the two operated mostly as a team, Haghani was far more daring. A natural trader, Haghani had an intuitive feeling for markets and a volatile, impulsive streak. If a model identified a security as mispriced and if the firm felt it understood why the distortion had occurred, Hilibrand tended to go right ahead. Haghani, who trusted his instincts, might gamble on the security’s becoming even more mispriced first. Barely thirty-one years old when Long-Term started (Hilibrand was thirty-four, Rosenfeld forty, and Meriwether forty-six), the swarthy, bearded Haghani routinely swung for the fences. Though a lively raconteur, he was less direct than Hilibrand: you could never tell if Haghani was challenging you in earnest or playing poker. He had a youthful impetuousness and belief in himself, perhaps the result of his privileged background.

The son of a wealthy Iranian importer-exporter and an American mother, Haghani grew up keenly aware of the political crosscurrents that often overwhelm the best-laid business plans. As a teenager, he had spent two years in Iran with his father, whom he adored; then the revolution had forced them to flee. At Salomon Brothers, Haghani had spent a lot of time in the London and Tokyo bureaus, where he had pushed the local traders to adopt the Arbitrage Group’s model of markets and had exhorted the often bewildered staffers to trade in bigger size. He returned to London with Long-Term Capital Management just as the Continent was bubbling with talk of monetary union.

Haghani shunned the City, London’s buttoned-down equivalent of Wall Street, and rented quarters in Mayfair, a lively fashion district. He ran the office informally, encouraging the staff to join him in give-and-take and spirited banter. His traders and analysts worked long hours, but they were motivated by the lure of Long-Term’s growing profits and humbled by the sight of their boss trundling to the office on a bicycle. When the action abated, the traders would drift to a poolroom off the trading floor, where Haghani would issue challenges to visitors. (J.M., too, on his visits to London, would inevitably pick up the cue stick and take on all comers.) Less introverted than some of his partners, Haghani frequently invited traders home to dinner. After Long-Term’s first big month, in May, he assembled the entire London staff, including the secretaries, and told them how the money had been made. This would have been heresy at the stiffer and more secretive Greenwich headquarters, where a rigid caste system prevailed.

Haghani’s biggest trade was Italy—a bold choice. Italian finance was a mess, as was Italian politics. The fear that Italy might default on its loans, coupled with the still considerable strength of the Italian Communist Party, had pushed Italy’s interest rates to as much as 8 percentage points over Germany’s—a huge spread. Italy’s bond market was still evolving, and the government was issuing lots of paper, partly to attract investors. For bond traders, it was fertile territory. Obviously, if Italy righted itself, people who had bet on Italy would make out like bandits. But what if it didn’t?

The Italian market was further complicated because Italy had a quirky tax law and two types of government bonds—one of which paid a floating rate, the other a fixed rate. Strangely, the Italian government was forced (by an untrusting bond market) to pay an interest rate that was higher than the rate on a widely traded interest rate derivative known as “swaps.” Swap rates are generally close to private-sector bank rates. Thus, the bond market was rating the Italian government as a poorer risk than private banks.