The source of the trouble seemed so small, so laughably remote, as to be insignificant. But isn’t it always that way? A load of tea is dumped into a harbor, an archduke is shot, and suddenly a tinderbox is lit, a crisis erupts, and the world is different. In this case, the shot was Long-Term Capital Management, a private investment partnership with its headquarters in Greenwich, Connecticut, a posh suburb some forty miles from Wall Street.
“He took a bunch of guys who in the corporate world were considered freaks,” noted Jay Higgins, then an investment banker at Salomon. “Those guys would be playing with their slide rules at Bell Labs if it wasn’t for John, and they knew it.”9 The professors were brilliant at reducing a trade to pluses and minuses; they could strip a ham sandwich to its component risks; but they could barely carry on a normal conversation. Meriwether created a safe, self-contained place for them to develop their skills; he adoringly made Arbitrage into a world apart. Because of Meriwether, the traders fraternized with one another, and they didn’t feel the need to fraternize with anyone else.
Pundits repeatedly prophesied a correction or a crash; though always wrong, they were hard to ignore.
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.
In a strict sense, there wasn’t any risk—if the world had behaved as it did in the past. –MERTON MILLER, ECONOMIST AND NOBEL LAUREATE
Notice that there is a key difference between a share of IBM (or an infectious disease) and a pair of dice. With dice, there is risk—you could, after all, roll snake eyes—but there is no uncertainty, because you know (for certain) the chances of getting a 7 and every other result. Investing confronts us with both risk and uncertainty. There is a risk that the price of a share of IBM will fall, and there is uncertainty about how likely it is to do so.
Including the money from new investors, the firm’s equity capital had, in less than two years, virtually tripled, to a total of $3.6 billion. Long-Term’s assets had also grown, to the extraordinary sum of $102 billion. Thus, at the end of 1995, it was leveraged 28 to 1. Of course, its return on total assets—both those that it owned and those that it had borrowed—was far, far less than the gaudy return cited above. This return on total capital was approximately 2.45 percent.23 This minuscule figure is what Long-Term would have earned had it invested only its own money. But even this figure is too high because it doesn’t reflect Long-Term’s derivative trades, which, as noted, weren’t recorded on its balance sheet. But derivatives most certainly increased Long-Term’s exposure. (Whether you buy a bond or simply bet on its price, you are exposed to the same potential gain or loss.) And these off-balance-sheet trades most definitely increased Long-Term’s riskiness.
Taking its derivative trades into account, its cash-on-cash return was probably less than 1 percent.24 The exact number is unimportant. The point is that almost all of its heady 59 percent return was due to the remarkable power of leverage.
The question the partners could have asked themselves was, how hard had they stretched to make that 59 percent, and what sort of claims might they face after a storm?
By the spring of 1996, Long-Term had an astounding $140 billion in assets, thirty times its underlying capital. Though still unknown to 99 percent of Americans, Long-Term was two and a half times as big as Fidelity Magellan, the largest mutual fund, and four times the size of the next largest hedge fund.1 Meriwether, Hilibrand, Haghani, and company now controlled more assets than Lehman Brothers and Morgan Stanley and were within shouting distance of Salomon.
“You can overintellectualize these Greek letters,” Pflug reflected, referring to the alphas, betas, and gammas in the option trader’s argot. “One Greek word that ought to be in there is hubris.”
The pursuit of money may have been central to their lives, but as is often the case, it went far beyond any conceivable lifestyle needs. The money was a scorecard, a proof of their superlative trading skills. For Merton and Scholes, it added a worldly validation to their academic successes.
Of course, Tannenbaum was only a salesman and scarcely had authority to approve major deals. Salesmen often become close to the clients they cover; that is why ultimate responsibility rests with higher-ups. But by year-end, although nothing had been signed, Scholes’s warrant was getting a hearing from UBS senior traders and managers.
Their total profits in 1996 were an astounding $2.1 billion.15 To put this number into perspective, this small band of traders, analysts, and researchers, unknown to the general public and employed in the most arcane and esoteric of businesses, earned more that year than McDonald’s did selling hamburgers all over the world, more than Merrill Lynch, Disney, Xerox, American Express, Sears, Nike, Lucent, or Gillette—among the best-run companies and best-known brands in American business.
Despite its scientific pretensions, economics still remains more of an art than a science. –ROBERT KUTTNER
Although pricing a bond can largely be reduced to math, valuing a stock is far more subjective.
Over the short run, stocks are subject to the whim of often emotional traders. Over the long run, they vary with business performance, which is subject to great uncertainty and is notoriously hard to forecast.
“God Almighty does not know the proper price-earning multiple for a common stock.”
“The only trouble is, if you’re wrong on a government bond the spread may change by a half a point. If you’re wrong on risk arb, you can lose half your position.” In short, the reason that deal spreads were so much wider than bond spreads was that you could lose a lot more money on merger arbitrage. Tisch left feeling that Long-Term didn’t know what it was doing.
Markets can remain irrational longer than you can remain solvent. –JOHN MAYNARD KEYNES
The rare Long-Term man with Renaissance interests, Modest, who was raised in Boston, loved the arts, literature, and opera. His interest in finance was more academic than entrepreneurial; he had never liked the senior partners’ autocratic reign and control over his time and had been thinking of bolting until 1998, when he had been made a junior partner.
In the United States and Europe, markets shuddered from a swelling list of negatives: the crisis in Russia, weakness in Asia, Iraq’s refusal to permit full weapons inspections, the possibility of China devaluing its currency, and President Clinton’s testimony about his relationship with a White House intern, Monica Lewinsky. As global investors bailed out of Russia and Asia, they furiously piled into Treasurys, a bulwark of safety when no one wanted risk. Thirty-year bond yields touched another new low: 5.56 percent.
On an active day, Krasker knew, U.S. swap spreads might change by as much as a point. But on this morning, swap spreads were wildly oscillating over a range of 20 points. They ended an astonishing 9 points higher, at 76, up from 48 in April. In Britain it was the same story: swap spreads surged to 62, a dozen points wider than they had been in July.
Hilibrand, once worth half a billion dollars, was paying for the work on his extravagant new mansion out of his wife’s checking account.
Mattone smiled sadly. “When you’re down by half, people figure you can go down all the way. They’re going to push the market against you. They’re not going to roll [refinance] your trades. You’re finished.”
The partners were in an unfamiliar place, a territory the modelers hadn’t explored. Stavis felt the partners had gotten to “a kind of volatility they didn’t understand.” Theoretically, the odds against a loss such as August’s had been prohibitive; such a debacle was, according to the mathematicians, an event so freakish as to be unlikely to occur even once over the entire life of the Universe and even over numerous repetitions of the Universe.
losses in a broader story on financial distress,2 and James Cramer, an on-line financial columnist, stingingly observed that perhaps the term “genius”
He was like a drowning man trying to dictate terms to a rescuer on shore; in his heart of hearts, he was unsinkable.
Buffett was proposing to pay $250 million for a fund that had been worth $4.7 billion at the start of the year. By day’s end, Long-Term, which was suffering yet another down day in markets, would be worth only $555 million. But even next to this startlingly reduced net worth, Buffett’s offer was decidedly cheap. The partners—worth hundreds of millions apiece only weeks earlier—would be wiped out. What’s more, they would be fired. Also, just to make sure that Meriwether would not shop his offer around, Buffett issued a deadline of 12:30 P.M., not quite an hour away. Meriwether handed the fax to Rickards. “What do we do with it?” J.M. asked.