Great story on the fall of LTCM in today's WSJ:
interactive.wsj.com
September 11, 2000
How LTCM Approached
The Edge of the Abyss
Hedge Fund's Losses Seemed
To Imperil Financial Markets
The 1998 meltdown of Long-Term Capital Management was a
singular debacle. Markets around the globe plunged and the financial
system itself seemed in peril -- all on account of a tiny band of
secretive bond traders who had been envied as the best and brightest
of Wall Street.
Markets had been in an increasing state of panic ever since Russia
had defaulted on loans in August 1998. Then, in the ensuing five
weeks, LTCM suffered horrific losses, bringing it to the verge of
bankruptcy. With the prospects of a forced liquidation of its assets --
which totaled a staggering $100 billion -- and the sudden unwinding
of its trading positions, which linked it to every major financial house,
William J. McDonough, president of the New York Fed, feared that
markets would "possibly cease to function." Thus, on Sept. 22 and 23,
Mr. McDonough orchestrated an unprecedented rescue by 14 private
banks and defused the crisis.
The following are excerpts from "When Genius Failed: The Rise and
Fall of Long-Term Capital Management," by former Wall Street
Journal reporter Roger Lowenstein. As the excerpts begin, LTCM,
based in Greenwich, Conn., had enjoyed a fabulous run, with nary a
serious downturn. With bond markets obligingly balmy, LTCM had
quadrupled its money (before deducting fees to its partners) in a mere
four years. And two of LTCM's academic superstars, Robert C.
Merton and Myron S. Scholes, had recently been awarded the Nobel
Prize in economics. By 1998, however, John W. Meriwether, the
acclaimed trader and founder of LTCM, was increasingly troubled by
the lack of opportunities in bond arbitrage, LTCM's stock in trade. Its
returns for the first quarter were flat -- the fund's first dry spell -- and
Wall Street traders were beginning to get nervous.
***
The end of April, approximately, was the low point for bond spreads, the
high point for confidence, and the high point for Long-Term Capital
Management. In the manner of markets, the first hints of trouble were
scattered, small and seemingly unrelated. Lloyd Blankfein, a partner at
Goldman Sachs, complained to Peter Fisher, who ran trading activities at
the New York Fed, that people weren't distinguishing among risks,
meaning that yield differentials between riskier and less risky bonds were
narrowing to the vanishing point. For the moment, everything was trading
like a Treasury bill.
For Steve Freidheim of Bankers Trust, the
alarm sounded during a spring trip to
Singapore and Hong Kong. What Freidheim
saw in Asia shook him: "A lot of big players"
were taking money off the table. Freidheim
returned to the United States in a pessimistic
mood. "We began to short the market after
that," he recalled. In the U.S., credit spreads --
that is, the premium that traders charge for less
risky bonds -- had never been tighter. There
was only one way for them to go, Freidheim
felt, especially if the still fragile condition of
Asia should become apparent.
Imperceptibly at first, other Wall Street traders
started to reach similar conclusions. Banks and
securities firms began to cut back their
inventories of riskier, less liquid bonds -- which were the very types of
bonds in Long-Term's portfolio.
By June, spreads between bonds had begun to widen, exactly the opposite
of what LTCM's computer models had forecast. In short, LTCM, relying
on historical models, had bet that perceived risk would diminish, but prices
were moving the opposite way. Jim McEntee, J.M.'s friend and the one
partner who relied on his nose, as distinct from a computer, sensed the
trade winds changing. He repeatedly urged his partners to lower the firm's
risk -- lower, that is, their potent leverage and derivative exposure -- but
McEntee was ignored as a nonscientific, old-fashioned gambler.
Since moving to Connecticut, the partners, who no longer had to jostle
with the throngs on Wall Street every day, had become even more isolated
from the anecdotal, but occasionally useful, gossip that traders pass
around. They found it easy to brush off McEntee's alarms, particularly
since McEntee's trades had been losing money. Increasingly frustrated,
McEntee met James Rickards, Long-Term's general counsel, after work
one night at the Horseneck Tavern in Greenwich. Rickards was leaving the
next morning on an expedition to climb Mount McKinley in Alaska. "By
the time you get back, the world will have completely changed," McEntee
predicted darkly.
LTCM suffered a 6% loss in May and a troubling 10% drop in June.
The partners insisted that losses were to be expected after their
prolonged success, and predicted a speedy recovery. But then, on
Aug. 17, Russia defaulted. By the end of the month, the stunned
partners were frantically looking for new investors.
By Friday, August 21, traders everywhere were panicking. Stock markets
in Asia and in Europe plunged. The Dow fell 280 points before noon, then
recouped most of its losses. In Greenwich, on that golden late-August
Friday, Long-Term's office was largely deserted. Most of the senior
partners were on vacation; it was a sultry morning, and the staff was
moving slowly. McEntee, the colorful "sheik" whose doleful warnings had
been ignored, was minding the store. Bill Krasker, the partner who had
constructed many of the firm's models, was anxiously monitoring markets,
clicking from one phosphorescent page to the next. When he saw the
quotation for U.S. swap spreads, a standard barometer of credit market
anxiety, he stared at his screen in disbelief.
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. Krasker couldn't believe it. He sought out Matt
Zames, a trader, and Mike Reisman, the firm's repo man, and heatedly
broke the news. The traders hadn't seen a move like that -- ever. True, it
had happened in 1987 and again in 1992. But Long-Term's models didn't
go back that far. As far as Long-Term knew, it was a once-in-a-lifetime
occurrence -- a practical impossibility -- and one for which the fund was
totally unprepared. One of the analysts called a trader at home and asked,
"Would you like to guess where swap spreads are?" When the analyst told
him, the trader snapped, "F--- you -- don't ever call me at home again!"
Nothing in any market went right that day. Long-Term lost money in
Russia, Brazil -- even the U.S. stock market. The skeleton crew in
Greenwich tracked Meriwether down at a dinner in Beijing, and the boss
took the next flight home. Before he left, J.M. called Jon Corzine, the chief
executive of Goldman Sachs, a major Long-Term trading partner, at
Corzine's home. "We've had a serious markdown," Meriwether advised
him, "but everything is fine with us."
But everything was not fine. Long-Term, which had calculated with such
mathematical certainty that it was unlikely to lose more than $35 million on
any single day, had just dropped $553 million -- 15% of its capital -- on
that one Friday in August. Since the end of April, it had lost more than a
third of its equity.
The following Monday, a week after Russia's default, the partners started
dialing for dollars. With their gilt-edged roster of contacts, their brilliant
record, their lustrous reputations, no modern Croesus was beyond their
reach. Greg Hawkins tapped a friend in George Soros's fund and set up a
breakfast for Meriwether, Soros and Stanley Druckenmiller, the
billionaire's top strategist.
Meriwether argued, calmly but persuasively, that Long-Term's markets
would snap back; for those with deep pockets, the opportunities were
great. Soros listened impassively, but Druckenmiller peppered J.M. with
questions. He smelled a chance to recoup Soros's recent losses in Russia.
Then, Soros boldly said he would be willing to invest $500 million at the
end of August -- that is, a week later -- provided that Long-Term could
restore its capital by raising another $500 million in addition.
But as their losses mounted, the dream of raising money from Mr.
Soros faded.
The partners began to sense that they might not make it. "We were
desperate at the end of August," Eric Rosenfeld admitted. Their tone
changed to disbelief and bitterness at having left themselves exposed to
such needless humiliation. They were much too rich to have gotten into so
much trouble.
Badly in need of a lift, Meriwether called an old friend, Vinny Mattone,
who had been the fund's first contact at Bear Stearns, LTCM's clearing
broker. Mattone, who had retired, was everything that J.M.'s elegant
professors were not. He wore a gold chain and a pinkie ring, and he
showed up at Long-Term in a black silk shirt, open at the chest. He
looked as if he weighed 300 pounds. Unlike J.M.'s strangely wooden
partners, Mattone saw markets as exquisitely human institutions --
inherently volatile, ever-fallible.
"Where are you?" Mattone asked bluntly.
"We're down by half," Meriwether said.
"You're finished," Mattone replied, as if this conclusion needed no
explanation.
For the first time, Meriwether sounded worried. "What are you talking
about? We still have two billion. We have half -- we have Soros."
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."
September was even worse. And with the fund losing money day after
day, the partners' spirits began to suffer.
In every class of asset and all over the world, the market moved against
the hedge fund in Greenwich. The correlations had gone to one; every roll
was turning up snake eyes. The mathematicians at Long-Term had not
foreseen this. Random markets, they had thought, would lead to standard
distributions -- to a normal pattern of black sheep and white sheep, heads
and tails, and jacks and deuces, not to staggering losses in every trade, day
after day after day. The professors had ignored the truism -- of which they
were well aware -- that in markets, rare events nonetheless occur.
Stuck in their glass-walled palace far from New York's teeming trading
floors, they had forgotten that traders are not random molecules, or even
mechanical logicians such as themselves, but people moved by greed and
fear, capable of the extreme behavior and swings of mood so often
observed in crowds. And in the late summer of 1998, the bond-trading
crowd was extremely fearful, especially of risky credits.
Thursday, September 10 was a very bad day. Swap spreads --
Long-Term's biggest bond market trade -- jumped another seven points;
other credit spreads widened, too. In a spot of bad luck -- or was it a
portent? -- a rocket ferrying a dozen Globalstar satellites fell out of the sky
and exploded. Long-Term, as it happened, owned Globalstar bonds. The
partners almost laughed: Even the heavens were against them. In the
risk-management meeting, the traders went around the table, each
reporting his results. When it became clear that every trader had lost,
David Mullins, a partner and previously the U.S. Fed's vice chairman,
demanded sarcastically, "Can't we ever make money -- just for one day?"
So far in September, they hadn't; not once.
The fund was immobilized by its sheer mass. The smaller fish around it
were liquidating every bond in sight, but Long-Term was helpless, a
bloated whale surrounded by deadly piranhas. The frightful size of its
positions put the partners in a terrible bind. If they sold even a tiny fraction
of a big position -- say, of swaps -- it would send the price plummeting
and reduce the value of all the rest. Ever since his Salomon Brothers days,
LTCM's Victor Haghani had pushed his colleagues to double and even
quadruple their positions. Now he saw that size extracts a price.
As the firm's losses mounted, the latent divide between the inner group of
partners and the others fermented into sour wine. Inevitably, the lesser
partners blamed Lawrence Hilibrand and Haghani for blowing so much
wealth. Hawkins and Hilibrand, never the best of friends, became bitter
toward each other, and Scholes and Hilibrand were barely speaking. The
unhappy partners resented not just Hilibrand's and Haghani's investment
calls but their domineering, insensitive style. Scholes felt that the secretive
Hilibrand hadn't really been a partner; Larry [Hilibrand] hadn't trusted the
others. Ironically, it was the same complaint that the banks had been
making all along. McEntee, meanwhile, was increasingly absent from the
firm. He was immobilized by an aching back, a symbolic expression of the
partners' despair, and increasingly bitter that Meriwether hadn't heeded his
warnings.
Given their frayed nerves and their enormous losses, it was only human for
the partners to show some tension. They were losing not only their fortunes
but also their reputations. Meriwether was facing the unbearable indignity
of a second disaster in a once shining career. Eric Rosenfeld, the most
emotional of the group and the most devoted to the firm, was touchingly
affected. At least he was not afraid to scream when the anguish overcame
him. Merton, his former teacher, was upset, too; he was distraught and not
himself. Worrying that Long-Term's collapse would undermine the standing
of modern finance -- all he had really worked for -- Merton repeatedly
broke into tears. The professor was wonderfully human, after all.
After Wall Street's leading CEOs met in two historic and heated
meetings at the Fed, a consortium of 14 banks announced that they
would invest $3.65 billion and take over the fund. But unknown to the
world, the deal was far from assured, and LTCM was still facing
imminent bankruptcy.
The LTCM partners got copies of the consortium contract early Saturday,
two days before the deadline for signing. They immediately exploded. It
was indentured servitude, they hollered -- it denied them bonuses,
incentives, liability protection and freedom to start anew. Accustomed to
the extraordinary lives of the superrich, the partners could not conceive of
working for a salary, and one of merely $250,000 at that. They had lived
in a bubble so long they had forgotten the recent event -- their own
impending bankruptcy -- that had brought them to this pass. On
Wednesday, J.M. had been "appreciative"; by Saturday, the gang was
refusing to sign. There was nothing in it for them.
This show of petulance carried a serious threat. The consortium could not
invest without the partners' signatures. And the consortium was now
publicly committed to doing the deal. By contrast, the partners had little left
to lose. They could always, they intimated, let the fund blow up, seek
cover in personal bankruptcy, and go get seven-figure jobs on Wall Street.
Skadden, Arps, Slate, Meagher & Flom, the law firm representing the
consortium, had set out two big conference rooms and a series of private
suites on the 33rd floor to accommodate an expected onslaught of lawyers
and bankers. By Saturday morning, 140 lawyers were scurrying back and
forth in near pandemonium, trying to get a handle on the hedge fund's
numbingly complex assets, its debts, its structure, its management
company. The lawyers had discovered that the agreement they had come
to negotiate actually didn't exist; too many issues divided them.
J. Gregory Milmoe, the Skadden partner in charge, was in a terrible bind.
Trying to craft a contract that would be acceptable to fourteen banks and
each of the partners all within 72 hours, Milmoe naturally had to fashion
compromises. As the day wore on, the bank lawyers began to feel that
Milmoe was conceding too much to Greenwich. At one point, striving for a
consensus, the congenial attorney said, "I'd like to represent LTCM's
demands." John Mead, a lawyer for Goldman, snapped, "How can they
have demands? They're going bankrupt on Monday!"
Over the weekend, the fragile consortium came undone several times,
only to be patched together by Merrill Lynch banker Herbert Allison.
Finally, on Monday, the absolute last day for signing, the rescue faced
a final threat -- from LTCM's stubborn star trader, Mr. Hilibrand.
Meriwether, not quite satisfied, said, "Our guys still won't sign until it says
we can go out and do a new fund." That was their goal now -- to get free
of Long-Term.
Allison, who knew the banks would never invest $3.65 billion if the
partners were plotting to desert, pulled J.M. aside and explained that he
couldn't put it into writing. The partners would have to commit to three
years each; markets would have little faith in the new consortium unless it
was seen as truly "long term." But in time, Allison ventured, the partners
might be free to leave. J.M. heard this as a promise; he had gotten all he
could.
The waivers were in, and the Federal Reserve had been alerted to keep its
electronic-payments wire open past its usual 6:30 closing time. The Fed
was expecting wires from fourteen banks totaling $3.65 billion.
The partners were ready to sign. They stood in a knot at the far end of the
room, a cathedral-sized space that seemed to dwarf the small band of
diminished arbitrageurs. Hilibrand was reading the contract, which was
hopelessly illegible to all but the lawyers. The margins were jammed with
penciled revisions and crossed-out sentences and arrows up and down, as
though the contract were a visual representation of the confusion of the last
three days. Rickards and a couple of other attorneys were trying to tell
Hilibrand what it meant, but he didn't want to listen, he wanted to read it
himself, and he could barely see it through the tears that were streaming
down his face.
He didn't want to sign, he wailed; there was nothing in it for him, better to
file for bankruptcy than be someone else's indentured servant with no hope
of ever earning his way out. Meriwether took Hilibrand aside and talked to
him about the group, and how the others were in it and needed him to be in
it, and still, Hilibrand, who had never needed anyone and who had once
rebelled at paying for his share of the company cafeteria but now couldn't
pay his debts, refused. Then Allison talked to him and said they were trying
to restore the public's faith in the system and not to destroy anybody, and
J.M. said, "Larry, you better listen to Herb." And Hilibrand signed, and the
fund was taken over by 14 banks. |
