"[LTMC] made the same dumb mistakes everyone makes, only with a lot more money at stake." - NYTimes
"Hedge Fund Debacle Offers Look Into a Secret Financial
World"
September 30, 1998
By JOSEPH KAHN and LAURA M. HOLSON
The near-collapse of Long-Term Capital Management
has provided a rare chance to pull back the
curtain on John
Meriwether's cloistered financial brain trust.
But behind the veil, Meriwether and his Nobel
Prize-winning colleagues appear less the wizards that
people once imagined, and the levers they pulled seem
rather ordinary. Awe has turned to sympathy, even
disdain.
"Maybe they were brilliant guys or something, but they
made some very ordinary trades," said Jon Najarian of
Mercury Trading in Chicago. "They made the same dumb
mistakes everyone makes, only with a lot more money at
stake."
Indeed, if the mark of the ultimate salesman had once
been the guy who could sell ice cubes to Eskimos, then
Meriwether may well be remembered as the trader who
taught banks about loans. By the tens of billions of
dollars, the best and brightest financiers on Wall
Street fed Long-Term Capital's insatiable appetite for
securities that, it turns out, thousands of other fund
managers considered easy and common targets.
Meriwether is still in day-to-day control of Long-Term
Capital after a rescue effort by a consortium of big
banks that is now valued at $3.6 billion. His new
banking partners have signed pledges of confidentiality
when they review his books, but details are leaking
out.
Early indications are that though his financing was
often exotic, his trades were more garden-variety.
Long-Term Capital bet on minor price differences
between similar sorts of securities that financial
history suggested should not exist.
Like many arbitragers, it gambled that troubled mergers
would eventually be completed as planned. Meriwether
underwrote a popular form of insurance to investors
worried that the stock market would fall.
"There was nothing exotic about the trades," said a
Wall Street executive close to the Long-Term Capital
rescue, who spoke on the condition of anonymity. The
mystery, he said, was how Wall Street agreed to lend so
much money to a trader whose black box looked much like
their own. "The question is simply why did we let this
happen. Why did the Street finance this guy to this
extent?"
Long-Term Capital did produce stellar returns for
investors who put money in at the fund's inception, in
1994. From then until the end of last year, every
dollar invested would have grown to $2.82, the kind of
profit that would take a decade in the strongest bull
markets.
But given the end-of-August picture of Long-Term
Capital's trading portfolio, which put Meriwether's
equity holdings at around 60 times his $2.2 billion in
capital, the fund had access to a free flow of bank
credit that would make other fund managers salivate.
But some have been unimpressed that in its best years
the fund could coax 40 percent returns from leverage
that amplified its capital base several score or more.
"With the amount of money they had, 100-1 leverage,
they could have been doubling, tripling their money
each year," said Andrew Brenner, a director of Fimat
USA, a New York trading firm. "Where's the rocket
science?"
The rocket science, in turns out, was everywhere:
Meriwether's team was betting on all kinds of
securities and on many different markets, including
some in which he had little or no known expertise. What
tied them together was that the emerging-market turmoil
sent securities plunging in tandem in August, knocking
the legs out from under the fund's highly leveraged
positions.
Long-Term's scattershot trading patterns, including
signs that it doubled up on many bets through
derivatives, suggest that it might have had trouble
finding profitable uses for its flood of bank capital.
One thing that surprised people looking at Long-Term's
trades was the degree to which the fund had recently
delved into equity risk arbitrage. Meriwether's
traditional expertise was thought to be bond arbitrage
-- seeking temporary price anomalies in the wide
universe of government and corporate bonds,
mortgage-backed securities and other credit
instruments.
Indeed, Long-Term Capital Management is said to have
transformed itself into one of the largest players in
stock arbitrage on Wall Street, investing as much as $1
billion in takeover stocks, as well as derivatives tied
to those investments. That may seem small compared with
the bets it made on bonds. But it is still surprising
that Long-Term Capital played the merger game at all,
given its bond specialization.
"They wanted to do size and they wanted to do it in a
rush," said one stock trader who asked not to be
identified. Currently the hedge fund has liquidated
almost all of its equity arbitrage positions, in part
because they were forced to get rid of the most liquid
investment to raise cash quickly.
Many were abandoned at an inopportune time. For
example, the hedge fund sold shares in MCI
Communications the week after Labor Day, only days
before its deal with Worldcom was consummated, sending
its share price higher. Last week, Long-Term Capital
was thought to be behind a large-scale dumping of stock
in American Stores Co., bailing out before it completes
a planned merger with Albertson's.
Long-Term also took a beating, traders say, on its
investment in telecommunications equipment maker Ciena
Corp., which was expected to be acquired by Tellabs
Inc. Traders say the hedge fund owned as much as 2
million shares of Ciena and lost millions when they,
along with other investors, watched those shares fall
from a high of $92 in July to $13 the day the deal was
scrapped.
Long-Term also became a leading seller of a kind of
option, which is effectively an insurance against
unusual swings in stock prices. Through these options,
Long-Term assumed the risk of investors who feared that
their stock portfolio, swollen by years of strong
gains, would fall victim to sharp falls in prices. The
business is a great one in a bull market, when
investors pay big premiums for that protection. But it
is a potentially devastating one when stocks turn
south, as they did in August. Traders say Long-Term was
one of the biggest losers in that business.
But perhaps the main undoing at Long-Term Capital was
in its core area of competence, bond "convergence." In
bets on Danish mortgages, British interest rates,
Italian and Russian bonds and U.S. commercial
mortgage-backed securities, Long-Term Capital was the
600-pound gorilla, buying tens of billions of dollars'
worth of bonds it viewed as cheap relative to
government securities, the main benchmark.
In Denmark, for example, Long-Term Capital was known as
perhaps the single largest holder of mortgages. The bet
was that the relatively inexpensive Danish bonds would
rise in price to match those of neighboring Germany,
especially because Europe is preparing to adopt a
unified currency.
Just as Long-Term Capital had a big Danish position, it
and hundreds of other bond funds were making similar
predictions buying Italian, Spanish and Greek bonds:
Those less stable European government bonds would rise
in value as European nations began the first stage of
monetary union in January.
Long-Term Capital also rolled the dice in the United
States. Here, commercial mortgage-backed securities,
traded versions of loans made on shopping malls,
offices and land, have usually sold at a small premium
to a benchmark bank lending rate called the London
interbank offered rate.
If that spread of rates prevails, prominent hedge funds
like Long-Term Capital can borrow money from banks at
smaller premiums to the London rate to buy those
mortgages. The profit margin is not large, but the
biggest hedge funds leverage their positions 10, 20 or,
in Long-Term's case, perhaps 60 or 100 times,
magnifying gains.
Or losses. Turmoil in Asia, Russia and other emerging
markets turned such bets sour this year because the
spreading loss of confidence created an unwillingness
among investors to take what were previously considered
low-level risks.
Price alignments that Long-Term Capital uses to program
its computers have everywhere fallen out of whack.
Spreads on bonds meant to converge ended up diverging,
sometimes by huge margins, and they have stayed that
way longer than most thought possible.
Even ahead of European union, Danish bonds have sunk in
value as safer German bonds rise. U.S. commercial
mortgage-backed securities have lost value relative to
the London interbank rate, meaning that investors are
watching their portfolio of such bonds sink even as
banks demand loans back. Long-Term Capital had some
winning positions as well. But its bad bets overwhelmed
its good ones, and the heavy leverage proved deadly.
"He was betting on convergence when the world was
watching historic divergence," one trader said. "Many
people made that mistake. But they did not owe the
banks as much money as Meriwether did. That was fatal."
Copyright 1998 The New York Times Company |
