*** LTC article ***
Long-Term Capital: A Case of Markets Over Minds
By DOUGLAS FRANTZ and PETER TRUELL
NY Times
Bond traders nicknamed Long-Term Capital Management "Salomon North," a reference to the many partners in the Greenwich, Conn., hedge fund who were veterans of Salomon Brothers. But a more apt choice might have been "MIT South."
The people -- and the mathematical "rocket science" -- at the core of the elite hedge fund had strong ties to the Massachusetts Institute of Technology, and the working atmosphere was far closer to the studied tranquillity of academia than to a frenetic trading floor.
Even the setting in wealthy, quiet Greenwich was chosen to contrast with the gray skyscrapers and crowded, narrow streets of Manhattan's financial district. The partners, many of whom had mined those financial canyons for tens of millions of dollars, traded suits and ties for polo shirts and chinos, preferring to relieve stress with a game of pool or a fishing break.
The mood was collegial, recalled Peter van Rijssen, a recent college graduate who spent a pleasant three months as a $17-an-hour temp at Long-Term Capital in the summer of 1996. "Everyone was extremely friendly, from the boss on down," he said. "It was very calm and ordered."
That order was shattered last month as Long-Term Capital ran out of money and was deemed too big to fail without disrupting the global financial markets, leading to an emergency $3.6 billion capital infusion by a consortium of brokerage firms and banks organized by the Federal Reserve Bank of New York.
As the winds of turmoil strip away some of the firm's secrecy, a portrait emerges of a group of highly analytical, extremely rational former academics who believed they had created a mathematical trading model to withstand the sharpest gyrations of the global marketplace.
In hindsight, their lack of trading instincts and their adherence to numerical models -- which showed that their bets would eventually pay off -- kept them from understanding the gravity of their situation until it was too late.
So certain were they of the firm's infallibility that they kept virtually all their money in the fund, treating it as a checking account, and borrowed money to increase their personal stakes in it. Some expected to attain riches that would put them on a par with the wealthiest dynasties in America.
One of the 16 partners, Lawrence E. Hilibrand, an MIT graduate who earned $23 million at Salomon in 1990, borrowed $24 million last year to increase his investment in the fund. Now Hilibrand, his partners and many of firm's 180 employees are scrambling to avoid financial ruin and anguishing over the damage they have inflicted to themselves and their investors.
"Our wealth has been knocked down to zero in many cases," said a person involved with the firm. "But most of us came from backgrounds of academics and teaching, and it wasn't too long ago that we didn't have much." Of course, many of them have long become accustomed to the trappings of wealth.
The partners at Long-Term Capital have laid low, generally declining requests for interviews. "They have always been extraordinarily secretive and didn't want to be in any publication," said Antoine Bernheim, who could not even get enough information to include Long-Term Capital in his annual hedge fund directory. But several people involved with the firm agreed to speak on condition that their names be withheld.
John W. Meriwether, a pioneer in betting on fluctuations in bond prices, a strategy known as bond arbitrage, recruited many of the finest minds in finance, most from his former firm, Salomon Brothers, to create Long-Term Capital in 1993. They shared an intellectual approach to the world of trading, one that flowed from their backgrounds in academia and their doctorates in finance.
"These guys are among the best and the brightest," said William A. McIntosh, a former Salomon partner and a former colleague of many Long-Term Capital principals.
The partners "tried not to react to things too quickly," said one person involved since the early days. "We have tried to study things very carefully. We have tried to do it very slowly."
That strategy was well suited to the good times but would come back to haunt the partners when market volatility outstripped their ability to react.
Among the fund's original partners were two academics who had spent time at MIT and who would later share a Nobel Prize, Myron S. Scholes of Stanford University and Robert C. Merton of Harvard University, whose groundbreaking work in 1973 had turned risk management into a science and opened up Wall Street to the era of "rocket scientists," the mathematics and physics whizzes who trade according to formulas instead of hunches.
Scholes, whose Greenwich house overlooks Indian Harbor on a private road, played a key role in soliciting money for the original fund, according to one fund investor. "At the presentation, he was just the brightest guy I'd ever heard," the investor said. "It was a collection of uniquely intelligent men."
The rocket scientists included Eric R. Rosenfeld, a former professor at the Harvard Business School who had been a managing director at Salomon, and Gregory D. Hawkins, another former Salomon managing director and a former finance professor at the University of California at Berkeley.
Like Hilibrand, Rosenfeld and Hawkins did graduate work at MIT when Merton was on the faculty there. Scholes did his pioneering work while a junior faculty member at MIT. David W. Mullins Jr., who left the No. 2 spot at the Federal Reserve Board to join the venture, received his doctorate from MIT at the same time Scholes was teaching there.
Later, two others with MIT connections joined Long-Term Capital: David M. Modest, who had moved to Berkeley as a finance professor after graduating from MIT, and Chi-Fu Huang, an expert on creating models for swap contracts, financial instruments designed to take advantage of currency, bond and other price differences.
Success came fast. The firm, which is organized as a limited partnership with a minimum investment of $10 million, began trading in February 1994 and produced a net return of 20 percent that year, 43 percent in 1995 and 41 percent in 1996. In the first three years, investors more than doubled their money, far better than they would have done in a typical American stock fund. The fees that the firm charged investors were hefty, too -- a 2 percent
management fee and a 25 percent annual "incentive" fee, both well above those of other firms -- but no one was complaining.
Along with attracting money from wealthy individuals and institutions, the partners contributed about $150 million of their own money to the investment pool and then treated the fund like a private bank.
"Some months they would withdraw $10,000, and when they had a big purchase, they would take out more," said one person involved with the firm.
Some purchases were big, indeed, befitting risk takers who were reaping big rewards. Some of the partners had bought into a golf course in Ireland. Others began to learn about wine and developed a taste for $100-a-bottle Burgundies, like Gevrey-Chambertin.
Meriwether, a top earner on Wall Street for 15 years, already owned a 67-acre estate in Westchester County, N.Y. But even after earning $23 million in 1990 at Salomon Brothers, Hilibrand and his family remained in a $1 million colonial on about an acre in Scarsdale, N.Y.
In 1996, though, he and his wife, Deborah, paid $2.1 million for a 15-acre lot in a gated development in northwest Greenwich and began to build a $4 million home, according to records on file with the town's division of buildings. Construction is nearly completed, and the builder said recently that no one had told him to stop work.
Hilibrand shuns interviews and refused to have his photograph taken when he was a managing director at Salomon. Friends describe him as a political libertarian and say he is obsessed with his privacy.
Hilibrand is one of at least four Long-Term Capital partners who took out personal loans, secured by their shares in the firm, to increase their investments in the portfolio, according to people involved in the transactions. His loans are the largest, at $24 million.
Hans U. Hufschmid, who received $18 million in compensation from Salomon in 1993, according to a former firm official, also borrowed heavily. People involved with the firm said Hufschmid, a foreign-exchange expert who works out of the firm's London office, had borrowed $14.6 million to increase his fund equity.
Now Hilibrand and Hufschmid are negotiating with creditors from Credit Lyonnais and other banks to reschedule their debts and to persuade lenders to take a claim on future earnings, say bankers and others involved in the talks.
It is probably too soon to say whether anyone will be pushed into personal bankruptcy. "If banks require them to pay it today, they can't pay it," said one person involved in the firm's finances. "Their assets must stay in the fund. They also have other liquid things in their names. I believe everything can be worked out."
At the very least, the fabulous wealth has evaporated, and some partners may lose everything they have accumulated in recent years, from mansions to wine cellars.
"If people have to sell their homes, it's not the end of the world," said the person involved in the finances.
Scholes may have at least some money outside the fund. After he and Merton shared the $1 million for the Nobel economics prize in 1997, Scholes told a reporter that he would not be investing his portion in the hedge fund. "I thought about that," he told Institutional Investor magazine. "But I think it's in bad taste."
For some lower-level employees, the collapse of the firm means more than just lost wealth. A couple of days after the Sept. 23 bailout, a trader entered the office of one partner and began to weep. He said he feared that he would have to cancel his wedding because he had been wiped out, said a person who witnessed the scene.
The partners' decision to hang on to their market positions even as their capital evaporated and markets turned against them was completely in tune with their "take it slow" character. Trouble became apparent in May, when the portfolio lost 6.5 percent. In June, it lost 10 percent, leaving it down 5 percent for the first half of 1998, its first period in the red, according to people involved with the firm.
The cataclysm came on Aug. 17, when Russia devalued its currency and halted payments on its debt, sending bond prices down almost across-the-board. Only United States Treasury securities were spared as investors decided safety was everything.
Nearly every big investment house and bank that trades bonds took a hit, but Long-Term Capital was devastated because its positions were spread across the globe and it had invested as much as $100 billion in borrowed money.
By the end of August, the portfolio was down 44 percent for the month and 52 percent for the year.
After failed attempts to raise more money, the partners agreed to a rescue in late September by the consortium of 14 brokerage firms and banks. In exchange for an infusion of $3.6 billion in capital, the equity of the investors, including the partners and employees, was reduced to 10 percent and tight restrictions were set on their ability to withdraw funds.
For the moment, Long-Term Capital, rescued by its nervous creditors, has narrowly avoided a meltdown, and its partners with big debts, like Hilibrand and Hufschmid, seem sanguine about avoiding bankruptcy.
Things could still get worse -- if the financial markets eat away at the fund's capital and the rescue falls apart -- but the bulk of the risk has been shifted from Greenwich back to Wall Street, no small bit of rocket science itself.
"There is an old axiom in the restructuring business: If you're going to fail, then fail very big," said Thomas Maloney, a partner at Cleary Gottlieb Steen & Hamilton. That way, he explained, your creditors have to bail you out. |
