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

by Roger Lowenstein

Long-Term, a bond-trading firm, was on the brink of failing. The fund was run by John W. Meriwether, formerly a well-known trader at Salomon Brothers. Meriwether, a congenial though cautious mid-westerner, had been popular among the bankers. It was because of him, mainly, that the bankers had agreed to give financing to Long-Term—and had agreed on highly generous terms. But Meriwether was only the public face of Long-Term. The heart of the fund was a group of brainy, Ph.D.-certified arbitrageurs. Many of them had been professors. Two had won the Nobel Prize. All of them were very smart. And they knew they were very smart.

The prices did converge, and Salomon made a bundle. Hardly anyone traded financial futures then, but Meriwether understood them. He was promoted to partner the very next year. More important, his little section, the inauspiciously titled Domestic Fixed Income Arbitrage Group, now had carte blanche to do spread trades with Salomon’s capital. Meriwether, in fact, had found his life’s work.

and son of a Metropolitan Opera soprano. Homer, author of the massive tome A History of Interest Rates: 2000 BC to the Present, was a gentleman scholar—a breed on Wall Street that was shortly to disappear.

The models didn’t order them to trade; they provided a contextual argument for the human computers to consider. They simplified a complicated world. Maybe the yield on two-year Treasury notes was a bit closer than it ordinarily was to the yield on ten-year bonds; or maybe the spread between the two was unusually narrow, compared with a similar spread for some other country’s paper. The models condensed the markets into a pointed inquiry. As one of the group said, “Given the state of things around the world—the shape of yield curves, volatilities, interest rates—are the financial markets making statements that are inconsistent with each other?” This is how they talked, and this is how they thought. Every price was a “statement”; if two statements were in conflict, there might be an opportunity for arbitrage.

The whole experiment would surely have failed, except for two happy circumstances. First, the professors were smart. They stuck to their knitting, and opportunities were plentiful, especially in newer markets such as derivatives. The professors spoke of opportunities as inefficiencies; in a

perfectly efficient market, in which all prices were correct, no one would have anything to trade. Since the markets they traded in were still evolving, though, prices were often incorrect and there were opportunities aplenty. Moreover, the professors brought to the job an abiding credo, l...

And swap spreads did tighten—to 1 percentage point and eventually to a quarter point. All of Wall Street did this trade, including the Salomon government desk, run by the increasingly wary Coats. The difference was that Meriwether’s Arbitrage Group did it in very big dollars. If a trade went against them, the arbitrageurs, especially the ever-confident Hilibrand, merely redoubled the bet. Backed by their models, they felt more certain than others did—almost invincible. Given enough time, given enough capital, the young geniuses from academe felt they could do no wrong, and Meriwether, who regularly journeyed to academic conferences to recruit such talent, began to believe that the geniuses were right.

The Arbitrage Group, about twelve in all, became incredibly close. They sat in a double row of desks in the middle of Salomon’s raucous trading floor, which was the model for the investment bank in Tom Wolfe’s The Bonfire of the Vanities.

A misfit among Wall Street’s Waspish bankers, J.M. identified more with the parochial school boys he had grown up with than with the rich executives whose number he had joined. Unlike other financiers in the roaring eighties, who were fast becoming trendy habitués of the social pages, Meriwether disdained attention (he purged his picture from Salomon’s annual report) and refused to dine on any food that smacked of French. When in Tokyo, he went to McDonald’s. Ever an outsider, he molded his group into a tribe of outsiders as cohesive, loyal, and protective as the world he had left in Rosemoor. His cohorts were known by schoolboy nicknames such as Vic, the Sheik, E.R., and Hawk.

Traders had an anxious life; they’d spend the day shouting into a phone, hollering across the room, and nervously eyeballing a computer screen. The Arbitrage Group, right in the middle of this controlled pandemonium, seemed to be a mysterious, privileged subculture. Half the time, the boys were discussing trades in obscure, esoteric language, as if in a seminar; the other half, they were laughing and playing liar’s poker. In their cheap suits and with their leisurely mien, they could seemingly cherry-pick the best trades while everyone else worked at a frenetic pace.

Maughan, a bureaucrat, was too smart to go for this and tried to refashion Salomon into a global, full-service bank, with Arbitrage as a mere department. Hilibrand, who was dead opposed to this course, increasingly asserted himself in J.M.’s absence. He wanted Salomon to fire its investment bankers and retrench around Arbitrage. Meanwhile, he made a near-catastrophic bet in mortgages and fell behind by $400 million. Most traders in that situation would have called it a day, but Hilibrand was just warming up; he coolly proposed that Salomon double its commitment! Because Hilibrand believed in his trade so devoutly, he could take pain as no other trader could. He said that the market was like a Slinky out of shape—eventually it would spring back. It was said that only once had he ever suffered a permanent loss, a testament to the fact that he was not a gambler. But his supreme conviction in his own rightness cried out for some restraining influence, lest it develop a reckless edge.

As far as securities law is concerned, there is no such thing as a hedge fund. In practice, the term refers to a limited partnership, at least a small number of which have operated since the 1920s. Benjamin Graham, known as the father of value investing, ran what was perhaps the first. Unlike mutual funds, their more common cousins, these partnerships operate in

Wall Street’s shadows; they are private and largely unregulated investment pools for the rich. They need not register with the Securities and Exchange Commission, though some must make limited filings to another Washington agency, the Commodity Futures Trading Commission. For the most part, they keep the contents of their portfolios hidden. They can borrow as much as they choose (or as much as their bankers will lend them—which often amounts to the same thing). And, unlike mutual funds, they can concentrate their portfolios with no thought to diversification. In fact, hedge funds are free to sample any or all of the more exotic species of investment flora, such as options, derivatives, short sales, extremely high leverage, and so forth.

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.

J.M.’s design was staggeringly ambitious. He wanted nothing less than to replicate the Arbitrage Group, with its global reach and ability to take huge positions, but without the backing of Salomon’s billions in capital, credit lines, information network, and seven thousand employees. Having done so much for Salomon, he was bitter about having been forced into exile under a cloud and eager to be vindicated, perhaps by creating something better.

While he was an undergrad at Cal Tech, another interest, investing, blossomed. Merton often went to a local brokerage at 6:30 A.M., when the New York markets opened, to spend a few hours trading and watching the market. Providentially, he transferred to MIT to study economics. In the late 1960s, economists were just beginning to transform finance into a mathematical discipline. Merton, working under the wing of the famed Paul Samuelson, did nothing less than invent a new field. Up until then, economists had constructed models to describe how markets look—or in theory should look—at any point in time. Merton made a Newtonian leap, modeling prices in a series of infinitesimally tiny moments. He called this “continuous time finance.” Years later, Stan Jonas, a derivatives specialist with the French-owned Société Générale, would observe, “Most everything else in finance has been a footnote on what Merton did in the 1970s.” His mimeographed blue lecture notes became a keepsake.

jumped at the opportunity to join Long-Term Capital because it seemed a chance to showcase his theories in the real world. Derivatives, he had recently been arguing, had blurred the lines between investment firms, banks, and other financial institutions. In the seamless world of derivatives, a world that Merton had helped to invent, anyone could assume the risk of loaning money, or of providing equity, simply by structuring an appropriate contract. It was function that mattered, not form. This had already been proved in the world of mortgages, once supplied exclusively by local banks and now largely funded by countless disparate investors who bought tiny pieces of securitized mortgage pools.

Unfortunately, Merton was of little use in selling the fund. He was too serious-minded, and he was busy with classes at Harvard. But in the summer of 1993, J.M. recruited a second academic star: Myron Scholes.

But in truth, Scholes was the fund’s best salesman. Investors at least had heard of Scholes; a couple had even taken his class. And Scholes was a natural raconteur, temperamental but extroverted. He used a vivid metaphor to pitch the fund. Long-Term, he explained, would be earning a tiny spread on each of thousands of trades, as if it were vacuuming up nickels that others couldn’t see. He would pluck a nickel seemingly from the sky as he spoke; a little showmanship never hurt. Even when it came to the fund’s often arcane details, Scholes could glibly waltz through the math, leaving most of his prospects feeling like humble students. “They used Myron to blow you away,” said Maxwell Bublitz, head of Conseco’s investment arm.

Republic New York Corporation, a secretive organization run by international banker Edmond Safra, was mesmerized by Long-Term’s credentials and seduced by the possibility of winning business from the fund.18 It invested $65 million. Long-Term also snared Banco Garantia, Brazil’s biggest investment bank.

Long-Term opened for business at the end of February 1994. Meriwether, Rosenfeld, Hawkins, and Leahy celebrated by purchasing a shipment of fine Burgundies ample enough to last for years. In addition to its eleven partners, the fund had about thirty traders and clerks and $10 million worth of SPARC workstations, the powerful Sun Microsystems machines favored by traders and engineers. Long-Term’s fund-raising blitz had netted $1.25 billion—well short of J.M.’s goal but still the largest start-up ever.

The beauty of the trade was that Long-Term’s cash transactions were in perfect balance. The money that Long-Term spent going long (buying) matched the money it collected going short (selling). The collateral it paid equaled the collateral it collected. In other words, Long-Term pulled off the entire $2 billion trade without using a dime of its own cash.

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.

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.

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.

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 wi...

However, Long-Term’s approach was so mathematical, it’s doubtful that all this intelligence made much difference. Its models said simply that Italy was “cheap” relative to historical patterns and anticipated risks. The partners assumed that, all else being equal, the future would look like the past. Therefore, in they went. Moreover, its models were hardly a secret. “You could pick up a Journal of Finance and see where someone was applying models,” a London-based trader at Salomon Brothers noted with respect to the Italy trade. “Anyone who had done first-year math at university could do it.” In truth, traders at other firms had been doing similar trades for years. By the time Long-Term started to trade, spreads in Italy had begun to narrow; rival firms were bidding arrivederci. Haghani got his first billion dollars’ worth or so of Italian bonds from Salomon, which wanted out. The common notion that Long-Term had a unique black box was a myth. Other Wall Street firms had also found their way to MIT, and most of the big banks were employing similar models—and, what’s more, were applying them to the same couple of dozen spreads in bond markets.

If the amount of the typical change—the “volatility”—were known, they believed, the odds that a stock, bond, or any other asset would rise or fall by some proportion over time could be derived as well. The differential equations used to solve the Black-Scholes formula were adapted from physics equations that describe, among other phenomena in the physical world, the way cream spreads through a cup of coffee.4 Any one molecule’s trip is random, but as a group, the molecules distribute themselves in predictable fashion, from the center out. The cream will never go all to one side.

But Black-Scholes makes a very key assumption: that the volatility of a

To say that the value of an option to buy IBM depends on its volatility is meaningless unless you can agree on what its volatility is. Therefore, the professors treated the volatility of a security like an inherent, unchanging trait. You have blue eyes; IBM has a volatility of X. You or I might assume that the market fluctuations of so many yesterdays are so much noise—arbitrary, not necessarily likely to recur, and best forgotten. But to Black, Scholes, and Merton—and to Long-Term—these fluctuations were invested with deep predictive significance. Each tick of the market up or down was latent with an unerring forecast of future risk. This implied that markets were efficient and rational at every step.

At each infinitesimal moment, traders would readjust the price of options on IBM, keeping them in synchrony with the price of the stock. And traders who owned both could—by nimbly buying or selling—keep their portfolio in an Edenic, risk-free state of balance. In short, Merton assumed a perfect, risk-free arbitrage. This assumption may approximate real markets when they are calm—but only then. In 1987, so-called portfolio insurance was marketed (with absurd ballyhoo) to institutional investors as a technique of limiting losses via continuous selling when markets fall. These portfolio insurers helped to exacerbate a market crash that was later dubbed Black Monday. That day, the market was highly discontinuous. Portfolio insurers who had counted on nimbly limiting their losses couldn’t keep pace with the panic that broke out on Wall Street and, indeed, lost their shirts.

Merton’s perfect-arbitrage assumption was an essential building block in Long-Term’s (and many other firms’) hedging strategies. The partners, of course, had worked with the same risk assumptions at Salomon Brothers and had racked up phenomenal profits—albeit with the occasional nasty loss. This gave them tremendous confidence. Their trades usually were sensible, meaning that they were aligned with the odds. Nonetheless, the

fact that the group’s ship hadn’t capsized in the past didn’t guarantee that the group had properly calculated the odds of a tidal wave—just that such waves were relatively infrequent. Merton’s theories were seductive not because they were mostly wrong but because they were so nearly, or so nearly often, right. As the English essayist G. K. Chesterton wrote, life is “a trap for logicians” because it is almost reasonable but not quite; it is usually sensible but occasionally otherwise: It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.

Eric Rosenfeld, who had studied at MIT in the 1970s, looked up to Merton as an “unbelievable mathematician.” He noted that a single unpublished paper of Merton’s had triggered a host of dissertations by a cadre of inspired disciples. Of course, Merton’s entire oeuvre depended on his assumptions about random walks, with their close tie-in to the physical world. As the unassuming Rosenfeld described it, he and his fellow Merton protégés used to run to the physics library looking for formulaic solutions that they could “jam into finance.”

and how do we know that the next new period won’t change the story again? To focus on a single company, IBM lives in a dynamic, ever-changing world, in which managers perpetually confront new possibilities, new problems, and novel products, the risks of each of which would seem impossible to quantify. If a manager at Big Blue proposed to rely on the past as an accurate gauge of future risk, he would probably be fired.

If you follow the market even casually, you probably have a gut feeling that stocks (or bonds) are often inexplicably volatile; they do an awful lot of bouncing around. The most obvious example was Black Monday, when, on no apparent news, the market plunged 23 percent. Economists later figured that, on the basis of the market’s historic volatility, had the market been open every day since the creation of the Universe, the odds would still have been against its falling that much on any single day. In fact, had the life of the Universe been repeated one billion times, such a crash would still have been theoretically “unlikely.”13 But it happened anyway. Obviously, past volatilities do not prepare investors for shocks that lie in wait—

Curiously, Fama devoted the rest of his career to justifying the efficient-market hypothesis. He argued that Black Monday had been a rational adjustment to a (one-day?) change in underlying corporate values. On the other hand, Lawrence Summers, now the U.S. Treasury secretary, told The Wall Street Journal after the crash, “The efficient market hypothesis is the most remarkable error in the history of economic theory.”

The evangelical Merton showed disdain for the very possibility that investors could be anything but calculating automatons, and he blithely ignored the times when their emotions ran riot. Thus, he took credit for the contribution that his theories made to “the portfolio-insurance products of the 1980s”—as if he were blind to the fact that, when real people had tried those products, portfolio insurance had miserably failed.15 Even the word “speculative” he put into quotes, as though the notion that it might apply to real investors was so unpleasant he had to handle it with forceps. Indeed, when Merton referred to “well-known and colorful passages by Keynes,” he was knocking the English economist and man of letters for the sin of letting a vivid, human adjective or two slip into his copy. He had the disease of perfect belief, which makes compromise impossible. When Robert J. Shiller, an American economist, dared to suggest that markets were too volatile to

fit the model of perfect markets, you could sense that for Merton, to entertain any doubt at all was to risk seeing the entire edifice crumble: “We need hardly mention the significance of such a conclusion. If Shiller’s rejection of market efficiency is sustained, then serious doubt is cast on the validity of this cornerstone of modern financial economic theory.”

Even though we didn’t get charged a haircut, we had a risk management process where we calculated our hypothetical working capital. We went through every trade and said, “Suppose we are in a really stressful time, how much would the haircut be?” As Long-Term’s strategies grew more diverse, the fund felt comfortable taking bigger positions. It focused on its portfolio as a whole, and thus it was willing to pile bigger trades onto each of its “risk” dollars back in the vault. The theory, of course, was that the likelihood of many leveraged trades collapsing simultaneously was slim, just as an insurer does not expect that all of its clients will file claims simultaneously.

But this was not the whole picture either. On their own, Long-Term’s vaguely worded disclosures were next to meaningless. Aside from broad generalizations such as “interest rate swaps” or “government securities,” it was impossible to tell what its assets were. The derivative disclosures were especially opaque. Imagine asking your local bank for a personal loan on the basis of your “real estate assets” without bothering to say whether the real estate was in Appalachia or in Beverly Hills.

The world of bond arbitrage is relatively small. Certainly, the banks knew enough to ask for more specific disclosure. And of course, they could have declined to do business with Long-Term if satisfactory answers were not forthcoming.

floor and answered his phone with a gruff hello. He was famous for exhorting employees not to waste paper clips. Greenberg’s partner, James Cayne, the chief executive, had made his name by daring to make a market in New York City bonds in the difficult 1970s, when a young J.M. had been pursuing a similar strategy. Under Greenberg’s and Cayne’s unflinching management, Bear was informal, pragmatic, and relentlessly focused on its own self-interest. This worried Long-Term.

By 1996, Long-Term had grown to well over a hundred employees and the partners were building immense fortunes. All along, they had been deferring the 25 percent of the outside investors’ profits that they took as fees, thus leaving the money in the fund, where, untouched by the tax man, it could compound all the faster. As their third year drew to a close, the partners collectively had a stake in the fund of $1.4 billion, nine times their initial $150 million investment. It was an incredible fortune to have made in so little time—and all from bond spreads! The partners’ nervy decision to keep redoubling their bets had vaulted them into the ranks of the superrich overnight. Unlike corporate titans, who hedged their bets by continually peeling off shares, J.M., Hilibrand, Rosenfeld, and the rest left every nickel on the table. When they needed spending money, they simply redeemed a bit of the fund, which they treated like a personal checking account.

money was a scorecard, a proof of their superlative trading skills.

Only Meriwether, who had lived through more ups and downs than his

But the size of Haghani’s position was stunning. Long-Term bet $2.3 billion—half of it long on Shell, the other half short on Royal Dutch—without, of course, any assurance that the spread would contract. In practical terms, a position that large was totally illiquid.

Contrary to common supposition, there is nothing wrong with being illiquid—unless you are vulnerable to being forced to sell in a hurry. But Long-Term, being highly leveraged, was in that very spot—for, as we have seen, leveraged investors can accumulate losses with terrifying speed. Ignoring this oft-proven verity, Haghani struck a gargantuan trade with borrowed money. He was under stress due to the ill health of his father, who died later that year, and he felt pressure due to the deteriorating landscape in bond arbitrage. Still, there is no explaining the size of the Royal Dutch/Shell trade, other than to accept that Haghani was beginning to believe in his own invincibility. “It was ridiculously big,” said an executive at a Wall Street bank.

Veteran arbs quickly realized that somebody new had entered the game and that the somebody was both very big and indiscriminate—or, as Rosenfeld put it, not “information sensitive.” By buying in such volume, Long-Term was boosting deal stocks across the board, squeezing spreads to unprofitable levels. As usual, Long-Term was content to earn relatively tiny spreads because it intended to multiply its returns with leverage. Still, one marvels at Long-Term’s audacity, sauntering into a corner of Wall Street—one in which savvy veterans had been working for years—and rewriting the economics of the field overnight. Long-Term was the gorilla that announces the rules wherever it goes. One night, Hilibrand, J.M., and Mullins had dinner with Daniel Tisch, a prominent risk arbitrageur. Tisch, son of the investor Larry Tisch, had the impression that Long-Term was thinking about the business solely in mathematical terms. Indeed, Hilibrand expressed every financial puzzle in terms of a spread. In risk arb, spreads were roughly 4 percent to 10 percent, much greater than bond spreads. “Our business looks very attractive next to their business, where they trade to make a couple of basis points,” Tisch noted. “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 mer...

What mattered to J.M. and company was that they could make a huge investment in CBS with no money down and without having to make all of the usual disclosures. And despite Reg T, it was perfectly legal. The Fed, after all, merely restricted loans toward the purchase of stocks. Long-Term wasn’t purchasing anything; it was making side bets on the direction of stocks—which amounted to the same thing.