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

by Roger Lowenstein

The first modern swap was engineered in 1981. IBM had bonds denominated in Swiss francs and German marks and wanted to convert this debt to dollars. David Swensen, a Yale Ph.D. newly arrived at Salomon, suggested that perhaps some other borrower could be persuaded to issue debt that, aside from being denominated in dollars, was identical to IBM’s. One obvious choice was the World Bank, which had an appetite for holding debt in a variety of currencies. As an inducement to borrow, Salomon gave the bank a slightly lower-than-market interest rate. Then the two borrowers switched—IBM winding up with dollar debt, the World Bank with the foreign stuff—and voilà! the world of swaps was born. The business grew—at first slowly, then exponentially. Soon, banks were swapping obligations for currencies, interest rate payments, equities, any future stream of cash that could be traded for another. In 1990, there were $2 trillion worth of interest rate swaps (just one type of derivative) outstanding. By 1997, the total had soared to $22 trillion.5 One offshoot—largely unintended—of this tremendous growth was that banks’ financial statements became increasingly obscure. Derivatives weren’t disclosed in any way that was meaningful to outsiders. And as the volume of deals exploded, the banks’ balance sheets revealed less and less of their total obligations. By the mid-1990s, the financial statements of even many midsized banks were wrapped in an impenetrable haze.

Term, the group had a total derivative book worth $650 billion. Within two years, the total doubled, to an astounding $1.25 trillion. Given the opaque nature of Long-Term’s (and everyone else’s) disclosures, it was impossible to pinpoint the fund’s derivative risks according to specific trades. And since many of its contracts were hedges that tended to cancel each other out, it was impossible to calculate Long-Term’s true economic exposure. One could say only that it appeared to be growing very quickly—as were exposures up and down Wall Street. Almost imperceptibly, the Street had bought into a massive faith game, in which each bank had become knitted to its neighbor through a web of contractual obligations requiring little or no down payment.

With regard to derivatives, the policy-making arm of the Fed took a laissez-faire approach—starting with Greenspan, who was enamored with the seamless artistry of the new financial tools. In public debates, Greenspan repeatedly joined forces with private bankers, led by Citicorp’s John Reed, who were fighting tooth and nail to head off proposals for tougher disclosure requirements. Even as hedge funds increasingly used swaps to dodge the Fed’s own margin rules, Greenspan cast an approving eye. Incredibly, rather than trying to extend some form of margin rule to the derivative world, Greenspan proposed to eliminate the margin rules entirely. His 1995 testimony to Congress read like a banker’s brief. At its heart was a beguilingly simple idea: that more trading (and hence more lending) was always and inherently good because it bolstered “liquidity.”

Removal of these financing constraints would promote the safety and soundness of broker-dealers by permitting more financing alternatives and hence more effective liquidity management. . . . In the case of broker-dealers, the Federal Reserve Board sees no public policy purpose in it being involved in overseeing their securities credit.10 A bit of liquidity greases the wheels of markets; what Greenspan overlooked is that with too much liquidity, the market is apt to skid off the tracks.11 Too much trading encourages speculation, and no market, no matter how liquid, can accommodate all potential sellers when the day of reckoning comes. But Greenspan was hardly the first to be seduced by the notion that if only we had a little more “liquidity,” we could prevent collapses forever.

Save

for the Fed, the only ones who could restrain derivative lending were the banks. But Wall Street never polices itself in good times. The banks’ own balance sheets were steadily ballooning; by the late 1990s, Wall Street was leveraged 25 to 1.12 Awash with liquidity if not quite drowning in it, the banks had to find an outlet for their capital. The most tempting targets were hedge funds. “People were looking at the good side of the world,” noted Steve Freidheim, a trader and hedge fund manager at Bankers Trust. “I could borrow any amount I wanted, and the rates kept coming down. I’d get calls from banks saying, ‘Hey, we got another fifty million for you—we got a hundred million!’” As banks relentlessly chased the fund business, they silently ...

chortled

“The simple fact is that very sophisticated banks loaned to Indonesian companies, without any real knowledge of their financial condition,” noted James Wolfensohn, president of the World Bank.21

Warren Buffett, who, through Berkshire Hathaway, was Salomon’s biggest shareholder, was constitutionally opposed to investing more money in failing enterprises, which time and again he had equated with throwing good money after bad. Deryck Maughan, the chief executive of Salomon, made it clear that the only other option was to sell the company. “Warren wanted to sell so badly,” a director of the company said.

But to whom? Maughan sounded out Chase, but the bank rebuffed him. Then he had lunch with Sanford I. Weill, chairman of Travelers, the insurer and parent of broker Smith Barney. Weill was one of the great second acts in American business. The son of a Brooklyn dress manufacturer, Weill had founded a humble four-man brokerage firm and, via mergers, stitched together the giant Shearson Lehman. Eventually, he had sold to American Express, lost out in a power struggle and resigned. Then, in the late 1980s and early ’90s, he had done it again, getting control of a small credit company and using it to take over Smith Barney and also Travelers. He disliked arbitrage, which he considered too volatile, but he had dreams of building a premier investment bank, a rung above the ragtag brokerage business in Wall Street’s social hierarchy. Perhaps Smith Barney and Salomon could put their two second-class banks together, Weill proposed. After the lunch with Maughan, Weill called back to insist that he would have to be in charge if Travelers and Salomon merged. Buffett didn’t care who ran the new company, he just wanted to sell the old one—at a good price, naturally. Weill offered $9 billion in stock, bailing the Omaha sage out of one of his most troubled investments. Ever diplomatic, Buffett praised Weill as a “genius” at building shareholder value.25 Weill’s underlings were aghast that he had paid so much for a second-rate firm, particularly one in which the primary source of profits wa...

Salomon still had a profitable arbitrage unit, but its attempt to build a broad bank had failed. Long-Term, while toying with the idea of diversifying, had remained focused, a smart decision thus far. But as both firms well knew, arbitrage was entering a tougher period. Their responses were 180 degrees apart. By merging Salomon with a more diversified partner, Buffett had diluted the Salomon shareholders’ interests in arbitrage and in the rest of Salomon’s business. Now they would own pieces of a much larger Travelers. Long-Term’s partners had made the exact opposite decision: to a great extent, they had bought out their partners, thus redoubling their bets on arbitrage. The irony was that Buffett had converted a chronic loser into $9 billion while Long-Term’s partners had converted a consistent winner into a giant—and still unrealized—bet on the future.

UBS, Long-Term’s new big investor, also had gambled on equity volatility, and that and other exotic trades were turning into a disaster for the bank. Rumors were circulating of massive losses in the derivatives unit, run (with total autonomy) by Goldstein, who had pocketed an $11.5 million bonus for 1996.35 When toted up, UBS’s losses in 1997 would reach $644 million. Among other bad trades, UBS lost heavily on Japanese convertibles, which Long-Term had understood better. Cabiallavetta, the bank’s chief executive, had long protected Goldstein. Now he finally realized that his pet trader was destroying the bank. In November, Cabiallavetta fired Goldstein. Then, in December, Cabiallavetta admitted that his bank was bereft of leadership and humbly struck a merger with the archrival Swiss Bank. Although Cabiallavetta would stay as chairman and the bank would keep the UBS name, Swiss Bank was clearly the winner. Basel filled most of the important jobs and imposed its more conservative culture on the gunslingers in Zurich. Ironically, by merging with its flamboyant rival, Swiss Bank had become a party to the Long-Term warrant that it previously had spurned.

He gave a brief toast, expressing gratitude and also regret that Fischer Black hadn’t lived to share the award.

Therefore, if you knew the price of an option, you could infer the level of volatility the market was expecting.

But the trades were quite risky nonetheless. For one, forecasting the market’s volatility is notoriously dicey—unless you believe that the past is a reliable predictor of the future. Who could predict when a crisis in Asia might develop—or how jittery markets would become if one did? Who could say how volatile the market “should” be? It was like forecasting a frost in Florida.

And Long-Term would have to settle up—paying or receiving monies according to how option prices moved—every day. It might be right on equity vol in the long run, but only if it could stand the pain in the short run. And over five years, the pain suffered on such a large trade could be considerable. On a given day, it was possible that no one would want to sell, in which case Morgan could mark up the asset to whatever higher price it decided was reasonable. Therefore, Long-Term wasn’t betting only on the extent of ultimate realized volatility, it was betting on day-by-day inferred volatility, as determined by what other investors would pay for options. In effect, it was betting that these other, and presumably less rational, investors wouldn’t bid up prices further. This was—so unlike the partners’ credo—rank speculation. By putting themselves at the mercy of short-term fluctuations, the partners had abandoned whatever advantage lay in their precise mathematical models.

Long-Term shorted options at prices that implied a market volatility of 19 percent a year (traders refer to this as “selling volatility at 19 percent”). As option prices rose, Long-Term continued to sell. Other firms sold in tiny amounts. Not Long-Term. It just kept selling. Rosenfeld, Hilibrand, and Modest worked the trade in Greenwich; Haghani and Hufschmid did it in London. Eventually, they had a staggering $40 million riding on each percentage point change in equity volatility in the United States and an equivalent amount in Europe—perhaps a fourth of the overall market. Morgan Stanley coined a nickname for the fund: the Central Bank of Volatility.

mood at Long-Term was relaxed, too. Though the fund’s leverage was up, and though the partners had taken out huge personal loans, their exposure seemed tolerable. According to one estimate, Hilibrand alone was worth half a billion dollars and Meriwether was in the low hundreds of millions. And the partners had seemingly tailored the fund’s portfolio to control the risk. According to their models, the maximum that they were likely to lose on any single trading day was $45 million—certainly tolerable for a firm with a hundred times as much in capital.2 According to these same models, the odds against the firm’s suffering a sustained run of bad luck—say, losing 40 percent of its capital in a single month—were unthinkably high. (So far, in their worst month, they had a lost a mere 2.9 percent.) Indeed, the figures implied that it would take a so-called ten-sigma event—that is, a statistical freak occurring one in every ten to the twenty-fourth power times—for the firm to lose all of its capital within one year.

And Hilibrand and Haghani weren’t really listening. Younger colleagues espied an impulsive streak, not so surprising in Haghani, perhaps, but totally baffling in the case of Hilibrand. The intellectually curious Modest was deeply resentful of having to be, as a colleague teased him, “Larry’s execution slave.” 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. When he saw his partners departing from their trademark prudence, the firm lost all its meaning for him. Totally dominated by the two senior traders, Long-Term had become a lopsided firm; it was a partnership only in name.

In April, Sandy Weill, still trying to digest his ill-considered acquisition of Salomon, announced the biggest financial merger in history: Travelers and Citicorp. The deal was emblematic of the Street’s Panglossian mood. Thirty-year Treasury yields had dipped below 6 percent, reminiscent of the stable and innocent bond markets of Meriwether’s youth. The belief in a brighter tomorrow, coupled with the general willingness to lend, pushed down rates for even the least creditworthy of borrowers. Spreads fell to their lowest levels in years. A-rated bonds fell to 60 points (down from 75 at the start of the year). The shrinking spreads worked like a tonic on Long-Term’s profit-and-loss statement. Having been flat in the first quarter, the fund earned almost 3 percent in April. The end of April, approximately, was the low point for spreads, the high point for confidence, and the high point for Long-Term Capital, which boasted $134 billion in assets. In just over four years, an investment in the fund had quadrupled, before accounting for the partners’ fees. After deducting this tithe, the value of a single dollar invested at the start had risen to $2.85—a phenomenal 185 percent profit in barely fifty months.

In response to a question, Succo declared that the senior managements at some—possibly all—Wall Street firms had no idea of the risks being run by their twenty-six-year-old traders. He hedged a bit, adding that his management was better informed. But the heresy was accomplished. For suggesting that Wall Street’s top brass was uninformed, the prophetic Succo was forced to resign from Lehman.

By far, the firm where unease lay heaviest was Travelers. The firm’s bosses had been shocked to learn that the fixed-income arbitrageurs at Salomon Brothers, their newly acquired subsidiary, routinely took home year-end bonuses of $10 million and more. Weill and his top lieutenant, Jamie Dimon, were hostile to the star system pioneered by Hilibrand, under which traders at Salomon (now Salomon Smith Barney) took home a percentage of their profits. Since the traders were not penalized for losses, they had a perverse incentive to bet as much of the company’s money as they could. Essentially, Weill and Dimon viewed arbitrage as a dressed-up form of gambling. Not surprisingly, they took a dim view of Long-Term, a major Salomon client. Shortly after the merger, Dimon asked Long-Term for more information. Meriwether reflexively replied that such information was private. Dimon, who had no allegiance to Greenwich, threatened to cut Long-Term off, and J.M. meekly complied with Dimon’s request.9 A new breeze was blowing.

All over Wall Street, McEntee’s fellow traders were now speaking of a “flight to quality”—that is, to Treasury bonds. By mid-June, the yield on the thirty-year Treasury had fallen to 5.58 percent, the lowest since the government had started issuing thirty-year bonds in 1977.

And Goldman, which was hoping to go public in the fall, did not wait long to see if the optimism it had generated in Russia lingered. It quickly unloaded its inventory of Russian bonds so as not to be stuck with the paper it had floated to investors.

By the end of June, thanks to bonds issued by Goldman as well as J. P. Morgan and Deutsche Bank, foreign markets were beginning to choke on Russian paper. Interest rates on one-year Russian bills skyrocketed to 90 percent.

Bear Stearns, the fund’s clearing broker, also took a strong interest in Long-Term’s losses. But in July, the fund recovered. “Since we could see the daily P&L [profit-and-loss statement], we knew in early July there was a significant recovery,” noted Bear’s Mike Alix. “The story was, they had gone back and retested all their models and come to the conclusion that June was an expected aberration. That was the party line.”

The surest sign of Long-Term’s continued confidence was that the fund continued to recruit new people. Always infatuated with new technology, the partners hired eight new software whizzes over the summer. The staff hit a peak of 190.

If people did not care, it was because the monetary policemen had been so quick to patch any sign of trouble. In July, at Secretary Rubin’s urging, the IMF and various nations worked out a $22.6 billion Russian bailout, seemingly demonstrating that there was no financial problem that they couldn’t fix. (Much of the bailout money would be stolen by Russian oligarchs and siphoned out of the country.)

(Churchill had declared in 1939, “I cannot forecast to you the action of Russia. It is a riddle wrapped in a mystery inside an enigma.”) In 1998, too, Russia was beyond the realm of econometrics, even of the computers in Greenwich.

In contrast to this well-founded caution, Fed chief Greenspan was still singing the praises of unfettered derivative markets. On July 30, testifying before the Senate Committee on Agriculture, Nutrition, and Forestry, Greenspan declared that derivative traders “have managed credit risks quite effectively through careful evaluation of counterparties.” The words can only mean that, in Greenspan’s view, a Merrill or a Morgan was carefully scrutinizing clients such as Long-Term—a view that would soon become demonstrably false.

During the second week of August, Russia’s markets snapped. On August 13, with dollars fleeing the country, its reserves dwindling, its budget overtapped, and the price of oil, its chief commodity, down 33 percent, the government imposed controls on the ruble. The banking system froze for lack of reliable and solvent banks. The Moscow stock market briefly halted trading. It ended the day down 6 percent—and down 75 percent for the year. Short-term interest rates surged to almost 200 percent. Long-term Russian bonds fell to half their price of only two months earlier, when Goldman had happily floated them. As the world waited for a ruble devaluation, which the government still insisted would not occur, the Communist-dominated Duma, the lower house of Parliament, rejected reform measures urged on it by the IMF. Then the members went on vacation. When the government begged the Duma to reconvene, the members refused—but by then many government leaders, including President Boris Yeltsin, were also at seaside dachas, leaving the country to sort out its misery. It was a hard thing to model.

Naturally, credit spreads kept widening. Since April, the high point for bond arbitrage, A-rated bonds had moved from 60 points over Treasurys to 90 points. U.S. swap spreads were rising, too. At every Wall Street bank, arbitrage desks were cutting back; capital was fleeing from bond arbitrage just as it had fled from Asia. The Fed, at first, had been favorably disposed toward the trend. Spreads had been tight, credit too easy. But now, in the context of Russia’s meltdown, the Fed’s nerves were on edge.

Their fund had $3.6 billion in capital, of which two fifths was personally theirs. It would take only five weeks for them to lose it all.

On Monday, August 17, Russia declared a debt moratorium. The government simply decided it would rather use its rubles to pay Russian workers than Western bondholders.

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 percent of its capital—on that one Friday in August. It had started the year with $4.67 billion. Suddenly, it was down to $2.9 billion. Since the end of April, it had lost more than a third of its equity.

Buffett met Hilibrand at the airport that Thursday and escorted him back to his office, a modest suite in a pale high-rise across the street from a pizzeria. Hilibrand was his usual methodical self. He was candid about Long-Term’s losses but totally controlled. He did not strike Buffett as desperate. The arbitrageur went over his battered portfolio in detail. Hilibrand stressed that he saw great potential going forward—given his personal debts, he had little choice. But Long-Term was in a hurry to raise money, Hilibrand said, and thus he offered to cut the fund’s usual fee in half.

The damage in Long-Term’s markets was acute. Equity volatility broke above 30 percent. Yields on Treasurys dropped, widening credit spreads ever more. Spreads on investment-grade bonds exploded upward—on that one day—from 133 points to 162! In truth, such spreads had to be inferred, because almost nothing in bond markets traded that day. The bond market had effectively closed; no one could trade out of anything, or not without suffering horrendous losses. It was as if a bomb had hit; traders looked at their screens, and the screens stared blankly back. Buyers were simply nowhere to be found. “August thirty-first was a unique day,” said Curtis Shambaugh, the bond strategist at Credit Suisse First Boston. “So few issues traded, you had to guess where they were.” For a fund that had to lighten its load, the month had ended with the most nightmarish kind of bond market imaginable: no bond market at all.

August was the worst month ever recorded in credit spreads.25 In the past, such ballooning spreads had presaged an economic collapse. But this time, no depression threatened Main Street; perhaps a slowdown, but nothing more. The bond market collapse was caused by a panic not in the mainstream economy but on Wall Street itself, where too much optimism (and too much leverage) had suddenly come undone.

Three quarters of all hedge funds lost money in August, and Long-Term did the worst of any of them. In one dreadful month, Meriwether’s gang lost $1.9 billion, or 45 percent of its capital, leaving it with only $2.28 billion. The Soros opportunity was gone—hopelessly gone. And Long-Term’s portfolio still was dangerously bloated. The fund had $125 billion in assets—98 percent of its prior total and an extraordinary fifty-five times its now-shrunken

shrunken equity—in addition to the massive leverage in its derivative bets, such as equity volatility and swap spreads. This leverage was simply untenable. If its assets continued to fall, its losses would eat through that $2.28 billion sliver of equity in an eye blink. Yet that leverage could no...

Long-Term faxed the confidential letter on September 2, but one of the investors leaked it to Bloomberg, the financial news service, which published it even before the last investor had gotten his copy. This dollop of unwanted publicity hit the partners like a splash of ice water. The Wall Street Journal gave top billing to Long-Term’s losses in a broader story on financial distress,² and James Cramer, an on-line financial columnist, stingingly observed that perhaps the term “genius” should be reserved for Mozart and not for arbitrageurs.

their worst crisis yet, the partners moved $38 million out of the portfolio and into LTCM (which they personally owned) in the form of a loan. This dubious transaction provided the cash to pay salaries through the end of 1998, buying LTCM some time with the employees. The fund’s outside directors approved the loan, reasoning that if LTCM failed, the fund itself could topple. But the loan, even though contractually permissible, was shot through with conflicts of interest. The partners were withdrawing—or, technically, borrowing against—their own investment in the fund without giving the same opportunity to the outside investors for whom they were trusted fiduciaries. It was a sign of rank desperation.

And Long-Term had bet on risk all over the world. In every arbitrage, it owned the riskier asset; in every country, the least safe bond. It had made that one same bet hundreds of times, and now that bet was losing.

UBS, Long-Term’s biggest investor, was feeling even worse than Bear. David Solo, a derivatives whiz from the old Swiss Bank, realized—too late—that the newly merged UBS was in for horrendous losses. As Solo analyzed the warrant package, UBS had taken a huge risk for a potential return of only 8 percent—which now, of course, it would never realize. “All this discussion of option hedging, volatility and premiums is ridiculous,” he tapped in an urgent September 14 e-mail to Marcel Ospel, formerly head of Swiss Bank and now CEO of UBS. In a dig at their merger partners, Solo added conspiratorially, “This trade was approved by the UBS group executive board and by many people sitting around your table.”

Long-Term did have one escape hatch: the revolving credit it had obtained in 1996 from the bank syndicate led by Chase. The $900 million revolver (raised from $500 million initially) was a standby facility that Long-Term could tap when it wanted. Usually, such facilities terminate automatically if the borrower suffers a sharp deterioration, known as a “material adverse change.” But in its eagerness to deal with Long-Term, Chase had omitted the material-adversechange clause. The revolver was cancelable if, at the end of any accounting period, Long-Term’s equity fell by more than half. And the banks were squawking that the fund’s losses had freed them of their obligation to fund. But the last “accounting period” had ended on July 31—at which time Long-Term had still had plenty of equity. So technically, the banks were on the hook. Thanks to Chase’s sloppy drafting, the banks would have to lend $900 million to an insolvent.

In Greenwich, Goldman’s sleuths, who had the run of the office, left no stone unturned. Long-Term’s staff couldn’t keep track of who the Goldman people were, so many were rummaging through the hedge fund’s files. A key member of the Goldman team was Jacob Goldfield, a lanky and brilliant but abrasive trader. According to witnesses, the headstrong Goldfield appeared to be downloading Long-Term’s positions, which the fund had so zealously guarded, from Long-Term’s own computers directly into an oversized laptop (a detail that Goldman later denied). Meanwhile, Goldman’s traders in New York sold some of the very same positions. At the end of one day, when the fund’s positions were worth a good deal less, some Goldman traders in Long-Term’s offices sauntered up to the trading desk and offered to buy them.19 Brazenly playing both sides of the street, Goldman represented investment banking at its mercenary ugliest. To J.M. and his partners, Goldman was raping Long-Term in front of their very eyes.

Very interesting taunt against Goldman!

In every class of asset and all over the world, the market moved against the hedge fund in Greenwich. Rickards, the house attorney, described it to colleagues as the “LTCM death trade.” The correlations had gone to one; every roll was turning up snake eyes. The mathematicians 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, the tails are always fat. 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 Hilibrand, 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. The professors hadn’t modeled this. They had programmed the market for a cold predictability that it had never had; they h...

But Goldman was hardly alone. Knowledge of Long-Term’s portfolio was, by now, commonplace. Salomon was, and had been, pounding the fund’s positions for months. Deutsche Bank was bailing out of swap trades, and American International Group, which hadn’t shown any interest in equity volatility before, was suddenly bidding for it. Why this sudden interest, if not to exploit Long-Term’s distress? Morgan and UBS were buying volatility, too. Some of this activity was clearly predatory. The game, as old as Wall Street itself, was simple: if Long-Term could be made to feel enough pain—could be “squeezed”—the fund would cry uncle and buy back its shorts. Then, anyone who owned those positions would make a bundle.