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

by Roger Lowenstein

With the exception of stocks in America, which are specifically subject to insider trading laws that are enforced as nowhere else, trading on private information goes on all the time. Investment banks that also operate proprietary bond-trading desks, such as Salomon and Goldman, publicly boasted of exploiting their knowledge of the “customer flow.” Translated, this meant that when a Salomon or a Goldman got wind of which way its customers were running, it often ran there too—and fast. This was why Goldman’s previous stewards had refused to get involved in proprietary trading; the possibility of conflicts of interest was just too great. But by 1998, Goldman was known as an aggressive, bare-knuckled trader that had long since abandoned any pretense of being a gentleman banker.

Normally, a free market cures such bubbles on its own. In 1980, for instance, the Hunt brothers had tried to corner the silver market, briefly taking the price to $50 an ounce. But then people began to sift through attics for stowed-away silver, and scrap dealers all over the world started melting it down. When all that metal reached the market, the price went back to $5 an ounce, and the Hunts filed for bankruptcy. But equity volatility was a rare bird. No one had stored volatility in his attic, there was no surplus source of supply. “Equity volatility was the ultimate short squeeze,” said a knowledgeable Long-Term employee. “There were only four or five dealers. And they refused to sell.”

The crisis was now public. On September 15, George Soros warned the House Banking Committee that Russia’s implosion had led to a global credit crunch. He blamed banks for fostering a “daisy chain of derivatives transactions”—language that seemed informed by his secret dealings with Long-Term.

Not surprisingly, the lenders were horrified by what they had wrought. “We had no idea they would have trouble—these people were known for risk management. They had taught it; they designed it,” reflected Dan Napoli, the Merrill risk manager who had so enjoyed golfing with the partners in Ireland. “God knows, we were dealing with Nobel Prize winners!” Ironically, only a very intelligent gang could have put Wall Street in such peril. Lesser men wouldn’t have gotten the financing or attracted the following that resulted in such a bubble.

Very interesting!!

Term’s total loss on Monday was $553 million, coincidentally equal to its loss of a month before. In percentage terms, this Monday’s loss was far worse: it ate through a third of Long-Term’s equity, leaving it with just under a billion dollars. And the fund still had more than $100 billion in assets. Thus, even omitting derivatives, its leverage was greater than 100 to 1—a fantastic figure in the annals of investment. Now, if Long-Term lost even a mere 1 percent more, it would be wiped out.

night in London—still afternoon in Greenwich—Andy Siciliano, the UBS manager, decided he had to see the hedge fund first-hand. He hopped the Concorde and bumped into Victor Haghani on the flight. Though both were jet-lagged by the time they arrived, neither man had any intention of sleeping. They shared a limousine to Greenwich, where J.M., Rosenfeld, and the laureates were holding court in the conference room. Goldman was still in the building, like an invading army that had established a beachhead. In the conference room, a bunker mentality prevailed. The partners couldn’t stop talking about how the Goldman traders were calling New York on their cell phones—though of course they couldn’t know what the traders were saying. But the notion that a conspiracy had done them in had become an obsession for the partners. When they finished with Goldman, they heaped their fury on Bear Stearns, disingenuously implying that Bear had sprung its letter out of the blue. Conveniently forgetting how disdainful they had been before, the partners abjectly wondered why their friends had abandoned them.

Fisher’s concern was the broader notion of “systemic risk”: if Long-Term failed, and if its creditors forced a hasty and disorderly liquidation, he feared that it would harm the entire financial system, not just some of its big participants. Greenspan later used the phrase “a seizing up of markets,” conjuring up the image of markets in such disarray that they might cease to function—meaning that traders would cease to trade.8 McDonough evoked a parallel fear—that losses in so many markets and to so many players would spark a vicious circle of liquidations, extreme fluctuations in interest rates, and then still further losses: “Markets would . . . possibly cease to function for a period of one or more days and maybe longer.”

Meriwether greeted the bankers with aplomb, but Hilibrand looked haggard and nervous; the losses had taken a toll on the master trader, who was also so personally leveraged. By now, meetings between Long-Term and inquiring bankers had a staged, too-familiar air. The partners were weary of reluctant suitors; what’s more, markets were moving so fast that the bankers had no way of knowing what the portfolio was worth. Conservatively valuing the portfolio at a discount, the bankers arrived at bids for the various pieces that added to little more than zero. Haghani seemed wounded by their minimal valuations. “Thank you for coming,” he told a Merrill banker with an air of rebuke, “but we don’t think you’re right. You ought to be investing with us.” He was like a drowning man trying to dictate terms to a rescuer on shore; in his heart of hearts, he was unsinkable. But Long-Term had sustained another loss Tuesday of $152 million, taking its equity down to $773 million. Jimmy Cayne, chief executive of Bear Stearns, advised Fisher that Long-Term had enough cash to get through Tuesday—but Wednesday could be a problem.13 What could it possibly do in twenty-four hours? The Morgan option was dead. Corzine doubted that “Mr. Big” would surface, either. That left it to Allison.

wanted to from the gang in Greenwich. For four years, the partners had held themselves aloof, picking off the best trades from each of the banks and not even trying to hide their smug superiority. Now the partners had the look of false prophets. The bankers felt taken—they had been so credulous. Several said the partners should be fired. Why give them the money? Allison and Corzine repeatedly broke away from the talks to give Meriwether updates (at least two banks were in on every phone call, to avoid the possibility of secret dealing). Meriwether sounded mortified to hear of the anger directed at him. “Look, I’ll help however I can,” he murmured.

Goldman’s Thain, who had the most intimate knowledge of Long-Term, described the portfolio risks. The group agreed that any investment should be in the form of equity, but no one beyond the four lead firms was ready to commit. Most of the banks thought they would lose less than $250 million if Long-Term failed; why throw good money after bad? Allison said that the fallout could be truly scary, even worse than after Russia. Long-Term had $100 billion of assets and $1 trillion in notional derivative exposure, he reminded the group.

While Kraus, Goldman’s investment banker, prepared a written offer, Buffett placed a call to Meriwether. “John,” he said in his unmistakable twang, “you’re going to get a bid for the portfolio with my name on it. I just want you to know that it’s me.” Meriwether was noncommittal.

Then, the focus shifted to Long-Term. Corzine said the partners were expendable. “We don’t need these guys; they created this mess,” Corzine said. No one exactly sympathized with Meriwether, but Allen Wheat of Credit Suisse First Boston said it would be a mistake to fire him. If the Street invested all this money in the fund, they would need someone to run it. And the guys

in Greenwich obviously knew it better than anyone. Corzine, though, insisted that the consortium at least had to get full control, including the right to fire J.M. and the other partners. It would need contracts locking the partners in and strict supervision over trading limits. Corzine went from one extreme to the other—now wanting J.M. as his partner, now wanting him in shackles. But he understood the flaws in Long-Term better than anyone else. The firm had no controls, no one above the level of trader. Insisting that Goldman would never invest without accountability, Corzine called Meriwether to make sure he would swallow the terms; otherwise, Goldman was out.

At 5:15 P.M., Allison called Meriwether with the terms. Long-Term would be getting $3.65 billion from a new “spoke” representing fourteen banks. In exchange, the banks would receive 90 percent of the equity of the fund. Long-Term’s existing investors would retain a 10 percent interest, worth about $400 million. But the partners’ share of the latter would be totally subsumed by the debts against themselves and LTCM. In short, their investment in Long-Term—once worth $1.9 billion—was totally gone, most of it lost in a mere five weeks. The details of the new arrangement had yet to be

The most inward of men, Meriwether had become a public figure identified with the arrogance, greed, and speculative folly of Wall Street taken to staggering excess. He and his devoted arbitrageurs were the authors of a historic collapse, one that had threatened the entire system. Camera crews descended on Greenwich, and television helicopters buzzed the firm’s formerly tranquil offices. Meriwether was at least spared the suggestion of personal dishonor, but otherwise late September was for him the worst kind of nightmare. He retained his uncanny calm, though one wondered if it masked a certain detachment from his tragedy. His only public utterance was a one-sentence remark, released through his press agent, in which he blandly expressed appreciation for the consortium’s capital.

Skadden started the negotiations Friday, three days before the deadline. Seventy lawyers from the various banks piled into Merrill’s boardroom. The lawyers discovered that the agreement they had come to negotiate actually didn’t exist; too many issues divided them. As the lawyers talked, the markets tumbled again, knocking Long-Term’s capital down to $400 million—91 percent below its level of January 1.

The partners got copies of the contract early Saturday. 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.

The prestigious Midtown law firm had set out two big conference rooms and a series of private suites on the thirty-third 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.

his debts behind him. Of course, that would take the fund down, too. Après moi . . . Hilibrand’s antics reminded the bankers of how little they wanted to be there. They were loath to help the partners personally. Only fear kept them in the deal. Allison thought it would be worse for the markets—much worse—if Long-Term failed now, after a deal had been announced. Moreover, Merrill’s reputation was on the line. And Long-Term’s lawyers knew how badly Allison wanted the deal; they played the game of chicken masterfully. “The consortium said, ‘You have no alternative but us,’ ” recounted Bell, the Long-Term lawyer. “And we said, ‘You have no alternative but us.’ ” Though it is seldom realized, a creditor is also beholden to his debtor.

Corzine, who was returning from a weekend at his majestic beachfront home in the Hamptons, called the meeting room from his cell phone. When Corzine reiterated that Goldman would not invest unless Chase left its money in, Pflug, who had steadily been losing patience, exploded. “Jon,” he said, “there is no polite way to say this—Goldman can go fuck themselves!” Corzine, who was stuck in traffic on the Long Island Expressway, let it pass; he was used to getting heat from his bickering partners, who were backing away from the consortium again. After talking to Corzine, Katz said resignedly, “We can’t get an answer tonight.” So Goldman was out, too. Katz said Goldman’s executive committee would meet Monday morning at 6:30 and decide then. Now it was the turn of Steve Black, the Salomon Smith Barney executive, to erupt. All Goldman really wanted, he fumed, was twelve hours’ time to trade in Japan before it made up its mind. “No way!”

Merton was more distraught over the stain that Long-Term’s failure cast on modern finance and on his own prodigious academic oeuvre. Though tacitly conceding that the models had failed, he insisted that the solution was to design ever-more elaborate and sophisticated models.² The notion that relying on any formulaic model posed inescapable risks eluded him.

Merrill Lynch’s stock price plummeted by two thirds in a mere three months—not as severe, and certainly not as enduring, as the 92 percent loss from top to bottom in Long-Term’s equity, but astonishing nonetheless. Komansky and Allison had taken such pride in shielding Merrill from proprietary trading, but Merrill’s bond traders lost close to a billion dollars all the same. Suddenly anxious that Merrill’s own credit rating would come under pressure, Merrill, led by Allison, aggressively cut costs and fired 3,500 people, largely in the bond department. By mid-October, not only was Long-Term imploding again, but its new owners, the leading banks on Wall Street, were in deepening trouble.

The fallout from the bust fell broadly but—as is usually the case—unevenly on various of Long-Term’s investors, employees, counter parties, and Wall Street friends. Herb Allison, who had done more than anyone to save the fund, was soon resented within Merrill Lynch for his role in Merrill’s zealous cost cutting. When the crisis passed and memories of the panic faded, Allison was blamed for overreacting. Informed that he was not in line to succeed Komansky, Allison resigned and went to work for Senator John McCain’s presidential campaign. Daniel Napoli, Merrill’s risk manager, took the fall for Merrill’s losses. Replaced, he went on long-term leave.

Excellent!