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October 4 - October 8, 2022
Ironically, by merging with its flamboyant rival, Swiss Bank had become a party to the Long-Term warrant that it previously had spurned.
Moreover, Merton was highly agitated about the fund’s compensation structure, which was top-weighted toward Hilibrand and Haghani. As an options expert, he knew that the senior partners had an added incentive to shoot for the moon—a “moral hazard,” as economists say.
In times of trouble, markets become more closely linked, and seemingly unrelated assets rise and fall in tandem.
Markets can remain irrational longer than you can remain solvent.
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.
By now Long-Term was succumbing to the fatal temptation to put its money someplace.
“We misread the haircuts that we needed to be protected,” Dunn admitted. “It wasn’t a mistake we made singly for Long-Term. The whole market was pressuring us. To suffer the organization telling you that you are losing business—it takes a tremendous amount [of courage] to stand up and say, ‘I’m not going to do it.’ The Street all got that collectively wrong.”
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,
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Jim McEntee, J.M.’s friend and the one partner who relied on his nose, as distinct from a computer, sensed the trade-winds changing. He repeatedly urged his partners to lower the firm’s risks, but McEntee was ignored as a nonscientific, old-fashioned gambler. Since moving to Connecticut, the partners, who no longer had to jostle with the throngs on Wall Street every day, had become even more isolated from the anecdotal, but occasionally useful, gossip that traders pass around.
To their credit, Travelers’ Weill and Dimon smelled a rat in Russia when others didn’t. “Sandy hated Russia,” according to one of his London traders. “He said it was lawless.” An IMF official met with Salomon in June and urged the bank to back Moscow, whose leadership he praised. The IMF mission chief in Moscow tried a different tack, assuring Salomon that the United States would never let a nuclear power default. But Weill and Dimon were uncomfortable with being exposed to surprises, and they sensed that Russia would bring nothing but. Though fascinated by geopolitics and Russia in
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Russia was a singularly poor laboratory for Long-Term’s type of trading. Less than a decade removed from communism and struggling to become a democratic society, Russia was almost inherently unpredictable. Haghani’s knowledge of history should have told him that. (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.
The default shattered the lazy but convenient assumptions of investors that the safety net would always be there. It “punctured a moral hazard bubble”³ that had been inflating expectations since Rubin had ridden to the rescue of Mexico.
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.
Now Rosenfeld figured there was no one better to offer Long-Term’s merger portfolio to than Buffett. The billionaire liked to deal in size. He had done risk arbitrage before. And thanks to widening deal spreads, prices were attractive. Buffett listened attentively. But he quickly noted that he hadn’t been involved in merger arbitrage in a while and wasn’t up to speed. No sale. Graciously, he asked if there was anything else he could do.
“I had a different view,” Soros noted.12 The speculator saw markets as organic and unpredictable. He felt they interacted with, and were reflective of, ongoing events. They were hardly sterile or abstract systems. As he explained it, “The idea that you have a bell-shape curve is false. You have outlying phenomena that you can’t anticipate on the basis of previous experience.” Russia, where Soros’s funds had just lost $2 billion, was an example of just such an “outlying phenomenon” that lay outside the professors’ curves.
Long-Term knew it had to reduce its positions, but it couldn’t—not with markets under stress. Despite the ballyhooed growth in derivatives, there was no liquidity in credit markets. There never is when everyone wants out at the same time. This is what the models had missed. When losses mount, leveraged investors such as Long-Term are forced to sell, lest their losses overwhelm them. When a firm has to sell in a market without buyers, prices run to the extremes beyond the bell curve. To take just one example, yields on News Corporation bonds, which had recently been trading at 110 points over
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This was hardly enough for Buffett. In his opinion, Long-Term’s fees had been too high as they were.21 In any case, he had little interest, at least for now. Buffett said thanks, but no thanks.
And the partners were tortured by the memory of having returned—despite the Sheik’s strenuous objections—$2.7 billion to investors. Worse, they had forced their investors to take it! That money would have solved their problems, but of course, the investors were no longer enamored of Long-Term, nor were they begging to reinvest. What’s more, many of the banks were themselves under stress. This is a timeless irony: when you need money most, the most likely sources of it (in Long-Term’s case, other operators such as Soros, as well as investment banks and institutions) are likely to be hurting as
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“Where are you?” Mattone asked bluntly. “We’re down by half,” Meriwether said. “You’re finished,” Mattone replied, as if this conclusion needed no explanation. For the first time, Meriwether sounded worried. “What are you talking about? We still have two billion. We have half—we have Soros.” Mattone smiled sadly. “When you’re down by half, people figure you can go down all the way. They’re going to push the market against you. They’re not going to roll [refinance] your trades. You’re finished.” Not long after Mattone’s visit, Meriwether and McEntee went for a drink at a local inn favored by
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The entire Street had lost its nerve. The cool, unemotional traders of Merton’s models no longer existed, if they ever had. Now they were in full-fledged panic.
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.
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 equity—in addition to the massive leverage in its derivative bets, such as equity volatility and swap spreads.
Ironically, the secrecy-obsessed hedge fund had become an open book. Markets, as Vinny Mattone might say, conspire against the weak. And thanks to Meriwether’s letter, all Wall Street knew about Long-Term’s troubles.
Hilibrand had not been wrong: when you bare your secrets, you’re left naked.
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.
They had forgotten the human factor.
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.
Being so self-absorbed, the arbitrageurs naturally assumed that the banks were obsessed with Greenwich, too. But the simple fact is that by mid-September, the Wall Street banks were not principally worried about Long-Term Capital—they were worried about themselves. Given that every bank had many of the same trades as Long-Term, exiting from their positions was a matter of self-preservation. Goldman in particular was steeped in losing trades and, with its stock offering just weeks away, was desperate to cut its losses.
“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.”
Finance is often poetically just; it punishes the reckless with special fervor.
The banks’ willingness to finance Long-Term without any haircuts had enabled the fund to operate right up to the edge. Now, if it defaulted, nothing would be left. 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.
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Bankruptcy does not prevent derivative parties from seizing collateral. If Long-Term filed, it could expect to find its fax machine humming with claims from each of its fifty or so counterparties. In fact, if Long-Term defaulted on any of its seven thousand derivative contracts, it would automatically trigger a default in every one of the others, which covered some $1.4 trillion in notional value. In a bizarre touch, even a contemplation of bankruptcy was considered an act of default.
Long-Term’s equity was down to $1.5 billion. It was astonishing to think that only a month had passed since Russia’s default. In that one month, Long-Term had lost six tenths of its capital, one of Wall Street’s epic collapses.
But he got his point across all the same. Buffett was willing to let Goldman handle the details, but under no circumstances did he want his investment to be managed by LTCM or to have anything to do with John Meriwether. Then the connection blacked out.
Markets would . . . possibly cease to function.
THE FEDERAL RESERVE SYSTEM was created, in 1913, for many reasons, but the underlying one was that people no longer trusted private bankers to shepherd the financial markets. Prior to the Fed’s founding, the government had had no effective weapon to temper the country’s economic cycles, nor was there much it could do to ease the periodic crises that afflicted Wall Street. Too often, the government had had to go hat in hand to a private banker for help. By the Progressive Era, with its suspicion of trusts and its faith in regulation, people wanted a bank that would represent the public
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At first it seemed astonishing that so many trades should have collapsed simultaneously. But gazing over the portfolio, Fisher had an epiphany: Long-Term’s trades were linked—they had been correlated before the fact. “They had the same spread trade everywhere in the world,” Fisher thought. Gensler had a related thought: During a crisis, the correlations always go to one. When a quake hits, all markets tremble. Why was Long-Term so surprised by that?
Through their carelessness, their reckless financing, their vain attempts to ingratiate themselves with a self-important client, the Wall Street banks had created this fiasco together. Their instinct had been to savage as much of the carcass of Long-Term as possible, but now they had begun to see that doing so would risk bringing themselves down as well. One by one, they were concluding that they might have to do the very thing that was most antithetical to their nature: they might have to work together.
Buffett, who was traveling, was again unreachable, but he had made his strategy clear: buy the portfolio, let the world see that it was now in strong hands, let prices recover—and then sell.
Finally, at 11:40, Meriwether pulled a one-page fax from the machine. It said that Berkshire Hathaway, AIG, and Goldman Sachs would be willing to buy the fund for $250 million. If accepted, they would immediately invest $3.75 billion more to stabilize the operation, with $3 billion of the total coming from Berkshire. Buffett was proposing to pay $250 million for a fund that had been worth $4.7 billion at the start of the year. By day’s end, Long-Term, which was suffering yet another down day in markets, would be worth only $555 million. But even next to this startlingly reduced net worth,
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Purcell of Morgan Stanley turned beet red. He fumed, “It’s not acceptable that a major Wall Street firm isn’t participating!”19 It was as if Bear were breaking a silent code; it would pay a price in the future, Allison vowed.
The other issue was how long to invest for. The bankers wanted their money back quickly, but if the consortium were perceived as transitory, other traders would start shooting at it. To be credible, the consortium needed staying power. The bankers agreed on a three-part agenda: reduce the fund’s risk level, return capital to the new investors, and—last—try to realize a profit. To a man, the bankers would be happy just to get out whole.
Komansky thought the rival banks had done noble work, though of course they had saved their own hides and not just Meriwether’s. What the bankers had done was choose a certain risk of $300 million over the mere possibility of a loss whose magnitude was unknowable. It signified that the bankers had—finally—lost their appetite for gambling.
For Meriwether, it was a horror of a different sort. Everything he had done since the scandal at Salomon had been, at least in his mind, aimed at restoring his reputation and career. Now it had all come crashing down. 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.
This was fortunate for the banks, because the partners were hoping to win back through negotiations what they had lost in the marketplace. Incredibly, Meriwether and his cohorts were already plotting a new hedge fund—the partners’ only chance of resurrection—as if Long-Term could be put behind them like a bad trade.
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
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.
Late Saturday, Joseph Flom, Skadden’s name partner, called Milmoe to see how things were going. Flom was distressed by what he heard. “This is the first time that one case could fuck up our relations with three quarters of our clients,” Flom noted. “So don’t screw it up.”
“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.
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!”
