The Chastening

by Paul Blustein

  At 5 A.M. on Monday, September 21, 1998, an alarm clock awakened the forty-two-year-old Fisher at his Maplewood, New Jersey, home, and as is his custom, he promptly checked a small electronic device by his bedside to see how overseas markets were faring. In the weeks since the Russian default, the bad news had come thick and fast, and this morning, he was anticipating another onslaught. The results in Asian and European stock markets confirmed his fears. Hong Kong had closed down 3.7 percent, Singapore 3.3 percent, and Tokyo’s Nikkei index had plunged to a new twelve-year low. In mid-morning trading, Frankfurt was down 3.7 percent, Paris 3.9 percent, Milan 4.4 percent, London 2.3 percent, Madrid 4.9 percent, and Amsterdam 6 percent. Within hours, the Dow would be following suit, and market sages would appear on TV screens explaining the day’s developments as a reaction to the imminent release of a videotape showing President Clinton’s grand Jury testimony on the Monica Lewinsky matter. This market commentary struck Fisher as idiotic: Why, he wondered, would anyone blame the Clinton videotape for moves in markets as far-flung as Singapore? Then again, Fisher had a pretty good idea what was really behind the sell-off.

  The previous day, a Sunday, he had paid a secret visit to Long-Term Capital Management, a hedge fund in Greenwich, Connecticut, to examine its books. Virtually unknown to the American public, Long-Term was a major player in global financial markets, but after enjoying wondrous success in the mid-1990s, it now was on the brink of going bust. Word was spreading fast on Wall Street about Long-Term’s plight—indeed, several firms had sent people to Greenwich over the weekend to study the books to see if they should take a stake in Long-Term or buy part of its holdings, but the outlook for such a rescue was dim. Fisher had been staggered by the potential damage that a collapse of Long-Term might mean, because of its deep and tangled transactions with brokerage firms and banks. Virtually every stock, bond, and other security in its vast portfolio was pledged as collateral to the firms with which it traded, and a default by Long-Term would leave those firms suddenly holding a huge quantity of securities to unload. With many of those same firms, moreover, Long-Term had engaged in a huge number of trades in the derivative markets, which involve agreements to make payments based on the movement of a particular stock or bond. In essence, these trades provided the firms with insurance against losses on other positions they had taken in the markets, and if Long-Term suddenly ceased to exist, they would likely sell out those positions in great haste.

  As Fisher saw it, the slaughter under way in Asia, Europe, and New York on September 21 was but a foretaste of the selling pressure building as Wall Streeters who sensed what was coming scrambled to get out of the way. Once a default occurred, he feared, the strain on the markets might be so extreme as to cause a full-fledged breakdown.

  The Long-Term saga has been told before, and many of its most colorful aspects are well known—in particular the firm’s star-studded list of partners, who included a former Fed vice chairman and two Nobel Prize-winning economists whose theories of how markets are supposed to behave provided the basis for much of Long-Term’s trading strategy. Still, the essential facts about Long-Term’s meteoric rise and fall remain flabbergasting: The firm had opened its doors only four and a half years earlier, and its staff never exceeded 190 employees. Yet its profits of $2.1 billion in 1996 were greater than those of McDonald’s or Disney or Xerox or Gillette; and the $140 billion in assets it held rivaled the largest financial institutions in the world. At its peak, Long-Term had $7 billion in capital (the accumulated investments and profits of its owners), which surpassed that of Salomon Smith Barney and nearly topped that of Merrill Lynch. But it all went up in smoke in a period of about five weeks, bringing the global crisis closer than ever to shattering U.S. economic stability.

  Irony abounds in the story of Long-Term, for its founder, John Meriwether, and his academic accomplices prided themselves on having figured out a way to incur minimal risk while raking in returns of about 40 percent a year for their investors. They weren’t speculating on pork bellies or Internet stocks; nor were they betting the bulk of their money on the overall direction of particular markets. They invested in a wide range of markets and financial instruments, with the aim of putting their eggs in numerous baskets, and in general, for every bond or stock they bought long, they sold another one short, so the losses on one investment would be offset (and, they hoped, exceeded) by gains on another. Their portfolio, they believed, was almost ideally insulated against any broad change in the economic climate and protected against the pitches and tosses of financial markets.

  Meriwether, a onetime high school math teacher from an Irish Catholic neighborhood in Chicago’s South Side, had first demonstrated his magic at Salomon Brothers, which he Joined in 1974 at age twenty-seven, fresh out of the University of Chicago business school. He was soon heading a group at Salomon that invested the firm’s own capital in arbitrage trades—not the kind of arbitrage that Bob Rubin did at Goldman, which involved merger stocks, but a form of investing even more rooted in precise calculations of mathematical probabilities. He hired Ph.D.s and assistant professors who built computer models showing how different types of securities—bonds, in particular—had maintained highly predictable relationships with each other over time, meaning that money could be made when those relationships diverged from their historical patterns. Meriwether and his team were particularly fond of exploiting the profit opportunities that presented themselves when the spreads on relatively risky, high-yielding bonds widened to unusual levels beyond the yields on safer, lower-yielding bonds. The yield on corporate bonds with a single-A rating, for example, tended to be about 1.25 to 1.5 percentage points above Treasuries. If that spread widened to an abnormal extent, the computer model would signal to Meriwether’s group that corporate bonds were a bargain—specifically, a bargain relative to Treasuries. So the group would buy tens of millions of dollars worth of corporate bonds, while selling short an equal amount of Treasury bonds, anticipating that when the yields converged toward a more normal level, the profits they made on one side of their trade would exceed their losses on the other. The strategy worked so beautifully that the arbitrage group accounted for the bulk of Salomon’s profits in the late 1980s, earning about $500 million a year.

  Meriwether hatched plans to create his own arbitrage firm after resigning from Salomon in 1991 because of a bond-trading scandal in which he was tangentially involved. Thanks to his Midas reputation, he was able to raise $1.25 billion from a host of investors, including foreign banks, U.S. university endowment funds, Wall Street executives, and business big shots such as Hollywood agent Michael Ovitz and Nike chief executive Phil Knight—each of whom had to pony up a minimum of $10 million. In February 1994, Long-Term set up shop in a Greenwich office complex, with a trading floor overlooking Long Island Sound.

  If you were to try to duplicate Long-Term’s strategy at home using the funds in your bank account, you wouldn’t get very far (unless your net worth approximates Bill Gates’s), because an integral part of the formula the firm used was its size and its capacity to use enormous amounts of borrowed money to leverage its bets on tiny anomalies in the markets. For example, one of the firm’s first trades was based on the observation that the thirty-year Treasuries issued in August 1993 (the on-the-run bond at the time) was yielding 7.24 percent, while the off-the-run thirty-year bond issued the previous February was yielding 7.36 percent—a spread greater than normal. The two bonds, each with a face value of $1,000, differed only about $16 in price. By buying the bond issued in February and shorting the one issued in August, Long-Term was certain it could pocket a couple of dollars profit on each pair of bonds. But the only way to make such a bet worthwhile was to buy and sell in enormous volume—to be exact, a $1 billion “long position” and a $1 billion “short position.” To make the gamble pay off handsomely, Long-Term used borrowed funds to finance the transaction, fattening its own bottom line by employing money provided by others.

  Although this trade differed in some im
portant respects from the thousands of others Long-Term executed, it illustrates the basic approach the firm took as it arbitraged Italian bonds against German bonds, ten-year German bonds against five-year German bonds, and a variety of other trades involving such exotica as Danish mortgages and options on the Tokyo stock index. Meriwether and the professors knew their strategy was not totally foolproof, that sometimes their trades would lose money. When that happened, the firm would have to forfeit cash instantly; it collected on its winners, and paid up on its losers, on a daily basis. But the models showed that with the passage of enough time, historical relationships would reassert themselves, so that all the firm had to do was hold on, maintain a comfortable cushion of capital, and play the law of averages. The results seemed to leave little doubt about Long-Term’s basis for faith in its models. In 1994, Long-Term earned 28 percent on its investors’ money (of which the investors got 20 percent after deducting the hefty fees Meriwether and his partners took for themselves). In 1995, it earned 59 percent (43 percent after deduction for fees), and in 1996 it earned 57 percent (41 percent after fees).

  Wall Street firms and commercial banks, awed by Meriwether’s seeming invincibility and the professors’ braininess, lined up to lend money to the firm on extremely easy terms. As a result, by the end of 1995, Long-Term had accumulated over $102 billion in assets, all but $3.6 billion of which was derived from borrowing, and it continued to operate with debt twenty to thirty times the size of its capital. Creditors received quarterly statements showing Long-Term’s assets and liabilities, but they knew almost nothing about the details of its trades—and neither did the firm’s investors, for Meriwether and his team were fiercely determined to prevent rivals from stealing the secrets of their success. In fact, to throw an even thicker smoke screen around its activities, Long-Term typically avoided relying on a single lender to finance both “legs” of a trade; it might rely on Goldman, Sachs to lend the money for the purchase of some bonds and on Merrill Lynch to finance the offsetting short position. Lenders could take comfort from the knowledge that they held collateral—that is, the securities involved in the individual trades they financed. The danger inherent in this arrangement—that nearly all of Long-Term’s bets would go sour at the same time, and the creditors might have to dispose of all that collateral in a hurry—was given little thought; it seemed only a theoretical possibility as long as the firm continued to rack up double-digit returns.

  But the theoretical started moving closer to reality five days after Russia’s default; on August 21, 1998, markets began moving in ways that Long-Term’s battery of Ph.D.s had figured almost impossibly remote. That day, much of the top brass was away from the firm’s new headquarters, which included an expanded trading floor and a 3,000-square-foot gym. Meriwether was in Beijing, and one of his chief lieutenants, Eric Rosenfeld, was Just starting a family vacation in Sun Valley, Idaho. They were soon Jetting back to Greenwich after getting frantic reports from colleagues about the figures appearing on the screens of their Sun workstations. The flight for safety was in full wing. All over the world, investors were piling into Treasury bonds, German government bonds, anything that carried the least amount of risk possible, and bailing out of bonds with lower ratings. That, of course, meant that bonds Long-Term had bought were falling in price, while those it had sold short were rising. Spreads between low-risk and high-risk bonds were not only widening but widening at speeds nobody in the markets had ever seen before. Long-Term was losing tens of millions of dollars an hour on its supposedly well-hedged bets on pairs of bonds, because it held such huge positions and had borrowed so much to do so. For good measure, the firm also took big hits on speculative plays it had uncharacteristically made in Russian bonds and merger stocks. By day’s end, the firm’s losses totaled more than a half billion dollars.

  In a meeting that began at 7 A.M. on Sunday, August 23, Long-Term’s partners gathered to concoct a turnaround strategy based on the new and shocking reality that more days like August 21 might be in store. Although the firm still had its own capital of nearly $3 billion, its position was perilous nonetheless, because with over $100 billion in assets purchased with borrowed money, further losses in its positions of even a few percentage points would wipe out the capital. Unlike a gambler in a casino who decides to quit while ahead, Long-Term didn’t have the option of cashing in its chips. Its holdings were so enormous that modest sales would send prices plummeting and reduce the value of other securities that it still held. Their best hope, the partners agreed, was to persuade a deep-pocketed outsider, or several deep-pocketed outsiders, with the following pitch: All we need is a couple of billion dollars in capital to help us ride out this storm, because sooner or later, markets will return to normal, and our trades will turn profitable again.

  Meriwether and his partners tried tapping George Soros. They called Warren Buffett, the billionaire “sage of Omaha” who ran one of the world’s most successful investment companies, Berkshire Hathaway Inc. They sought help from Salomon Smith Barney, Merrill Lynch, Goldman, Sachs, and other investment banks, offering partnership deals in exchange for capital. Nobody was seriously interested. Instead of gaining the capital it needed, Long-Term continued to lose tens of millions or hundreds of millions a day in the markets. At the beginning of September, with the firm’s capital down to $2.28 billion, Meriwether was forced to inform his investors that the firm’s net worth had shrunk 44 percent in the month of August. “Losses of this magnitude are a shock to us as they surely are to you, especially in light of the historical volatility of the fund,” he wrote.

  Although Long-Term’s partners were convinced that the markets had to right themselves soon, spreads widened relentlessly in September as the chain of events in the bond markets described by Salomon’s Purcell took hold. By the middle of the month, further losses had eroded the firm’s capital to the $1.5 billion level. Long-Term continued to implore its Wall Street creditors for help in finding capital, but this was proving a double-edged sword. Goldman, Sachs was finally enlisted to seek potential investors and arrange a possible takeover of the firm. But the chances of finding willing investors were far from certain, and in the meantime, rumors on the Street about Long-Term’s desperation were leading traders to intensify the selling of securities that they suspected the firm might be forced to liquidate. Naturally, that only aggravated the spiral.

  What Wall Street needed at that moment was someone to fill the role J. P. Morgan had performed in 1907 when the Knickerbocker Trust Co. failed, triggering hysteria that threatened to drag down other financial houses and throw the economy into recession. The formidable Morgan, whose bank was by far the largest and most powerful in the land, ordered the stock market to remain open, delivered a public warning that short-sellers would be “properly attended to,” and summoned leading bankers to his Manhattan library to craft a plan for dealing with Knickerbocker’s debts. They obeyed, and Morgan’s efforts would go down in history for bringing the panic of 1907 to a swift and relatively painless halt.

  But in 1998, no single financier had the clout to duplicate Morgan’s feat. The task of rounding up market players and exhorting them to act in their collective self-interest could be performed only by someone vested with the moral authority of government.

  As in the Korean crisis, the New York Fed—the “eyes and ears” of the U.S. central bank on Wall Street—stepped into the breach. This time, however, the political sensitivities were explosive. It is one thing to use official influence to help prevent a country from going under. It is quite another to do the same for a hedge fund.

  Friday, September 18 was a particularly rough day in the markets, as investors were Just getting over their dashed hopes for a coordinated interest rate cut by the G-7. The New York Fed’s McDonough was aware of Long-Term’s travails, since Meriwether had called him a couple of times earlier in the month to inform him of the firm’s efforts to raise fresh money. Now, with Long-Term apparently unlikely to survive the next week on its current trajectory, t
he firm had invited McDonough to visit Greenwich for a briefing on the firm’s portfolio. McDonough called a number of Wall Street CEOs, and as he later told a congressional panel, their opinion was unanimous: Long-Term’s demise could have a “serious effect” on world markets. Following conversations with Greenspan and Rubin, agreement was reached that the New York Fed would take the lead in assessing the situation and determining what the market impact might be. McDonough himself would not go to Greenwich; he was scheduled to deliver a speech in London on Tuesday, and he told Greenspan and Rubin that he feared canceling the trip would only roil the markets even more. Instead, Peter Fisher would go to Greenwich.

  The next morning, a Saturday, Gary Gensler, the Treasury’s assistant secretary for financial markets, was bouncing his two-year-old daughter on his knee at his Chevy Chase, Maryland, home when a call came from Rubin. Gensler, a balding forty-year-old former partner of Rubin’s at Goldman, had Joined the Treasury in fall 1997 and, because of his experience in markets, often took part in meetings in Rubin’s office about how to handle the crises in Asia. Now he was going to become more directly involved in crisis containment. “Shhh!—Isabel, please!” he admonished his daughter as Rubin started to speak.

  The Treasury, like the Fed, had been watching U.S. financial markets keenly for any sign of an imminent failure by a major financial institution that might present “systemic risk”—the term economists use to describe the problem of one firm’s bankruptcy threatening to cause a much broader-based collapse. Only in cases posing systemic risk is the government supposed to get involved in saving a financial institution from going belly-up. Mostly, the department’s officials were keeping an eye on the dozen or so biggest money-center banks and the four or five biggest broker-dealers on Wall Street, since a failure by one of those to fulfill a financial obligation could cause such widespread interruptions in payments as to bring down many other institutions. Among the banks, Bankers Trust was reportedly in some distress, as was Lehman Brothers among the broker-dealers. Since hedge funds presumably posed no systemic dangers, the Treasury hadn’t been paying much attention to them, but Long-Term looked well out of the ordinary. Although the New York Fed was playing the lead role, Rubin asked Gensler to accompany Fisher to Greenwich the next day, because the Treasury chief wanted as much information as possible about the potential impact of a default by Long-Term. “They have $1.3 trillion in derivatives,” Rubin said. “Gary, is that a lot?”