The Snowball

by Alice Schroeder

  Hilibrand had gone deep into debt to pump up his personal investment in the firm, leveraging the leverage with which Long-Term had already leveraged itself. He spent the day going over every position the firm owned and stressing the incredible opportunity he was offering to Buffett.23 “He wanted me to put in capital. He described the seven or eight big fundamental positions. I knew what was happening with relationships and on prices in these areas. I was getting more interested as time went along, because they were crazy relationships and spreads. But he was proposing a deal to me that didn’t make any sense. They thought they had time to play the hand out. But I said no, so that was that.” Buffett told him, “I am not an investor in other people’s funds.”24 He was only interested as an owner.

  Long-Term didn’t want an owner, only an investor. It came close to finding somebody else, but then he backed out.25 By month-end, when it had to report to its investors, the fund had lost $1.9 billion—almost half of its capital—through a historically unusual combination of stock-market declines and almost hysterical aversion to risk in the bond markets.26 Since the model had contemplated losses of twenty percent as being a one-in-one-hundred-year event—like a moderate West Coast earthquake—this was somewhat like a Category 4 hurricane hitting New York City. Meriwether wrote his investors a letter saying losses of half the fund’s money were a “shock,” but “the opportunity set in these trades at this time is believed to be among the best that LTCM has ever seen…. The Fund is offering you the opportunity to invest in the Fund on special terms related to LTCM fees.”27 Long-Term was behaving as though it could raise capital to wait out the crisis and profit from its turnaround. But with the kind of leverage it had taken on, it didn’t have that option. This was the fallacy of defining risk as anything other than losing money. Long-Term had not prepared for that. The firm’s insular culture and years of getting its way had blinded the partners to the reality that no investor would put in money to save it without also taking control.

  The day he read this, Buffett wrote a letter to a colleague and forwarded Meriwether’s entreaty, saying:

  Attached is an extraordinary example of what happens when you get 1) a dozen people with an average IQ of 160; 2) working in a field in which they collectively have 250 years of experience; 3) operating with a huge percentage of their net worth in the business; 4) employing a ton of leverage.28

  Anything times zero is zero, Buffett said. A total loss is a “zero.” No matter how small the likelihood of a total loss on any given day, if you kept betting and betting, the risk kept stacking up and multiplying. If you kept betting long enough, sooner or later, as long as a zero was not impossible, someday a zero was one hundred percent certain to show up.29 Long-Term, however, had not even tried to estimate the risk of a loss greater than twenty percent—much less a zero.

  In September the earthquake kept rumbling. Long-Term searched desperately for money, having now lost sixty percent of its capital. Other traders had started putting the squeeze on the fund, shorting positions they knew Long-Term owned because they knew Long-Term needed to sell, which would force prices lower. Investors were fleeing anything risky in favor of anything safe, to a point that Long-Term’s models had never considered possible because it made no economic sense to them. Long-Term hired Goldman Sachs, which came in as a partner to buy half the firm. It needed $4 billion, an almost unimaginable sum for a hedge fund in distress to raise.

  Goldman Sachs got in touch with Buffett to see if he was interested in a bailout. He wasn’t. However, he would consider teaming with Goldman to buy the entire portfolio of assets and debt. Together they would be strong enough to wait the crisis out and trade the positions deftly for a profit. But Buffett had a condition: no Meriwether.

  Long-Term owed money to a subsidiary of Berkshire. It owed money to people who owed money to Berkshire. It owed money to people who owed money to people who owed money to Berkshire. “Derivatives are like sex,” Buffett said. “It’s not who we’re sleeping with, it’s who they’re sleeping with that’s the problem.” As Buffett headed to Seattle that Friday to meet the Gateses and embark on a thirteen-day “Gold Rush” trip from Alaska to California, he called a manager and told him, “Accept no excuses from anyone who doesn’t post collateral or make a margin call. Accept no excuses.”30 He meant that if the Howie-equivalents out there paid the rent one day late, then seize their farms.

  The next morning he, Susie, the Gateses, and three other couples flew to Juneau to helicopter over the ice fields. They cruised up the fjords to view huge blue icebergs and waterfalls cascading over three-thousand-foot cliffs. But as Buffett sat politely through a slide presentation on glaciology on board the ship that evening, his mind wandered to whether Goldman Sachs would be able to put together a bid for Long-Term. Predatory sellers had pushed prices so far down that Long-Term was a cigar butt. An opportunity to buy such a large bundle of distressed assets had never arisen so quickly in his career.

  The next day, the Gates party went ashore at low tide to view the hundreds of brown grizzly bears that frequented Pack Creek. Jon Corzine, the head of Goldman Sachs, called Buffett on his satellite phone but kept being cut off. “The phone didn’t work because of these half-mile-high rock walls on either side of the boat. The captain would point out, Look, there’s a bear. I was saying, To hell with the bear. Let’s get back where I can hear the satellite phone.”

  Two or three hours went by with Buffett held incommunicado as the party spent the afternoon crossing Frederick Sound so they could view the humpback whales. Corzine stewed in New York before he regained brief—and final—contact with Buffett. By the time Buffett resignedly trudged off to view a slide show on Alaskan marine wildlife that evening, Corzine had gathered that he could make a bid, as long as the investment had nothing to do with, and was not managed by, John Meriwether.

  On Monday, Buffett remained out of touch and Corzine grew pessimistic about working out a bid. He had begun to talk with Peter Fisher, who ran trading activities at the Federal Reserve, and was drawing together Long-Term’s creditors to negotiate a joint bailout. The Federal Reserve had held a conference call at which its chairman, Alan Greenspan, spoke of an “international financial maelstrom” that must be causing “considerable breakage to crockery somewhere.”31 Hope began to stir that the Fed would cut interest rates.

  Meanwhile, Long-Term lost another half billion dollars; the banks picking over its books were using what they learned against it.32 The fund now had less than a billion dollars of capital left. The irony was the $2.3 billion it had paid out to its own investors a year before in order to increase the share of the fund owned by its partners. If it had that money now, Long-Term might have been in a position to survive on its own. Instead, it had a hundred dollars of debt for every dollar of capital—a ratio no sane lender would ever entertain.

  Buffett was en route to Bozeman, Montana, with the Gates party, but Corzine had reached him earlier that morning and gained permission to enlist a large insurer, AIG, which owned a derivatives business, to join the bid. Its chairman, Hank Greenberg, was on friendly terms with Buffett. AIG had the experience and the team to replace Meriwether as manager, and Greenberg’s powerful presence would balance out Buffett’s—and it might make Buffett’s bid more palatable to Meriwether.

  The next morning, forty-five bankers arrived at the Fed, as summoned, to discuss a bailout of the customer that had bullied them so relentlessly for the past four years. Long-Term had them over a figurative barrel once again, for if it went down, other hedge funds would go down with it. As one domino fell after another, a global financial meltdown was a real possibility—a repeat of Salomon. This was the warning that Buffett and Munger had been repeating at their shareholder meetings since 1993. Some of the banks now feared for their survival unless they helped save the fund. They were reluctantly contemplating putting more money into Long-Term—money that would only go to pay Long-Term’s debts—on top of money they had already invested in the fund and lost. When Corzine t
old them Buffett was also bidding, the idea that he was going to come in and buy it to make a killing went down poorly, even though he would be bailing everybody out. Somehow, Buffett always won. People found it irksome. New York Federal Reserve Bank President William McDonough called Buffett to find out if he was serious. About to board a bus for Yellowstone National Park, Buffett told McDonough that, yes, indeed, he was ready to make a bid and could do so on short notice. He couldn’t see why the Federal Reserve would be orchestrating a bailout when Berkshire, AIG, and Goldman Sachs, a group of private buyers, stood ready to solve the whole problem without government assistance. He called Long-Term around eleven o’clock New York time on a crackly satellite phone and said, “I want you to know, I’m going to bid for the entire portfolio. You’ll hear from my representatives, but I want you to know it’s coming from me, and I hope you’ll take it seriously.”

  “I didn’t want to hold the bus up, so I went along. It was killing me. And Charlie was in Hawaii. I still knew the basic positions that were involved, and I knew these spreads were really getting more and more extreme. On that Wednesday morning, it was changing by the hour.”

  An hour later, Goldman faxed a single page to Meriwether offering to buy the fund for $250 million. As part of the deal, Meriwether and his partners would be fired. If Meriwether accepted, AIG, Berkshire, and Goldman would put another $3.75 billion into Long-Term, with Berkshire funding most of that. To minimize the chance of Long-Term shopping the bid to gin up a higher offer, Buffett had given them only an hour to decide.

  By then, Long-Term had just over $500 million left, and Buffett was bidding just under half that. After paying off debt and losses, Meriwether and his partners would be wiped out, their nearly $2 billion of capital gone. But the document had been drafted by Goldman with a mistake in it. It offered to buy LTCM, the management company, instead of its assets, which Meriwether knew was what Buffett wanted. Meriwether’s lawyer said he needed his partners’ consent to sell the entire portfolio rather than the management company.33 Long-Term asked for a temporary emergency investment pending receipt of the approvals. But they couldn’t reach Buffett on his phone. If they’d reached him, he said later, he would have taken that deal. While everybody else on the Gold Rush trip was looking at hot springs, Buffett was dialing and redialing the satellite phone in Yellowstone, trying to call Corzine at Goldman and Hank Greenberg at AIG. The phone didn’t work. He had no idea what was going on back in New York.

  The people at Long-Term did not know what was going on in the room with the bankers, where McDonough was in a quandary. He had an offer from the Berkshire-Goldman-AIG consortium but no deal. It was hard to justify government involvement in orchestrating a bailout when there was a viable private bid on the table. Finally, he told the assembled bankers that the other bid had failed for “structural reasons.” Buffett was not there to make a counterargument. The Federal Reserve brokered a deal in which fourteen banks put up a total of $3.6 billion. Only one bank, Bear Stearns, refused to participate, earning the long-lasting enmity of the rest. Meriwether’s crew negotiated an arrangement for themselves that they considered slightly better than “indentured servitude.”34

  That night at the Lake Hotel, Buffett found out what had happened. He felt that Meriwether didn’t want to sell to him. If he had wanted to, he would have found a way. Perhaps it had weighed on Meriwether’s mind that, as one of the fund’s partners said, “Buffett cares about one thing. His reputation. Because of the Salomon scandal he couldn’t be seen to be in business with J.M.”35 Meriwether had certainly gotten a better deal from the bailout than he would have with Buffett.

  The next day, as they boarded the bus to visit Old Faithful geyser, Buffett was still turning over in his mind whether there was some way to undo it. Gates had a treat in store. When they arrived in Livingston, Montana, in early afternoon to board a nine-car private train fitted out with burnished wood and polished leather that Gates had rented, Sharon Osberg was waiting along with Fred Gitelman, a low-key computer programmer and bridge player. Gates had flown them in. While everyone else was admiring the cliffs and waterfalls of the Wind River Canyon, the foursome retired to an upstairs lounge with a transparent dome for a twelve-hour bridge marathon. Periodically, Buffett’s phone rang and he talked with someone in New York about Long-Term as the spectacular scenery rolled past. It still might not be too late to unwind the impending bailout and resurrect a private deal. But it wasn’t working out.36 At least the bridge distracted him.

  The next morning, after a final round of bridge, the train rolled to a halt and dropped Osberg and Gitelman off in Denver, then continued through Devil’s Hole Canyon and Dead Man’s Gulch. Over the next few days, as the others went white-water rafting and mountain biking and the train wound its leisurely way to the Napa Valley via the Grand Canyon, Buffett read about the rescue in the newspapers and gradually lost hope of participating.

  Only seven years after the regulators had contemplated letting Salomon fail—with all the consequences that that potentially entailed—the Federal Reserve had now engineered the bailout of a private investment firm, an unprecedented intervention in the market to avoid a similar event. Afterward, the Fed slashed interest rates three times in seven weeks to help keep the financial stumble from paralyzing the economy. It was by no means certain that any such paralysis would occur, but the stock market took off like a screaming banshee.37 Long-Term’s partners and most of the staff worked for a year for $250,000—pauper’s wages for people used to making millions a year—to unwind the fund’s positions and pay back most of the emergency creditors.38 Hilibrand, in debt for $24 million, signed the employment contract with tears streaming down his cheeks.39 Still, nobody starved, even though Eric Rosenfeld had to auction off Long-Term’s wine collection. Most of them got good jobs afterward. Meriwether made a comeback to start a smaller, less leveraged fund, taking some of his team. People thought the partners had gotten off light, considering that they had nearly sent the whole financial world into a seizure. And Buffett considered it one of the great missed opportunities of his life.

  Eric Rosenfeld had an insight. Maybe models didn’t work when the world went mad. For that you needed a lot of capital, the kind that Berkshire Hathaway offered. After all, if you were going to bet by a hundred billion or more in favor of risk, you needed a partner, even a parent, one with so much capital that it essentially undid the leverage, somebody to provide a big umbrella in a storm.40 By implication, maybe they would have been better off being owned by somebody like Berkshire Hathaway. But that would have meant giving up their ownership…. You couldn’t have it both ways. If you wanted Berkshire to take the risk and put up the money, to it went the gains.

  To think otherwise was unrealistic—that somehow risk could be laid off to someone else without also giving up the rewards. But that point of view was growing and beginning to dominate the financial markets of the late 1990s. It would have profound consequences over time.

  It is hard to overstate the significance of a central-bank-led rescue of a private money manager. If a hedge fund, however large, was too big to fail, then what large financial institution would ever be allowed to collapse? The government risked becoming the margin of safety.41 No serious consequences had come about in the end from the derivatives near-meltdown. The market afterward seemed to behave as if no serious consequences ever could. This threat, the so-called “moral hazard,” was a chronic worry of regulators. But the world would always be full of people who loved risk. When it came to business, Buffett’s veins were filled with ice, but plenty of other people’s pulsed with adrenaline much of the time. Some of them had even been members of his own family.

  52

  Chickenfeed

  Decatur, Illinois, and Atlanta • 1995–1999

  Howie and Devon were on the lam. He had walked out of the office at ADM on a Friday knowing he would never return. A pack of reporters had been camped out in their driveway ever since. He and Devon started packing. They sneaked out
of Decatur at dawn on Sunday on a rented prop plane to fly to Chicago, where they met family friend Don Keough, who was giving them a ride to Sun Valley on his private jet. Since reporters weren’t allowed inside the Allen conference, Howie thought they would be safe.

  He had been pacing the floor for ten days, ever since Mark Whitacre, an excitable manager he knew at ADM, suddenly confessed to him that he was acting as an FBI mole. Whitacre told him that the FBI was going to arrive at Howie’s house at six o’clock on Tuesday night for an interview. Now Howie knew why Whitacre kept showing up at work for several days in a row in the same greenish polyester suit: He had been wearing a wire. Ever since Whitacre made his confession, he’d been calling every day, blathering his anxieties at Howie, who tried to disentangle himself. Howie hadn’t busted Whitacre, but he could tell from the panic in Whitacre’s voice that he must be cracking under the stress.

  That Tuesday night, Devon tried to fix dinner with shaking hands. When the doorbell rang, Howie wanted to throw up. In came a guy in a suit—who told him he was not a target. Three hundred FBI agents were fanned out across the country, interviewing other people about price-fixing of an ADM product called lysine that was used in chicken feed.

  Howie was terrified but had made up his mind to be completely forthcoming with the FBI. He said he didn’t trust Dwayne Andreas, who had put him in charge of funneling requests for political contributions, a role, given Andreas’s history, that might have made anybody’s stomach churn.1 He told the agent that the previous fall Andreas had rebuked him when he raised ethical questions about providing entertainment to a Congressman. Howie didn’t know anything about price-fixing, however.