A lot of unusual things have happened in the four months since Long-Term Capital Management ann-ounced that it lost more than $4 billion in a bizarre six-week financial panic late last summer, but nothing nearly so unusual as what hasn't happened. None of the 180 employees of the hedge fund have stood up to explain, to fess up or to excuse themselves from the table.
Even the two Nobel Laureates on staff, who could very easily have slipped back into their caps and gowns in the dead of night and pretended none of this ever happened, have stayed and worked, quietly. The man in charge, John Meriwether, has shown a genius for lying low.
Photographers in helicopters circle his house, and journalists bang on his front door at odd hours and frighten his wife. Yet whenever the question 'Who is John Meriwether?' has demanded an answer, it has been supplied not by those who know him and work with him but by a self-appointed cast of casual acquaintances and perfect strangers. They have described Meriwether and his colleagues as reliable Wall Street stereotypes: the over-reaching, self-deluded speculators. In doing so they have missed pretty much everything interesting about them.
Not long ago, I visited the hedge fund's offices in Greenwich, Connecticut, to see if its collapse made any more sense from the inside than it did from the outside. What I found offered a neat illustration of the limits of reason in human affairs.
The first time I saw a market panic up close was also the last time I had seen John Meriwether - the stock market crash of October 19, 1987. I was working at Salomon Brothers, then the leading trading firm on Wall Street. A few yards to one side of me sat Salomon's CEO, John Gutfreund; a few yards to the other side sat Meriwether, the firm's most beguiling character. The stock market plummeted and the bond market soared that day as they had never done in anyone's experience, and the two men did extraordinary things. I didn't appreciate what they had done until much later.
The events of those few hours were in many ways the most important I ever saw on Wall Street. The markets in a panic are like a country during a coup. One small group of people with its old, established way of looking at the world was hustled from its seat of power. Another small group of people with a new way of looking at the world was rising up to claim the throne. And it was all happening in a few thousand square feet at the top of a tall office building at the bottom of Manhattan.
John Gutfreund and Craig Coats Jr, Salomon's head of government-bond trading, decided that the world was coming to an end. The end of the world is good news for the bond market - which is why it was soaring. Gutfreund and Coats decided to buy $2 billion worth of the newly-issued 30-year United States Treasury bond. They were marvellous to watch, a pair of lions in their jungle.
Except that they were wrong. The world was not coming to an end. Bond prices were not about to keep rising. The world would pretty much ignore the stock market crash. In the end, the gut decision to buy cost Salomon Brothers $75 million.
Meanwhile, 20 yards away was Meriwether. When I think of people in American life who might have been like him, I think not of financial types but creative ones - Harold Ross of the old New Yorker, say, or Quentin Tarantino. Meriwether was like a gifted editor or a brilliant director: he had a nose for unusual people and the ability to persuade them to run with their talents. Beside him were his first proteges, four young men fresh from graduate schools - Eric Rosenfeld, Larry Hilibrand, Greg Hawkins and Victor Haghani. Meriwether had taken it upon himself to set up a sort of underground railroad that ran from the finest graduate finance and maths courses directly onto the Salomon trading floor. Robert Merton, the economist, complained that Meriwether was stealing an entire generation of academic talent.
No one back then really knew what to make of the 'young professors'. They were physically unintimidating, their bodies merely life support systems for their brains, which were in turn extensions of their computers. They were polite and mild-mannered and hesitant. When you asked them a simple question they thought about it for eight months, then gave an answer so complicated you wished you had never asked.
The financial markets were spawning vastly complicated new instruments: options, futures, swaps, mortgage bonds and more. Their complexity baffled lay people, and still does, but created opportunities for those who could parse it. At the behest of John Meriwether, the young professors were reinventing finance.
But at that moment of panic, the young professors did not fully appreciate their own powers. All their well-thought-out strategies, which had yielded them profits of perhaps $200 million over the first 10 months of 1987, wilted that October day in the heat of other people's madness. They lost at least $120 million, which was sufficient to ruin the quarterly earnings of the firm. Two years before, they were being paid $29,000 to teach elementary finance to undergraduates. Now they had lost $120 million! They were unnerved, until Meriwether convinced them they should not be unnerved but energised. He told them to pick their two or three most promising trades and triple them.
They did it, of course. They paid special attention to one big trade. They sold short the newly issued 30-year US Treasury bond of which Craig Coats had just purchased $2 billion, and bought identical amounts of the 30-year bond the Treasury had issued three months before - that is, a 29-year bond (to 'short' a stock or bond means to bet that its price will fall). The young professors were not the first to see that the two bonds were nearly identical. But they were the first to have studied so meticulously the relationship between them. Newly-issued Treasury bonds change hands more frequently than older ones. They acquire what is called a 'liquidity premium' which is to say that professional bond traders pay a bit more for them because they are a bit easier to resell. In the panic, the premium on the 30-year bond became grotesquely large. The young professors laid a bet that the premium would shrink when the panic subsided.
Three weeks after the 1987 crash, when the markets calmed down, they cashed out of the Treasury bonds with a profit of $50 million. The lesson in this was not lost on the young professors: panic was good for business. The stupid things people did with money when they were frightened was an opportunity for more reasonable people to exploit. It was a lesson they would regret during the next big panic, far bigger and more mysterious than the Crash of October 1987 - the panic of August 1998.
In the five years after the 1987 crash, Meriwether and the young professors made billions for Salomon and tens of millions for themselves. They started out as oddballs but became the heart of the firm. But after Salomon became embroiled in a scandal over phony bids for US Treasury bonds, Meriwether quit, taking many of the young professors with him, and established his own firm, Long-Term Capital Management.
If you didn't know who John Meriwether was, you wouldn't have the slightest curiosity about him. He has small, even features, a shock of cowlicky brown hair that droops boyishly down over his forehead, and a blank expression that could mean nothing or everything. His movements are quick, and so is his talk. He speaks in fragments and moves rapidly from one idea to the next, leaving behind a trail of untidy thoughts.
When I arrived, he was hunched over at his desk on the trading floor, but by the time I got to him he was in his office: a token office, big and empty and conspicuously unused. It had a nice view of some trees, which I'm sure no one had glanced at in months.
Meriwether offered me a book, Miracle On The 17th Green, a fantasy for adults about a regular middle-aged man who one day is blessed with the talent of a golf champion. 'Extraordinary things happen to ordinary people,' said the back of the dust jacket. About the first thing he said after we sat down was: 'I don't want this story to be about me.' Yet the story of Long-Term Capital is the story of how Meriwether lost control of his esoteric markets. Of the $4.4 billion lost, $1.9 billion belonged to the partners personally, $700 million to Union Bank of Switzerland and $1.8 billion to other investors, half of them European banks including Barclays.
The big losses that destroyed Long-Term Capital occurred in the areas the young professors had for years been masters of. The killer blows - a good $3 billion of the $4.4 billion - came from two bets that Meriwether and his team had been making for at least a decade: so-called interest-rate swaps and long-term options in the stock market.
Like most of Long-Term Capital's trades, these bets required the strategists to buy one thing and sell short another, so that they maintained a Swiss-like neutrality in the market. Like most of their trades, the thing they bought was similar to the thing they sold. (Their gift was for mathematical metaphor: they noticed similarities where others saw nothing but differences.) But like only some of their trades, the thing they bought became - or was supposed to become, after a period of time - identical to the thing they sold.
One way to understand this, and to see how bizarre was the panic of August 1998, is to imagine a world with two kinds of dollars, blue dollars and red dollars. The blue dollar and the red dollar are both worth a dollar, but you can't spend them for five years. In five years, you can turn them both in for green dollars. But for all sorts of reasons - a mania for blue, a nasty article about red - the blue dollar becomes more expensive than the red dollar. The blue dollar is selling for $1.05 and the red dollar for 95 cents.
If you are an ordinary sane person who holds blue dollars, you simply trade them in for more red dollars. If you are Long-Term Capital, or any large Wall Street firm for that matter, and are able to borrow money cheaply, you borrow against your capital and buy a lot of red dollars and sell the same number of blue dollars. The effect is to force the price of red dollars and blue dollars back together again. In any case, you wait for blue dollars and red dollars to converge to their ultimate value of a dollar apiece.
At best, the odd passions that drove the red and the blue dollar apart subside quickly, and you reap your profits now. At worst, you must wait five years to collect your profits. The 'model' tells you that you will one day make at least five cents for every red dollar you buy for 95 cents and another five cents for every blue dollar you sell at $1.05.
Which brings us to the case of Long-Term Capital in August 1998, when the red dollar and the blue dollar were driven apart in value to ridiculous extremes. Actually, when you look at the young professors' books, you can see that the first sign of trouble came earlier, on July 17, when Salomon Brothers announced it was liquidating all its red dollar-blue dollar trades, which turned out to be the same trades Long-Term Capital had made. For the rest of that month, the fund [Long-Term] dropped about 10 per cent because Salomon Brothers was selling all the things it owned.
Then, on August 17, Russia defaulted on its debt. At that moment the heads of the other big financial firms recanted their beliefs about red dollars and blue dollars. Their fear overruled their reason. Once enough people gave into their fear, fear became reasonable. Fairly rapidly the other big financial firms unwound their own trades, which, having been made in the spirit of Long-Term Capital, were virtually identical to the trades of Long-Term Capital. The red dollar was suddenly worth 25 cents and the blue dollar $3. The chance of that happening was 1 in 50 million.
August 21, 1998, was the worst day in the young history of scientific finance. On that day alone, Long-Term Capital lost $550 million. The young professors' attachment to higher reason was a great advantage only as long as there was a limit to the market's unreason. Suddenly there was no limit. Alan Greenspan, Federal Reserve chairman, and Robert Rubin, US Treasury Secretary, said they had never seen such a crisis, and neither had anyone else.
By the end of August, Long-Term Capital had run through $2 billion of its $4.8 billion capital. Even so, the fund might well have survived and prospered. But what started as a run on the markets, at least from Long-Term Capital's point of view, turned into a run on Long-Term Capital. 'It was as if there was someone out there with our exact portfolio,' Victor Haghani says, 'only it was three times as large as ours, and they were liquidating all at once.' For nearly 15 years, Meriwether and the young professors had been engaged in an experiment to determine how far human reason alone could take them. They failed to appreciate that their fabulous success had made them part of the experiment. No longer were they the creatures of higher reason who could remain detached and aloof. They were lab rats lost in the maze.
Inside Long-Term Capital, the collapse is understood as a two-stage affair. First came the market panic by big Wall Street firms that made many of the same bets as Long-Term Capital. Then came a kind of social panic. Word spread that Long-Term was weakened. That weakness, Meriwether and the others say, very quickly became an opportunity for others to prey upon.
By the end of August, Long-Term Capital badly needed $1.5 billion. The trades that the strategists had made lost money, but they would recover their losses if they could obtain the capital to finance them. If Long-Term Capital could ride out the panic, Meriwether figured, it would make more money than ever.
But the game of saving Long-Term Capital was over before it began. First came the rumours. Traders at other firms began to use 'Long-Term' the way weathermen used El Nino - to justify whatever they needed to justify. On one occasion, a CNN newsreader explained that certain stocks were falling because Long-Term Capital was selling them. The young professors, who had not been selling stocks or anything else, watched in wonder. 'Every rumour about the size of our positions was always double the truth,' Richard Leahy, Meriwether's oldest business partner, says. 'Except the rumour about our position in Danish mortgages. That was 10 times what we actually had.' According to the young professors, Wall Street firms began to get out in front of the fund's positions [sell stock or instruments which they knew LTCM held]: if a trader elsewhere knew Long-Term Capital owned a lot of interest-rate swap, for instance, he sold interest-rate swaps, and further weakened Long-Term's hand. The idea was that if you put enough pressure on Long-Term Capital, Long-Term Capital would be forced to sell in a panic and you would reap the profits.
The losses in August were part of a market rout. The losses that continued into September were part of a rout of Long-Term Capital.
The trouble led the New York Federal Reserve to help bring together a consortium of Wall Street banks and brokerage houses to come to the rescue. Goldman Sachs, a consortium member, was dissatisfied to find itself one of many. It had hoped to control Long-Term, and to acquire the wisdom of the young professors. And so before the consortium finalised its plans, Goldman Sachs turned up with the legendary investment guru Warren Buffet and about $4 billion in an attempt to buy the firm.
On the very day, September 21, that Warren Buffett and Goldman Sachs turned up, Long-Term Capital, for the second time in its history, lost more than $500 million in one day. Half of that was lost in its second disastrous trade, a short position in five-year equity options. Meriwether received phone calls from JP Morgan and the Union Bank of Switzerland telling him that the options he had sold short were rocketing up in quiet markets thanks to bids from AIG, the US insurance company. The brokers were outraged on Meriwether's behalf, as they assumed that AIG was trying to profit from Long-Term's weakness.
But what the people who called Meriwether did not know was that at just that moment, AIG was, along with Warren Buffett and Goldman Sachs negotiating to purchase Long-Term Capital's portfolio.
One consequence of AIG's activities was to pressure Meriwether to sell his company and its portfolio cheaply. Meriwether is convinced that AIG was trying to put him out of business, a contention that AIG would not comment on. On September 23 the game was finally up. A consortium of 14 Wall Street banks and brokerage houses gave Long-Term $3.6 billion, in exchange for 90 per cent of the firm.
Meriwether had this to say about his treatment at the hands of the big Wall Street firms: 'I like the way Victor [Haghani] put it: the hurricane is not more or less likely to hit because more hurricane insurance has been written. In the financial markets this is not true. The more people write financial insurance, the more likely it is that a disaster will happen, because the people who know you have sold the insurance can make it happen. So you have to monitor what other people are doing.' The events of August and September 1998 have left Meriwether and the young professors exactly where they did not want to be, back working for the large Wall Street firms. In place of the hundreds of millions they made each year for themselves, they are now on salaries of $250,000, or the wage of a junior bond trader without a bonus.
And for the first time in 15 years, John Meriwether and his young professors cannot steer toward some moment of certainty in the distant future. What they hope will happen next is no longer the same as what they think will happen next. Which is to say that they are, for the first time in 15 years, just like everyone else.
This is an edited version of a story which first appeared in the New York Times magazine
Staring into the abyss
On the night of Sunday September 20 last year, the world looked into the financial abyss. An investment fund - little known outside Wall Street's magic circle, but hugely famous within it - told the US Federal Reserve it was facing massive losses. President Clinton called the resulting crisis 'the biggest threat to the global financial system in 50 years'.
America's central bankers concluded that the fund, Long-Term Credit Management, could not be allowed to fail. It was not the wipe-out LTCM's investors would face that prompted the Fed to action, nor even the multi-million dollar losses facing a raft of blue-chip banks. No, the Fed was worried that the impact on confidence in financial markets already reeling from a series of crises from South-east Asia to Russia would be devastating.
Investors would head en masse for the exit. Some markets could be forced to close. Interest rates would almost certainly soar, slamming the brakes on global growth and sending the cost of borrowing for anything from corporate invstment to mortgages through the roof.
Within 48 hours the Fed persuaded LTCM's bankers including Barclay's in Britain to back a $3.5 billion rescue package. It worked: the world stepped back from the brink. But the financial world would never be quite the same again.
Masters of the market
John D Rockefeller The founder of modern capitalism. In the 1860s, he saw the oil industry's potential and, through audacious takeovers, formed the world's biggest company, Standard Oil. By the early 20th century he was the first modern billionaire. Despite Roosevelt's trustbusters in 1906, who broke Standard Oil into smaller companies, he remained a force on Wall Street and laid the foundations of the Chase Manhattan Bank. In the midst of 1929's Great Crash, he and his son bought shares to peg the value of Standard Oil stock at $50 each. As a result, the Dow Jones staged a recovery.
JP Morgan Founder of the legendary investment bank JP Morgan, still among Wall Street's most feared, Morgan was quick to see the profits to be made from takeovers and was instrumental in creating the first global steel company, US Steel. During the 1907 panic on Wall Street, Morgan told his fellow bankers it was their duty to save the tottering Trust Company of America, and protect their investments. The panic was stopped. Some 22 years later, during the Great Crash, his firm called leading financiers together and put together a pool of funds to prop up the creaking edifice. It failed.
Henry Kaufman During the 1970s and 1980s, the most influential figure on Wall Street was Henry Kaufman, senior partner in investment bankers Salomon Brothers. Kaufman, a mild-mannered economist and respected intellectual, could move billions through the market by his pronoucements, enriching his firm. It was Kaufman who, in 1982, after the deepest recession since the 1930s, accurately predicted that interest rates would now fall and the Dow Jones soar. He ushered in one of the speediest bull markets in Wall Street history, brought to a temporary halt by the crash of 1987. Ivan Boesky Slim, aquiline and ruthless, Ivan Boesky came to prominence during the bull market of the 1980s and was the inspiration for the greedy financier in Oliver Stone's film Wall Street. His technique, not unlike that of today's hedge funds, was to spot discrepancies in prices between markets and exploit them. His presence on the share register usually meant a bid was looming. His uncanny knack for making a profit was later shown to have been the result of insider trading for which he was jailed. His evidence of cheating on Wall Street and in the City led to the Guinness affair in Britain.
Warren Buffett Known as the sage of Omaha, Buffett is the world's most successful investor. Starting with $100 in 1956, he made this into $25 million in 13 years. In 1965 Buffett took control of an obscure company, Berkshire Hathaway, and built it into the greatest investment fund in the world, buying insurance companies and other investment vehicles, too. In October 1998, when Long-Term Capital Management fell apart almost sinking Wall Street, Buffett offered a rescue package. Even the hint of a Buffett presence on a share register or in the commodity markets can send them soaring.
George Soros A survivor of the Nazi occupation of Hungary and the post-war Communist era, George Soros fled Budapest for the West in 1956. After studying at the LSE he plunged into Wall Street, then started the Soros Fund, which became the Quantum Fund in 1973 with $12 billion. Soros found discrepancies between markets or economies that were going wrong. In September 1992 he was among the first to realise the pound was grossly overvalued. His huge selling wiped out Britain's reserves, forced the UK out of the ERM, and brought his funds $1 billion in profits.
