Читать книгу When Genius Failed: The Rise and Fall of Long Term Capital Management - Roger Lowenstein - Страница 11

They [Long-Term] are in effect the best finance faculty in the world. –INSTITUTIONAL INVESTOR

THE GODS SMILED on Long-Term. Having raised capital during the best of times, it put its money to work just as clouds began to gather over Wall Street. Investors long for steady waters, but paradoxically, the opportunities are richest when markets turn turbulent. When prices are flat, trading is a dull sport. When prices begin to gyrate, it is as if little eddies and currents begin to bubble in a formerly placid river. This security is dragged with the current, that one is washed upstream. Two bonds that once journeyed happily in tow are now wrenched apart, and once predictable spreads are jolted out of sync. Suddenly, investors feel cast adrift. Those who are weak or insecure may panic or at any rate sell. If enough do so, a dangerous undertow may distort the entire market. For the few who have hung on to their capital and their wits, this is when opportunity beckons.

In 1994, as Meriwether was wrapping up the fund-raising, Greenspan started to worry that the U.S. economy might be overheating. Mullins, who was cleaning out his desk at the Fed and preparing to jump to Long-Term, urged the Fed chief to tighten credit.¹ In February, just when interest rates were at their lowest—and, indeed, when investors were feeling their plummiest—Greenspan stunned Wall Street by raising short-term interest rates. It was the first such hike in five years. But if the oracular Fed chief had in mind calming markets, the move backfired. Bond prices tumbled (bond prices, of course, move in the opposite direction of interest rates). And given the modest nature of Greenspan’s quarter-point increase, bonds were falling more than they “should” have. Somebody was desperate to sell.

By May, barely two months after Long-Term’s debut, the thirty-year Treasury bond had plunged 16 percent from its recent peak—a huge move in the relatively tame world of fixed-income securities—rising in yield from 6.2 percent to 7.6 percent. Bonds in Europe were crashing, too. Diverse investors, including hedge funds—many of which were up to their necks in debt—were fleeing from bonds. Michael Steinhardt, one such leveraged operator, watched in horror. Steinhardt, who had bet on European bonds, was losing $7 million with every hundredth of a percentage point move in interest rates. The swashbuckling Steinhardt lost $800 million of his investors’ money in a mere four days. George Soros, who was jolted by a ricochet effect on international currencies, dropped $650 million for his clients in two days.²

For Meriwether, this tumult was the best of news. One morning during the heat of the selling, J.M. walked over to one of his traders. Glancing at the trader’s screen, J.M. marveled, “It’s wave after wave of guys throwing in the towel.” As J.M. knew, panicky investors wouldn’t be picky as they ran for the exits. In their eagerness to sell, they were pushing spreads wider, creating just the gaps that Meriwether was hoping to exploit. “The unusually high volatility in the bond markets … has generally been associated with a widening of spreads,” he chirped in a—for him—unusually revealing letter to investors. “This widening has created further opportunities to add to LTCP’s convergence and relative-value trading positions.”³ After two flat months, Long-Term rose 7 percent in May, beginning a stretch of heady profits. It would hardly have occurred to Meriwether that Long-Term would ever switch places with some of those panicked, overleveraged hedge funds. But the bond debacle of 1994, which unfolded during Long-Term’s very first months, merited Long-Term’s close attention.

Commentators began to see a new connectedness in international bond markets. The Wall Street Journal observed that “implosions in seemingly unrelated markets were reverberating in the U.S. Treasury bond market.”⁴ Such disparate developments as a slide in European bonds, news of trading losses at Bankers Trust, the collapse of Askin Capital Management, a hedge fund that had specialized in mortgage trades, and the assassination of Mexico’s leading presidential contender all accentuated the slide in U.S. Treasurys that had begun with Greenspan’s modest adjustment.

Suddenly markets were more closely linked—a development with pivotal significance for Long-Term. It meant that a trend in one market could spread to the next. An isolated slump could become a generalized rout. With derivatives, which could be custom-tailored to any market of one’s fancy, it was a snap for a speculator in New York to take a flier on Japan or for one in Amsterdam to gamble on Brazil—raising the prospect that trouble on one front would leach into the next. For traders tethered to electronic screens, the distinction between markets—say, between mortgages in America and government loans in France—almost ceased to exist. They were all points on a continuum of risk, stitched together by derivatives. With traders scrambling to pay back debts, Neal Soss, an economist at Credit Suisse First Boston, explained to the Journal, “You don’t sell what you should. You sell what you can.” By leveraging one security, investors had potentially given up control of all of their others. This verity is well worth remembering: the securities might be unrelated, but the same investors owned them, implicitly linking them in times of stress. And when armies of financial soldiers were involved in the same securities, borders shrank. The very concept of safety through diversification—the basis of Long-Term’s own security—would merit rethinking.

Steinhardt blamed his losses on a sudden evaporation of “liquidity,” a term that would be on Long-Term’s lips in years to come.⁵ But “liquidity” is a straw man. Whenever markets plunge, investors are stunned to find that there are not enough buyers to go around. As Keynes observed, there cannot be “liquidity” for the community as a whole.⁶ The mistake is in thinking that markets have a duty to stay liquid or that buyers will always be present to accommodate sellers. The real culprit in 1994 was leverage. If you aren’t in debt, you can’t go broke and can’t be made to sell, in which case “liquidity” is irrelevant. But a leveraged firm may be forced to sell, lest fast-accumulating losses put it out of business. Leverage always gives rise to this same brutal dynamic, and its dangers cannot be stressed too often.

Long-Term was doubly fortunate: spreads widened before it invested much of its capital, and once opportunities did arise, Long-Term was one of a very few firms in a position to exploit the general distress. And its trades were good trades. They weren’t risk-free; they weren’t so good that the fund could leverage indiscriminately. But by and large, they were intelligent and opportunistic. Long-Term started to make money on them almost immediately.

One of its first trades involved the same thirty-year Treasury bond. Treasurys (of all durations) are, of course, issued by the U.S. government to finance the federal budget. Some $170 billion of them trade each day, and they are considered the least risky investments in the world. But a funny thing happens to thirty-year Treasurys six months or so after they are issued: investors stuff them into safes and drawers for long-term keeping. With fewer left in circulation, the bonds become harder to trade. Meanwhile, the Treasury issues a new thirty-year bond, which now has its day in the sun. On Wall Street, the older bond, which has about 29½ years left to mature, is known as off the run; the shiny new model is on the run. Being less liquid, the off-the-run bond is considered less desirable. It begins to trade at a slight discount (that is, you can purchase it for a little less, or at what amounts to a slightly higher interest yield). As arbitrageurs would say, a spread opens.

In 1994, Long-Term noticed that this spread was unusually wide. The February 1993 issue was trading at a yield of 7.36 percent. The bond issued six months later, in August, was yielding only 7.24 percent, or 12 basis points, less. Every Tuesday, Long-Term’s partners held a risk-management meeting, and at one of the early meetings, several proposed that they bet on this 12-point gap to narrow. It wasn’t enough to say, “One bond is cheaper, one bond is dearer.” The professors needed to know why a spread existed, which might shed light on the paramount issue of whether it was likely to persist or even to widen. In this case, the spread seemed almost silly. After all, the U.S. government is no less likely to pay off a bond that matures in 29½ years than it is one that expires in thirty. But some institutions were so timid, so bureaucratic, that they refused to own anything but the most liquid paper. Long-Term believed that many opportunities arose from market distortions created by the sometimes arbitrary demands of institutions.⁷ The latter were willing to pay a premium for on-the-run paper, and Long-Term’s partners, who had often done this trade at Salomon, happily collected it. They called it a “snap trade,” because the two bonds usually snapped together after only a few months. In effect, Long-Term would be collecting a fee for its willingness to own a less liquid bond.

“A lot of our trades were liquidity-providing,” Rosenfeld noted. “We were buying the stuff that everyone wanted to sell.” It apparently did not occur to Rosenfeld that since Long-Term tended to buy the less liquid security in every market, its assets were not entirely independent of one another, the way one dice roll is independent of the next. Indeed, its assets would be susceptible to falling in unison if a time came when, literally, “everyone” wanted to sell.

Twelve basis points is a tiny spread; ordinarily, it wouldn’t be worth the trouble. The price difference was only $15.80 for each pair of $1,000 bonds. Even if the spread narrowed two thirds of the way, say in a few months’ time, Long-Term would earn only $10, or 1 percent, on those $1,000 bonds. But what if, using leverage, that tiny spread could be multiplied? What if, indeed! With such a strategy in mind, Long-Term bought $1 billion of the cheaper, off-the-run bonds. It also sold $1 billion of the more expensive, on-the-run Treasurys. This was a staggering sum. Right off the bat, the partners were risking all of Long-Term’s capital! To be sure, they weren’t likely to lose very much of it. Since they were buying one bond and selling another, they were betting only that the bonds would converge, and, as noted, bond spreads vary much less than bonds themselves do. The price of your home could crash, but if it does, the price of your neighbor’s house will likely crash as well. Of course, there was some risk that the spread could widen, at least for a brief period. If two bonds traded at a 12-point spread, who could say that the spread wouldn’t go to 14 points—or, in a time of extreme stress, to 20 points?

Long-Term, with trademark precision, calculated that owning one bond and shorting another was one twenty-fifth as risky as owning either bond outright.⁸ Thus, it reckoned that it could prudently leverage this long/short arbitrage twenty-five times. This multiplied its potential for profit but—as we have seen—also its potential for loss. In any case, borrow it did. It paid for the cheaper, off-the-run bonds with money that it borrowed from a Wall Street bank, or from several banks. And the other bonds, the ones it sold short, it obtained through a loan, as well.

Actually, the transaction was more involved, though it was among the simplest in Long-Term’s repertoire. No sooner did Long-Term buy the off-the-run bonds than it loaned them to some other Wall Street firm, which then wired cash to Long-Term as collateral. Then Long-Term turned around and used this cash as collateral on the bonds that it borrowed. On Wall Street, such short-term, collateralized loans are known as “repo financing.”

The beauty of the trade was that Long-Term’s cash transactions were in perfect balance. The money that Long-Term spent going long (buying) matched the money it collected going short (selling). The collateral it paid equaled the collateral it collected. In other words, Long-Term pulled off the entire $2 billion trade without using a dime of its own cash.*

Now, normally, when you borrow a bond from, say, Merrill Lynch, you have to post a little bit of extra collateral—maybe a total of $1,010 on a $1,000 Treasury and more on a riskier bond. That $10 initial margin, equivalent to 1 percent of the bond’s value, is called a haircut. It’s Merrill Lynch’s way of protecting itself in case the price of the bond rises.

The haircut naturally acts as a check on how much you can trade. But if you could avoid the haircut, well, the sky would be the limit. It would be like driving a car that didn’t burn gas: you could drive as far as you wished. What’s more, the rate of return would be substantially higher—if you didn’t have that extra margin tied up at Merrill Lynch.

And from the very start, it was Long-Term’s policy to refuse to pay the haircut or else to substantially reduce it. The policy surely flowed from Meriwether, who, for all his unassuming charm, was fiercely competitive at trading, golf, billiards, horses, and whatever else he touched. Rosenfeld and Leahy, two of the more congenial and laid-back partners, were usually the ones who met with banks, though Hilibrand also got involved. In any case, the partners would insist, politely but firmly, that the fund was so well heeled that it didn’t need to post an initial margin—and, what’s more, that it wouldn’t trade with anyone that saw matters differently. Merrill Lynch agreed to waive its usual haircut requirement and go along. So did Goldman Sachs, J. P. Morgan, Morgan Stanley, and just about everyone else. One firm that balked, PaineWebber, got virtually none of Long-Term’s business. “You had no choice if you were going to do business with them,” recalled Goldman Sachs’s Jon Corzine, J.M.’s admiring rival.

Although Long-Term’s trades could be insanely complex and ultimately numbered in the thousands, the fund had no more than a dozen or so major strategies.⁹ Some, such as the Treasury arbitrage, involved buying and selling tangible securities. The others, derivative trades, did not. They were simply bets that Long-Term made with banks and other counterparties that hinged on the fate of various market prices.

Imagine, by illustration, that a Red Sox fan and a Yankees fan agree before the season that each will pay the other $1,000 for every run scored by his rival’s team. Long-Term’s derivative contracts were not dissimilar, except that the payoffs were tied to movements in bonds, stocks, and so forth rather than balls and strikes. These derivative obligations did not appear on Long-Term’s balance sheet, nor were they “debt” in the formal sense. But if markets moved against the fund, the result would obviously be the same. And Long-Term generally was able to forgo paying initial margin on derivative deals; it made these bets without putting up any initial capital whatsoever.

Frequently, though not always, it got the same terms on repo financing of actual securities. Also, Long-Term often persuaded banks to lend to it for longer periods than the banks gave to other funds.¹⁰ Thus, Long-Term could be more patient. Even if the banks had wanted to call in Long-Term’s loans, they couldn’t have done so very quickly. “They had everyone over a barrel,” noted a senior executive at a top investment bank.

This was where Meriwether’s marketing strategy really paid dividends. If the banks had given it a moment’s thought, they would have realized that Long-Term was at their mercy. But the banks saw the fund not as a credit-hungry start-up but as a luminous firm of celebrated scholars and brilliant traders, something like that New Age “financial intermediary” conjured up by Merton. After all, it was generally believed that Long-Term had the benefit of superior, virtually fail-safe technology. And banks, like some of the press, casually assumed that it was so. Business Week gushed that the fund’s Ph.D.s would give rise to “a new computer age” on Wall Street. “Never has this much academic talent been given this much money to bet with,” the magazine observed in a cover story published during the fund’s first year.¹¹ If a new age was coming, no one wanted to miss it. Long-Term was as fetching as a debutante on prom night, and all the banks wanted to dance.

The banks had no trouble rationalizing their easy credit terms. The banks did hold collateral, after all, and Long-Term generally settled up (in cash) at the end of each trading day, collecting on winners and paying on losers. And Long-Term was flush, so the risk of its failing seemed slight. Only if Long-Term lost money with unthinkable suddenness—only if, say, it was forced to dump the majority of its assets all at once and into an illiquid market—would the value of the bankers’ collateral be threatened and would the banks themselves be exposed to losses.

Also, many of the banks’ heads, such as Corzine and Merrill Lynch’s Tully, liked Meriwether personally, which tilted their organizations in Long-Term’s favor. But Long-Term’s real selling point was its connections to other powerful traders around the world. A firm that did business with Long-Term might gain valuable inside knowledge—totally legal in the bond world—about the flow of markets. “How do you get people to come to your party? You tell them that every cool person in town is coming,” said a banker in Zurich who financed Long-Term with a zero percent haircut. “So everyone said, ‘OK, I’ll do it, but if anyone else gets a haircut, I get one too.’” This was especially clever of Long-Term. The partners could say to each new bank, “If we give you a haircut, we have to give it to everyone.” So they ended up giving it to nobody. (On a small number of riskier trades they did agree to haircuts—but very skimpy ones.)

Since the banks, too, were doing arbitrage trading, Meriwether viewed them, not unjustly, as his main competitors.¹² Long-Term resembled other hedge funds such as Soros’s Quantum Fund less than it did the proprietary desks of its banks, such as Goldman Sachs. The Street was slowly shifting from research and client services to the lucrative business of trading for its own account, fostering a wary rivalry between Long-Term and its lenders.

Having worked at a major Wall Street bank, J.M. felt that investment banks were rife with leaks and couldn’t be trusted not to swipe his trades for themselves. Indeed, most of them were plying similar strategies. Thus, as a precaution, Long-Term would place orders for each leg of a trade with a different broker. Morgan would see one leg, Merrill Lynch another, and Goldman yet another, but nobody would see them all. Even Long-Term’s lawyer was kept in the dark; he would hear the partners speak about “trading strategy three,” as though Long-Term were developing a nuclear arsenal.

Hilibrand, especially, refused to give the banks a peek at his strategies or to meet them halfway on terms. He would call a dealer, purchase $100 million in bonds, and be off the phone in seconds.¹³ “I’m just concerned about margin requirement, and I’m not putting up any margin,” he bluntly told Merrill Lynch. Kevin Dunleavy, a Merrill Lynch salesman, sometimes called Hilibrand two or three times a day, trying to pitch strategies he had devised with the clever Hilibrand in mind. But Dunleavy was repeatedly frustrated by Hilibrand’s obsessive secrecy, which made it nearly impossible to service the account. “Rarely could you take your ideas and implement them into LTCM’s strategy,” noted Dunleavy, an unaffected New Yorker with a military brush cut. “It was very unusual, not to take input from the Street. Larry would never talk about the strategy. He would just tell you what he wanted to do.”

The fund parceled out its business, choosing each bank for particular services and keeping a distance from all of them. Chary of becoming dependent on any one bank, Long-Term traded junk bonds with Goldman Sachs, government bonds and yen swaps with J. P. Morgan, mortgages with Lehman Brothers. Merrill Lynch was the fund’s biggest counterparty in derivatives, but it was far down the list in repo loans. To be sure, there was something shrewd about this divide-and-conquer strategy, for Long-Term did each set of trades with the bank that boasted the most specific expertise. But Long-Term thus forfeited the benefits of a closer, ongoing relationship. J. P. Morgan, for one, was extremely curious about Long-Term and eager to develop a closer working alliance, but it couldn’t get past the fund’s unwillingness to share confidences. “How can you propose ideas to them without knowing what their appetite is?” wondered the head of risk management at a major Wall Street firm. As arbitrageurs, the partners tended to see every encounter as a discrete exchange, with tallyable pluses and minuses. Every relationship was a “trade”—renegotiable or revocable if someone else had a better price. The partners’ only close ties were within Long-Term, mimicking the arrangement within their beloved group at Salomon.

They were a bred type—intellectual, introverted, detached, controlled. It didn’t work to try to play one off against the other; they were too much on the same wavelength. Andrew Siciliano, who ran the bond and currency departments at Swiss Bank Corporation, was stunned by their uncanny closeness. One time, Siciliano called Victor Haghani, the head of the London office, and followed up in Greenwich with J.M. and Eric Rosenfeld a month or two later. The American-based partners didn’t miss a beat; Siciliano had the eerie feeling that he was continuing the same conversation he’d had with Haghani.

Not that there weren’t tensions within the firm. A small group—J.M., Hilibrand, Rosenfeld, and Haghani—dominated the rest. As at Salomon, compensation was skewed toward the top, with the inner circle garnering more than half the rewards. This group also had voting control. Lesser partners such as Myron Scholes were forever angling for more money, as well as more authority. But the inner circle had been together for years; as in a family, their exclusive and inbred alliance had became second nature.

If the firm could have been distilled into a single person, it would have been Hilibrand. While veteran traders tend to be cynical and insecure, the result of years of wrong guesses and narrow escapes, Hilibrand was cool and maddeningly self-confident. An incredibly hard worker, he was the pure arbitrageur; he believed in the models, stuck to his prices, was untroubled by doubt. Rosenfeld hated to hedge by selling a falling asset, as theory prescribed; Hilibrand believed and simply followed the form. Hilibrand’s colleagues respected him immensely; inevitably, they turned to him when they needed a quick read. He was highly articulate, but his answers were like unrefined crystals, difficult for novices to comprehend. “You could refract the light with Larry’s mind,” said Deryck Maughan of Salomon Brothers. Like the other partners, but to a greater degree, Hilibrand saw every issue in black and white. He was trustworthy and quick to take offense at perceived wrongdoing but blind to concerns outside his narrow sphere. His Salomon colleagues used to joke that, according to the libertarian Hilibrand, if the street in front of your home had a pothole you ought to pave it yourself. But money probably meant less to him than to any of them. He found his passion in the intellectual challenge of trading. Aside from his family, he showed interest in little else. If anyone brought Hilibrand out of himself a bit, it was J.M. Hilibrand had a filial attachment to the chief, perhaps stemming from his close relationship to his own father. Rosenfeld had a similar devotion to Meriwether.

Outsiders couldn’t quite explain J.M.’s hold on the group. He was an unlikely star, too bashful for the limelight. He spoke in fragments and seemed uncomfortable making eye contact.¹⁴ He refused to talk about his personal life, even to close friends. After organizing Long-Term, J.M. and his wife moved out of Manhattan, to a $2.7 million, sixty-eight-acre estate in North Salem, in Westchester County—complete with a 15,000-square-foot heated indoor riding ring for Mimi.¹⁵ The estate was set back three quarters of a mile on a private drive that the Meriwethers shared with their only neighbor, the entertainer David Letterman. As if to make the property even more private, the Meriwethers did extensive remodeling, fortifying the house with stone. J.M. liked to control his private life, as if to shelter it, too, from unwanted volatility.

Though he attended a church near home and made several visits to Catholic shrines, J.M. didn’t speak about his faith, either. His self-control was implacable. Nor did he open up among his traders. At firm meetings he was mostly quiet. He welcomed frank debates among the partners, but he usually chimed in only at the very end or not at all.

The firm’s headquarters were the ground floor of a glassy four-story office complex, on a street that ran from the shop-lined center of affluent Greenwich past a parade of Victorian homes on Long Island Sound. Several dozen of Long-Term’s growing cadre of traders and strategists worked on the trading floor, where partners and nonpartners sat elbow to elbow, cramped around a sleek, semicircular desk loaded with computers and market screens. The office had an elaborate kitchen that had been put in by a previous tenant, but the partners lunched at their desks. Food meant little to them.

J.M., Merton, and Scholes (the latter two because they didn’t trade) had private offices, but J.M. was usually on the trading floor, a mahogany-paneled room that looked out through a full-length picture window to the water, resplendent and often speckled with sailboats. Aside from the natty Mullins, the partners dressed casually, in Top-Siders and chinos. The room hummed with trader talk, but it was a controlled hum, not like the chaos on the cavernous New York trading floors. Only occasionally did the partners revert to their past life for a few rounds of liar’s poker.

Besides the Tuesday risk meetings, which were for partners only, Long-Term had research seminars on Wednesday mornings that were open to associates and usually another meeting on Thursday afternoons, when partners would focus on a specific trade. Merton, usually in Cambridge, would join in by telephone. The shared close quarters fostered a firm togetherness, but the associates and even some of the partners knew they could never be part of the inner circle. One junior trader perpetually worried that his trades would be found out by the press, which he feared could cost him his job. Associates in Greenwich, even senior traders, were kept so much in the dark that some resorted to calling their London counterparts to find out what the firm was buying and selling. Associates were never invited back to the partners’ homes—there seemed to be an unwritten rule against partners and staff fraternizing. Leahy, a college hockey player, exchanged the normal office banter with the employees, but most of the partners treated the staff with cool formality. They were polite but interested only in one another and their work. The analysts and legal and accounting staffs were second-class citizens, shunted to a room in the back, where the pool table was.

Like everyone else on Wall Street, Long-Term’s employees made good money. The top staffers could make $1 million to $2 million a year. There was subtle pressure on the staff to invest their bonuses in the fund, but most of them were eager to do so anyway—ironically, it was considered a major perk of working at Long-Term. And so, the staff confidently reinvested most of their pay.

Just as predicted, Long-Term’s on-the-run and off-the-run bonds snapped back quickly. Long-Term made a magical $15 million—magical because it hadn’t used any capital. As Scholes had promised, Long-Term had scooped up a nickel and, with leverage, turned it into more. True, many other firms had done the same kind of trade. “But we could finance better,” an employee of Long-Term noted. “LTCM was really a financing house.”

Long-Term preferred to reap a sure nickel than to gamble on making an uncertain dollar, because it could leverage its tiny margins like a high-volume grocer, sucking up nickel after nickel and multiplying the process thousands of times. Of course, not even a nickel bet was absolutely sure. And as Steinhardt, the fund manager, had recently been reminded, the penalty for being wrong is infinitely greater when you are leveraged. But in 1994, Long-Term was almost never wrong. In fact, nearly every trade it touched turned to gold.

Long-Term dubbed its safest bets convergence trades, because the instruments matured at a specific date, meaning that convergence appeared to be a sure thing. Others were known as relative value trades, in which convergence was expected but not guaranteed.¹⁶

The bond market turmoil of 1994 seeded the ground for a huge relative value trade in home mortgage securities. Mortgage securities are pieces of paper backed by the cash flow on pools of mortgages. They sound boring, but they aren’t. Some $1 trillion of mortgage securities is outstanding at any given time. What makes them exciting is that clever investment bankers have separated the payments made by homeowners into two distinct pools: one for interest payments, the other for principal payments. If you think about it—and Long-Term did, quite a bit—the value of each pool (relative to the other) varies according to the rate at which homeowners pay off their loans ahead of schedule. If you refinance your mortgage, you pay it off in one lump sum—that is, in one giant payment of principal. Therefore, no further cash goes to the interest-only pool. But if you stand pat and keep writing those monthly checks, you keep making interest payments for up to thirty years. Therefore, if more people refinance, the interest-only securities, known as “IOs,” will fall; if fewer people prepay, they will rise. The converse is true for principal-only securities, or POs. And since the rate of refinancings can change quickly, betting on IOs or POs can make or lose you a good deal of money.

In 1993, when Long-Term was raising capital, America was experiencing a surge of refinancings. With mortgage rates dropping below 7 percent for the first time since the Vietnam War, baby boomers who had never given their mortgages a second thought were suddenly delirious with the prospect of cutting their payments by hundreds of dollars a month. Getting the lowest rate became a point of pride; roughly two in five Americans refinanced in that one year—in fact, some folks did it twice. Naturally, the prices of IOs plummeted. Actually, they fell too much. Unless you assumed that the entire country was going to refinance tomorrow, the price of IOs was simply too low. Indeed, Meriwether, Hilibrand, Rosenfeld, Haghani, and Hawkins bought buckets of IOs for their personal accounts.

In 1994, as Long-Term was beginning to trade, IOs remained cheap for fear there would be another wave of refinancings. Bill Krasker had designed a model to predict prepayments, and Hawkins—an outgoing, curly-haired mortgage trader with backwoods charm—continually checked the model against the record of actual prepayments. The IO price seemed so out of whack that Hawkins wondered, “Is there something wrong with the model, or is this just a good opportunity?” The methodical Krasker carefully retooled the model, and it all but screamed, “Buy!” So Long-Term—once again with massive leverage—started buying IOs by the truckload. It acquired a huge stake, estimated at $2 billion worth.

Now, when interest rates rise, people aren’t even going to think about refinancing. But when rates fall, they run to the mortgage broker. That means that IOs rise and fall in sync with interest rates—so betting on IOs is like betting on interest rates. But the partners didn’t want to forecast rates; such outright speculation made them jittery, even though they did it on occasion. Because interest rates depend on so many variables, they are essentially unpredictable. The partners’ forte was making highly specific relative bets that did not depend on broad unknowns.

In short, the partners merely felt that, given the present level of interest rates, IOs were cheap. So the partners shrewdly hedged their bet by purchasing Treasurys, the prices of which move in the opposite direction from interest rates. The net effect was to remove any element of rate forecasting. The partners excelled at identifying particular mispriced risks and hedging out all of the other risks. If Haifa oranges were cheap relative to Fuji apples, they would find a series of trades to isolate that particular arbitrage; they didn’t simply buy every orange and sell every apple.

In the spring, when interest rates soared, Long-Term’s IOs also soared, although its Treasury bonds, of course, fell. Thus, it was ahead on one leg of its trade and behind on the other. Then, in 1995, when interest rates receded, Long-Term’s Treasurys rose in price. But this time people did not rush to refinance, so Long-Term’s IOs held on to much of their former gains. Presumably, people who had gotten new mortgages in 1993 were not so eager to do it again. Long-Term made several hundred million dollars. It was off to a sizzling start.

Despite appearances, finding these “nickels” was anything but easy. Long-Term was searching for pairs of trades—or often, multiple pairs—that were “balanced” enough to be safe but unbalanced in one or two very particular aspects, so as to offer a potential for profit. Put differently, in any given strategy, Long-Term typically wanted exposure to one or two risk factors—but no more. In a common example—yield-curve trades—interest rates in a given country might be oddly out of line for a certain duration of debt. For instance, medium-term rates might be far higher than short-term rates and almost as high as long-term rates. Long-Term would concoct a series of arbitrages betting on this bulge to disappear.

The best place to look for such complex trades was in international bond markets. Markets in Europe, as well as in the Third World, were less efficient than America’s; they had yet to be picked clean by computer-wielding arbitrageurs (or professors). For Long-Term, these underexploited markets were a happy hunting ground with a welter of opportunities. In 1994, when the trouble in the U.S. bond market rippled across the Atlantic, the spreads between German, French, and British government debt and, respectively, the futures on each country’s bonds, widened to nonsensical levels. Long-Term plunged in and made a fast profit.¹⁷ It also sallied into Latin America, where spreads had widened as well.¹⁸ The positions were small, but Long-Term was pursuing every angle—you don’t find nickels lying on the street. Then, Eric Rosenfeld found a few “coins” in Japan, arbitraging warrants on Japanese stocks against options on the Tokyo index—one of Long-Term’s first excursions into equities.

By the mid-1990s, Europe had become a playground for international bond traders, who were hotly debating the outlook for monetary union. Its markets were increasingly unsettled by the prospect—still much in doubt—that France, Germany, Italy, and other age-old nation-states would really merge their currencies, abandoning their francs, marks, and lire for freshly minted euros. Every trader had a different view—just the sort of uncertain climate in which Long-Term thrived. Many investment banks were betting that bonds issued by the weaker countries, such as Italy and Spain, would strengthen relative to those of Germany, on the theory that if union did come about, it would force a convergence of interest rates all across Europe. Long-Term did some of these trades, but as usual, the partners were reluctant to risk too much on a broad economic theory. Long-Term’s expertise was in the details. When it came to forecasting geopolitical trends, it did not have any apparent edge. What’s more, the mostly American partners were Euro-skeptics. With Europe’s highly regulated economies perennially trailing America’s, the Continent seemed hopelessly rigid. A Swiss partner, Hans Hufschmid, tried to push the convergence theme, but the American partners, including Victor Haghani, the free-spirited London chief, resisted.

Haghani preferred to focus on strategies that were confined to single countries, where there would be fewer risk factors. For instance, he arbitraged two issues of gilts, the British equivalent of Treasurys, one of which was cheaper owing to an unfavorable tax treatment. When the U.K. government reversed its stance, Long-Term quickly made $200 million.¹⁹

Haghani frequently traded the yield curve of a country against itself. Thus, he might go long on Germany’s ten-year bonds and sell its five-year paper, a subtle trade that required command of the math along with a keen appreciation for local economic trends. But at least it did not require comparing the trends in Germany with, say, the trends in Spain.

Newspaper accounts of Long-Term generally overlooked Haghani, who was intensely private. The press played up Meriwether’s leadership and Merton’s and Scholes’s “models.” But in fact Haghani was a critical player. While J.M. presided over the firm and Rosenfeld ran it from day to day, Haghani and the slightly senior Hilibrand had the most influence on trading. Similarly brilliant and mathematically adept, they spoke in a code that outsiders found impenetrable.

Although the two operated mostly as a team, Haghani was far more daring. A natural trader, Haghani had an intuitive feeling for markets and a volatile, impulsive streak. If a model identified a security as mispriced and if the firm felt it understood why the distortion had occurred, Hilibrand tended to go right ahead. Haghani, who trusted his instincts, might gamble on the security’s becoming even more mispriced first. Barely thirty-one years old when Long-Term started (Hilibrand was thirty-four, Rosenfeld forty, and Meriwether forty-six), the swarthy, bearded Haghani routinely swung for the fences. Though a lively raconteur, he was less direct than Hilibrand: you could never tell if Haghani was challenging you in earnest or playing poker. He had a youthful impetuousness and belief in himself, perhaps the result of his privileged background.

The son of a wealthy Iranian importer-exporter and an American mother, Haghani grew up keenly aware of the political crosscurrents that often overwhelm the best-laid business plans. As a teenager, he had spent two years in Iran with his father, whom he adored; then the revolution had forced them to flee. At Salomon Brothers, Haghani had spent a lot of time in the London and Tokyo bureaus, where he had pushed the local traders to adopt the Arbitrage Group’s model of markets and had exhorted the often bewildered staffers to trade in bigger size. He returned to London with Long-Term Capital Management just as the Continent was bubbling with talk of monetary union.

Haghani shunned the City, London’s buttoned-down equivalent of Wall Street, and rented quarters in Mayfair, a lively fashion district. He ran the office informally, encouraging the staff to join him in give-and-take and spirited banter. His traders and analysts worked long hours, but they were motivated by the lure of Long-Term’s growing profits and humbled by the sight of their boss trundling to the office on a bicycle. When the action abated, the traders would drift to a poolroom off the trading floor, where Haghani would issue challenges to visitors. (J.M., too, on his visits to London, would inevitably pick up the cue stick and take on all comers.) Less introverted than some of his partners, Haghani frequently invited traders home to dinner. After Long-Term’s first big month, in May, he assembled the entire London staff, including the secretaries, and told them how the money had been made. This would have been heresy at the stiffer and more secretive Greenwich headquarters, where a rigid caste system prevailed.

Haghani’s biggest trade was Italy—a bold choice. Italian finance was a mess, as was Italian politics. The fear that Italy might default on its loans, coupled with the still considerable strength of the Italian Communist Party, had pushed Italy’s interest rates to as much as 8 percentage points over Germany’s—a huge spread. Italy’s bond market was still evolving, and the government was issuing lots of paper, partly to attract investors. For bond traders, it was fertile territory. Obviously, if Italy righted itself, people who had bet on Italy would make out like bandits. But what if it didn’t?

The Italian market was further complicated because Italy had a quirky tax law and two types of government bonds—one of which paid a floating rate, the other a fixed rate. Strangely, the Italian government was forced (by an untrusting bond market) to pay an interest rate that was higher than the rate on a widely traded interest rate derivative known as “swaps.” Swap rates are generally close to private-sector bank rates. Thus, the bond market was rating the Italian government as a poorer risk than private banks.

Haghani thought the market was seriously overstating the risk of the government’s defaulting—relative to the price it was putting on other risks. With characteristic derring-do, he recommended a king-size arbitrage to exploit the supposed mispricing. It was a calculated gamble, because if Italy did default, Long-Term’s counterparties might walk away from their contracts—and Long-Term could lose its shirt. To the American partners, who remained skeptical about Italy, this was a major worry. The risk-averse Bill Krasker was especially concerned, and the partners heatedly debated Italy for hours.

In simple terms, the arbitrage zeroed in on the market’s utter lack of respect for Rome. But nothing at Long-Term was ever simple. Specifically, Haghani, who eventually prevailed, bought the fixed-rate Italian government bonds and shorted the fixed rate on Italian swaps. He also bought the floating-rate government paper, a coup for Long-Term because few others could get hold of this thinly traded security. Haghani balanced that with a short position, too. At first, Long-Term hedged the entire position, taking out a rather expensive Italian-default insurance policy (it even took out a second policy, in case the insurer went broke).²⁰ But as the Italian position got bigger, Long-Term couldn’t afford to keep buying more insurance, and it simply took a chance. An insider judged that had Italy gone bust, the fund could have lost half of its capital.

The virtually unregulated hedge fund did not disclose its risk in Italy to investors; indeed, it didn’t tell them anything about how and where their money was invested, save for broad generalities. J.M.’s letters were saturated with statistics on volatilities but mute on what the firm was actually doing. He covered for his shyness by adopting an aloof, impersonal tone, as though he were doing his investors a favor by disclosing anything. “It is our intent to maintain ongoing communications with you, our investors,” he declared stiffly. Even the few dry nuggets that J.M. did disclose he asked investors to keep confidential, as if Long-Term’s genius were a tender woodland plant that couldn’t tolerate the glare of sunlight. The partners went to obsessive lengths to stay out of the press. They even repurchased the rights to photographs that had run in Business Week to keep their pictures from public view.

For all its attention to risk, Long-Term’s management had a serious flaw. Unlike at banks, where independent risk managers watch over traders, Long-Term’s partners monitored themselves. Though this enabled them to sidestep the rigidities of a big organization, there was no one to call the partners to account.

Traders needed approval from the risk-management committee to initiate a trade; however, Hilibrand and Haghani, who would fight relentlessly for what they wanted, had a way of getting it. Sooner or later, the other partners would defer, if only out of sheer exhaustion. Meriwether was largely to blame for this tolerant regime. If J.M. had a cardinal weakness, it was his failure to insert himself into the debates. And there was no one else who could have played the role of nanny, as there had been at Salomon—no Gutfreund. The traders were their own watchdogs.

The partners did go to considerable lengths to research their trades, the Italian trade being a prime example. Haghani recruited a network of intelligence sources to bolster his knowledge of Italy. He hired—first as a consultant, later full-time—Alberto Giovannini, a former official in the Italian Treasury and professor at Columbia University. Giovannini, who had also studied at MIT, would shuttle back and forth between London and Rome, where he could see his family and gossip with Italian officials. Still not satisfied, Haghani brought in Gérard Gennotte, yet another MIT grad, who was the son of Belgium’s ambassador to Italy and was fluent in Italian. “Victor was always keen on Italy,” an associate noted. And of course, Long-Term was plugged in to Italy’s central bank, which had invested $100 million in the fund and lent it $150 million more.

However, Long-Term’s approach was so mathematical, it’s doubtful that all this intelligence made much difference. Its models said simply that Italy was “cheap” relative to historical patterns and anticipated risks. The partners assumed that, all else being equal, the future would look like the past. Therefore, in they went. Moreover, its models were hardly a secret. “You could pick up a Journal of Finance and see where someone was applying models,” a London-based trader at Salomon Brothers noted with respect to the Italy trade. “Anyone who had done first-year math at university could do it.” In truth, traders at other firms had been doing similar trades for years. By the time Long-Term started to trade, spreads in Italy had begun to narrow; rival firms were bidding arrivederci. Haghani got his first billion dollars’ worth or so of Italian bonds from Salomon, which wanted out. The common notion that Long-Term had a unique black box was a myth. Other Wall Street firms had also found their way to MIT, and most of the big banks were employing similar models—and, what’s more, were applying them to the same couple of dozen spreads in bond markets.

Long-Term’s edge wasn’t in its models but, first, in its experience in reading the models. The partners had been doing such trades for years. Second, the firm had better financing. During its first year, Rosenfeld sewed up repo financing with thirty banks and derivative facilities with twenty—all on liberal terms.²¹ With financing so accessible—and with the partners so supremely confident—Long-Term traded on a greater scale, and it kept squeezing nickels long after others had quit. “We focused on smaller discrepancies than other people,” one trader said. “We thought we could hedge further and leverage further.”

At least one observer had grave doubts about the fund’s seemingly cavalier approach to debt. Seth Klarman, the general partner of Baupost Group, a collection of smallish hedge funds based in Cambridge, Massachusetts, wrote to his investors that he had been offered a stake in a new fund run by former Salomon bond traders—obviously Long-Term—and had declined. Klarman was perturbed by a seemingly reckless trend on Wall Street. Investment banks possessed of the equivalent of financial Veg-O-Matics were slicing and dicing financial assets into potent, newfangled securities—IOs and POs—that investors were scooping up with reckless élan. What was worse, investors had rediscovered their thirst for leverage. With double-digit bond yields a thing of the past, investors—particularly the new hedge funds that were “popping up all over”—were resorting to borrowing to inflate their returns. How could investors be so certain that markets would always be liquid?, Klarman wondered. He feared that investors were turning “a blind eye to the consequences of ‘Outlier’ events,” such as the sudden disturbances and occasional crashes that, historically, have always upset the best-laid plans of investors. In general, Klarman warned, “Successful investors have positioned themselves to avoid the 100-year flood. Increasingly, that way of thinking has become passé.” Turning to the former Salomon traders’ fund—that is, to Long-Term—Klarman noted that, given its projected leverage, even a single serious mistake would put a “major dent” in the fund’s capital. “Two major errors at the same time, of course, would be catastrophic.”²²

* Maintaining the position wasn’t completely cost-free. Though a simple trade, it actually entailed four different payment streams. Long-Term collected interest on the collateral it paid out and paid interest (at a slightly higher rate) on the collateral it took in. It made some of this deficit back because it collected the 7.36 percent coupon on the bond it owned and paid the lesser 7.24 percent rate on the bond it shorted. Overall, it cost Long-Term a few basis points a month.