When Genius Failed

The Rise and Fall of Long Term Capital Management

Roger Lowenstein

• Publisher: William Collins
• Year: 2014
• ISBN:
  9780007375790
• Topic: Business
• Subtopic: Finance
• Index: Business

THE RISE OF LONG-TERM CAPITAL MANAGEMENT

1
MERIWETHER

IF THERE WAS one article of faith that John Meriwether discovered at Salomon Brothers, it was to ride your losses until they turned into gains. It is possible to pinpoint the moment of Meriwether’s revelation. In 1979, a securities dealer named J. F. Eckstein & Co. was on the brink of failing. A panicked Eckstein went to Salomon and met with a group that included several of Salomon’s partners and also Meriwether, then a cherub-faced trader of thirty-one. “I got a great trade, but I can’t stay in it,” Eckstein pleaded with them. “How about buying me out?”

The situation was this: Eckstein traded in Treasury bill futures—which, as the name suggests, are contracts that provide for the delivery of U.S. Treasury bills, at a fixed price in the future. They often traded at a slight discount to the price of the actual, underlying bills. In a classic bit of arbitrage, Eckstein would buy the futures, sell the bills, and then wait for the two prices to converge. Since most people would pay about the same to own a bill in the proximate future as they would to own it now, it was reasonable to think that the prices would converge. And there was a bit of magic in the trade, which was the secret of Eckstein’s business, of Long-Term Capital’s future business, and indeed of every arbitrageur who has ever plied the trade. Eckstein didn’t know whether the two securities’ prices would go up or down, and Eckstein didn’t care. All that mattered to him was how the two prices would change relative to each other.

By buying the bill futures and shorting (that is, betting on a decline in the prices of) the actual bills, Eckstein really had two bets going, each in opposite directions.* Depending on whether prices moved up or down, he would expect to make money on one trade and lose it on the other. But as long as the cheaper asset—the futures—rose by a little more (or fell by a little less) than did the bills, Eckstein’s profit on his winning trade would be greater than his loss on the other side. This is the basic idea of arbitrage.

Eckstein had made this bet many times, typically with success. As he made more money, he gradually raised his stake. For some reason, in June 1979, the normal pattern was reversed: futures got more expensive than bills. Confident that the customary relationship would reassert itself, Eckstein put on a very big trade. But instead of converging, the gap widened even further. Eckstein was hit with massive margin calls and became desperate to sell.

Meriwether, as it had happened, had recently set up a bond-arbitrage group within Salomon. He instantly saw that Eckstein’s trade made sense, because sooner or later, the prices should converge. But in the meantime, Salomon would be risking tens of millions of its capital, which totaled only about $200 million. The partners were nervous but agreed to take over Eckstein’s position. For the next couple of weeks, the spread continued to widen, and Salomon suffered a serious loss. The firm’s capital account used to be scribbled in a little book, left outside the office of a partner named Allan Fine, and each afternoon the partners would nervously tiptoe over to Fine’s to see how much they had lost. Meriwether coolly insisted that they would come out ahead. “We better,” John Gutfreund, the managing partner, told him, “or you’ll be fired.”

The prices did converge, and Salomon made a bundle. Hardly anyone traded financial futures then, but Meriwether understood them. He was promoted to partner the very next year. More important, his little section, the inauspiciously titled Domestic Fixed Income Arbitrage Group, now had carte blanche to do spread trades with Salomon’s capital. Meriwether, in fact, had found his life’s work.

Born in 1947, Meriwether had grown up in the Rosemoor section of Roseland on the South Side of Chicago, a Democratic, Irish Catholic stronghold of Mayor Richard Daley. He was one of three children but part of a larger extended family, including four cousins across an alleyway. In reality, the entire neighborhood was family. Meriwether knew virtually everyone in the area, a self-contained world that revolved around the basketball lot, soda shop, and parish. It was bordered to the east by the tracks of the Illinois Central Railroad and to the north by a red board fence, beyond which lay a no-man’s-land of train yards and factories. If it wasn’t a poor neighborhood, it certainly wasn’t rich. Meriwether’s father was an accountant; his mother worked for the Board of Education. Both parents were strict. The Meriwethers lived in a smallish, cinnamon-brick house with a trim lawn and tidy garden, much as most of their neighbors did. Everyone sent their children to parochial schools (the few who didn’t were ostracized as “publics”). Meriwether, attired in a pale blue shirt and dark blue tie, attended St. John de la Salle Elementary and later Mendel Catholic High School, taught by Augustinian priests. Discipline was harsh. The boys were rapped with a ruler or, in the extreme, made to kneel on their knuckles for an entire class. Educated in such a Joycean regime, Meriwether grew up accustomed to a pervasive sense of order. As one of Meriwether’s friends, a barber’s son, recalled, “We were afraid to goof around at [elementary] school because the nuns would punish you for life and you’d be sent to Hell.” As for their mortal destination, it was said, only half in jest, that the young men of Rosemoor had three choices: go to college, become a cop, or go to jail. Meriwether had no doubt about his own choice, nor did any of his peers.

A popular, bright student, he was seemingly headed for success. He qualified for the National Honor Society, scoring especially high marks in mathematics—an indispensable subject for a bond trader. Perhaps the orderliness of mathematics appealed to him. He was ever guided by a sense of restraint, as if to step out of bounds would invite the ruler’s slap. Although Meriwether had a bit of a mouth on him, as one chum recalled, he never got into serious trouble.¹ Private with his feelings, he kept any reckless impulse strictly under wraps and cloaked his drive behind a comely reserve. He was clever but not a prodigy, well liked but not a standout. He was, indeed, average enough in a neighborhood and time in which it would have been hell to have been anything but average.

Meriwether also liked to gamble, but only when the odds were sufficiently in his favor to give him an edge. Gambling, indeed, was a field in which his cautious approach to risk-taking could be applied to his advantage. He learned to bet on horses and also to play blackjack, the latter courtesy of a card-playing grandma. Parlaying an innate sense of the odds, he would bet on the Chicago Cubs, but not until he got the weather report so he knew how the winds would be blowing at Wrigley Field.² His first foray into investments was at age twelve or so, but it would be wrong to suggest that it occurred to any of his peers, or even to Meriwether himself, that this modestly built, chestnut-haired boy was a Horatio Alger hero destined for glory on Wall Street. “John and his older brother made money in high school buying stocks,” his mother recalled decades later. “His father advised him.” And that was that.

Meriwether made his escape from Rosemoor by means of a singular passion: not investing but golf. From an early age, he had haunted the courses at public parks, an unusual pastime for a Rosemoor boy. He was a standout member of the Mendel school team and twice won the Chicago Suburban Catholic League golf tournament. He also caddied at the Flossmoor Country Club, which involved a significant train or bus ride south of the city. The superintendents at Flossmoor took a shine to the earnest, likable young man and let him caddy for the richest players—a lucrative privilege. One of the members tabbed him for a Chick Evans scholarship, named for an early-twentieth-century golfer who had had the happy idea of endowing a college scholarship for caddies. Meriwether picked Northwestern University, in Evanston, Illinois, on the chilly waters of Lake Michigan, twenty-five miles and a world away from Rosemoor. His life story up to then had highlighted two rather conflicting verities. The first was the sense of well-being to be derived from fitting into a group such as a neighborhood or church: from religiously adhering to its values and rites. Order and custom were virtues in themselves. But second, Meriwether had learned, it paid to develop an edge—a low handicap at a game that nobody else on the block even played.

After Northwestern, he taught high school math for a year, then went to the University of Chicago for a business degree, where a grain farmer’s son named Jon Corzine (later Meriwether’s rival on Wall Street) was one of his classmates. Meriwether worked his way through business school as an analyst at CNA Financial Corporation, and graduated in 1973. The next year, Meriwether, now a sturdily built twenty-seven-year-old with beguiling eyes and round, dimpled cheeks, was hired by Salomon. It was still a small firm, but it was in the center of great changes that were convulsing bond markets everywhere.

Until the mid-1960s, bond trading had been a dull sport. An investor bought bonds, often from the trust department of his local bank, for steady income, and as long as the bonds didn’t default, he was generally happy with his purchase, if indeed he gave it any further thought. Few investors actively traded bonds, and the notion of managing a bond portfolio to achieve a higher return than the next guy or, say, to beat a benchmark index, was totally foreign. That was a good thing, because no such index existed. The reigning bond guru was Salomon’s own Sidney Homer, a Harvard-educated classicist, distant relative of the painter Winslow Homer, and son of a Metropolitan Opera soprano. Homer, author of the massive tome A History of Interest Rates: 2000 BC to the Present, was a gentleman scholar—a breed on Wall Street that was shortly to disappear.

Homer’s markets, at least in contrast to those of today, were characterized by fixed relationships: fixed currencies, regulated interest rates, and a fixed gold price ($35 an ounce). But the epidemic of inflation that infected the West in the late 1960s destroyed this cozy world forever. As inflation rose, so did interest rates, and those gilt-edged bonds, bought when a 4 percent rate seemed attractive, lost half their value or more. In 1971, the United States freed the gold price; then the Arabs embargoed oil. If bondholders still harbored any illusion of stability, the bankruptcy of the Penn Central Railroad, which was widely owned by blue-chip accounts, wrecked the illusion forever. Bond investors, most of them knee-deep in losses, were no longer comfortable standing pat. Gradually, governments around the globe were forced to drop their restrictions on interest rates and on currencies. The world of fixed relationships was dead.

Soybeans suddenly seemed quaint; money was the hot commodity now. Futures exchanges devised new contracts in financial goods such as Treasury bills and bonds and Japanese yen, and everywhere there were new instruments, new options, new bonds to trade, just when professional portfolio managers were waking up and wanting to trade them. By the end of the 1970s, firms such as Salomon were slicing and dicing bonds in ways that Homer had never dreamed of: blending mortgages together, for instance, and distilling them into bite-sized, easily chewable securities.

The other big change was the computer. As late as the end of the 1960s, whenever traders wanted to price a bond, they would look it up in a thick blue book. In 1969, Salomon hired a mathematician, Martin Leibowitz, who got Salomon’s first computer. Leibowitz became the most popular mathematician in history, or so it seemed when the bond market was hot and Salomon’s traders, who no longer had time to page through the blue book, crowded around him to get bond prices that they now needed on the double. By the early 1970s, traders had their own crude handheld calculators, which subtly quickened the rhythm of the bond markets.

Meriwether, who joined Salomon on the financing desk, known as the Repo Department, got there just as the bond world was turning topsy-turvy. Once predictable and relatively low risk, the bond world was pulsating with change and opportunity, especially for younger, sharp-eyed analysts. Meriwether, who didn’t know a soul when he arrived in New York, rented a room at a Manhattan athletic club and soon discovered that bonds were made for him. Bonds have a particular appeal to mathematical types because so much of what determines their value is readily quantifiable. Essentially, two factors dictate a bond’s price. One can be gleaned from the coupon on the bond itself. If you can lend money at 10 percent today, you would pay a premium for a bond that yielded 12 percent. How much of a premium? That would depend on the maturity of the bond, the timing of the payments, your outlook (if you have one) for interest rates in the future, plus all manner of wrinkles devised by clever issuers, such as whether the bond is callable, convertible into equity, and so forth.

The other factor is the risk of default. In most cases, that is not strictly quantifiable, nor is it very great. Still, it exists. General Electric is a good risk, but not as good as Uncle Sam. Hewlett-Packard is somewhat riskier than GE; Amazon.com, riskier still. Therefore, bond investors demand a higher interest rate when they lend to Amazon as compared with GE, or to Bolivia as compared with France. Deciding how much higher is the heart of bond trading, but the point is that bonds trade on a mathematical spread. The riskier the bond, the wider the spread—that is, the greater the difference between the yield on it and the yield on (virtually risk free) Treasurys. Generally, though not always, the spread also increases with time—that is, investors demand a slightly higher yield on a two-year note than on a thirty-day bill because the uncertainty is greater.

These rules are the catechism of bond trading; they ordain a vast matrix of yields and spreads on debt securities throughout the world. They are as intricate and immutable as the rules of a great religion, and it is no wonder that Meriwether, who kept rosary beads and prayer cards in his briefcase, found them satisfying. Eager to learn, he peppered his bosses with questions like a divinity student. Sensing his promise, the suits at Salomon put him to trading government agency bonds. Soon after, New York City nearly defaulted, and the spreads on various agency bonds soared. Meriwether reckoned that the market had goofed—surely, not every government entity was about to go bust—and he bought all the bonds he could. Spreads did contract, and Meriwether’s trades made millions.³

The Arbitrage Group, which he formed in 1977, marked a subtle but important shift in Salomon’s evolution. It was also the model that Long-Term Capital was to replicate, brick for brick, in the 1990s—a laboratory in which Meriwether would become accustomed to, and comfortable with, taking big risks. Although Salomon had always traded bonds, its primary focus had been the relatively safer business of buying and selling bonds for customers. But the Arbitrage Group, led by Meriwether, became a principal, risking Salomon’s own capital. Because the field was new, Meriwether...