When Genius Failed: The Rise and Fall of Long Term Capital Management. Roger Lowenstein
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