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