When Genius Failed: The Rise and Fall of Long Term Capital Management. Roger Lowenstein
was talking investments, what could be more thrilling than to demurely drop, at court-side, the name of a young, sophisticated hedge fund manager who, discreetly, shrewdly, and auspiciously, was handling one’s resources? Hedge funds became a symbol of the richest and the best. Paradoxically, the princely fees that hedge fund managers charged enhanced their allure, for who could get away with such gaudy fees except the exceptionally talented? Not only did hedge fund managers pocket a fat share of their investors’ profits, they greedily claimed a percentage of the assets.
For such reasons, the number of hedge funds in the United States exploded. In 1968, when the SEC went looking, it could find only 215 of them.5 By the 1990s there were perhaps 3,000 (no one knows the exact number), spread among many investing styles and asset types. Most were small; all told, they held perhaps $300 billion in capital, compared with $3.2 trillion in equity mutual funds.6 How-ever, investors were hungry for more. They were seeking an alternative to plain vanilla that was both bold and safe: not the riskiest investing style but the most certain; not the loudest, merely the smartest. This was exactly the sort of hedge fund Meriwether had in mind.
Emulating Alfred Jones, Meriwether envisioned that Long-Term Capital Management would concentrate on “relative value” trades in bond markets. Thus, Long-Term would buy some bonds and sell some others. It would bet on spreads between pairs of bonds to either widen or contract. If interest rates in Italy were significantly higher than in Germany, meaning that Italy’s bonds were cheaper than Germany’s, a trader who invested in Italy and shorted Germany would profit if, and as, this differential narrowed. This is a relatively low-risk strategy. Since bonds usually rise and fall in sync, spreads don’t move as much as the bonds themselves. As with Jones’s fund, Long-Term would in theory be unaffected if markets rose or fell, or even if they crashed.
But there was one significant difference: Meriwether planned from the very start that Long-Term would leverage its capital twenty to thirty times or even more. This was a necessary part of Long-Term’s strategy, because the gaps between the bonds it intended to buy and those it intended to sell were, most often, minuscule. To make a decent profit on such tiny spreads, Long-Term would have to multiply its bet many, many times by borrowing. The allure of this strategy is apparent to anyone who has visited a playground. Just as a seesaw enables a child to raise a much greater weight than he could on his own, financial leverage multiplies your “strength”—that is, your earning power—because it enables you to earn a return on the capital you have borrowed as well as on your own money. Of course, your power to lose is also multiplied. If for some reason Long-Term’s strategy ever failed, its losses would be vastly greater and accrue more quickly; indeed, they might be life-threatening—an eventuality that surely seemed remote.
Early in 1993, Meriwether paid a call on Daniel Tully, chairman of Merrill Lynch. Still anxious about the unfair tarnish on his name from the Mozer affair, J.M. immediately asked, “Am I damaged goods?” Tully said he wasn’t. Tully put Meriwether in touch with the Merrill Lynch people who raised capital for hedge funds, and shortly thereafter, Merrill agreed to take on the assignment of raising capital for Long-Term.
J.M.’s design was staggeringly ambitious. He wanted nothing less than to replicate the Arbitrage Group, with its global reach and ability to take huge positions, but without the backing of Salomon’s billions in capital, credit lines, information network, and seven thousand employees. Having done so much for Salomon, he was bitter about having been forced into exile under a cloud and eager to be vindicated, perhaps by creating something better.
And Meriwether wanted to raise a colossal sum, $2.5 billion. (The typical fund starts with perhaps 1 percent as much.) Indeed, everything about Long-Term was ambitious. Its fees would be considerably higher than average. J.M. and his partners would rake in 25 percent of the profits, in addition to a yearly 2 percent charge on assets. (Most funds took only 20 percent of profits and 1 percent on assets.) Such fees, J.M. felt, were needed to sustain a global operation—but this only pointed to the far-reaching nature of his aspirations.
Moreover, the fund insisted that investors commit for at least three years, an almost unheard-of lockup in the hedge fund world. The lockup made sense; if fickle markets turned against it, Long-Term would have a cushion of truly “long-term” capital; it would be the bank that could tell depositors, “Come back tomorrow.” Still, it was asking investors to show enormous trust—particularly since J.M. did not have a formal track record to show them. While it was known anecdotally that Arbitrage had accounted for most of Salomon’s recent earnings, the group’s profits hadn’t been disclosed. Even investors who had an inkling of what Arbitrage had earned had no understanding of how it had earned it. The nuts and bolts—the models, the spreads, the exotic derivatives—were too obscure. Moreover, people had serious qualms about investing with Meriwether so soon after he had been sanctioned by the SEC in the Mozer affair.
As Merrill began to chart a strategy for raising money, J.M.’s old team began to peel off from Salomon. Eric Rosenfeld left early in 1993. Victor Haghani, the Iranian Sephardi, was next; he got an ovation on Salomon’s trading floor when he broke the news. In July, Greg Hawkins quit. Although J.M. still lacked Hilibrand, who was ambivalent in the face of Salomon’s desperate pleas that he stay, Meriwether was now hatching plans with a nucleus of his top traders. He still felt a strong loyalty to his former colleagues, and he touchingly offered the job of nonexecutive chairman to Gutfreund, Salomon’s fallen chief—on the condition that Gutfreund give up an acrimonious fight that he was waging with Salomon for back pay. Though overlooked, Gutfreund had played a pivotal role in the Arbitrage Group’s success: he had been the brake on the traders’ occasional tendencies to overreach. But it was not to be. At Long-Term, J.M. would have to restrain his own disciples.
In any case, J.M. wanted more cachet than Gutfreund or even his talented but unheralded young arbitrageurs could deliver. He needed an edge—something to justify his bold plans with investors. He had to recast his group, to showcase them as not just a bunch of bond traders but as a grander experiment in finance. This time, it would not do to recruit an unknown assistant professor—not if he wanted to raise $2.5 billion. This time, Meriwether went to the very top of academia. Harvard’s Robert C. Merton was the leading scholar in finance, considered a genius by many in his field. He had trained several generations of Wall Street traders, including Eric Rosenfeld. In the 1980s, Rosenfeld had persuaded Merton to become a consultant to Salomon, so Merton was already friendly with the Arbitrage Group. More important, Merton’s was a name that would instantly open doors, not only in America but also in Europe and Asia.
Merton was the son of a prominent Columbia University social scientist, Robert K. Merton, who had studied the behavior of scientists. Shortly after his son was born, Merton père coined the idea of the “self-fulfilling prophecy,” a phenomenon, he suggested, that was illustrated by depositors who made a run on a bank out of fear of a default—for his son, a prophetic illustration.7 The younger Merton, who grew up in Hastings-on-Hudson, outside New York City, showed a knack for devising systematic approaches to whatever he tackled. A devotee of baseball and cars, he studiously memorized first the batting averages of players and then the engine specs of virtually every American automobile.8 Later, when he played poker, he would stare at a lightbulb to contract his pupils and throw off opponents. As if to emulate the scientists his father studied, he was already the person of whom a later writer would say that he “looked for order all around him.”9
While he was an undergrad at Cal Tech, another interest, investing, blossomed. Merton often went to a local brokerage at 6:30 A.M., when the New York markets opened, to spend a few hours trading and watching the market. Providentially, he transferred to MIT to study economics. In the late 1960s, economists were just beginning to transform finance into a mathematical discipline. Merton, working under the wing of the famed Paul Samuelson, did nothing less than invent a new field. Up until then, economists had constructed models to describe how markets look—or in theory should look—at any point in time. Merton made a Newtonian leap, modeling