When Genius Failed: The Rise and Fall of Long Term Capital Management. Roger Lowenstein
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Years later, Stan Jonas, a derivatives specialist with the French-owned Société Générale, would observe, “Most everything else in finance has been a footnote on what Merton did in the 1970s.” His mimeographed blue lecture notes became a keepsake.
In the early 1970s, Merton tackled a problem that had been partially solved by two other economists, Fischer Black and Myron S. Scholes: deriving a formula for the “correct” price of a stock option. Grasping the intimate relation between an option and the underlying stock, Merton completed the puzzle with an elegantly mathematical flourish. Then he graciously waited to publish until after his peers did; thus, the formula would ever be known as the Black-Scholes model. Few people would have cared, given that no active market for options existed. But coincidentally, a month before the formula appeared, the Chicago Board Options Exchange had begun to list stock options for trading. Soon, Texas Instruments was advertising in The Wall Street Journal, “Now you can find the Black-Scholes value using our … calculator.”10 This was the true beginning of the derivatives revolution. Never before had professors made such an impact on Wall Street.
In the 1980s, Meriwether and many other traders became accustomed to trading these newfangled instruments just as they did stocks and bonds. As opposed to actual securities, derivatives were simply contracts that derived (hence the name) their value from stocks, bonds, or other assets. For instance, the value of a stock option, the right to purchase a stock at a specific price and within a certain time period, varied with the price of the underlying shares.
Merton jumped at the opportunity to join Long-Term Capital because it seemed a chance to showcase his theories in the real world. Derivatives, he had recently been arguing, had blurred the lines between investment firms, banks, and other financial institutions. In the seamless world of derivatives, a world that Merton had helped to invent, anyone could assume the risk of loaning money, or of providing equity, simply by structuring an appropriate contract. It was function that mattered, not form. This had already been proved in the world of mortgages, once supplied exclusively by local banks and now largely funded by countless disparate investors who bought tiny pieces of securitized mortgage pools.
Indeed, Merton saw Long-Term Capital not as a “hedge fund,” a term that he and the other partners sneered at, but as a state-of-the-art financial intermediary that provided capital to markets just as banks did. The bank on the corner borrowed from depositors and lent to local residents and businesses. It matched its assets—that is, its loans—with liabilities, attempting to earn a tiny spread by charging borrowers a slightly higher interest rate than it paid to depositors. Similarly, Long-Term Capital would “borrow” by selling one group of bonds and lend by purchasing another—presumably bonds that were slightly less in demand and that therefore yielded slightly higher interest rates. Thus, the fund would earn a spread, just like a bank. Though this description is highly simplified, Long-Term, by investing in the riskier (meaning higher-yielding) bonds, would be in the business of “providing liquidity” to markets. And what did a bank do but provide liquidity? Thanks to Merton, the nascent hedge fund began to think of itself in grander terms.
Unfortunately, Merton was of little use in selling the fund. He was too serious-minded, and he was busy with classes at Harvard. But in the summer of 1993, J.M. recruited a second academic star: Myron Scholes. Though regarded as less of a heavyweight by other academics, Scholes was better known on Wall Street, thanks to the Black-Scholes formula. Scholes had also worked at Salomon, so he, too, was close to the Meriwether group. And with two of the most brilliant minds in finance, each said to be on the shortlist of Nobel candidates, Long-Term had the equivalent of Michael Jordan and Muhammad Ali on the same team. “This was mystique taken to a very high extreme,” said a money manager who ultimately invested in the fund.
In the fall of 1993, Merrill Lynch launched a madcap drive to recruit investors. Big-ticket clients were ferried by limousine to Merrill’s headquarters, at the lower tip of Manhattan, where they were shown a presentation on the fund, sworn to secrecy and then returned to their limos. Then, Merrill and various groups of partners took their show on the road, making stops in Boston, Philadelphia, Tallahassee, Atlanta, Chicago, St. Louis, Cincinnati, Madison, Kansas City, Dallas, Denver, Los Angeles, Amsterdam, London, Madrid, Paris, Brussels, Zurich, Rome, Sao Paulo, Buenos Aires, Tokyo, Hong Kong, Abu Dhabi, and Saudi Arabia. Long-Term set a minimum of $10 million per investor.
The road show started badly. J.M. was statesmanlike but reserved, as if afraid that anything he said would betray the group’s secrets. “People all wanted to see J.M., but J.M. never talked,” Merrill’s Dale Meyer griped. The understated Rosenfeld was too low-key; he struck one investor as nearly comatose. Greg Hawkins, a former pupil of Merton, was the worst—full of Greek letters denoting algebraic symbols. The partners didn’t know how to tell a story; they sounded like math professors. Even the fund’s name lacked pizzazz; only the earnest Merton liked it. Investors had any number of reasons to shy away. Many were put off by J.M.’s unwillingness to discuss his investment strategies. Some were frightened by the prospective leverage, which J.M. was careful to disclose. Institutions such as the Rockefeller Foundation and Loews Corporation balked at paying such high fees. Long-Term’s entire premise seemed untested, especially to the consultants who advise institutions and who decide where a lot of money gets invested.
Meriwether, who was continually angling to raise Long-Term’s pedigree, went to Omaha for a steak dinner with Buffett, knowing that if Buffett invested, others would, too. The jovial billionaire was his usual self—friendly, encouraging, and perfectly unwilling to write a check.
Rebuffed by the country’s richest investor, J.M. approached Jon Corzine, who had long envied Meriwether’s unit at Salomon and who was trying to build a rival business at Goldman Sachs. Corzine dangled the prospect of Goldman’s becoming a big investor or, perhaps, of its taking Meriwether’s new fund in-house. Ultimately, it did neither. Union Bank of Switzerland took a long look, but it passed, too. Not winning these big banks hurt. Despite his bravura, J.M. was worried about being cut out of the loop at Salomon. He badly wanted an institutional anchor.
Turning necessity to advantage, J.M. next pursued a handful of foreign banks to be Long-Term’s quasi partners, to give the fund an international gloss. Each partner—J.M. dubbed them “strategic investors”—would invest $100 million and share inside dope about its local market. In theory, at least, Long-Term would reciprocate. The plan was pure Meriwether, flattering potential investors by calling them “strategic.” Merton loved the idea; it seemed to validate his theory that the old institutional relationships could be overcome. It opened up a second track, with J.M. independently courting foreign banks while Merrill worked on recruiting its clients.
Merrill moved the fund-raising forward by devising an ingenious system of “feeders” that enabled Long-Term to solicit funds from investors in every imaginable tax and legal domain. One feeder was for ordinary U.S. investors; another for tax-free pensions; another for Japanese who wanted their profits hedged in yen; still another for European institutions, which could invest only in shares that were listed on an exchange (this feeder got a dummy listing on the Irish Stock Exchange).
The feeders didn’t keep the money; they were paper conduits that channeled the money to a central fund, known as Long-Term Capital Portfolio (LTCP), a Cayman Islands partnership. For all practical purposes, Long-Term Capital Portfolio was the fund: it was the entity that would buy and sell bonds and hold the assets. The vehicle that ran the fund was Long-Term Capital Management (LTCM), a Delaware partnership owned by J.M., his partners, and some of their spouses. Though such a complicated organization might have dissuaded others, it was welcome to the partners, who viewed their ability to structure complex trades as one of their advantages over other traders. Physically, of course, the partners were nowhere near either the Caymans or Delaware but in offices in Greenwich, Connecticut, and London.
The partners got a break just as they started the marketing. They were at the office of their lawyer, Thomas Bell, a partner at Simpson Thacher & Bartlett, when Rosenfeld excitedly jumped up and said, “Look at this! Do you see what Salomon did?” He threw down a piece of paper—Salomon’s earnings statement. The bank had finally decided to break out the earnings from Arbitrage, so Long-Term could now point to