When Genius Failed: The Rise and Fall of Long Term Capital Management. Roger Lowenstein
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remote, exquisitely manicured golf course, on the coast of southwestern Ireland, known as Waterville.
Early in 1994, J.M. bagged the most astonishing name of all: David W. Mullins, vice chairman of the U.S. Federal Reserve and second in the Fed’s hierarchy to Alan Greenspan, the Fed chairman. Mullins, too, was a former student of Merton’s at MIT who had gone on to teach at Harvard, where he and Rosenfeld had been friends. As a central banker, he gave Long-Term incomparable access to international banks. Moreover, Mullins had been the Fed’s point man on the Mozer case. The implication was that Meriwether now had a clean bill of health from Washington.
Mullins, like Meriwether a onetime teenage investor, was the son of a University of Arkansas president and an enormously popular lecturer at Harvard. Ironically, he had launched his career in government as an expert on financial crises; he was expected to be Long-Term’s disaster guru if markets came unstuck again. After the 1987 stock market crash, Mullins had helped write a blue-ribbon White House report, laying substantial blame on the new derivatives markets, where the snowball selling had gathered momentum. Then he had joined the Treasury, where he had helped draft the law to bail out the country’s bankrupt savings and loans. As a regulator, he was acutely aware that markets—far from being perfect pricing machines—periodically and dangerously overshoot. “Our financial system is fast-paced, enormously creative. It’s designed to have near misses with some frequency,” he remarked a year before jumping ship for Long-Term. With more omniscience regarding his future fund than he could have dreamed, Mullins argued that part of the Fed’s mission should be saving private institutions that were threatened by “liquidity problems.”16
Wry and soft-spoken, the intellectual Mullins dressed like a banker and was thought to be a potential successor to Greenspan. Nicholas Brady, his former boss at Treasury, wondered when Mullins joined Long-Term what he was doing with “those guys.” Investors, though, were soothed by the addition of the congenial Mullins, whose perspective on markets may have been much like their own. Indeed, by snaring a central banker, Long-Term gained unparalleled access for a private fund to the pots of money in quasi-governmental accounts around the world. Soon, Long-Term won commitments from the Hong Kong Land & Development Authority, the Government of Singapore Investment Corporation, the Bank of Taiwan, the Bank of Bangkok, and the Kuwaiti state-run pension fund. In a rare coup, Long-Term even enticed the foreign exchange office of Italy’s central bank to invest $100 million. Such entities simply do not invest in hedge funds. But Pierantonio Ciampicali, who oversaw investments for the Italian agency, thought of Long-Term not as a “hedge fund” but as an elite investing organization “with a solid reputation.”17
Private investors were similarly awed by a fund boasting the best minds in finance and a resident central banker, who plausibly would be a step ahead in the obsessive Wall Street game of trying to outguess Greenspan. The list was impressive. In Japan, Long-Term signed up Sumitomo Bank for $100 million. In Europe, it corralled the giant German Dresdner Bank, the Liechtenstein Global Trust, and Bank Julius Baer, a private Swiss bank that pitched the fund to its millionaire clientele, for sums ranging from $30 million to $100 million. Republic New York Corporation, a secretive organization run by international banker Edmond Safra, was mesmerized by Long-Term’s credentials and seduced by the possibility of winning business from the fund.18 It invested $65 million. Long-Term also snared Banco Garantia, Brazil’s biggest investment bank.
In the United States, Long-Term got money from a diverse group of hotshot celebrities and institutions. Michael Ovitz, the Hollywood agent, invested; so did Phil Knight, chief executive of Nike, the sneaker giant, as well as partners at the elite consulting firm McKinsey & Company and New York oil executive Robert Belfer. James Cayne, the chief executive of Bear Stearns, figured that Long-Term would make so much money that its fees wouldn’t matter. Like others, Cayne was comforted by the willingness of J.M. and his partners to invest $146 million of their own. (Rosenfeld and others put their kids’ money in, too.) Academe, where the professors’ brilliance was well known, was an easy sell: St. John’s University and Yeshiva University put in $10 million each; the University of Pittsburgh climbed aboard for half that. In Shaker Heights, Paragon Advisors put its wealthy clients into Long-Term. Terence Sullivan, president of Paragon, had read Merton and Scholes while getting a business degree; he felt the operation was low risk.19
In the corporate world, PaineWebber, thinking it would tap Long-Term for investing ideas, invested $100 million; Donald Marron, its chairman, added $10 million personally. Others included the Black & Decker Corporation pension fund, Continental Insurance of New York (later acquired by Loews), and Presidential Life Corporation.
Long-Term opened for business at the end of February 1994. Meriwether, Rosenfeld, Hawkins, and Leahy celebrated by purchasing a shipment of fine Burgundies ample enough to last for years. In addition to its eleven partners, the fund had about thirty traders and clerks and $10 million worth of SPARC workstations, the powerful Sun Microsystems machines favored by traders and engineers. Long-Term’s fund-raising blitz had netted $1.25 billion—well short of J.M.’s goal but still the largest start-up ever.20
They [Long-Term] are in effect the best finance faculty in the world. –INSTITUTIONAL INVESTOR
THE GODS SMILED on Long-Term. Having raised capital during the best of times, it put its money to work just as clouds began to gather over Wall Street. Investors long for steady waters, but paradoxically, the opportunities are richest when markets turn turbulent. When prices are flat, trading is a dull sport. When prices begin to gyrate, it is as if little eddies and currents begin to bubble in a formerly placid river. This security is dragged with the current, that one is washed upstream. Two bonds that once journeyed happily in tow are now wrenched apart, and once predictable spreads are jolted out of sync. Suddenly, investors feel cast adrift. Those who are weak or insecure may panic or at any rate sell. If enough do so, a dangerous undertow may distort the entire market. For the few who have hung on to their capital and their wits, this is when opportunity beckons.
In 1994, as Meriwether was wrapping up the fund-raising, Greenspan started to worry that the U.S. economy might be overheating. Mullins, who was cleaning out his desk at the Fed and preparing to jump to Long-Term, urged the Fed chief to tighten credit.1 In February, just when interest rates were at their lowest—and, indeed, when investors were feeling their plummiest—Greenspan stunned Wall Street by raising short-term interest rates. It was the first such hike in five years. But if the oracular Fed chief had in mind calming markets, the move backfired. Bond prices tumbled (bond prices, of course, move in the opposite direction of interest rates). And given the modest nature of Greenspan’s quarter-point increase, bonds were falling more than they “should” have. Somebody was desperate to sell.
By May, barely two months after Long-Term’s debut, the thirty-year Treasury bond had plunged 16 percent from its recent peak—a huge move in the relatively tame world of fixed-income securities—rising in yield from 6.2 percent to 7.6 percent. Bonds in Europe were crashing, too. Diverse investors, including hedge funds—many of which were up to their necks in debt—were fleeing from bonds. Michael Steinhardt, one such leveraged operator, watched in horror. Steinhardt, who had bet on European bonds, was losing $7 million with every hundredth of a percentage point move in interest rates. The swashbuckling Steinhardt lost $800 million of his investors’ money in a mere four days. George Soros, who was jolted by a ricochet effect on international currencies, dropped $650 million for his clients in two days.2
For Meriwether, this tumult was the best of news. One morning during the heat of the selling, J.M. walked over to one of his traders. Glancing at the trader’s screen, J.M. marveled, “It’s wave after