In the early 1990s, Salomon Brothers trader John Meriwether assembled a tightly knit group of brilliant analysts whose use of complex predictive models enabled them to make a fortune off of bond arbitrage. Despite its success, however, the unit eventually caused friction in the company, and Meriwether himself left after his implication in a Treasuries trading scandal. Down but not out, Meriwether cashed in on the great results of his former colleagues, who were extremely loyal to him, and, in 1994, they went into business for themselves in a new hedge fund they called Long-Term Capital Management.
Meriwether and his inner circle (fellow traders Victor Haghani, Greg Hawkins, Larry Hilibrand, Dick Leahy, James McEntee, Eric Rosenfeld and Robert Shustak) formed the operational nucleus of Long-Term, but they also needed brand-name recognition. To get the firm off the ground, two of the world's top economists were brought in as principals, Myron Scholes, who co-developed the Black-Scholes option-pricing model, and Robert Merton, who developed a theory of continuous pricing as a means of hedging against stock losses. Together they provided Long-Term with a highly complex mathematical formula for pricing the markets and betting against gains and losses-an accomplishment important enough to later win them the Nobel Prize for Economics in 1997. Meriwether's traders, themselves brilliant Ph.D.s for the most part, knew how to work these models and did so with unusual aggressiveness, which was the same way they had made their mark at Salomon.
Before long, the fund had raised more than $1 billion in start-up capital, and it soon began making enormous, successful bets on bond arbitrage, especially with U.S., Japanese and European government bonds. Its returns became so incredible, in fact, that it earned enough clout to dictate terms to the very banks offering it leverage. Few dared question the arrangement because Long-Term was providing up to a 40% return to its investors. Its traders soon became fabulously wealthy.
Long-Term's success gave it a capital base so large that it needed new markets to move into, however, and that is where things went south. Long-Term extended its model-based form of trading to unfamiliar markets, such as S&P 500 options and mergers and acquisition arbitrage. Because enormous trades needed to be made in these markets to make any profit, the firm leveraged itself to extraordinary degrees, enabled by a banking industry cowed by the firm's audacity and numbed by its performance. By 1998, with only $4.72 billion in equity, the firm had borrowed some $125 billion against $129 billion in assets and had an off-balance sheet derivatives position worth about $1.25 trillion.
Long-Term's position had been pummeled in 1997 by the Asian financial crisis, but it was the 1998 global market downturn after the Russian government defaulted on its bonds that strained the fund beyond repair. Suddenly, the bond business that Long-Term was neck-deep in turned bad and, within four months, the fund lost nearly $5 billion. By September, the firm was almost out of equity and faced the possibility of defaulting on its debts to the rest of the banking world.
Fearing that the collapse of Long-Term would further exacerbate global turmoil in the financial markets, the New York Fed facilitated a buyout by a consortium of 19 banks and other financial firms. Together, these companies would absorb Long-Term's losses gradually and maintain enough liquidity in the banking system to prevent this catastrophe from overwhelming the entire financial sector.
It worked. And, eventually, those that came to Long-Term's rescue made out. One of the banks that was asked to help-but did not-was Bear Stearns, which had served as Long-Term's "clearing house" and figured that helping Long-Term now would be throwing good money after bad.
It seems a great irony, then, that a bank of Bear's size and experience, one that had seen first-hand the consequences of poor financial risk management, would itself be destroyed by a similar lack of foresight almost a decade later during the subprime lending crisis. Those who studied Bear's actions during Long-Term's downfall might think that the bank simply got what was coming to it. But the truth is that Bear is just one of the bigger casualties of the ongoing world credit crisis kicked off by the subprime meltdown. Many banks poisoned themselves with subprime lending, but Bear more so than others, and its failure to note that it was killing itself with imprudent financial deals mirrors Long-Term's own demise.
To mark the tenth anniversary of the collapse of Long-Term Capital Management-and while the smoke still swirls over Bear's own spectacular fall-let us take another look at where Meriwether and the rest of his inner circle went wrong and, more importantly, what lessons can be learned. Whether they are applied to a hedge fund or any company that seeks to temper its success with sustainability, the missteps of Long-Term Capital Management offer plenty of insight into how-whether a company knows it or not-its downfall is often its own doing.
#1. The secret is that there isn't one
Long-Term's reputation had been built, at least in part, on the notion that it was operating by a unique model that could predict things that others could not. By the time Long-Term was off and running, many Wall Street firms had similar models to Long-Term, and they used them extensively. Because of the high level of mathematical skill of Long-Term's principals, however, they could read their models with greater detail and get more information out of them. But in reality, Long-Term was using the same kind of tools as everybody else. The notion that they had unlocked a secret method of divining market movement was mere fantasy.
#2. Nothing is as simple as it seems
Long-Term's vaunted models were based on the notion of "continuous time" in financial markets. This theory suggests, among other things, that everything is always adequately priced by the market. In layman's terms, this means that even when a stock drops from 100 to 80 (or spikes from 80 to 100), it does not just jump; its price slides by tiny increments along very small slices of time. If you can grab that price during the slide (or spike), you can catch it before it hits the bottom (or top)-a concept that opens up all kinds of trading opportunities. This principle, however, also assumes the market exists in a universe that behaves under ideal conditions (such as volatility being a constant), which it most certainly does not.
Long-Term's traders had a nearly religious faith in the concepts behind continuous time, and simply could not grasp a world that did not behave that way. When they eventually realized how wrong they were, it was too late.
What is especially surprising about the adherence to continuous time is that there had already been a recent example of market behavior that went against it: the "Black Monday" market crash of 1987. Statistically speaking, Black Monday was a fluke of almost unimaginable proportions; the odds against it were so remote as to be non-existent. Yet it happened. Why? Because markets do not adhere to tidy rules.
Ultimately, Long-Term's executives failed to see that the world might behave differently than how they perceived it. It pays to keep an open mind, even if you have billions of reasons telling you not to.
#3. Know a bad risk when you see it
The manner in which Long-Term conducted such heavily leveraged trades, especially as it ventured into areas it was inexperienced with was a constant dance with destruction. Meriwether and company figured that they had the system beat and could operate close to the edge of disaster without falling over the cliff. This is because they thought, incorrectly, that it would take an impossible confluence of separate disasters to tank their entire portfolio. In reality, they had structured their business in such a way that it would only take one very large disaster (i.e., the Russian bond default) to shock every other market in Long-Term's entire portfolio. This, in turn, started the chain reaction that took down the fund. While nobody in Long-Term seemed to see this, there were those who did. Many of them were among the very banks that, even against their better judgment, continued to lend Long-Term capital. This elevated the collapse of Long-Term beyond the mismanagement of a single fund; it was, in reality, a systemic failure in risk management by all of Wall Street. And it was the exact same kind of widespread breakdown that would enable the subprime crisis 10 years later.
#4. Don't live in a box
Long-Term's headquarters were in Connecticut-far from Wall Street. Not every trading firm needs to be in Manhattan, but for Long-Term, the physical separation was almost an extension of its cultural isolation. Brainy, close-knit to a fault and not exactly sociable, Long-Term's top minds brushed off anyone that they thought was not as smart as them. And as success bred further resentment, Long-Term became a giant bubble of a company-a place where the principals could shut themselves away from a world they did not respect. This, in turn, reinforced the mindset that their training method was foolproof, even amid clear signs that it was not. By then, Long-Term's principals had convinced themselves that their way of seeing things was the only way.
#5. Don't believe your own press
The brains behind Long-Term were, without a doubt, some of the most brilliant people to ever work in finance. Among them were two Nobel prize winners, numerous Ph.D.s, and just an incredible amount of combined brainpower. This accumulated mental talent is what enabled the group to develop its pricing models, its business strategy and, ultimately, the extraordinary returns that made them all-at least for a time-fabulously wealthy. It also made them arrogant. To some degree, a feeling of superiority would have been hard to suppress, given Long-Term's initial success, but the extent to which Long-Term's partners treated the rest of the world, including its own financiers, like thick schoolchildren proved to be a destructive tendency. When the firm saw catastrophic losses in September 1998, it very quickly found itself not only without friends, but surrounded by former partners turned predators. Many of these made a fortune by trading against Long-Term's losses, hastening its collapse. This probably would have happened to a large extent anyway, since the era of gentleman banking is long over. However, there was no small degree of schadenfreude in the actions of Long-Term's cannibalistic associates.
#6. Use your power wisely
During its early days, Long-Term developed a tremendous degree of clout among Wall Street's top banks, which desperately wanted to benefit from the fund's enormous action. As such, Long-Term felt it could dictate terms. And it did, all but eliminating the "haircut" payments it would traditionally have had to give to its banks. Where it overstepped its bounds was when it played the same game with Bear Stearns, which it retained as a clearinghouse for the fund's activity.
Larry Hilibrand, the walking embodiment of the firm's arrogance, negotiated a hardball agreement between Long-Term and Bear that was never put down on paper. As a result, Bear could terminate its agreement with Long-Term whenever it liked, and when the fund began its string of horrendous losses, Bear's ability to pull the plug on Long-Term whenever it liked turned the crisis into a nightmare.
#7. Even loyalty has its downside
Meriwether cultivated his inner circle on loyalty and personal camaraderie and, as a result, he let his people run unchecked. When it came time to rein them in, Meriwether had neither the skills nor the disposition to do what needed to be done. In the meantime, Meriwether allowed his inner circle to isolate itself from the firm's other 100 or so employees. Anyone not part of the the fund's founding group could never penetrate its ranks-and they knew it. This bred resentment at a time when the fund could least afford it. As the fund's crisis hit its peak, the rank and file were left entirely in the dark, even though they had been subtly pressured to put their own personal finances into the fund. Near the end, Long-Term was literally relying on the goodwill of others to save the fund. When a firm's principals act with such disregard for the employees they depend upon, however, any lack of friends becomes a self-made situation.
#8. Watch your back
When Long-Term went to Goldman Sachs for help, according to some accounts, Goldman's traders not only demanded that Long-Term open its books, but Goldman then traded on that information, hammering Long-Term's position mercilessly. This anecdote underscores the mercenary mindset of Long-Term's environment, and what kind of risk the fund took both in protecting its secrets so jealously and then in revealing them to a party likely to run riot with them.
#9. Memories are short
Despite the staggering losses and maverick behavior that characterized Long-Term, those most directly responsible for the debacle detached themselves from the doomed firm and found careers elsewhere in the financial sector. Even Meriwether himself was back in business soon after, with $250 million in fresh capital. That there were those willing to lend him anything or trust his lieutenants to form a new firm essentially the same as Long-Term but supposedly with better risk management, shows that in the world of Wall Street, there may be no catastrophe so big that its perpetrators cannot be forgiven. Perhaps the collapse of Bear Stearns-and however many more collapses sure to happen in the future-are the surest proof of that.
#10. Keep reading
These thoughts on Long-Term's numerous shortcomings are only the tip of the iceberg. While Long-Term's collapse has been widely covered, those interested in learning more would do well to read any number of books and articles on the subject-as well as those already documenting the problems that led to the subprime meltdown. As the example of Bear Stearns shows, history repeats itself even on those who help to write it. Just as the subprime fiasco followed Long-Term's collapse, so will another financial crisis follow subprime. Those who learn to see the future by reading the past will be better risk managers for it.
Bill Coffin is publisher and editorial director of Risk Management.
