An Accident Waiting to Happen: Long-Term Capital’s Collapse

When Genius Failed: The Rise and Fall of Long-Term Capital Management , by Roger Lowenstein. Random House, 264 pages, $26.95.

The story of Long-Term Capital Management, the Greenwich, Conn., investment firm that lost $4.5 billion dollars in six months of 1998, is as good as any to be found in the annals of American financial markets. You would need to have a heart of stone not to laugh at this cautionary tale of Wall Street greed and academic innocence.

Yet the rescue of LTCM by its bankers, under the cosh of the Federal Reserve, raises some sober questions. How, precisely, was the American public served by saving those misguided financiers from bankruptcy? How long will the federal government, under the banner of global financial stability, reward recklessness and punish prudence? Won’t the market, like a river, in the end find a way down?

More sober yet, the story of Long-Term Capital Management dramatizes a clash in financial ideology that partakes, however remotely, in the secular war in philosophy between idealism and common sense. Long-Term, its founder John Meriwether, its Nobel laureates and its traders founded their business on the proposition that financial markets were as well-informed, rational and predictable as themselves.

The fund’s spectacular collapse, bail-out and eventual liquidation should have put paid to both terms of that syllogism; that is, both the efficient-market hypothesis and the careers of Mr. Meriwether and his friends. But as Roger Lowenstein writes in bearish delight, efficient marketry retains its scholastic hold on the American academy, and Mr. Meriwether is in business again. And that is the beauty of America: In the Old World, people sacrifice their lives for their ideals; in the New World, they sacrifice their fortunes.

The story continues where Liar’s Poker , Michael Lewis’ portrait of the trading culture at Salomon Brothers, left off. John Meriwether, a Chicago Irish-American with a reputation for straight dealing and a passion for gambling, headed the Arbitrage Group at that firm. Arbitrage, as it was then understood, comprised those trading mechanisms that seek to exploit minor discrepancies in price that sometimes arise, in our fallen world, in markets that are linked: say, a stock and an option to buy it at a price. Time and the very practice of arbitrage tend to close those discrepancies, thus generating a small gain.

To detect these discrepancies required some mathematics, and Mr. Meriwether, himself a former math teacher, began to recruit out of the university. Men such as Eric Rosenfeld, Victor J. Haghani and, notably, Lawrence Hilibrand were, it seems, more brilliant than gracious, but by the mid-1980′s they were making (and retaining) a lion’s share of Salomon Brothers’ profits.

There is no management, in the industrial or commercial sense, on Wall Street, but Mr. Meriwether seems to have been a good colleague. When, in 1991, a trader in another department admitted to making false bids for U.S. Treasury securities, Mr. Meriwether took the fall. In the wilderness, he became determined to rebuild the Arbitrage Group outside the firm, but many times scaled up.

Enticing his old team out from Salomon, he added, for good luck, a former vice chairman of the U.S. Federal Reserve, David W. Mullins, and two men reckoned among the most brilliant minds in academic finance: Harvard’s Robert C. Merton and Myron Scholes. Those last were well-known proponents of statistical theories (such as the Black-Scholes Model) that purported to quantify risk in financial markets. Mr. Merton, in particular, seems to have been quite unworldly: He liked to take credit for the “portfolio-insurance products of the 1980s,” which had proved no insurance at all on Black Monday, the day the stock market crashed in 1987.

Even so, those stellar names and some benign economic conditions outweighed Mr. Meriwether’s intense secrecy and high fees. Investors stampeded in, including such rank amateurs as the Bank of Italy. With $1.25 billion in equity capital and a deceptively wooden name, Long-Term Capital Management opened for business in premises overlooking the water in Greenwich, Conn., in February 1994.

To outsiders, LTCM was a large but expert firm that for two years made extraordinary gains from what appeared to be almost risk-free arbitrage trades in high-grade government and corporate securities. Maybe it hadn’t abolished risk, but it had made it predictable. In October 1994, Mr. Meriwether wrote to investors to say that, over the long term, they could lose 20 per cent of the fund only one year in fifty. The sycophancy of bankers and journalists makes nauseating reading today. In reality, of course, to generate its returns, Long-Term needed inordinate leverage; at one point, the firm carried a theoretical exposure to derivatives of $1.25 trillion. It was an accident waiting to happen.

Still, by the end of 1995, equity capital had ballooned to $3.6 billion and assets were over $100 billion. The firm had 100 employees on its payroll, and the partners were on their way to building dynastic fortunes. But the rest of Wall Street was flooding into Long-Term’s markets, and in order to keep up returns and justify their management fees, the partners began taking bets that were unhedged even by their own definitions: for example, in the stock of companies under the threat of takeover.

In retrospect, the award to Messrs. Merton and Scholes of the Nobel Prize in Economic Science in October 1997 was the moment to go short on LTCM. When a fashionable notion has reached the Royal Swedish Academy of Sciences, it has no further to go and can only retreat. With markets gyrating, Mr. Merton calmly told the academy that “dynamic trading prescribed by Black and Scholes … would provide a perfect hedge in the limit of continuous trading.” And I’m Albert Einstein.

At the turn of 1998, anxious about diminishing returns, the partners returned $2.7 billion to the outside investors, but that merely increased their own leverage, already blown up out of all proportion by a warrant on the fund rashly issued by Union Bank of Switzerland the previous summer. At such gearing, it was not the perfect storm or 100-year flood that did in Long-Term but a Russian default, some turbulence in Brazil and an increase in market volatility that did not greatly inconvenience cash investors. Efficient markets, constant volatility, the Black-Scholes model were revealed as mere Tory ideology. For markets are actually collections of human beings who will act as human beings act, doing all sorts of wild and unpredictable things. On a single Friday in August 1998, Long-Term lost $553 million.

With such a complex and demanding story, you need a safe pair of journalist’s hands. Mr. Lowenstein possesses these. What he possesses also is a quiet but beautifully controlled grasp of manners and social milieu. On becoming rich, Mr. Merton dyes his hair red, gets rid of his wife, sets up in Boston. You can hear the accent in which Vinny Mattone of Bear Stearns, a large man with a black silk shirt open at the chest, gold chain and pinkie ring, tells the geniuses: “You’re finished.”

Wall Street fell on Long-Term’s carcass. In the feeding frenzy, according to Mr. Lowenstein, Goldman Sachs was well to the fore. On the tense and bad-tempered meetings at the Fed and various law firms in late September, Mr. Lowenstein is enthralling. It is touching how the fund’s partners clung to their mathematic totems and blamed everybody but themselves.

Mr. Lowenstein is hard on the Federal Reserve and its chairman, Alan Greenspan. “Head in the sand before a crisis, intervention after the fact,” the Fed squandered an opportunity to discipline financial markets: what central bankers of a previous generation called “taking away the punch-bowl.” My guess is that, in a year or two, Long-Term and its losses will seem homely fare: the financial equivalent of a Norman Rockwell illustration.

James Buchan, a novelist, is also the author of Frozen Desire: The Meaning of Money (Farrar Straus & Giroux).