See also on LTCM: Wall Street's Changing Culture: The Cost
When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein, Random House [Order from Amazon.com]
When the financial madness of the late 20th century America fades into history, the saga of Long-Term Capital Management could well emerge as the quintessential story. Roger Lowenstein's When Genius Failed is likely to be a classical primary authority.
Lowenstein is a deeply professional writer, who reduces the arcane complexities of derivative dealings to lucid prose, and focuses on the crucial components in a confusing complex story. He brings the icy precision of the battlefield surgeon to the deafening chaos of Wall Street conflict. His chilling assessments of such phenomena as the appalling Larry Hillibrand, perhaps the key force at LTCM, a strangely-diminished Alan Greenspan, and the sinister force of Goldman Sachs, are likely to prove definitive.
As a member of the Frank Veneroso/Le Métropole Café circle, and consequently feeling in possession of some first-hand knowledge of the LTCM smash, I found this book stimulating and informative. So also would others with professional involvement. This is not a book to be ignored.
LTCM was set up to profit from irrational disparities in valuation between similar financial assets, primarily bonds. The assumption that these occurred randomly in a normal distribution pattern had become an article of religious faith at U.S. Business Schools in the previous 20 years. Two of the progenitors of the view, Robert Merton of Harvard, and Myron Scholes of Stanford (and of the Black/Scholes option valuation model) were LTCM partners. (Fischer Black had had the judgment to die an untimely death previously.) Careful reading of their work reveals that they assumed continuous markets and stable volatility ranges (neither always present in reality) and they acknowledged but ignored the fact that probability distributions in financial markets often show "fat tails" — in other words that extreme events occur far more frequently than a normal curve would predict. But they nonetheless built a "school" of like-minded thinkers and disciples. This group had become very influential on Wall Street by the late 90s.
Wall Street, in a sense, became a victim of the principal vice of the U.S. academic profession: the eagerness to set up introspective communities, dedicated to a dogma, which insulate themselves from fact-based criticism by exclusion and intimidation rather than argument. This behavior pattern, more redolent of Eastern European despotisms than of the English-speaking empirical tradition, turned out to be inimical to financial as well as intellectual health.
The life cycle of LTCM was quite simple. Profitability in the transactions the fund sought out was quite thin, if reasonably predictable. Therefore, from the start, the partners sought to maximize size and leverage. Central to this strategy was relentless, brutal pressure on credit sources, seeking the cheapest rates and least encumbering terms.
Founded in March 1994, with equity of $1.25 billion, the fund was able to pay out $2.7 billion at the end of 1997 to selected shareholders. This sharply increased the active partners' share of the pool at the expense of the investors, some of whom were in effect sent a check and told they were no longer involved. As LTCM did not reduce its enormous positions, this move also hugely increased LTCM's leverage.
By then, however, numerous other operators had entered the same field and opportunities were growing scarce.
It was widely thought LTCM was working on advanced and refined versions of Merton & Scholes' theories: this was not the case. Shortage of opportunity was dealt with simply by astonishing geographical diversification - Lowenstein cites 24 countries - and by an expansion into equity risk arbitrage. Up to 30 positions were carried, some in huge size. LTCM' s expertise had little to contribute in this area. In retrospect, this was a major strategic error by management.
Consequently, it is not surprising that the Russian default of August '98 triggered the demise of the firm. As Lowenstein says, "In seventy years, Russia's communists had not succeeded in dealing markets such a telling blow as did its deadbeat capitalists."
However, there is much more of importance in the LTCM saga than the rise and fall of hubristic, if well-funded, intellectuals. In my view, the most important document that appeared in the aftermath of the rescue was published in The Financial Times weekend edition Oct 10/11 1998. (Lowenstein does not mention it.) This was a leaked credit memorandum from Union Bank of Switzerland, one of the main losers in the smash, concerning the reasons the bank chose to do business with an entity leveraged far beyond the bank's normally tolerated limits. LTCM was a good credit, UBS hoped, because "eight strategic investors" including "generally government-owned banks in major markets" owned 30.9% of its capital, giving LTCM "a window to see the structural changes occurring in those markets to which the strategic investors belong."
This appears to be a bald statement that LTCM had access to inside information (which in the bond market, as Lowenstein points out, is not illegal) on particular national credit markets - because of its involvement with government institutions.
Who were these "generally government-owned banks"? Why would they want to give a foreign institution such privileges? In the case of the Italians, the only known Central Bank participant prior to this book, there was a reason, as Lowenstein reveals. Italian Government bonds were unpopular. "The bond market was rating the Italian government as a poorer risk than private banks." Investing $100Mn and lending $150Mn more, the Italians obtained the sympathy of a market player willing to operate on a staggering scale - quite enough to move the Italian market. LTCM made 38% of the $1.6 billion it earned 1994-95, its best years, from the Italian relative value/convergence trade. The Italian authorities got a bond market that appeared to be applauding their efforts to reach Germanic standards of financial probity. Who knows what other tasks LTCM was performing for its "generally government-owned" investors?
So who were the other "strategic partners"? World media displayed a peculiar lack of interest in this question. (I can vouch for this - I myself tried to get two major wire services to follow up.) Indeed, as Lowenstein remarks, the general press was also "stunningly silent" during the period when LTCM's death throes were starting to disturb markets.
But the author does have some answers: the Bank of Taiwan, the Government of Singapore Investment Corporation, The Hong Kong Land Authority and the Kuwait Pension Fund were names not publicized at the time. Some large private sector entities were: Sumitomo and Dresdner Banks, Paine Webber, the Liechtenstein Global Trust and of course UBS.
Still, several names are still needed to fulfill the UBS credit memorandum. Given LTCM's Latin American interests, one must suspect one or two of that region's notoriously free wheeling Central Banks were involved. Similarly, I have always thought the Dutch Central Bank, perhaps the Austrian, and one of the French para-statal banks, likely candidates.
The perspective clarifies an obvious puzzle: Why was the LTCM affair such a crisis? Lowenstein reports that the ubiquitous Peter Fisher of the New York Fed, when called in to evaluate the LTCM situation in mid-September 1998, guessed 17 counterparties might lose $3-$5 billion combined. While annoying and bonus- (even department-) threatening, this amount, or several times this amount, simply was not big enough to create systemic risk. The S&L, 3rd World debt and Russian crises were all far larger.
True, the exposure was all in, or related to, public markets, which might indeed have had a dramatic few days. But these were generally not outright risks where losses might never be recovered. LTCM was quite right to plead that their convergence or relative value trades would most likely work out, given time and enough carrying strength. This is in fact what happened, enabling the rescuers to recover their $3.65 billion injected in less than two years.
However, if members of the Central Bank fraternity stood to be embarrassed, and even surreptitious market manipulation revealed, the eagerness of the Federal Reserve to orchestrate a bailout (or coverup) becomes comprehensible. It must also be said that, although the likely losses might have been limited, some of the bonuses and jobs threatened by LTCM exposure and by involvement in similar trades were located at politically well-connected private institutions, notably Goldman Sachs. (Happily, the Treasury official working with Fisher on the rescue, Gary Gensler, was an ex-Goldman partner.)
The picture of Goldman Sachs painted by Lowenstein is perhaps the most significant aspect of the book. After reading it, and remembering the stories emerging from the Ashanti disaster of a year later, it is difficult to understand why any public company would want involvement with this firm. As Lowenstein portrays it, Goldman under Robert Rubin and Stephen Friedman in the 1980s dropped the old firm's previous inhibitions against, for instance, proprietary trading that might damage client's interests. The sheepdog in effect turned into a wolf. The dimwitted sheep in Corporate America have only just begun to realize this. In the LTCM case, hordes of Goldman people flooded into LTCM's offices in the guise of evaluating the portfolio for the purpose of raising capital: "Goldman's sleuths ... had the run of the office. According to witnesses, [one] appeared to be downloading Long-Term's positions... Meanwhile, Goldman's traders in New York sold some of the very same positions. Brazenly playing both sides of the street, Goldman represented investment banking at its mercenary ugliest."
Lowenstein dutifully records Goldman's denials, and their counter-arguments that they did own some of these trades anyway and were merely being prudent. He also notes that others appeared to be doing the same thing. But he seems to accept that LTCM's trades were singled out, makes clear that the partners - and some outsiders in the final rescue discussions - believed Goldman guilty and piles on such detail as to make it clear they were.
Goldman's behavior might be considered irresponsible, since it, along with others, was also having a bad time. It lost $1.5 billion in August and September 1998, and was obliged to put off its own IPO. A market meltdown must surely threaten all investment banks. But there were cards up its sleeve. Goldman's Jon Corzine, having eventually indicated an inability to raise funds for LTCM, held up the meeting of banks subsequently summoned by the New York Fed to announce a vulture bid by Warren Buffet, AIG and Goldman, at less than half LTCM's hugely eroded net worth. Since LTCM's assets, once again, were convergence or relative value trades, virtually certain to recover handsomely once panic receded, this transaction could have been extremely lucrative. It died essentially because Buffet's determination to humiliate the partners caused the proposal to be poorly-structured. (No doubt coincidentally, LTCM had aggressively shorted Berkshire-Hathaway stock.) Goldman's specially privileged legal representative spent the rest of the rescue meetings repeatedly jeopardizing the proceedings seeking (fairly successfully) improved terms for his client and more pain for the partnership.
One has to wonder at Goldman's behavior, especially after the Buffet bid failed. After all, it was still a partnership. The partners' own money, not that of anonymous shareholders, would be lost if the financial system had really crumbled. Morgan and Chase, in contrast, were quite cooperative. Was it just reckless selfishness - or was Goldman confident a bailout would indeed occur?
This brings us to the interesting question of gold, a market in which Goldman became peculiarly influential in the '90s. Eighteen months before LTCM's demise, Frank Veneroso was told by a prominent hedge fund manager (unmentioned in this book) that LTCM was short four hundred tonnes of gold. This seemed plausible, because we were aware of a more rapid expansion of Central Bank bullion lending than could be accounted for by known borrowers, and it was obvious that a heavy seller had been active in the market.
Moreover, it was becoming clear that large hedge funds and bank proprietary desks, having profited enormously from the "Yen carry" trade (borrowing cheap Yen to fund higher yielding positions in other markets) were hunting around for similar situations. Since gold interest costs ("lease rates") were even lower than Yen, and bearishness was rampant, such a strategy had logic. I was told by a sophisticated derivatives man that he doubted LTCM would take the "basis risk" (e.g. borrow or short gold with no hedge). But Lowenstein reveals that the fund took substantial basis risk right from inception: much of the Italian sovereign risk was unhedged (merely very closely watched).
We were never able to confirm this story. But given the manic secretiveness Lowenstein reports was characteristic at LTCM, this was hardly surprising. Anecdotal evidence continued to accumulate.
There is no mention of gold in any form in this book. In response to repeated assertions by Bill Murphy on Le Métropole Café, LTCM's counsel took the extraordinary step in June 1999 of sending an affidavit from LTCM partner Eric Rosenfeld (who seems to have been charged with being fund spokesman - he also answered written questions for Lowenstein) asserting LTCM had never had any dealings in gold "in any ... form whatsoever." Why it was necessary to respond in such a way to a obscure dissident website then only 9 months old, when no litigation was in process, is an interesting question.
Since those early days, Le Métropole Café has greatly extended its network of "Deep Throats" supplying information from all over the world. One of these has reported a conversation between Myron Scholes and a boyhood friend in Hamilton, Ontario to the effect that LTCM was indeed massively short gold, that the position was relieved by the authorities who swore the partners to secrecy for which they were indemnified. This conforms interestingly with otherwise curious behavior by LTCM partners towards Lowenstein. Davis Mullins and Eric Rosenfeld initially gave him formal interviews "but such formal co-operation quickly ceased. Subsequent attempts to resume the interviews and to gain formal access to … others of the partners, proved fruitless." Since the passage of time has vindicated the partners' view that their portfolio was capable of full recovery, and some of them are re-entering the business, this is precisely the reverse of the behavior one would have predicted. It must be said that Lowenstein's omitting dealing with the widespread rumors of an LTCM gold position is itself somewhat surprising.
Gold declined almost continuously over the life of LTCM. An unhedged borrowing of cheaply-priced gold credit would have been a bonanza. The reason for gold's decline was a substantial shift in the propensity of Central Banks to sell and lend - "mobilize" - their bullion. This development was accurately heralded by certain observers throughout. It was precisely the sort of "structural change" that LTCM "generally government-owned" "strategic investors" would have been able to identify.
The LTCM partners were well aware that their competitive advantage lay at least as much in developing cheap funding sources as in asset management. They were constantly, aggressively, searching for lower rates and more liberal terms, and their tight fistedness with their brokers was notorious throughout Wall Street. That a fund running over 60,000 positions in at least 24 countries, which had required considerable ingenuity and inventiveness to identify, should have overlooked gold borrowing, is simply incredible.
The Long-Term debacle reflects poorly on their creditor counterparties, and raises serious questions as to the sagacity with which these major financial entities are managed. Lowenstein is justifiably stern: "Through their carelessness, their reckless financing, their vain attempts to ingratiate themselves with a self important client, the Wall Street banks had created this fiasco together... They, too, were awed by ... the partners' reputation, degrees, and celebrity."
Interestingly, When Genius Failed confirms what Le Métropole Café alleged at the time: the Bankers Trust sale to Deutsche Bank was a distressed merger. What kind of grooming was necessary to achieve the appearance of a premium over Bankers Trust's preceding market price remains a question.
Union Bank of Switzerland, of course, was in the process of ruining itself with various types of derivative exposure: their writeoff of $700Mn on Long-Term was the largest announced loss. In large part this was due to an absurdly-priced warrant on LTCM's equity that the Bank sold the partners, hoping to improve their business relationship. (An ex-UBS man told me the delicious story that having closed the transaction, LTCM promptly shorted Union Bank's stock.) Credit Suisse First Boston sold a similar warrant. Another transaction which seems odd involved Merrill Lynch. In April 1998, with LTCM still appearing to be walking on water, Merrill's senior executives personally purchased most of the firm's stake in LTCM. This turned out to have the happy effect of getting Merrill out close to the top: But what would it have looked like if LTCM had continued to prosper?
Lowenstein judges the derivatives revolution harshly. He asks penetrating questions about the role of the authorities. Given that LTCM's "stunning losses betrayed the flaw at the very heart - the very brain - of modern finance" and that the concept it used "prevails at virtually every investment bank and trading desk," it is very strange to find Greenspan and Rubin (when Secretary of the Treasury) blocking all efforts to improve transparency and improve regulation even to the extent of forcing out the former CFTC head, Brooksley Born. A ridiculous situation has been allowed to arise where the balance sheets of major financial institutions have no reliable relationship to the actual economic situation of the firm, because of derivatives. Who benefits from this?
There are few appealing personalities in this drama. James Cayne, chief executive of Bear Stearns, LTCM's clearing broker, appears impressive. It was his inflexible determination to hold the fund to its promise to keep a $500Mn pool of liquidity with his firm which triggered the final crisis. According to Lowenstein, he precipitated a near-riot when he told the assembled rescuing banks that Bear Stearns would not be contributing to help its formerly lucrative client. "When did we become partners?" he asked. "They have a different view of the world" said a participant, "they're completely self-interested." Cayne personally was an investor with LTCM who had been allowed to stay in after the capital reduction.
In fact the figure who emerges with the most moral stature could be the lead perpetrator, John Meriwether, Long-Term's founding partner. Somehow managing to command the loyalty of a group of spectacularly arrogant, selfish and volatile men, and shepherding them from Solomon to the new vehicle he designed, Meriwether repeatedly displays in the book an eerie emotional self-control and discipline which in another era might perhaps have made him a great fighting general. A practicing Roman Catholic leading a mainly Jewish group (everyone compromised - he professed to be a liberal Democrat and they played a lot of golf), an intensely private man who with his wife has apparently endured the agony of infertility, Meriwether now appears to be engineering a third Wall Street career. The reader is left with the feeling that he probably deserves one.
The implications of the LTCM crisis are ominous for everybody. That the derivative vogue has undermined and weakened the world's major financial institutions - and to an unpredictable extent, courtesy inadequate reporting procedures mysteriously tolerated by the authorities - has been obvious to any sensible observer for some time. Having an example so skillfully explicated is nonetheless disquieting.
What is really alarming, however, is the insight into the modern Wall Street mindset. The Fed despaired of getting a private sector banker to lead the rescue. "Wall Street had many bankers but no J.P. Morgan." The reason for this is that proportionately more activity is now in the hands of entities with "a different view of the world" - like Bear Stearns. While Morgan in the 1907 Panic was able to dragoon virtually all significant financial actors, it is notable that no participation by the other great hedge funds is reported in LTCM's case - even though they stood to be seriously effected by any disruption.
On an operational level, LTCM was notorious for the atomistic view it took of business. It "analyzed every deal in terms of the profit and loss on discrete trades rather than in terms of the overall relationship." Minor technicalities were ruthlessly exploited - Merrill, which raised the initial capital, was stuck with a $7 million loss arising from a drafting error in a transaction document. The fact that Paine Webber's Chairman invested $10Mn personally, and the firm $100 Mn, did not prevent the firm being cut out of LTCM's trading because it wanted collateral. Complaints by counter-parties about the poor profitability of the relationship were ignored.
There is obviously a question as to the prudence of this, since LTCM was such a huge borrower. LTCM's staff below the partner level - many highly educated and skilled professionals - were treated with similar brutality. No social activity took place between partners and the rest, unusual for an American firm. Partners "treated the staff with cool formality. They were polite but interested only in one another and their work." Although the associates were encouraged to invest their substantial pay back into the firm, they were kept totally in the dark when things turned bad, despite their being as exposed personally.
"Explain to us why we should be ... here" demanded an employee after the rescue. "That's a valid question. We'll get back to you" was the answer. There is no J.P. Morgan to rally Wall Street not because there are not men of similar financial stature - Morgan was not especially wealthy - but because the current beneficiaries of the American capitalist system lack a sense of community. One day we may all regret this very much.
October 18, 2000
