by Bob Woodward
In 1994 and 1995, LTCM made more than 40 percent profit each year for its partners and investors, who had put billions into the firm. Another $100 billion was borrowed from banks and various large investment banking firms such as Goldman Sachs. Competition from other firms who started to use the same methods soon increased, and LTCM began to buy into various leveraged stock market investments and foreign currency transactions—not just bonds.
The Russian default had started a stampede. Instead of converging, bond prices moved away from the norms that LTCM was counting on. In early September, LTCM notified its investors that it had lost $1.8 billion, or nearly half the investors’ own capital that had been put in the firm. It was a staggering loss. A large number of their current investments couldn’t be sold, because the worldwide bond market was nearly frozen. But this information was not getting out to the public, largely because Ken Starr had published his lurid 452-page report of Clinton’s sexual relationship with Monica Lewinsky.
• • •
On Friday, September 18, New York Fed President Bill McDonough was in his lush, old-world paneled office when he received a call from LTCM’s Meriwether and Mullins. He was well aware their high-flying firm was in trouble.
Their message was simple: LTCM had suffered some quite large losses, and they were having difficulty finding banks or investment firms that would loan them money to avoid defaulting. There was no panic in their voices.
McDonough knew Meriwether was a cool customer who probably would never sound panicky, and Mullins was a real market pro. Nonetheless, they were blowing the whistle on themselves. They were nearly out of capital. All this was sufficiently significant, they said, that they would like representatives from the Fed and Treasury to come to Connecticut. “We’d like you guys to take a good look at our books so you know what’s going on.”
McDonough realized that this request meant they had really lost their asses. Meriwether and Mullins would not let outsiders into one of the most secretive financial concerns in the world unless the trouble was big. McDonough considered himself the battlefield commander, so it was for him to decide whether representatives of the Fed should go up there. This was also partly a policy question, so the Fed chairman had at least to know and give his approval.
McDonough knew he was more of an activist than Greenspan, who would obviously prefer a free-market solution. As the president of the New York Fed in the tradition of Corrigan, McDonough understood that he was supposed to be in charge of activism. He had better play his role. In some respects, he was Greenspan’s ambassador in New York. That’s what ambassadors are for, he thought. On occasion they get shot.
He called Greenspan, explained the situation and said he wanted to send a team to LTCM. They would be better off if they knew more, and they weren’t going to know more unless they went to Connecticut. Nobody had the picture of how big this thing was. They had to get it.
Greenspan gave his approval.
McDonough spoke with the heads of about 10 major banks and securities firms. “What’s going on, what are you hearing?” he asked. Everyone volunteered concern about the losses at LTCM and whether it could have an impact on world markets. They were indirectly expressing worry about the impact on their own businesses.
McDonough called Rubin. The treasury secretary wondered aloud what would happen if it leaked that Federal Reserve and Treasury officials were looking at LTCM’s books, but he agreed it was worth the risk. Ignorance was not something that would be to their benefit. At the same time, Rubin thought LTCM was a relatively minor problem by itself but was a symptom of the breakdown in discipline. In his opinion, it was not going to cause major problems.
McDonough had a speech scheduled in London. If he canceled, and that cancellation were linked to a possible leak about a Fed-Treasury team visit to LTCM, they could set off a real panic. He went to London.
• • •
McDonough dispatched Peter Fisher, his number two at the New York Fed, to Connecticut on Sunday, September 20. About 10 a.m. that morning, Fisher, a tall, curly-haired Harvard Law graduate, arrived at LTCM, which was housed in a plain brick building that could have been dentists’ offices.
For about six hours, Fisher reviewed the books. There were a number of huge surprises. First, LTCM had large positions in stock options, and perhaps, according to one estimate, their buying and selling was responsible for 30 percent of one speculative market, where they bet stocks would be less volatile. Second, LTCM had cross-default terms on all their loans. This meant that if they defaulted to a single lender, that default would automatically trigger defaults to all their lenders. A single default would mean all of their assets, their investments, would be dumped back to the lenders.
Fisher could imagine the fax machines at LTCM running non-stop with close-out orders to their lenders as word of any initial default spread. Up to 16 big banks and Wall Street firms, including Goldman, Merrill and the other big Wall Street investment houses, had money in LTCM. The collapse of LTCM would ricochet through the United States and the world financial system. A fire-sale liquidation, an abrupt and chaotic close-out, could start a chain reaction of more selling. Investor confidence would plummet. People would rush out of the bond market, leading to a further widening of the interest rate spread between private bond debt and U.S. Treasuries. The vicious cycle would lead to higher credit costs to U.S. businesses and a giant impact on the American economy. And all of this would occur at a time when markets were not functioning well to begin with.
This is for the history books, Fisher thought, a potential once-in-a-century meltdown. He called McDonough.
There is a 1 in 10 probability of wiping out the U.S. bond market for a week or a month, he said. After that, no one could know what might happen next.
• • •
On Monday, September 21, a big Asia sell-off occurred. The early news reports said that it was because the videotape of President Clinton’s grand jury testimony in the Lewinsky investigation was being played on television. Fisher laughed at the notion. Savvy investors were anticipating LTCM’s failure and were dumping.
Greenspan set up a conference call of the FOMC that day to make sure everyone was on board for testimony he was planning to give on the Hill. He wanted to hint more directly that a rate decrease was coming without formally committing himself or the FOMC. No one objected.
McDonough returned from London about midnight Tuesday. The details were terrifying. An abrupt and disorderly close-out of LTCM’s investments could pose a real risk to the American economy, he concluded. By Wednesday morning, it was clear that LTCM was going to have to be bought by somebody, or it had to have a capital infusion of several billion dollars. Unless one of these things happened that day, LTCM would collapse the next.
McDonough and Fisher realized that the large Wall Street investment banking firms like Goldman were as highly leveraged in some respects as LTCM. The consequences of a run were unimaginable.
Fisher had arranged for representatives, mostly the CEOs, of 16 banks and brokerage firms to meet at the New York Fed at 10 a.m. Wednesday morning. Jon Corzine, the head of Goldman, told McDonough that it was possible that billionaire investor Warren Buffett, the head of Berkshire Hathaway and the second richest man in the world, might head a team that would buy LTCM.
I want to talk to Warren, McDonough said, to make sure this is for real. He knew Buffett well enough to know that if Buffett were going to invest $4 billion, it would not be a lighthearted decision.
Buffett was in Montana with Bill Gates, head of Microsoft and the richest man in the world, on a bus touring Yellowstone National Park with four other couples. Buffett was willing to buy LTCM. He had calculated that if he put up $4 billion for the firm, the purchase would stabilize the worldwide markets and he could liquidate with a profit of several billion dollars. With all his money, he realized he could wait for the fat, easy pitches and swing. This was an opportunity to do just that.
McDonough called Buffett’s private unlis
ted number. The line was one that Buffett regularly answered himself. At first he would try to disguise his voice until he confirmed he wanted to talk to the caller.
A nice, soft midwestern voice answered.
It’s Bill McDonough, may I speak with Mr. Buffett?
Hi, Bill, Buffett said. The offer is real and he had put it in writing, he said. He would not let it fail. But his offer was good only for about an hour, given the bond market’s volatility. He would need an answer from LTCM by about noon.
McDonough expressed relief and went into his boardroom, where the CEOs and representatives of the 16 firms waited.
Fellas, he said, there is another proposal available. I think that many of you would find that more attractive than anything else that could come along, in that it would completely solve the problem. And therefore with appropriate apologies I’d like you all to go back home or do whatever you want to do and come back at one o’clock.
• • •
That same Wednesday morning, Greenspan received a call from a familiar voice from the past—Gerald Corrigan, the former New York Fed president and old enforcer from the 1987 stock market crash. Corrigan was now a senior partner and managing director at Goldman Sachs and co-chairman of the firm’s risk committee.
Alan, Corrigan said in his deep, friendly baritone, I want to pass along some information to you. I neither expect nor want any reaction or comment from you.
Greenspan listened.
The liquidity in the marketplace had just evaporated across the board, as the chairman surely knew. There were payments of hundreds of millions of dollars due that evening, Corrigan said, and if those weren’t made . . . Of course, Greenspan was aware of the various meetings at the New York Fed. It was very dangerous, not quite as high up on the Richter scale as the 1987 thing, but it was close.
Thank you very much, Dr. Corrigan, the chairman said as he hung up.
• • •
About 12:30 p.m., LTCM rejected the Buffett offer, saying that they did not have the authority under their agreement with their shareholders to sell to Buffett.
In Montana, Buffett joked with Gates that the national park outing had cost him several billion dollars. Had he been in New York, he was convinced he would have closed the deal.
McDonough now realized that this was very convenient for Meriwether and Mullins, because they would have been kicked out at once had Buffett taken over. Now they had a chance to leave with more money.
The only rescue possible at this point would have to come from the 16 banks, securities and investment banking firms that had money in LTCM, and their leaders were waiting in McDonough’s conference room.
In the 1950s, McDonough had served in the U.S. Navy as the damage control officer on a small destroyer escort. Damage control meant making the best of a bad situation. It was often obvious what to do to limit damage, such as sealing men in a compartment that was flooding and losing them in order to save the ship and the rest of the crew. But the question was whether you had the courage to do it.
In most respects, he found his next step an easy call. Although the Fed should not technically intervene in any way, McDonough thought that the consequences of inaction were grave enough to justify his involvement. Calling a meeting to get the major firms together was, in some ways, like a fire truck driving the wrong way down a one-way street to put out a raging fire. The normal rules didn’t apply when the potential for damage was this large. It was time to be the Fed’s enforcer, and he was in charge of fixing the mess.
He believed there were times to go into such a meeting and breathe heavily and say you have to do this—be a big shot, knock heads together, force a resolution. This time, he believed, it was different. He knew some of their secrets. These firms had enough of the picture to realize the danger to themselves. Some of them could go out of business if the markets went out of control. Several of the firms were operating as highly leveraged speculative hedge funds themselves and were in precarious positions. He decided it was better to play it low-key. He believed that it was almost a no-brainer for the firms, because the alternative was terrible. They had to find some way to rescue LTCM.
He also realized that the firms were scared, because no one was in charge. Normally, the markets were king and in charge, but the markets were not functioning.
Around the table were the current masters of the universe—fierce, secretive and competitive men. Distrust and suspicion ran deep. Some were angry. Speaking one at a time, they expressed very different views about how serious the problem was. They could speak for their banks or firms, but each would have to get approval from their boards of directors for any commitment of money.
McDonough offered sandwiches and coffee. He informed them that Buffett’s offer had been rejected. It is much better in the public interest, he said, that these positions not be dumped on the market—that LTCM not fail. We all agree that it will fail tomorrow unless you do something today.
Herbert Allison, the president and number two at Merrill, took the floor. Small framed, balding, with ramrod-straight posture, Allison read from notes. The capital losses for all of those represented in the room could total $20 billion, he said, many times the $4 billion that was needed by LTCM to survive. The $20 billion loss would be a catastrophe. That might only be the beginning. They either found the $4 billion LTCM needed or it would be dead tomorrow. After an LTCM failure, they would then have very large holdings with no one to trade with, period. A fire sale of unimaginable proportions could begin, with prices crashing and everyone rushing to the door at once. The entire system was at risk. “Don’t we have an obligation to the public,” he said, not just to ourselves or our clients? “We’re all in this together.”
Allison proposed a crude solution—each of the 16 firms would contribute $250 million. One, Lehman Brothers, said it had problems and could put up only $100 million. Two others offered less. The major firms upped their contributions to $300 million. After five tense hours, agreement was reached at about 6 p.m. In all, $3.6 billion would be contributed. They would take over LTCM, and if the markets stabilized, they might get their money back with a small profit.
Everyone applauded.
Uptown at Citicorp, John Reed received a detailed report. Citi didn’t have any direct exposure, but all of the bank’s best customers—Goldman, Merrill Lynch and Salomon Smith Barney—were up to their eyeballs. Don’t laugh, he told his credit managers, we have big bucks outstanding to them all. Citi loans to those at the table at the New York Fed totaled tens of billions of dollars, Reed estimated. If any one of those were to get in trouble, we’re going to be in trouble. We are just one step away.
The agreement on LTCM, which had stabilized the markets somewhat, fell apart about five times over the next weekend. One bank tried to pull out but finally agreed to stay, and the deal was formally sealed on Monday, September 28.
McDonough explained to Greenspan that he and the New York Fed had just played the role of catalyst and honest broker. No public money had been offered or spent. He didn’t have to pressure anyone to participate, but he believed that only the Fed could have called all of the players together into one room.
Greenspan wasn’t happy. McDonough had lent the good name of the Fed to the resolution. The meeting could have been held in any other boardroom in New York. The Fed didn’t have to play matchmaker. Greenspan thought that McDonough had exercised bad judgment, rushed in a little too fast. The probability that LTCM’s collapse would unravel the entire world financial system was significantly less than 50 percent, but that was still enough to be worrisome. And so, to a certain extent, Greenspan was of two minds. But now it was over, and Greenspan felt it was his job to rally around the Federal Reserve System, and the best way to do that was to back McDonough.
The question now was what to do with interest rates. The fed funds rate had been kept steady at 51/2 percent for 18 months.
• • •
On Tuesday, September 29, at 9 a.m., Greenspan gathered the FOMC.
The focus of the discussion was global financial turmoil and its growing impact on the United States. The Russian debacle and LTCM had created new economic conditions.
Greenspan proposed a 1/4-point cut in rates as a cushion and as insurance against erosion. The cut had little to do with inflation, or even with the U.S. economy in general. The need to send a signal was strong, and a rate cut was their only meaningful signal. Reports of market volatility and an increasing appetite for risk reduction by buying U.S. Treasuries abounded. If everybody fled to U.S. Treasuries, it would further drive down the prices of other business and non–U.S. government bonds. This would make borrowing costs for businesses that much higher.
Alice Rivlin, surprised to learn what a house of cards the international bond market had become, judged that the Fed was in a sense acting as the central bank of the world.
McDonough agreed. As the only superpower, and with the world’s largest economy, they had little choice, he said. If they didn’t raise their hands and take charge, who would? Neither the president nor the secretary of the treasury nor the Congress could do much. Only the Fed.
After a long discussion, the FOMC agreed unanimously on a 1/4 percent cut and included a bias toward another rate cut in its directive.
McDonough received disappointed reports from Wall Street. Some had hoped that the Fed would send a louder, clearer message with a bigger rate cut. Was the Fed awake? Did Greenspan understand what was happening?
• • •
Two days later, on Thursday morning, October 1, the House Banking Committee called Greenspan and McDonough to testify about LTCM and the Fed’s role in what had occurred.
