Armed with Soros’s pledge, Meriwether scrambled to find the other $500 million. He explored the possibility of a deal with his old colleagues at Salomon Brothers. He dispatched Larry Hilibrand to Omaha to make Buffett a new and better offer. He made overtures to Prince Alwaleed of Saudi Arabia and to the computer magnate Michael Dell. He called up Herb Allison, the boss of Merrill Lynch, but even the relationship forged on the golf links in Ireland was not enough to save him. “John, I’m not sure it’s in your interest to raise money,” Allison counseled. “It might look like you’re having a problem.”33 The advice was infuriating but true.34 While rebuffing Hilibrand, Buffett was reacting to Long-Term’s evident distress by ordering his lieutenants to monitor Berkshire Hathaway’s exposure to hedge funds. The bosses at Salomon Brothers were issuing similar edicts, demanding that its brokerage unit cease extending loans to almost all the hedge funds that it dealt with.35 The more Long-Term scrambled to raise money, the more the panic spread—and the more Long-Term’s bets on a calm world declined in value. The partners were running on a moving carpet that was pulling them away from home. Far from boosting the fund’s capital, their sales efforts were destroying it.
It was not just that the Slinky effect had been suspended. Arbitrageurs were experiencing a kind of Pogo moment: “We have met the enemy and he is us!” said the character in Walt Kelly’s comic strip. The Russian blowup, coming on the heels of the East Asian turmoil, had caused all the main arbitrage players to lose money; like LTCM, they were scrambling for fresh capital. In these stressed circumstances, the arbitrageurs lacked the muscle to correct pricing anomalies; indeed, they faced margin calls from their brokers that forced them to dump positions, driving prices away from their efficient equilibrium. The partners’ faith in arbitrage, exaggerated at the best of times, was now 180 degrees off target—arbitrage had been replaced by a kind of reverse arbitrage. The unwinding of each arbitrage portfolio damaged all the other ones: The cycle was self-reinforcing. Meriwether’s own legacy, the Arbitrage Group at Salomon Brothers, had performed so badly earlier in the year that its bosses had resolved to close it down; the selling hammered other arbitrage outfits, LTCM included. Every trade in Long-Term’s portfolio went wrong in a correlated way, not necessarily because they were similar in an economic sense but because they were similar in terms of the types of fund that held them. Looking back on LTCM’s history, Eric Rosenfeld considers the failure to anticipate this trader-driven correlation to be the fund’s central error. If LTCM had foreseen this possibility, its risk calculations would have come out differently. No longer would diversification have appeared to magic risk away. Every LTCM trade would have been sized more cautiously.36
Meanwhile, Long-Term was discovering another risk that it had underestimated. It had not fathomed that its own success could create a special vulnerability. Even though Long-Term shrouded itself in secrecy, routing its trades through multiple brokers so that none of them could understand its bets, an army of imitators had pieced together much of its strategy. The upshot was that LTCM’s large portfolio was mirrored by an even larger superportfolio created by its disciples, meaning that LTCM’s trades were monstrously crowded.37 By the spring of 1998, every bank or hedge fund that might buy LTCM’s positions had already followed Meriwether’s example and bought them; if a trade went wrong and Meriwether needed to retreat, there would be nobody to sell to. Moreover, the canny players on Wall Street could see what was going on. On the one hand, there was nobody left to buy LTCM’s positions, so there was no way they were going up. On the other hand, a shock that forced the arbitrageurs to sell would cause LTCM’s portfolio to collapse precipitously. The “central bank of volatility” was indeed like a central bank. Its trading presented predators with a one-way bet, and as soon as the predators woke up to this fact, the game would be over.
There was a painful irony in LTCM’s predicament. For the first four years of its short life, it had earned billions by trading against adversaries whose behavior was driven by institutional imperatives as opposed to market judgments. But now, with the arbitrage army suddenly bereft of capital, Long-Term had become the victim of just such an institutional imperative—banks and brokerages were pulling loans, so arbitrageurs had become forced sellers. To a predatory trader, the biggest prize in this environment was to short anything Long-Term might own. Meriwether noticed grimly that the LTCM trades that were unknown to Wall Street bounced back after the post-Russia Friday shock; it was the known trades that kept bleeding money. Spreads between risky bonds and risk-free Treasuries grew wider and wider, and the premium between the shares of Royal Dutch and Shell Transport leaped from 8 percent to 17 percent despite there being no fundamental reason why they should do so. “It ceased to feel like people were liquidating positions similar to ours,” one of Meriwether’s team recalled. “All of a sudden they were liquidating our positions.”38
That month, August 1998, turned out to be one of the most brutal in the history of hedge funds. By the time Labor Day arrived, three out of four funds had lost money. Meriwether and his partners lost 44 percent of their capital, or $1.9 billion.39 They calculated that this loss should have occurred less than once in the lifetime of the universe. But it had happened anyway.
At the end of the month, Meriwether put a call in to Vinny Mattone, an old friend from Bear Stearns.
“Where are you?” Mattone asked brusquely.
“We’re down by half,” Meriwether replied.
“You’re finished,” Mattone said matter-of-factly.
“What are you talking about?” Meriwether protested. “We still have two billion. We have half—we have Soros.”
“When you’re down by half, people figure you can go down all the way,” Mattone said. “They’re going to push the market against you.”40
Meriwether called Merrill Lynch, UBS, and Deutsche Bank, seeking a capital infusion. Nobody would cough up $500 million, and the Soros opportunity vanished.
MERIWETHER REPORTED LTCM’S LOSSES IN AN INVESTOR letter on September 2. He reaffirmed his faith in arbitrage, writing optimistically of “this unusually attractive environment.” But nobody was fooled. The letter was leaked even before the last copy was faxed out, and the Wall Street Journal ran a front-page story the next day detailing Meriwether’s losses. Now the whole world knew that Long-Term was on deathwatch, and every player on Wall Street started to trade against it.41 Most junk bonds rallied in early September, but the particular bonds that LTCM owned remained dead in the water. Long-Term had a small position in hurricane bonds, securities that permit insurers to sell the risk of a hurricane; the day Meriwether’s letter leaked, the bonds plummeted 20 percent, even though the probability and cost of hurricanes was utterly unaltered.42 In Europe, the gap between government bonds and market interest rates widened in Britain and narrowed in Germany, for no fundamental reason other than that Long-Term was betting that the opposite would happen. “It’s not about the market anymore; it’s about you,” the general counsel, Jim Rickards, told Meriwether. “If you’re long, they’re short. If you’re short, they’re long.”43
On September 13 Meriwether appealed to Jon Corzine of Goldman Sachs. He needed help in raising $2 billion, the amount that Long-Term now needed to stave off bankruptcy. Corzine said yes, but at an extraordinary price. In exchange for $1 billion from Goldman plus a promise to raise an additional billion elsewhere, Goldman demanded half of the LTCM management company, full access to the fund’s strategies, and the right to impose limits on the fund’s positions; what’s more, the deal would only go through if Goldman raised the money and Long-Term passed a detailed inspection of its portfolio. These terms meant that Goldman would win either way. Either it would get half of Long-Term at a bargain price or it would get the right to inspect Long-Term’s trading books, paying nothing at all for information that might be worth millions. The predeal due diligence would allow Goldman’s experts to see precisely what Long-Term owned and therefore precisely which trades would crater if Long-Term’s
demise forced it to dump holdings.
Long-Term sensed it might be setting itself up for abuse, but it had no alternative. Jim Rickards tried to get Goldman’s inspection team to sign a nondisclosure agreement; he was brusquely informed that Goldman would sign nothing.44 According to Rickards, Goldman’s inspectors plugged an oversized laptop into LTCM’s network and downloaded the details on its positions. Goldman denied that this occurred, but pretty soon the bank’s proprietary trading desk was selling positions that resembled LTCM’s, feeding on Long-Term like a hyena feeding on a trapped but living antelope. The firm made only a qualified effort to defend what it was up to. A Goldman trader in London was quoted as saying: “If you think a gorilla has to sell, then you sure want to sell first. We are very clear on where the line is; that’s not illegal.” Corzine himself conceded the possibility that Goldman “did things in markets that might have ended up hurting LTCM. We had to protect our own positions. That part I’m not apologetic for.”45 Goldman’s defense was that its selling was not influenced by its privileged knowledge of LTCM’s books and that a Chinese wall separated the inspectors who visited Long-Term from the traders who managed Goldman’s proprietary capital. There was no proof to the contrary, but some Wall Streeters suspected that the Chinese wall might be porous.
Meriwether and his partners decided it was time to inform the Federal Reserve that failure was a possibility. William McDonough, the head of the New York Fed, was on his way out of town. It fell to Peter Fisher, the number two, to wade into the crisis.
On Sunday, September 20, Fisher hitched a ride in an assistant’s Jeep from his home in New Jersey to Greenwich. If anyone could figure out a way to fix this mess, Fisher was the man; an expert financial plumber and unflappable nice guy, he had a way of cutting through complexity with simple propositions. But as Fisher listened to the details of Long-Term’s positions, no neat solutions came to mind. Because it was so leveraged, LTCM held a sprawling portfolio worth $120 billion, but that was only the beginning of the challenge. What really rattled Fisher was that Long-Term’s portfolio included a few extraordinarily concentrated bets: He figured that Long-Term’s position in futures on British government bonds, or “gilts,” might represent as much as half of the open interest in that market. LTCM owned a similarly outlandish position in Danish mortgages, and its portfolio of equity options was enormous. The issue was not simply that LTCM’s collapse would cause a broad fall in markets around the world. Fisher was worried that some particular markets might cease trading altogether.46
According to Long-Term’s calculations, its seventeen biggest counterparties stood to lose something in the range of $3 billion among them if the fund was wound up immediately. But if LTCM’s holdings had to be liquidated in a rush, the losses would be considerably bigger. Moreover, Fisher presumed that the big players on Wall Street had similar trades on their own books, so if Long-Term was liquidated at speed, the damage would be magnified by a huge hit to the shadow portfolio. A speedy and costly liquidation seemed horribly likely. In past financial collapses involving a failed bank or brokerage, regulators had been able to take charge of the remaining assets and avoid a fire sale. But Long-Term was a different case. Because it was a hedge fund, it had no assets for regulators to seize; rather, its assets were held by its brokers, as collateral against borrowing. If Long-Term defaulted on just one loan agreement, the cross-default clauses in all the other ones would be automatically triggered. Closeout agreements would flutter from a thousand fax machines, and ownership of Long-Term’s positions would be transferred to its brokers—which would dump them, rapidly. Sitting among the unmanned workstations in Long-Term’s quiet offices, conferring with a colleague from the Treasury, Fisher confronted a problem that had bedeviled the failure of Askin Capital Management and would haunt regulators in the next decade.47 Firms that entangle themselves with dozens of partners can be too complex and intertwined to be buried easily.
Fisher got back into his assistant’s Jeep, still worrying about the consequences of a sudden liquidation. East Asia was in a recession, Russia was fast heading for one, and the resulting market turmoil had already inflicted sharp losses on Wall Street.48 The prospect of a $3 billion-plus hit to Wall Street’s capital would have been unlovely at the best of times, but it was especially nasty given the Street’s compromised immune system.49 There were already rumors that Lehman Brothers was teetering on the brink of bankruptcy; if LTCM’s collapse pushed Lehman over, Lehman’s collapse would certainly have further consequences. Moreover, the precarious state of Wall Street’s balance sheets reduced the odds of the best sort of solution—a private-sector takeover of Long-Term that would save it from chaotic fire sales. Later that evening, Jon Corzine called Fisher to warn him that Goldman’s efforts to find a buyer were not making progress. Meanwhile, Long-Term was losing hundreds of millions of dollars per day. It would be lucky to make it to another weekend.
When Fisher arrived at work on Monday, he felt his fears were coming true even faster than expected. Markets in Asia and Europe were tumbling, and Wall Street looked set to follow. Television commentators were speculating that the release of President Clinton’s videotaped deposition on the Monica Lewinsky sex scandal, scheduled for later that morning, was rattling investors—a theory that Fisher found grimly amusing.50 But the truth was that the word was out: Each attempt to arrange LTCM’s rescue had spread the knowledge of its trouble to another predator, and now every bank, brokerage, and hedge fund was feeding on the bloodied torso. Salomon executives reported that Goldman’s Tokyo desk was “banging the shit” out of Long-Term; Goldman executives reported that Salomon was doing the same thing in Europe. Around midday, attacks on Long-Term’s positions in equity options grew so extreme that options prices implied a crash every month. By the end of that Monday, LTCM had lost $550 million, one third of its equity. For the first time its capital had sunk below $1 billion.51
Fisher stayed in touch with the bosses of the big three banks—Goldman, Merrill Lynch, and J.P. Morgan. He kept hoping for signs of a private-sector rescue, but it was clear that a lone bank would be unable to perform that role safely. If a lone purchaser bought LTCM’s entire portfolio, it would have to sell some of the holdings; knowing this, others would continue to sell positions to get in front of the inevitable liquidation. The solution to this problem was for a consortium to purchase the portfolio: That way, each would get a piece that was small enough to hold, and the hyenas would stop feeding. The hitch was that traditional rivalries among the main banks seemed to preclude such an alliance—unless the Fed brokered one.
Toward the end of Monday, Fisher invited the heads of the big three banks to breakfast at the Fed the next morning. Once gathered around the table, all three said they favored joint action; it would protect the markets from chaos and be less painful for everyone. The question was how to structure a rescue. LTCM’s creditors could each buy bits of the portfolio, lifting them out of the fund. Alternatively, a consortium could inject capital into the fund to stabilize it. After two hours of discussions, Fisher asked the bankers to go away and develop a rescue plan that all three of them could back. Then Fisher would convene a larger meeting at the Fed involving a wider group of the fund’s creditors.
By the end of the day, the bankers had converged on the view that money would have to be injected into Long-Term. Lifting bits of the portfolio out was not going to work; LTCM’s cat’s cradle of trades was too complicated. But if new capital was to be injected, who should bear the cost? The price tag was rising: Back in August, when Meriwether had breakfasted with Soros and Druckenmiller, LTCM had needed a lifeline of $1 billion; three weeks later Meriwether had asked Corzine to raise $2 billion; now it would take a $4 billion injection to stabilize the portfolio. Collectively, the bankers knew that coughing up the $4 billion was their least bad option; if they let LTCM go down, its massive portfolio would crash on the markets, costing every major Wall Street player a fortune. But each bank had an incentive to free ride—to let rivals should
er the cost of the recapitalization.
When Fisher convened LTCM’s sixteen main counterparties at the Fed on Tuesday evening, it was impossible to conclude a deal. The big three banks had come up with a blueprint that involved the sixteen top creditors kicking in $250 million each; inevitably, the smaller banks complained that their burden should be lighter. Around 11:00 P.M., with no resolution in sight, Fisher suggested that the group break until ten the next morning.
When the bankers’ negotiations resumed, they were no easier than they had been the previous evening. Lehman Brothers pleaded, with some reason, that its balance sheet was so fragile that it could not put up the $250 million. Two French banks refused to share their part of the burden, each offering only $125 million. The biggest shock came from Bear Stearns, Long-Term’s lead broker. Despite having earned millions in fees from Long-Term in the good times, Jimmy Cayne, the CEO of Bear, adamantly refused to put up a single dollar. Philip Purcell, the chairman of Morgan Stanley, protested that Bear’s free riding was “not acceptable,” and David Komansky of Merrill Lynch exploded in Cayne’s face. The discussions grew so ugly that Peter Fisher began gaming out the consequences of an impasse. “I remember thinking, ‘If this thing isn’t going to work, I’m going to have to stand on the table and say, ‘Don’t touch your cell phones. Close the door. We’re now going to draft a statement that says there’s no deal,’” Fisher recalled later. The lack of a rescue would tip global markets into a free fall. The bankers that had been party to the failure should not be allowed to sell ahead of ordinary investors.52
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