Fortune's Formula (34 page)

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FTER THE FALL OF COMMUNISM,
billions in Western money flowed into Russia. With the money came daring and opportunistic Westerners, many of them Americans of Russian Jewish descent. This reverse exodus included Ivan Boesky and Caesar Kimmel. Boesky volunteered his expertise in guiding Russia into a market economy. Kimmel managed one of Moscow’s new gambling casinos.

As in America, Russia’s casinos had links to organized crime. Unlike in America, the banks did too. Many of those who started Russian banks were gangsters of the
vorovskoi mir
—“thieves’ world,” also known as the Russian Mafiya.

In July 1998, the International Monetary Fund made a $17 billion loan package to Russian banks. It has been reported that about $4.5 billion of this money was quickly wired to mobsters’ offshore bank accounts.

The thug-controlled banks had no intention of repaying many of the Western loans. The Russian treasury was scarcely more credit-worthy. The U.S. Treasury has such a flawless credit record that economists often fall into the error of identifying its bonds with the “risk-free” investment of theory. No one made that mistake in Russia. Russia’s treasury bonds, called GKOs, were the junkiest of junk bonds, paying 40 percent interest and up. About half of Russia’s tax collections went to pay interest on treasury debt.

LTCM’s Greg Hawkins devised an ingenious trade that let the fund collect rich interest at GKO rates yet get paid in American dollars. Hawkins had no illusions about the Russian treasury or the mob-controlled Russian banks. He arranged things so that LTCM had no direct contact with these dubious parties. LTCM dealt only with Western banks, which in turn dealt with the Russians. The Russian banks were kept at a remove from LTCM, like viruses in a hazmat chamber.

Hawkins began running this trade in 1997. By August 1998, the GKOs were paying 70 percent interest. Then, on August 17, Prime Minister Sergei Kiriyenko announced that Russia was devaluing the ruble and defaulting on the GKOs.

LTCM instantly lost millions. It had reason to count itself lucky. Others did worse.

One was a hedge fund accurately called High-Risk Opportunities Fund (HRO). HRO was running many of the same strategies LTCM did, including a version of its Russian GKO trade. The Russian default came on a Monday. HRO was in default of its own obligations by Wednesday. It was rumored (apparently incorrectly) that Lehman Brothers had suffered steep losses in Russia, too.

The real and imagined problems set off a medium-size panic. The big investment banks pulled out of Russia. It was a “flight to quality.” Everyone wanted to shift funds from riskier investments in developing economies to safer, more liquid investments in the United States and Western Europe.

This psychological reaction was much like the one that had caused New York City’s near-default to depress municipal bonds nationwide. But Meriwether was not profiting this time. LTCM’s overarching philosophy was that people pay too much for safe and liquid investments. The Russian default temporarily changed that. This hurt not only the Russian trades but much of LTCM’s portfolio.

By the end of the week, LTCM had shed $551 million. It desperately needed collateral to cover too many simultaneous losing trades. Positions were liquidated at a loss. The fund tried to raise money from Warren Buffett and George Soros.

Meriwether spoke with a trusted friend, Vinny Mattone, formerly of Bear Stearns. “Where are you?” Mattone asked.

“We’re down by half,” Meriwether answered.

“You’re finished,” Mattone said.

“What are you talking about? We still have two billion. We have half—we have Soros.”

“When you’re down by half,” Mattone explained, “people figure you can go down all the way. They’re going to push the market against you. They’re not going to roll your trades. You’re
finished
.”

As Mark Twain wrote, “A banker is a fellow who lends you his umbrella when the sun is shining but wants it back the moment it rains.” LTCM’s creditors stopped lending new money and insisted that the fund put up cash (safe securities) to protect the lenders from further exposure. In late August, Meriwether called Merrill Lynch chairman Herb Allison to ask for $300 to $500 million in additional funds. Allison’s answer was, “John, I’m not sure it’s in your interest to raise the money. It might look like you’re having a problem.”

The gambler using borrowed money must determine how much he can lose without touching off a disastrous chain of misfortunes from which recovery is impossible. “When they first started losing,” observed Jarrod Wilcox, “obviously they had less discretionary wealth so they should have pulled down their leverage multiple. Instead, they allowed the leverage to drift up to like sixty times. That’s a horrible mistake. No Las Vegas gambler would ever make that mistake—no surviving one.”

As word of the fund’s troubles spread, a lot of people started worrying. The U.S. Federal Reserve feared that an LTCM collapse might imperil the whole market economy. The Western world’s biggest investment banks were partners in LTCM’s trades.

The first outsider to view the Risk Aggregator was Peter Fisher of the Federal Reserve Bank of New York. In an emergency Sunday meeting on September 20, LTCM’s Larry Hilibrand handed the printout to Fisher. As Fisher read it, he was appalled.

The document was relatively simple. It summarized all of LTCM’s positions, reporting the potential loss in a “one-year storm”—the loss if rates or prices went the wrong way by an amount equal to the average volatility experienced in a year. That was the worst- and only-case scenario shown.

One of the shockers was the fifth entry. It was labeled “USD_Swap Spread.” This reported trades making a “bet” on the swap spread rate in the U.S. dollar. The annual volatility of this spread had been 15 basis points. The fund’s potential loss, should the spread change 15 basis points, was a staggering $240 million.

This floored Fisher because the U.S. swap spread had already moved 40 basis points in the first eight and a half months of 1998.

This was just the fifth entry on the first page. There were about twenty-five entries per page, and it was a fifteen-page document.

As Fisher scanned the report, he had another shock. LTCM was simultaneously making nearly the same bets all over the world. This was supposed to be diversification, but it wasn’t. The default in Russia affected credit all over the world.

According to another document Fisher was shown, the largest banks and brokerages that LTCM did business with—among them Merrill Lynch, Goldman Sachs, Morgan, and Salomon Brothers—would lose something like $2.8 billion if LTCM suddenly failed. This figure was candy-coated, too, Fisher believed. All of these firms were counting on income streams from LTCM that would suddenly dry up if the fund failed. The banks would rush to seize such collateral as existed and sell it, causing prices to plunge. Fisher guesstimated the real loss at $3 to $5 billion. “I’m not worried about markets trading down,” he said. “I’m worried that they won’t trade at all.”

Wednesday, September 23, 1998, was effectively LTCM’s last day of operation as a free agent. The U.S. Federal Reserve Bank of New York convened a meeting of banks and investment firms that were counterparties to LTCM’s trades. The consortium, as they called it, agreed to put a total of $3.625 billion into the fund. They were not buying out the original investors, who continued to own their much-devalued investments. They were investing in the fund until its positions could be slowly and safely dismantled.

LTCM had lost $4.4 billion from its peak asset value—about 90 percent. The fund’s partners alone had dropped about $1.8 billion. That was roughly what their investment in the fund had been worth earlier in the year, and now it had shriveled to $28 million.

It’s said that Merton lost as much as $100 million and that he was especially mortified at having talked Harvard into putting endowment funds into LTCM. Many of the partners had substantial fortunes before LTCM that they rolled over into the fund. Larry Hilibrand was said to be in tears at one meeting. He had taken out a personal loan of $24 million from Crédit Lyonnais to increase his stake in the fund. He was using leverage to buy his own fund, which was itself operating at nosebleed leverage levels. Hilibrand’s net worth went from over something like $100 million to $20 million in debt. Hilibrand requested that the bailout cover his personal debts. The consortium said no.

Warren Buffett marveled at how “ten or 15 guys with an average IQ of maybe 170” could get themselves “into a position where they can lose all their money.” That was much the sentiment of Daniel Bernoulli, way back in 1738, when he wrote: “A man who risks his entire fortune acts like a simpleton, however great may be the possible gain.”

T
HE PRESS TORE
into LTCM and most especially its newly minted (1997) Nobel laureates Merton and Scholes. “Rocket Science Blew Up on the Launching Pad,” went a
Business Week
headline. For Michael Lewis in
The New York Times Magazine
, the story was “How the Eggheads Cracked.”
Fortune
suggested that the two Nobelists had “swapped their laurels for the booby prize of the financial markets, which is the ignominy of being largely wiped out and viewed as bumbling losers.”

Journalists offered three reasons for the downfall: leverage, fat tails, and hubris. None was an entirely satisfying explanation.

LTCM’s web of interlocking trades was so complicated that its official leverage figures don’t tell much. The fund said it had a leverage ratio of 25.6 at the end of 1996. That was
less
than the leverage ratio of Morgan Stanley (26.5), Lehman Brothers (33.2), and Salomon (42.5). None of the banks imploded. They didn’t because their portfolios were less volatile and/or they had the resources to wait out convergence trades. Leverage is not always bad. You cannot even say, as a general rule, that thirty times leverage is always bad. It depends.

LTCM put “fat tails” in the semipopular lexicon. The term comes from the form of a bell-shaped curve. If you graph the probability distribution of typical security price or interest rate movements, you get a bell-shaped curve approximating the normal distribution of statistics classes. On closer inspection, the curve has “fat tails.” The left and right ends of the curve (the rim of the bell) do not hug the baseline so tightly as in a true normal distribution.

This simply means that big price or rate movements—Merton’s flealike jumps—are much more common than in a true normal distribution. A “fat tail” is thus an event that would be fantastically rare if it occurred by the usual workings of chance, but which is actually more common. You go your whole life without seeing a mime on a unicycle, then one day you stand in line behind three of them at the local Starbucks. Explanation: The circus is in town.

Thorp found that LTCM had based some of its models on a mere four years of data. In that short period, the spread between junk bonds and treasuries hovered in the range of 3 to 4 percentage points. The fund essentially bet that the spread would not greatly exceed this range. But as recently as 1990, the spread had topped 9 percent.

“People think that if things are bounded in a certain historical range, there’s necessity or causality here,” Thorp explained. Of course, there’s not. In 1998, when the spread widened suddenly to 6 percent, “they said this was a one-in-a-million-year event. A year or two later, it got wider, and two years after that, it got wider yet.”

The hubris theory was the most irresistible of all. For a few years, LTCM’s people were the cool clique in the high school of Wall Street. Few could resist taking delight in the humbling of the stuck-up. As to the nature of the hubris, most of the reportage saw it as the latest installment in the Frankenstein myth. The computer geeks who had taken over finance made the fatal mistake of placing too much faith in their machines. Exposed to the contagion of human unpredictability, the models withered. Roger Lowenstein’s bestselling book
When Genius Failed
charged that Merton and Scholes

Or as Nicholas Dunbar wrote in
Inventing Money
,