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© Copyright 2000 Rogers Media. The following article first appeared in the July 2001 edition of
BENEFITS CANADA magazine.
Inventing Money
The story of Long-Term Capital Management and the Canadian behind it.
By Nicholas Dunbar
With his three-month Securities and Exchange Commission (SEC)-imposed ban ending in December 1991, John
Meriwether at first seemed likely to return to Salomon Brothers. But chief executive officer Deryck Maughan
didn't want him back. Determined to build his own power base within Salomon, Maughan would only offer
Meriwether a post with diminished responsibility. Meriwether said no.
If there was one man who could have brought Meriwether back, it was Warren Buffett. While Meriwether has
always insisted that Buffet had regretted his resignation in 1991, Buffett didn't lift a finger to bring
Meriwether back to Salomon afterwards. So far as Buffett was concerned, the old vice-chairman's connection
to rogue bond trader Paul Mozer made him tainted goods.
Taking time to improve his golf during the summer of 1992, Meriwether started weighing up all the ideas and
advice coming from his friends. There was Robert Merton, saying that the function performed was more
important than the institution that performed it. There was also Myron Scholes, who had rolled up his
sleeves and shown how to set up a special trading entity and protect it against liquidity.
Then there was James McEntee, who was Meriwether's constant companion on the green. Close friends since
Meriwether's early years at Salomon, the duo spent that summer jetting back and forth between golf courses,
from New York state, to California and then to Ireland.
McEntee played the court jester to Meriwether's prince. When Myron Scholes joined the pair that summer on
one of his first ever golf trips, McEntee teased the bookish novice mercilessly, later commenting: "Myron
read 100 books about it to figure out the physics of the swing." But the prince himself still lacked a
kingdom.
By late 1992, Meriwether had thought up a plan of action. There would be no more dreaded 'customers' and no
more corporate bureaucracy. Investors were necessary, but would be kept at arm's length. The tight-knit
blood brotherhood that Meriwether had created at Salomon would be created anew. Meriwether had decided to
set up a hedge fund.
THE INVESTMENT COMPANY ACT
The roots of hedge funds lie in an obscure law passed by the U.S. Congress in 1940, called the Investment
Company Act. The Act was mostly concerned with protecting small investors against being ripped off by
crooked mutual fund managers claiming to be whiz kids of the stock market.
With the Crash of 1929 still on everyone's mind in 1940, the foremost concern was to ensure that all mutual
funds were tightly regulated by the SEC and other government agencies. But as an afterthought, the
Washington lawmakers decided to make an exception to the rule.
If an investor was wealthy enough, reasoned the lawmakers, surely they didn't need the government
interfering in what they did with their money. The lawmakers decided that by wealthy, they meant anyone
with more than a million dollars to their name. Discreet fund managers who only dealt with fewer than 100
such investors and didn't advertise would be largely exempt from the rules, save for some cursory reporting
requirements.
With the excitement of the Second World War diverting people's attention, it was not until 1949 that
someone took advantage of this special loophole. That man was a journalist called Alfred Winslow Jones, and
he called his investment company a 'hedge fund' because it would not just buy the stocks it liked, but it
would also sell stocks short that it felt were overvalued. Since it was 'hedged' in this way, the fund was
less susceptible to big market moves than traditional funds.
After Jones paved the way, hedge funds started popping up like mushrooms. By 1968, there were 120 of them.
AUGUST 17, 1998
Value at Risk (VAR) became the near-universal means of controlling market risks after international
regulators gave their final approval in 1996. The risk managers were powerful figures, and their radar
systems were wired into the trading desks. Every minute that a position was marked-to-market, the VAR
number on risk manager's computer screen would pick up any changes.
And now, on the week of 17 August, Russian losses began to filter through. All the biggest firms had been
involved in this market to some extent, and all acknowledged that this was a volatile market.
But how is VAR calculated? Essentially, you multiply each position's volatility by its size in dollars and
add them together, allowing for the fact that some risks cancel each other out by having negative
correlation.
Now, with sudden mark-to-market losses, the Russian contribution to VAR rose rapidly. The effect was to
cause many trading desks to breach their VAR limits. According to the Basle committee rules, once such a
breach took place so many times, more capital would have to be allocated or positions had to be cut.
All the big investment banks are leveraged to some degree, and capital is a precious commodity. Cutting
positions was the route taken. So risk managers would phone head traders and tell them to cut back--not
just in Russia, but everywhere. Even when positions are profitable? asked the traders. Rules are rules,
replied the risk managers.
A similar story was happening at dozens of hedge funds, many of which used VAR to manage their risks. Not
having Long-Term Capital Management's (LTCM's) luxury of choosing how to cut positions, many had to reduce
exposure across the board, as capital was eaten away by the Russian debacle. Many banks instructed their
hedge fund clients to put up more capital against their trades--which had the same effect.
Where did the hedge funds and prop desks find the money to do this? They had to raid their other,
still-profitable positions. The result was that capital began flowing out of those swap and government bond
markets which LTCM, other hedge funds and the world's biggest proprietary desks had been specializing in.
By telling you how much you can lose in a given day, most of the time, VAR is a warning system that can be
used to control risks. If you breach that limit too often, you cut back in a controlled way until you
return to the safety zone again. That is the theory.
But during August 1998, everyone tried to do this at once. As we saw with Black Monday, the result is
inevitable. The opportunists who take advantage of short-term price drops disappear. Market makers widen
the spread between buy prices and sell prices, and finally there are huge jumps downwards in price. Like
the proverbial fire in a movie-theatre, everybody rushed for the exits.
AUGUST 20, 1998
At LTCM, Larry Hilibrand had made a large bet that telecommunications company Tellabs would successfully
take over its rival Ciena. This was a 'risk arbitrage' trade, just like the one Merton had successfully
done as a student all those years back.
But then, on Thursday, 20 August, Ciena revealed it had lost an important contract, and analysts speculated
that the merger might be cancelled. The value of Hilibrand's trade declined by $100 million.
At LTCM, things were done differently to the banks. Rather than be forced to reduce positions according to
a VAR computer program, the fund had contracts permitting it to maintain positions as long as it liked--so
long as sufficient collateral was in place. But the mark-to-market losses moved positions 'off-market'
triggering automatic calls for additional collateral. This began eating into LTCM's core capital balance.
By Friday, 21 August, the devastating effect was apparent. Shocked traders in Greenwich and London stared
at their screens. By the end of the day, LTCM had lost a total of $551 million--over half a billion
dollars.
AUGUST 27, 1998
Meriwether and the principals tried not to show their feelings to their 200-odd staff. The official line
was that the markets were full of opportunities and that LTCM would weather the storm. Robert Shustak went
as far as borrowing $38 million from the Bear Stearn's cash account in order to pay all staff in advance up
to Christmas.
On 27 August, Meriwether transferred some property he owned into his wife's name. LTCM sources insist that
this was an ongoing part of Meriwether's estate planning and not an attempt to hedge his own bankruptcy
risk.
By the week ending 28 August, everyone in the firm could see that LTCM's mightiest bets were in deep
trouble. For example, dollar swap spreads--one of LTCM's biggest single trades--were at levels which had
not been seen since 1987. The giant inverted pyramid might even topple over unless capital was found to
prop it up. The fear was that if news leaked out about how dire the situation really was, no one would
invest.
There was one alternative--cut positions. But everyone else was doing that already. LTCM had had its chance
back in July, and had blown it. Against Scholes's advice, many of the relatively liquid positions which now
could have given LTCM vital breathing space were gone.
David Modest recalls: "We reduced our non-core positions; we were unable to liquidate most of our core
positions because for some of the markets we were involved in trading had ceased. Nobody wanted to take
positions. The people who would normally take positions off of us, namely the investment banks, were trying
to step back at the same time."
It was now the end of the week, and soon LTCM would have to announce its August results. They would make
grim reading. In a single month, the fund had lost $1.85 billion in capital, leaving it with
$2,281,428,786. The net return was 44.78%, which was a thirteen standard deviation event.
On 2 September, a remarkable letter was drafted and sent to LTCM's investors. It was signed "John W.
Meriwether." He began: "As you are all too aware, events surrounding the collapse in Russia caused a large
and dramatically increasing volatility in global markets throughout August."
He continued: "Investors everywhere have experienced large declines in their wealth. Unfortunately,
Long-Term Capital Portfolio has also experienced a sharp decline in net asset value." After revealing the
month's returns, Meriwether's letter said, "Losses of this magnitude are a shock to us as they surely are
to you."
He went on to attempt to explain why the losses had occurred, saying "August saw an accelerating increase
in the demand for liquidity in nearly every market around the world. Many of the fund's investment
strategies involve providing liquidity to the market. Hence our losses across strategies were correlated
after-the-fact from a sharp increase in the liquidity premium."
In these words we see the self-delusion that blinded so many players during those weeks. Meriwether seems
to be saying, 'everyone else out there is going crazy, but we're not. We're the innocent victims.'
If that was delusion, the next part of the letter went to extremes in trying to sound upbeat. "Risk and
position reduction is occurring in some strategies," Meriwether continued. "On the other hand, we see great
opportunities in a number of our best strategies and these are being held by the fund. As it happens, the
best strategies are the ones we have worked on over many years."
There is a note of bravado here. Meriwether and the principals had no choice but to stick with their
biggest positions, which were unsaleable. Even those which could be sold, LTCM could only sell at a
substantial loss--which would further eat into precious capital. It was all wishful thinking.
In the letter, Meriwether went on to assure investors that "our capital base is over $2.3 billion"--the
glass was half full in other words--and that term financing arrangements ensured that LTCM would have all
the time it needed to reduce positions. Just in case anyone thought of asking, the letter reminded
investors that they couldn't withdraw any of their money until Christmas.
But the most poignant part of the letter came at the end. Meriwether said: "Since it is prudent to raise
additional capital, the fund is offering you the opportunity to invest on special terms related to LTCM
fees." It gave them Dick Leahy's phone number, in the vain hope that someone might take the bait.
SEPTEMBER 1998
Back in Greenwich the news filtered through to stunned LTCM staff. One of the traders who had invested his
own life savings in the fund broke down in tears in Eric Rosenfeld's office. Now he was wiped out, he would
have to cancel his wedding.
Meanwhile, a hundred-strong due diligence team from Goldman Sachs was pouring over LTCM's positions--all
60,000 of them. And the losses were stupendous. Emerging markets trades--such as Russia--accounted for $430
million. Directional bets took care of $371 million, while equity pair trades lost $306 million. But the
two killer blows came from Modest's equity index volatility trades at $1.314 billion and the fund's core
fixed income arbitrage trades which lost $1.628 billion. Total losses were $4.6 billion.
And what about LTCM's spiritual founding fathers, Scholes and Merton? How did they feel now that their
wealth had declined virtually to zero? How did they feel as the world's press fed on this story of the
mighty laid low?
All the assumptions buried in the small print of the Fischer Black-Myron Scholes formula--liquid and
continuous markets, Normal distributions--had broken down that summer, as well as older shibboleths such as
diversification.
For Scholes, Merton and the tight-knit group of quants they had nurtured over the years, the world they
invented had fallen apart. The Nobel Prizes now must have felt like an albatross hung round their necks.
Inventing Money is published by John Wiley & Sons, Ltd. www.wiley.com/legacy/products/worldwide/canada.
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