The Empire of Sand

stock-exchange– Story of the Rise and Fall of a Hedge Fund Empire

On the Wednesday afternoon of September 23rd, 1998, New York, inside a formidable Florentine Renaissance building with its sharp straight edges and rusticated finishing, a group of well-suited men gathered in the early hours of the morning. These were no ordinary men; they count amongst themselves the most powerful people in the United States, whose collective wealth would make paupers of any third-world country. It was the first time in history where these men all gathered under one roof, the gravity of the situation could not be underestimated. The goal, collective co-operation out of a mess that could potentially destroy their life’s work, as well as bringing about a prolonged misery to their nation and beyond. You could be forgiven to imagine a scene straight out of the Godfather, but this gang of influential men were not the cigar chomping Italian gangsters that dominated the landscape of New York decades ago, they are the new breed of power, not gangsters, banksters.

Around the table were top executives and decision makers of every Wall Street bank. Majority of them have retired comfortably by the time you read this, yet their names continue to resonate in the hearts of financiers, imbedded in the legends of the financial fantasy. Jon Corzine of Goldman Sachs was present, so was James Cayne of Bear Stearns, Komansky of Merrill Lynch, Deryck Maughan of Salomon Smith Barney, Allen Wheat of Credit Suisse to name a few. Also at the meeting were representatives from the Federal Reserve, the Central Bank of US, and an authoritarian steward of the world’s economy. Despite the statuses of the attendees, the meeting was hastily arranged, and conducted under degrees of secrecy. The topic of discussion was not bailing out foreign sovereigns as one might expect, but to save one private company from bankruptcy. Contrary to the normal procedure of letting failing companies go bust, why were the bankers so desperate to prevent it? The answer lies in the firm’s enormous exposure to the entire financial system. At that moment in time, it had notional assets in hundreds of billions of US dollars

– Letting it fail was not an option

The firm in the spotlight was Long Term Capital Management, and this is a story of its spectacular rise and fall from grace. It is also a morality tale of over-ambition, an unshakeable belief in one’s own ability which gave to insatiable greed and inflated ego. The story began with John Meriwether, then head of fixed income arbitrage trading at Salomon Brothers, the biggest bond trader on the Street. Meriwether oversaw the firm’s dominance in bond trading, earning Salomon and himself legendary status, Meriwether was also widely known as the best poker player around. He was one of the principle characters in the infamous book Liar’s Poker, written about the inside dealings of investment banking. His ability to keep a cool head and the perfect poker face undoubtedly made him a great trader. Meriwether gradually felt his ambition was held back by office politics within Salomon Brothers, in 1993, Meriwether decided it was the right time to form his own trading fund. Meriwether rightly saw the importance of modelling in trading, and his star studded team reflected this principle. It mostly consisted of economics professors from Harvard, MIT and Stanford who were already well known and respected in the field of academic research.  Two of which, Robert C. Merton and Myron Scholes went on to receive the Nobel Prize for their contribution to Economics. Scholes received the Prize for co-authoring the famous Black-Scholes model, the principle tool on the trading floors to calculate risks in derivatives. The fund even had its political firepower in David Mullins, who was the vice-chair of the Federal Reserve, and many saw him as the successor to Alan Greenspan, the then chair of the Fed. Safe to say, the fund had everything for success – brains, reputations and political influence. It was to be called Long Term Capital Management.

Stanford's Myron Scholes and Harvard's Robert C. Merton

Stanford’s Myron Scholes and Harvard’s Robert C. Merton

LTCM would trade government bonds, chiefly US, Europe and Japanese. The professors created complex mathematical models on to spot bond arbitrage opportunities – meaning computers would notify if certain similar bonds are likely to converge in price in the future, which the traders could then take advantage. They also created models which informed them how likely their trades would go against them. In essence, the geniuses quantified uncertainty within financial markets and transformed it into statistical terms, they have cracked the market!

– The main back bone of their models was the belief that markets are efficient – participants in the market are rational and able to make sound decisions based on fundamental facts

For example, if a company reports a loss, the rational response in the market is a fall in its share price, reflecting the reduced value of the company as a commercial entity. This is what normally happens, and the professors believed wholeheartedly in market efficiency. So when two similar bonds, UK vs. France, both in broader economic spectrum share similar qualities, start to differ greatly in price, the traders call this difference the spread. Using the idea of market efficiency, the professors expect the spread to narrow in the future at the realisation of bonds mispricing. This particular strategy is known as bond arbitrage, similar to trades LTCM would put on.

Now that the brains quantified the risks in their trade down to a figure, they calculated that unless consecutive extreme events happen (market breakage), the fund would be liquid. The likelihood of those consecutive extreme events was so rare they said, it was practically impossible for the fund to lose much of its assets in short spaces of time. I have no doubt their collective reputations reinforced their air of intellectual superiority, they were fully aware the fund had the biggest brains in the game, as such, it made them feel invincible. The partners placed so much trust in their models; they invested almost their own net worth into the fund. The reputation and self acknowledged superiority worked wonderfully in their favour, from fund raising which initially proved difficult as the models were too complicated for everyone else, it gathered $1.25 billion, the biggest start-up ever at the time. Banks were also keen to do business with the fund, falling head over heels to offer better deals for a slice of their profits.

The fund was helped by leverage to achieve higher profit, which magnifies gains or losses. The fund leveraged through derivatives, which does not require much starting capital, and bank loans, which the banks were falling over themselves to lend at ever lowering margins. Meriwether took advantage of the banks eagerness and brokered many favourable deals at the risks of the banks. In some cases, the fund would post no haircut, i.e. no margins at all to trade through the banks! Why would banks do that?

  1. by facilitating a trade from LTCM, the bank would see where the flow of money is in the market and obtain a clearer view.
  2. there was of course a slice of the LTCM pie – profiting through commissions, and being allowed to invest into the winning fund.
  3. what was less obvious, was earning the bragging rights over other banks.

Combined with small commissions per trade and leverage, LTCM realised record profits, the trades were right and the times were good. Sooner or later the banks traded the same strategies themselves, the spread in bonds narrowed and there were less money that could be made in bond arbitrage. The professors took the decision to increase their leverage, magnifying their gains further. Of course, the risk of leverage is the magnification of losses as well as gains, but the brains were convinced as ever their trades were sound. LTCM also ventured into unfamiliar territory of Russia, Latin America and so on, where there were much greater uncertainty, hence a greater spread for potential profits. The professors were experts in European, US and Japanese bond market, but when it comes to emerging country debt, they had little experiences. The overall assumption was if the model works for existing market, why it wouldn’t be work for others. Sure enough, the fund made a killing in the wider spreads of emerging market bonds.

By 1998, the fund reached a behemoth $4.7 billion. The average return for the 4 years that the fund was in operation was nothing short of extraordinary, above 40% annually. In 1996, the fund made an astonishing $2.1 billion.

 – To put it into perspective, the few researchers, traders and analysts had made more profit in one year than McDonalds selling hamburgers worldwide’

The models had worked brilliantly and the partners’ reputation swelled, not to mention their wallet. The partners, with their own investment in the fund became multi-millionaires. Some partners continued to teach at Harvard and MIT, one gets the sense that it was not money they were after, but winning the intellectual game. Being proven right was more fulfilling than adding zeros to the end of their bank account. Money in a twisted way became a barometer of their intellectual superiority. Having studied Physics at University I fully appreciate their motivations, if you wanted money, you wouldn’t choose academia. It is about doing what you love, and doing it well. The only measure of success in academia is the researcher’s reputation; one can say Reputation is the currency of academia, and the partners want to be remembered not for their wealth, I suspect, but their intellectual prowess. Greed for reputation became and drove the greed for money, the partners reinvested their earnings back into the fund, and many even borrowed millions more from banks.

In 1997, foul air was arising from the East. The Asian financial crisis originated in Thailand spread through the region, destabilising economies and saw capital flight from foreign investors on a grand scale. Asian Bond spreads begin to widen as investors grew uneasy on riskier assets of emerging market debt. LTCM registered its first losing month. August 1998, Russia government effectively defaulted on their debt and their stock market tumbled down. Initially the response from the West was muted, but a few days later investors started to panic. No country was safe, not even the nuclear powered Russia. The default shattered the lazy but convenient assumption that there would always be a safe net from International Monetary Fund or elsewhere. Wide spread selling ensued as investors transferred whatever bonds they have to the safe harbour of US Treasury. The selling was aggravated by the exit of Salomon Brother’s bond arbitrage desk, which unwounded their positions at the worst possible time, causing further widening of spreads. This was precisely what the professors thought statistically impossible. What they deemed to be an efficient market was at that time, broken. Investors no longer relied on their rationale and merely wanted their money safe.

‘Fear is a very dangerous human emotion, and when it hits, all one think of is survival and no other function such as logic and rationale is spent, much like a stampede’

Investors feared their foreign investment region would be next, however remote from Asia or Russia, and quickly withdrew their funding. Latin American stocks tumbled as did markets across the globe. Every one of LTCM’s trade began to turn against them. LTCM was stuck in a position where if they too tried to unload their losing trade, they stand to lose a huge sum of money due to the sheer size of their positions. Like any losers in a casino, the professors doubled up, adding more to the losing bet in hope that investors began to realise market overreaction, and stop the aggressive selling.

The geniuses and Nobel Laureates in all their mathematical glory had forgotten one thing, one important parameter excluded from their equations – Human factor. In their attempt to model the perfect market away from uncertainty, they ignored the greatest uncertainty of them all. Had the financial market being run by calculating machines, this capital flight and liquidity issue might not have occurred. Humans, who are all too weak in their selfishness for self protection, ran at the first sign of trouble. Soon, people started to guess LTCM’s positions and traded against them, exploiting the inflexible hedge fund by shorting their holdings. As if a meaty shark had been tangled in seaweeds, little piranhas were ruthlessly devouring its flesh bit by bit.

Long Term Chart

From August 1998 to September, the fund went from over $4 billion dollars in assets to a little over $400 million. The models which had calculated with such certainty that it was unlikely to lose more than $35 million on any given day, had dropped $553 million on one August day alone. The partners still convinced this was gross over-reaction, tried their best to hold out for a change of tide, but as it always happens, time was running out fast. Meriwether who deserved praise for his honesty, informed the Federal Reserve their losses, the fund’s leverage, at that point, was at the notional value of over $100 billion, spreading over the entire Street in complex derivative deals. If the fund collapsed, which was a real possibility, the losses could be absorbed by the banks but what the real scare was the chain reaction that could follow

– Trading would cease followed by a credit crunch, illiquid banks fall, and all hell breaks loose.

Back in the meeting of the CEOs, at the home of New York Fed, debates were raging on how to rescue LTCM. Each premier had their own firm to protect, where banks were exposed to the hedge fund in varying degrees. They clashed on how the rescue package would be funded. Cayne of Bear Stearns was adamant they would not pay, causing much indignation. Eventually a deal was agreed, the geniuses was bailed out with tails between their legs, not to mention a rapid evaporation of their personal wealth. Hilibrand, the most gun-ho of the partners who had previously been worth close to half a billion dollars, awoke to discover that he was broke, and had to plead with Credit Lyonnais to spare him personal bankruptcy while he tried to work off a $24 million debt. David Mullins, the vice-chair of Fed never stood a chance of succeeding Alan Greenspan. The professors had lost more than just money, but their reputations too, which now lies in tatters.

When people now speak of Long Term, they see a bunch of greedy kids wanting more than their share. For me that was neither here nor there, it is a morality tale of the double edged sword of ambition. The partners were not in it purely for money, that was not their chief goal, what they wanted was the recognition of their genius. Ever increasing wealth was a way of confirming their superiority, assuring themselves their intellectual conquest of modelling the impossible. Their ambitions went unchecked, leveraging to unprecedented levels and diving into unchartered waters of the emerging markets. When they fell, they fell hard. As one can see, ambition is a funny thing, it can drive you relentlessly towards the goal, and it can also make you crash depending on how the journey was taken. Always check ambition and be careful on its execution. Take Lance Armstrong, his relentless drive to succeed pushed him to take enhancement drugs which ultimately lead to his fall from grace. I do not under any circumstances promote cheating in any way or form, but I cannot help but empathise with him. The external environment was so toxic in professional cycling, if he hadn’t taken any drugs he would probably never have won anything, in my humblest opinion, he cannot be solely blamed for cheating the world. Again, ambition left unchecked can be a real bitch.

What was also really worrying in the LTCM story was the professors’ unshakeable self belief, people often say always believe in oneself, which is true, but one should never be so close minded to not allow room for doubt. That doubt could be the making of something even greater than what we had. If the partners hadn’t been so gun-ho of their equations, instead bear in mind the human emotions in financial market, they probably could have avoided the massive losses incurred in 1998.

Lessons are learned, businesses go on. Or did they? Meriwether returned a few years later with another fund, using the exact same strategies as LTCM, which gathering $250 million.  Funnily enough it took another financial crisis in 2007 to break it apart, and Meriwether lost out yet again. Rumour has it Meriwether was considering a third fund. As someone candidly put it

‘High finance rewards handsomely for success, strangely it protects failure as well’

We are in a shifting world now, anything is possible.


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