Introduction The Federal Reserve Hank of New York is perched in a gray snd stone sla nthe are of Wall Sret. Though a city landmark ing eonsteucted in #934, the bank is a muted slmostunscen presence among its lvls entepreneuial neighbors, The are is dete with slsenunt stores and luncheonertes—and, almost everywhere, beoker age fms and banks. The Fed's immediate neighbors include shoe repair stand and 3 teriyaki house, and also Chase Manhattan Bank J-P Morgan is afew blocks aa. A bt fareher to the west, Merl Lynch, the people’ brokerage, gazes atthe Hluson River across which he the rest of America and most of Merri customers. The hank skyscrapers project an open, accommodative ain, hut the Fed building, a Florentine Renaissance showpiece, is distinctly forbid ding Is arched windows are encased in mital gill, ads main trance, on Liberty Set, is guarded by 3 row of black castiron The New York Fed i only a spoke, though the most important spoke, in the US. Federal Reserve System, Americas central hank, Because ofthe New York Fed's pronimity to Wall Steet, acts as the ‘eyes and eats into makes forthe bask’s governing hoard, in Washin every imaginable permutation. Its hardly a surprise that when the cycle turned and eit ightened—s, throughout recorded time, it petiodicallyhas-—Long-Term’s trades fll in lockstep. Tris ineresting ro compare Long-Term’ loses from various eat tomes of trades from Januaey 1, 1998, co the halout!* Russia and other emerging markets: $430 million Directional trades in developed counties (such as shorting Japanese bonds: $374 milion Equity pairs suchas Volkswagen and Shell: $286 million ‘Yelcurveaehiteage: $215 milion Standard & Poors soo stocks: $205 milion High-yeld (junk bond) acbieage: S09 milion “Merger arbitrage: Roughly even “These seven categories accounted for $1.6 billion in losses cat astrophic result. However, Long, Term could have survived them, "Now consider the losses is two biggest trades: ‘swaps 816 hilion Equity volaiiy: $13 billion Iwas these two rade that broke the firm, Long-Team go far 10 big in these markets—a cautionary eror Igo so bg that it distorted the very matkers on whose efficiency the fem relied. This wouldn't have mattered but forthe fact that Long-Teem also leveraged is cap ital 30 to «agin, n addition 0 the huge leverage impli in its de rivatves book: One ean be big (and therefore iliguid)y one can {within prodens limits) be leveraged. But the investor seho highly leveraged and liquid spaying Russian cule, for he most be right about the market not merely ar the end, but every single day. [One ‘wrong days and hei ut of business.) Long-Term was so slFvertain sto believe that the markets would never—nor even fora wild swing Some August and September—stray’ so far from its predictions. Reared on Merton's and Ssholevs teachings of efficent markets the professors actually belived that pices would go and go directly Ivhere the models sid they should. The profesors’ conceit was £0 ‘think that models could forecast che imis of behavior. In fast the models could tll them what was reasonable or what was predictable bhsed on the past The professors overlooked the fact that people, traders included, are not ahways easonable. This is he true eson of| Tong Terms demise. No matter what the models say, raders are not ‘machines guided by silicon chips they are impressionable and imita tives they run in flocks and retreat in hordes. [Even when traders get things “right” markets can hae be ex pected eo oscillate with the precision of sine waves. Prices and spreads ‘ary wich the uncertain progress of companies, government, and «ven civilizations. They are no more certain than the societies whoxe ‘economic activity the reflec, Die ae predictable down tothe dec- imal point; Rusia isnot; how traders will respond to Russia is less predictable sil. Unlike dice, markets are subject not merely to risk, an arithmetic concept, but also to the broader unceetanty that shad foes the future general: Unfortunately, uncertainty, as opposed to ‘6, i an indefinite condition, one that doesnot conform to numer seal suaijackess “The professors blurted this crucial distinction; they sent thee ‘mathematical Frankenstein gamely into the world as if i could tame the element af chance in life tslt. No selfdouhe tempered them 20 sense of perspective checked them as they wagered such staggering ‘The supreme irony i that the professors wer trying to deconstruct nd ulimately to minimise rit, not—they beleved-—to speclate on ‘overcoming st In tis the fund was not unigue, Long-Term was in fact the quintessential fund of the late twentieth century—an periment in harnessing the markets fo the tin new disciplines of Financial economics and computer programing, The heiet that t0 ‘morrow’ risks can be infered from yesterday’ prices and volatilities prevails at virally every investment bank and trading desk. This twas Long-Term’ hasie mistake, and iy stoning loses berayed the flaw atthe very heare—she very braia—of moder finance. None other than Merrill Lynch observed in its annual report for 398, "Merrill Lynch anes mathematical risk models ro help estimate its exposure wo marker ssh.” In a phrase ehat suggested some slight dawning awareness of the dangers in such models, the hank added that they “may provide a greater sense of security than warranted therefore, eliance on these models should e imited. "If Wal Street ist lean ust one lesson from the Long-Term debacle, it should be that. The next rime a Merton proposes an elegant model to manage risks and foretell odds, the next time a computer with a perfect mem ‘ry of the past i sad t0 quantity sks in the fate, investors shold run—and guickly—the other way. (On Wall Stree, though, few lessons remain learned. In NoveThe White House formed a blue-ribbon panel the President's “Working Group on Financial Markets, a muliagency group linlud Jing the Fed to study the LongeTerm debacle. ts report concluded, "The central public policy save raised by the LTCM episode is ow to constrain excessive leverage more effecivel.” Moreover, i cog ted the growing role of derivatives, soning, "Balance-sheet leverage By tel enor an adequate measure ofcsk."" Moweves, the report teas weaker when i eae to proposing solutions. Ie di cll for en hanced disclosure by hedge ands, etter risk and credit management polices by hanks, and tougher regulatory standards. But the eat Truly worded report, hich was issued in April 1999, did not have the fre to provoke action from Congzess, which in any case was api Torng intrest in Long-Term. "Last September and Octobet, {tras hot nse,” David Runkel, a spokesman forthe House Bank Jay Comittee, noted the summer after the css, “But not now: The furor over hedge funds also did down—and appropriately 0, The Long, Term css happened to involve 2 hedge fun, but the f thors ofthe crisis were the big Wal Steet banks, which let thei stan Gard prow lax at thee pocketbooks grew fush, At the time of the braowt the banks were depicted a vies that had been kee inthe (dak by Longer’ paented secrecy. Such a view was enkanced Dy ‘rious bankers” assertions of innocence (Komansky for one called Shend upon leaving the Federal Reserve and declared, “When tse theis postion, my fucking knees were shaking") Wich time, such {sine rang inceasngly bolle. Each Bank had known its own eX spon to Long Term trade by trade; i di not cake genius for them fo infer thatthe fund was doing similar business elsewhere. Patrick Parkinson, a Fe offic assigned ro the President's Work Sng Group, told a Senate committe a couple of months afer thers TCM appests to ave received very generous credit tems, tren though it took an exceptional depee of isk... Counter parties obained information from LUCM thar indicated hati Fad securities and derivatives postions that were very large re: pve to it capital Howeve, em fam seem to have really un Serstond LICM’ esk profil So the question becomes, why did the hankers lend? In a publi symposium carly in 1999, Walter Weiner the former chairman of Re bli minesine thi he aks a had no coce—or atleast no ‘choice other than the rare, courage f a ous one of rec busines To tote the lab, you had play by LTCM oe. The tems were on negotablo—take or leave "The banks tok They too. were freed and they were aed hy Longer’ performance and ded bike enn! wns dee nd ace may ve sneered by tee spermen,® Weiner akowedged. Unique in Wal Sree stony the fond hd laa aceos the anal ses like famous rock, halla, kalfmachine tac seminal re sear wl tn eon tors froma remot far the praised to have supered thera ak an fi tha ee ln he shadows of To sa fs aye ith esos fa in ‘esters atoshing pois loked less mre inthe ght of the losses that followed As witha inser who collet head pe um ut ae tec en a tr ba Longe po is were nom 3st all earned in par they were boro ‘evn te day wet woul tr Nv imeem Sein nan so ev al oe Indes Longer sa that he ye as tuning but inexplicably ta pram apna ede owe eal a ing the rks i he hones, Long Term incase severe orowingcould tan unattractive basinssinta beer neater sha lero Lanta wo ave mae mae fora major manager weakness: the absence of any independent heck onthe waders tn che end every partner ad st through the Tiskmamageentmecingy ar every on, ltt al acausced inte ees that sem eer parte ao Bae Long-Term pu supreme trst in divertiaton—one ofthe shi boleh of moder mesg, bt an overrated one, As Keynes ot ‘one bet soundly considered is preferable to many poorly understood. The Long-Term episode proved that epg separate Baskets a beck smultencuny. Moreover, Long Term old tint think ingit ha diverse in aubtance when, nat tad done vo oy inform. Basil the fund made the sme bet on lower ated onsIncreased the odds ofa furore disaster. “To be sure, some moral haz ard, however slight, may have boon created by the Federal Reserves involvement," the Fed chief declared. However, he judged that such negatives were outweighed by the risk of "serious distortions to mar ket prices had Long-Term been pushed suddenly into bankruptcy.” Tone looks ae the Long. Term episode insolation, one would tend tw agree thatthe Fed was right to intervene, just as if confeonted with { siddenly mentally unstable patient, most doctors would willing prescribe a tranquilizer The risks of a breakdown are immediate: those of addiction are long term. But ehe Long-Term Capital case must be sen for what ts: nota slated instance but the ats in {series in which an agency ofthe government (or the IMF has come to the rescue of private speculators. In one decade, this unfortunate fowter has giown to inclide the savings and loans, big commercial bank that had overlent to realestate, investors in Mexico, Thailand, South Korea, and Russia (where a baila was atempted, and now the various parties affiliated with Long-Term Capita. Ie is tue that the Feds involvement was limited and that no government money ‘was used, But the banks would nae have come together without the enormous power aad influence ofthe Fed behind them, and wiehout 4 join effort, Long-Term surely would have collapsed. Presumably, the banks and others would have suffeed mote severe losses— though nos, one thinks, as great as some suggested. Long-Term’ ex posure was ge, but, spread overall of Wall Street, it was hardly ff apocalyptic proportions. At some point the selling would have Stopped. At some point buyers would have recumed and markets would have seabilied. Other banks could have filed, though thar twas an outside chance at best Permitting suc loses to occur is what deters most other people and institutions fom taking imprudent risks, Now especially ster a ‘evade of prosperity and buoyant financial markers a reminder that foolishnest carries price would be no bad thing. Will investors in the next problem-chldto-be, having bees led by che soft landing engineered fr Long-Term, be counting onthe Fed, too? On balance, the Fads decison o ge involved though understandable given the panicky conditions of September 1998—reprettably squandered 3 ‘choice opportunity to send the markers 2 needed dose of discipline ‘McDonough always defended his actions though he seemed ds ‘pleased and perhaps embarrassed by the funds survival A year after the bailou, in an impolite burst of candor, the Fed president de cared, "LTCM is lose o being ou of busines. can ase yo that isa result that pleases me considerably Greenspan's more serous and longer-running ereor has been to consistently shrug off the need for reglaton and beter disclosure with regard to derivative products. Deluded as 10 the banks ability sa police themselves before the eis Greenspan called for 3 less bur dlensomezepalatory regime barely six months after it." Hs Neolithic ‘opposition 10 enhanced disclosure—which, because it allows ia- ‘sewtors the thee oven watchdogs, ever the het fiend offre cap ital markees—served to remind one of the early Greenspan who {in thrall wo Ayn Rand) once wrote, “The bass of regulation i armed force." Infact, ssi counties that lack transparency auch a8 Rus- hat markers need to be defended by soles 1 the Long-Term episode proved anything, i thatthe system of lsclosure dha has worked so well with regard to traditional secur ties has nor been able to do the job with respect to derivative com tracts. To put it plainly, investors have a pretty goad idea aboot halace-sheet risks hey ae completely beled with regard to de rivative sks. Some of the reporting standards are being changed {over the opposition of both Grceaspan and the banks), but gaping holes remain. As the use of derivavives grows, this deficiency will re turn to haunt us. “Moreover, aside fom improving reporting on derivatives, there is 8 strong argument to be made for restricting actual exposure, Regu lator lit the amount that Chase Manhattan and Ciibank ca lend, so tha dei loans do not exceed a cereain rato of eal. The rege lator do this fr good reason: banks have repeatedly shown that they will exceed the limits of prudence if they can. Why, then, does Greenspan endorse system in which banks can rack up aay ammount of exposure thatthe choose—as long a chat exposure is inthe form of derivatives? The Fed's ewo headed poicy—head in the sand before crisis n- teevention after the fact—is more misguided when viewed a one single policy: The governments emphasis should always be on pre vention, not om active intervention. Tes altogether proper that the government set rules in advance for regulated bodies such as banks crisis intervention on behalf of unregulated hedge funds is antherblamed the irrationality and venlityof other raders. Thy portrayed Tong Teem as the victim of outside events, specifically, of 2 liquidity shortage in August followed by hostile front-unning in September, ‘On the fist anniversary ofthe historic meeting athe Fed, Myron Scholes cogently argued in a talk at New York's Windows on the ‘World restaurant tha spreads on lower cated bonds had widened so year levels than could have been explained by mere defaul risk “Therefore, Scholes concluded, the spreads must have been “liquid ity spreads.” tepresenting the premium that investors were willing te pay for more liguid paper. There i 3 citcular nature to such ar fzuments when prices fall one may always blame che absence of buyers and hence of “liquidity.” As Scholes himself pointed out, there were very ral, underlying events that had seared the buyers “ways to wits investors had been counting on the IME 0 bail out de 1F had been incapable of protecting ‘loping Fegions, bur the I “The example I lke co give that ofa father with several sons ach som thinks thatthe fare will support him in his time of need. Bu, i one of his brothers needs support, the father then has fewer resources to support his activities and also those of his bother brothers. The value ofthe suppor option i diminished in ‘value. This, part is the cause ofthe light igudity in Aw {gst Figural, another son, Russia, could mor he suficiendy Supported, and as aes al ofthe ether sons, the underdeve: ‘oped countries, loked less credit worthy.” Scholes lamented that academics and praitoners hada't modeled this “stresslos quidity component” and its implications for prices But obviously illiguty was mecely the expression ofthe problem, not is cause. What was missing from these self-serving sound bites tvasany suggestion that Long. Term hi heen at fault for exposing i self to such pei, A man driving a cae at thirty miles an hour may blame the road if he skids om a patch of ce; 8 man desing ata hu red miles an howe may not ‘Scholes averted the question of why “academics and practitioners” haat ignored the long established and basicaly selFevident liguiity risks. Even ater thee historic loss, the Long-Term partners admiced ho essential mistake They had been done in they argued, by an foreseeable event—a perfect storm such a strikes once ina hundred years “I believe that," Rosenfeld explained after the crash. "I do fhink it was something that never happened before." OF course, it had happened, no once ina hundred years bt many imes—in Mex ico, on Wal Street, in stocks, in bonds, in silver, in Thailand, in Rus sia in Brazil. People caught in such financial cataclysm typically fee Singulaly nck but nancial history is replete wath examples of “fa tails" —anusoal and extreme price swings that, based on 3 read ing af previous prices, would have seemed implausible ‘Whatever they had learned from the trauma, the parmers contin ued to insist, jase a8 they had before the bailout, that spreads sere too wide, that now was the time 10 invest, that opportunites had never looked bette. The models sid so! On ths they were proven ‘wrong-—or at least, a yea after the bailout, they had ye to be prover ‘ight. Though Wall Steet recovered, Long Term’s brand of arbitrage ‘did nor. Under its new oviner, the fund enjoyed good lat quarter in 1998 and a good star tothe new year: then it wene into a talspin, In the summer of 1999, US. swap spreads once again ballooned, 0 112 poings—wides even thas atthe astronomical height ofthe pre: vious years panic. The once-in-a-ceneuty flood bad struck twice in On September 28, 1999, exactly a year after the bailout, swap spreads eemained at 93 points and equity volatligy was at 30 per ‘cent—each far higher than when Long-Term had entered the espe tive trade. In the first year after the bailout, che fund eatned 10 percent—harly a dramatic recovery. Then in adlition to this mod ft profit the fund redeemed the consoetiam's $3.65 billion in api tal For practical purposes, the fund had liquidated by early 2000. So Long-Term’s problem had nor been just iliguidry. Perhaps the fons enie strategy’ had been wrong, and the world (and Long ‘Teams perception of credit in 1998 had been a litle roo roxy. The evidence suggests that both Factors were at work: LongeTert mis- judged the markets, and the effec ofthat misudgment was sorely compounded in September, when-—to protect themselves against TLong-Teem’s imminent collapse—other taders went on strike and liguiity” disappeared. Alan Greenspan freely admined that by orchestrating a rest Long-Term, the Fed had encouraged futur risk takers and periyof foot dragging, had to dispatch some of ts members to London to ‘make sure the unyielding srbitrageu fel into line The partnes’ stely eleventivhour negotiations had guaranteed them a generous bonus—on average, $500,coo—in return for say Ing the Year. Otherwise, hey were treated like the hited hands they were forced 40 swallow a biter helping of their own gruel. Dis sgreements between them and the banks wete resolved in favor ofthe Consortium, which now held all the power The consorcism, wanting ‘no more embatrasment from the fee-swinging arbitrageur, mont tored the fund's image 00. bs a humiliating reversal of roles, they or ‘dered the partners to clear publi statements with their new bosses, implying that now it was the partners that couldn't he trusted “More distressing sil xpecally to firm that had prided self on itsclver avoidance of tes, the Internal Revenue Service launched slobal audi of LTCM and its various afiaes, The aut, which f= fuses oa the yeas 1996 and 1997, and which remained unresolved tightcen months ater the funds collapse, exposed the partners to the possiblity, one day down the road, of being bled for massive back taxes owed ‘After the crisis, the groups extraordinary unity broke down. Sev- «ral ofthe parners came o believe tht foe the good of he frm, Hil brand and Haghani should go, nor only for their pare im lening the ‘money but fr thei sonelling dispositions too. Neither was suited to teamwork. Meriwether heard complaints about the rwo fom Havekins, MeEntee, Modest, and Mullis. Bu he was singularly un prepared to deal with them, J.ML. beld afew meetings and teed co placate the mariners, but he was too deliberate, and 100 loyal 0 his longtime cohorts, to confront his two top trades. Hains fina searched out the boss and declared, in effect, that it was either Fil brand or him. J.M., always spare with words, sad, “Good luck co sou.” Then he left the room, Tnthe yea following the bailout, unhappy partners pradually (and swith he consortiums permission) lee the fez. Most wer abe co tap past connections and resume normal working ile. No stigma was tached; second acts on Wall Sree are 36 common as hey are in politics. Pethaps one cycle, be stan election cycle oF an economic ‘jl is the extent ofthe publics memory Scholes, who was bitter about she enie experince, returned with Jan tothe Boy Area, where he took up wring and oxcasional lst ing at Stanford. He and Chi Huang, the former head of Long Term’s Tokyo offic, were hired to manage money forthe Basse, the “Texas tycoons, Merton concinued to teach at Harvard, A year after the sescue, with the benefit of his hard-won fschand knowledge, Merton ‘was hired asa consultant in risk management by JP. Morgan ‘Modest, the intellectual modelen, became a managing diccctor in ‘equities at Morgan Stanley. Mullins, the cental banker, decided on yeta thie eateer change and became an adviser fo several startup companies that provided financial services over the Incernet Hawkins and MeEntee drew up plans for an investment fond. With the exception ofthe outspoken Scholes, wha was never shy about of- fering hs thoughts—including on Long-Tetm, on which he had kept detailed notes—the departed partners contentedly disappeared from publi view: ‘Mesiwether never doubted that he and his core group from So lomon would ty ro raise money and do t again. Almost 38 soon a8 the nk onthe bailout agrcement was dry, J.M. and his loyalists began to chae under the consort restrictions. The continually pestered thei overseers to let Her rie new money and JM, began to miter thar Allson—ho insted thar the group should wait a bit—was't living up to his promise, asf he groupys rescuer was in debt ro them. The partners went on the oad i late 1998 and early 1999 t0 vst their investors—ostensibly to explain dhe disaster but really to seed the ground for furure fund-raising. Allison was eunned to Jearn that, [LMG wa circulating a bref onthe disaster to nsestors in Europea prelude co maketing his next venture—and the consortium ordered him ro stop, “Do these guys possibly think they can redeem themselves?” one ‘of the consortium bankers wondered. Cleary they di. In their one publi interview before they were gaged, the partners put forth ar eeming and idealized view of themselves 2s 2 band of beiliant ‘ultrarationalists who, most unlucky, had been done in by an unrea soning and venal word, “The partners appeared to acept responsibility they said they did and apologized on various occasions: but they never made clear jast ‘what it was they were apologizing for J.M. & Co. generally dened that iter the leverage oF the sizeof thee portfolio had been 3 sg nificant contributing factors they denied, even, that their hase stat cay had been flat Rathes in meeting afer meeting, the partnersBankers Trust sufered caastophic losses in Russa, where it had bean an aggressive buyer of ruble securities, a8 well a in Brazil and ‘ther emerging markets. Apparenty making a mockery of the sl important pretensions of ts chairman, Frank Newman, the Bank was forced to sll ut t 4 German rival, Deutsche Bank. Though udged failure, Newman, who had aealyscotched the LongTerm rescue, Secured a golden parachote for himself estimated at Stoo milion, in the circumstances, am enormous undeserved bounty Sandy Weil ame out on top, ashe aways seemed 0. Citicorp and “Travcle/Salomon merged on schedole. Lehman Brothers, which had ben plagued by rumors, quickly recovered. Chase Manhatar— ‘without whose repeated help Long-Term would have surely faled— had ies loans repaid and came out whole. Indeed, chanks ro the rescue, Long, Term met every margin call. Al fits debts to reditors swore repaid in fll. . ‘Mose of Lang Terms outside investors came out ahead-~saved ito ‘cally by the forced repatriation oftheir capital a the end of 1997 Sone thitty-cight investors wha had Been licky enough to invest at the inception and to have been mostly cashed our in 1997 finished ‘with an average return of x8 percent a year—nor quite 38 high asthe major tock averages over the same span but very good all the same. [About am equal numberof investors who had fully cashed out before the catastrophic loses of 1998 did even beret Investors who had been granted che special dispensation of being allowed to keep more oftheir capital invested ulimately lst money. Tronialy Bears jimmy Cayne, who nearly brought the fund down, ‘was one such “favored” loser. Komansky, chairman of Merril, who invested at the top, was a loses, too. About a dozen big banks made ‘nly single-digit annual returns, and a dozen others—ineluding, no- tubly, UBS, Credit Suisse Fist Boston, and Dresdner—lose money: ‘The mixed results ofthe outside ravestors in no way diminished the magnitude of Long-Term’ faire. Even withthe headwind of is firs four highly successful years, Long-Teem’s final, cumulative loss vas staggering, Trough April £998, the value ofa dollar invested in Long-Term quadrupled to $4.11- By th time ofthe bailout, only five months later, precisely 3 cents of that coral remained, After deduct Ing the partner’ fees, te rests were even sorter each invested do lag having grown 0 $2.85, sheank to a meager 25 cents. In net erm, the greatest fund ever—surely the one wih che highest IQs—had lost > percent oft capital wle the ordinary tock marker investor had been more than doubling is money. Te fund’ employees, ike those at most Wal Sect firms, ad gotten ost of their ay in the form of yearend bonus money. Mos of those hoses had been invested in the fond and went down the drain, “We alllost our money” said 2 saffer who worked as an analyst. “We nded up working for nothing,” ssi another, 2 bond trader. In October, employees staged a minieevole, demanding that furore bonus money he placed in tase where i could not be squandered The stl alo craved a measure of recognition, some admission that their bosses had beon wrong to keep them inthe dark. But the part nor habit of secrecy was deeply ingrained. At one meeting of part nets and staff an employee demanded, “Explain tows why we should he siting here and nor looking for jabs." Replied partner, “Thar 4 valid question, We'll yt Bock to you." The talented, dedicated workers never did win their bosses rast "A month ater the rescue, Long. Term ai of thirty thre employ es, almost a fifth of the staff After that, thece ws a steady steam fof defections, The fund offered 2 small severance package, but even this was a carot for which JM. & Co. exacted a price. Departing Saf members were cajoled into signing termination agreements in ‘which they repeated a pledge never to say 2 word about the Fund — {sf the partners feared the revelation of some secret shame . ‘Once the fund stabilized, the partners found themselves in an un happy limbo, Though they sil reside over a huge fund, their hands were ie by thei new Wall tect masters, who monitored the fund's ‘very postion ike anxious schoolmaen. Investing in new teades was four of the question; the eomsortun's only interest as 10 BERS money back. The partners, who had fantasized that they might be fable to run the fund much ae etore, sere biterly disappointed. At the consortium’s directive, hey steadily dowsized, wimming pos: tions and reducing exposuees. Hagan took his sweet cme i un loading trades; the Oversight Commitee which suspected Haghanposure to tis nous class category that so recently had been the ‘nvy of ll Wal Street andl now had become a pata Tn fact, the exposures, while big, were not as threatening as larmists maintained there was no "second Long Term” waiting in ‘the wings. But Long-Term (and other hedge funds) did havea core sve occ om Well Set all she same. The banks had nor been able to resis the fre of the funds fabulous—i fleting-—profits, Flash wth capital, ehey had rushed ro set up their oven similar, trading But now LTCM was ia hock to Chase for $108 milion, co CGidit Lyonnais for $50 millon o Lloyds for $5 milion —and tits fo fal for $38 milion, Seeking capital yet again, Meriwether called a trio of Mell exe: unives September 6, the Sunday belore Labor Day. Daly aliemed, Merril’ Richard Dunn spent the holiday siting through the hank’. cexponures 10 Long-Term. Merl was now worried about loge th its own direc exposure. Dunn was thinking about what would hap pen tomarketsi' collapse by Long Ter sparked un forthe exits ‘Could the entre Srcet Bi through the same door at once? Merrill was so concerned that it deputized Dunleavy, the salesman, and Bol MeDonough, the credit manager to get some facts in Greenwich, Dalene, rho vaso fiendy terms sith the partners, ase ther point-blank, “Are you guys OK?” The partners, puting their usual positive spin om matters, sid thatthe firm, despite ts problems, ws liguid. Dunleavy later told colleges thatthe partners had ied £0 bi. ‘Bur JM. and eompany truly lieved that with spread so wide olden vindication ly around the corner. “We dreamed ofthe day When we'd have opportunities lke this,” Rosenfeld sai,” Wh they lacked was che means co exploit them, [.M, was now in Eekstein’s po sition, facing the prospect of having tole some new J.ML. make the killing. Just tobe onthe ste se, Meriwether told Bll McDonough, the New York Fed president, chat Long-Term was having to look for new money. .ML and othe Salomon executives had once been ei clued for not having advised the Fed of problem carly enough; IM. ‘would nor make that mistake again . Throughout the end of August and into September, the partners ‘mood! gyrated with thee prospects for fresh investment. They sie stepped the delicate issue of LCM cash problems and dwelled on the supposedly bright prospects for anyone who invested now. Mor ‘zan’s Mendoza was stil promising $200 million. He breezy dropped the names of ble , fy the firs capital was dows 40 S35 bilo The marker turmoil is rand no ene America The mming’s New York Times toned, ng compared eo the mn pal finanstal diasters n memory By the time Filan was aims he haw that stk i Tokyo hal fall 3 potent to a ewe se fn "The as asc thing is not ty pane” Riis Miyazawa, lps minister of Finance, ob serve Thar days Russian stuck prs oom fall 1 peruse ine them «cool 84 penser below heir vl atthe tare of che yea Infact, markers arm the workl wore planging Lond fll ype sent, Spin 6 percent, Bravo perc America’s markets ell spn wis ths wows The Dawe dropped 157 point oF 4 pervent Camaity prise, shuddering fom Fear oflimos constantly about how ro salaye varius of Long Term’ pos ‘sons Naturally Long: Term turned for help to Roberto Mend, the Morgan vice chairman to whom ie had offered a pactersip, Though close tothe partners, especially Merton, Mullins, and Rese feld, Mendoza had had no dea that Long-Term win serogs trou Ie. Rosenfeld old him, "We needa large amount of mney.” His Funeness shocked Mendasa. Understands the banker wanted t0 know a litle someching ahout LangeTerms portfolio, AM. asked Hilrand to explain the swap position to Mendoza, hut the wary Hilirand retuned. Almost 48 teas, Hilibrand spnered that he couldn’ say a word about his precious portfolio, He had been so ‘ertsin-he had bortowed so fesly. Now his tightly ordered world ‘vas heginning to cack, Personal bankeuptey was aot out of the oe ‘on. The possibility chat he had heen so wrong wis devastating. Tuc tis ime, .ML insisted Hilibrand would have wo dacose lie He something, The arbirageue grudgingly complied. Mendoza, the peters friend, loyally promised that Morgan (oti clients) woud he good for $200 milling. Now Long: Term needed $300 milion more it did nor seem so much, Rickards, the house lawyer, dated papers for an smminent closing On Tuesday, August 24, Meriwether made two more calls. One waste Heth Alison, che Merl president, Ordinal he two would hhave been chatting abour the upcoming trp to Waterville but this September there would he no golf weekend. LM. disclosed thatthe fund’ capital had fallen to 82> Dillon, He stresed tha Long. Term had plenty of liquidity an, indeed, eh Fgiity wasn'ta sean assertion that, even if siete, was navel a os with the fade alaring leverage. JM, sil elieved in the model, and the models were stil ashing bullish signals Nonetheless, JM. noted, Long-Term would ave to report it losses to investors at the end ofthe month he wou feel etter fhe could show them that new money sets coming in, Stothy swith ing gears, he emphasized the splendid opportunity for anyone who ‘nested now, Playing his trump card, he iaypied that big investor— Allison guessed he meant Soror—was already in. Perhaps Merril ‘would like ro joia him and commit, 4 $300 milion t0 $00 milion before the end of August? Though fond of Meriwether, Alison ‘howght i was a curious invitation, fr was Io of money to be want ing in a week. LMS other call chat day was to Jamie Dimon at Travelers the patent of Salomon Smith Barney, Instead ofthe two Bem pecking “ich other to death by ligondating arbitrage trades, he suggested, why borate Lang: Terms portolio with what was let of Salomon's A Fite Grp and manage them sgether? Going hack tothe mother firm, av a sense. couple of Ms partners eae Saloon, 100, 50 licking ther old fiends for capital. They said thatthe fund needed $1 Filion bu was well on the way toward geting it Bue Long-Term was lsing ground, not gaining it. Markers were steadily turing on the Fund, Morggage spreads jumped an addtional 4 points thar Monday, 6 more on Tuesday, and 3 more on Weds day, August 26. High yield spread blew out another 25 points. With fash tik, more of Longefern’s once abundant capital drained sway—the firm vas losing money faster than st could raise it Stunned by the unceasing losses and helpless ro do anything about them, traders were hecomming dazed ike infantry ina slavghte. “It was bizare,” one of them said. "Day aftr day we had massive losses and they didn't stop.” The frm was hemorehaging Tong Term knew it hd 0 rede ts postions, but could not with markets under sees. Despite the ballyhooed growth in de Fivatives cere was mo Taidty im eet markets. There never is ‘when everyone wanes ue a the same tine. This is whar the models had missed, When loses mut, leveraged investors such as Long ‘Term are forced toll est thet Iosses overwhelm them. When a fim, fas to sll n a markst withowr buyer, peices eua tothe extremes be yond the hell cure, Ta eake just one example, yields on News Cor poration bonds, which had xen been trading at 110 points over ‘Treasurys, bizarrely soared to #80 ver, eventhough the company’s prospects had nor changed one iota. In the Tong run, such a spread Inighe seem absurd, But fong-sean shining i a Taxtry not always available to the highly leveraged they may nr survive that long, The end of August is always a slow time in markets, bur this Av ust, trading in bond markets ll but vanished. The market for ew fond isues simply dried up. Scheduled new offerings were abruptly ‘withdrawn which was just as well, because there was no one 10 buy them, The lesser investors, the copycat the fashionable hedge funds, the newcomers to arbitrage, and the sales, European-based traders were quitting the spread-tading business or withdrawing thee cap tal from iti droves."from London) om UK. swaps and Royal DutchShell. Disturbing the eadere sad there wae no demand for Long-Term’ rad, despite their sccing soundness. The Tokyo pariners reported 3 simile story there simply weren't any buyers. In such a climate, there was no way Long-Term could get out of is humongous trades without ning the markets even more, The parsers had assumed that other srhirayere would recognize the was tha hey sas thei fret step forward mystified them’ Now ike generals who overcomsitt0 a distant wae they found the road our blocked Tnstinctively, Meriwether and the other senior partners gravitated rovward the same strategy: they would rise fesh capital to give the fir cushion and wait unt its rades turned around, They were cer tain that spreads would eventoally converge, ust a they had when a young FM. hod daringly ile out Beksten. His early heroics had ben am almost faultless pide to LMS career: Spreads aluys come ack Tut owing to its los of capital Long. Term’ leverage had become langerausly high dangeros Becaase loses accumulate faster 33 leverage increases. Thereort to reduce thei isk, the partners would have to sell something. But what? Investors wanted oly the Teast risky bonds, and Long Term did't own any. One candidate was merger arbitrage. Long-Term’ deal portfolio had mushroomed co 2 stunning billion worth of merger posons, including Ci oop/Travelers and MCIMWorldCom (the later a successor to MCTs reverconsommated inion with British Telecommanications). The partners thought most of these marriages would yo through (a, teed they did. Bur they were hardy cena a dhe funds portfolio [And if al of them did collapse, asthe Ciena merger hak Longe Term ‘ele that i could lose mee than hal ilon dolars—now an intolerable sk Thar same Sunday aight, Rosenfeld calle Warten Buffer, reach ing him at his home in Omaha. Rosentc had won tutes admira tion in 1991 after the Mazer sean, when he ad worked lige to gr Salomon pas the crs helping aso to exon its name. Now RRoneneld figured there was no-one better to offer Long: Terms merger portoio to than Bott. The billcsir liked to dealin size He had done risk arbitrage betore. And thanks to widening deal spreads, prices were atractive Wtf intened attentively, Bur he quickly noted that he hada bem involved in merger arbitrage i a while and wase't up 10 speed No sale. Graciously, he asked i there was anything ese he could do. Rosenfeld eal chink of anything The next day, August 2g, the partners started dialing for dollars. With their git-cged roster of contacts, thir brillant record, heir lustous eeputations, na madsen Crocsus was beyond thei reach, Grey Hasek tapped frend in Goorge Soros Fund and set up 2 breaktast for Meriwether, Soros, and Stanley Deuckennile, the bil lionaire’s top serait. Soros, a wily refayee from Communist Hur and Meriwether were as lifrent ay could he, Soros Eastern European origins ooze from his every pore. Fura and tif he had a tendency to lnanch into philosophical disqustions. He looked hike 4 graying owl, Merivther was informal, unpretentious, midwestern he oul have been the State Farm agent denen the street. They rp resented unlike styles in investing too. Long-Term envisioned mar ets as stable spstms in which prices moved about a central pot of rational equilibrium, “Thad a different view,” Soros noted.” The Speculator saw markers as organic and unpredictable. He fle they in Teraced with, and ere reflestve of, ongoing events. They were hardly soil or abstract systems. As he explained it, "The ile thar you have a bellshape curve is fale. Yow have outing phenomena that you can’ anticipate on the bass of previous experience.” Rus sia, where Soros’ funds had jot lost Shion, was an example of just such an "outlying phenomenon” that ly outside the professors” . Meriwether argued, calmly bur persuasively, chat Long-Term’ mar ets would snap hacks for those with deep pockets, che opportunities swore great. Soros listened impassvly hut Drackenmiller peppered [EM with questions He smell a hance t recoup Soror's Russian losses in a ury. Then, Soros bly sak he wold be willing 0 i vest $360 milion atthe end of Auguste is, 2 week lter—pro» Sided thar Long.Term could restore ss capital by raising another $509 milion in addition Now Rosenfeld elle J. Morgan, firm that lang ad thst for closer testo Greenwich, The bank sent two teams-—omne versed in hon the other i equities—to comb theough Long Terms books. From then om, Morgan peuple and Long-Feom people were talking‘When he saw the quotation for U.S. swap spreads, he staced at is sereen in disbelief On an active day, Krasker know, US. swap spreads might change by as much as point. But on this morning, soap spreads were willy oscillating over a range of 20 points. They ended an astonishing» points higher, t 76 up from 48 an Apr. tn Britain i was the same story: swap spread surged to 63, 8 dozen points wider than hey had been in Jul Krasker couldn belie it, He sought ous Mate Zanes, 2 trade, and Mike Reisman, the i's repo man, and heseely broke the ‘ews. One ofthe states grimaced and sid “Holy shi.” The traders Jha seen a move like that—ever, Tue, i fad happened in 198 and again in 1992. But Long-Term’: models didn go back that fa As far as Long-Term knew, it was a once-in- lifetime accurencs—a practical impossbley'—and one for which the fund was totally un prepared. One of the analysts called a crader at home al asked, Would you like to gues where swap spreads are?” When the ana lyst told im, the rader snapped, "Fuck you—don' ever call me at That Friday, LongeTeem lost money wherever it kaoked. Credit spreads simpy exploded. Mortgage spreads srged to 121 points up feom 107 only weeks before. High-yeh! bonds ehmbed from 26) 6. Offthe-run Teeasurys vaulted fom # basis points 10 138 Though these moves may seem sina absolute erm, the effect on Long Term was magnified by the fand’s poten level of leverage and ies immense poston sie ven iv seemingly related matkst, Long-Term sullen a deb Ding. The riskier Russian sn Brazilian bonds hat Long Tern owned longed, and hy fa more han the safer Russian and Bravikan bonds tha iad sold shor as the eg that were supposed ta ave made ts bets so safe. Infact, nothing in ae market Went right that day “Long-Term had dubiowy invested in Ciena Corporation, munications company thar was planning 6 mere wth Tell ie and had continued to hold the stk even whch it hal erp to within 45 eens che acquisition pr On that same Fada, Aug 21 merger was postponed and Ciena stock plummeted $25.50, t0 Sstas a share, Long Tern lst $1 go mlion, Yeas ean Rosen had been warned that risk arbitrage Was ike picking up nihels in frone of oncoming balllzers. One had filly nipped it, “The losses came from every cure. They were 0 sf, so ney “oped in their breadth, so utterly unexpected that the partners felt abandoned. They had suddenly lost control, as though the gods of Science had been dislodged and some unseen diabolical power had taken hold of thee fates, In Greenwich, the skeleton crew Fanticlly called sound the globe to reach the other partners. Victor Haghani ‘vas in Tay he hurried back to London, Ere Rosenfeld had jst ae rived in Sun Valley, Kaho, for a two-week vacation with his family He go a red-eye back to New York, Meriwether was in Chins. His prtners tracked him down at a dinner in Beings and the boss cook ‘he next light home. Before he lft, JM. called Jon Coezine, the ciet executive of Goldman Sachs, a major Long-Term trading partner, at Corsine’s home, “We've had a serious markdoven,” Meriwether ad sc im, “but everything is fine with ws." Bur everything was not fine. LongeTem, which had calelared wth such mathematical certainty that i was unlikely to lose more than S35 million om any single day, had jst dropped 8535 milion 15 pescent oft capital—on that one Friday in August had started the year with $4.67 Pilon. Suddenly it was down 9 S29 bill Since the end of April it had lost more than third wf city Worried by sich serious losses to 3 major clin Abe Als eh Bear Stemns executive who motored cal sks, hurriedly called Robert Shustak Lang Terns chict financials, Shustak panty went over the frm’ gui. Als way amsze hy Shuseak cal, thought that was tw come to Alix often inthe weeks ahead about Shustak and abour the other partners. They were true poker players Alix though Two days after the debacle, on Sunday Avgust 23. the partners 3s sembled inthe vonfeenee room at 7 &M. Outside the glasand: zante headquarters a fountain spewed jets of water over a seulpeure ‘oF a capper osprey. A if stricken by & premvonition, Meriter had same Jit Rckaws th gnc conse, ads the group aa ake keep a record ofthe proceeding. Having heen blindside by the Mozer sandal, JM. knew from bitter experienee chat once such mat ters hecame pb, 998 t09 late to sek aie, From that Sunday to, whenever the partners met, Rickards, a wyer with dees rm enn, Johns Hopkin, and New York Univesity, was almne always in arena [.M ad each reader eeport on his ac of expertise: Hilibrand on rik ath, Hawi on Bea Modesto equities, Hagan thy plone(On Monday, August 17, Russia delared 2 debe moratorium. The ‘government simply decide i would rather use bles to pay Rus sian workers than Western bondholders. Nor woul it attempt t maintain the value of thse rubles in foreign markets In short it was a devaluation and, om a leat some of ts borrowings, a defaule from ‘government chat had promised that it would do nether. Enigmatic to the end Russa said its moratorium would apply 10 $1.5 blion ‘of local (rable) debe breaking the rls, honored even i the depths fof the Lain American debt ers that a government honors isco “The reaction in markets was muted, at leas at fst. Mexican and Brazilian bonds fell, and stocks in Japan and various emerging mar Kets weakened, Burthe Dow rose nearly #30 points. American banks, honoring tradition that extended back to 1929, quickly declared that chy expected to weather the storm with ie il ffs. Robert Strong, chiot credit offer at Chase Manhattan, whose stock price was to fall 50 percent within six weeks, confidently proclaimed to Wall Set security analysts,“ do or view Russa as 4 major se for Chase or for other US, banks." In tems ofits ol indsbuedess Rusia was no big deal, harely another Venez Except that Russia was not Venezuela. Suppose, nuclear powers didnot default. And when Rossia dd, something in the markets di. “The comforting notion that the global nana cps would always be there to pur matters right was naw exposed as a fllay. This tie, there was no recite bythe INF, no hurried bailout by Robert Rubin forthe Geoup of Sever Western powers, “The fund and the managed to say 10," remarked Mores Goldstein, 9 former senior IME official” The implications of his eruth chilled global markets like a Siberian gale The defsultshaterd the lary but convenient a sumptions of investors thatthe safety net would always be there. I “punctured a moral hazard bubble” that had bee inating expos tions since Rubin had ridden ra the eeseue of Mexico, Investors fest singly and then en masse, conchided that ni emerging market vas safe In seventy yeas, Russia's Commins had nor succeeded dealing markets such ating ow as did its deadbeat capitals On Thursday, three days after the deft, markets around the world buckled. Shares in eastern Europe and Turkey were weak. The stock marker in Caracas plunged 9.5 percent. Venezaelans panicked and rushed to buy dollars. Bra’ fr larger bolea was off 6 percent finally Germany's stock market fell 2 percent, a ifthe Rusian menace could setualy tramp aeoss the easter fro Tnestors now were running not just from emerging markers, but toon investment risk wherever i lucked. The panic proved tae the Asan storm had never trly buon forgotton. Swap spreads—those basi thermometers of credit marketsroee like 4 dangerous fever. “The British bank Barclays ordered its tadevs to unload shor pos sions in U.K. swaps, eventhough its raders, ike those at Long-Term, thought swaps were unreasonably high Barclays" deision to aban dom the trade merely pusbed them highec” Barclays” management tide care. The bank wanted ou, Ie was done with taking esk, The nextday, Friday, August 21, traders everywhere wanted out. Stack markets in Asis and in Europe plunged. The Dow fll 286 points before noon, then rxoupedd most of is loses. This palpable Surge in volasiiy cost Long-Term several tens of millions of dolla, The damage to credit marksts was far worse. Treasirys rallied bt it was a rally driven hy pan, for investors ought Treasurys to get tout of inferior credits. A few months before, they had not distin fished one isk from the next, Now it was all they thought of, A ose-colored sword had suddenly gone dark, discolored hy Rusia, Tapa, even the Clinton-Lewinsky scandal a every rh wanted only the sifest bond. tthe United Sates, had to be the thiey-year Treasurys in Germany, the ten-year Bund, All over the works, people were huving safer (lowerielding) hon and selling riskier higher yielding! ones, pushing the spreads herween such bond pairs ever wider Minute by minute Long-Term was losing milion . {in Greenwich, on that golden lae-Auguse Friday, Long-Term’ fice was largely deserred, Mont he enor pects wer wacaions it tras sultry morning, and the sft was nung slow fon MEF, the colorful “sheik” whose dtl warsings hal fn ones Was minding the store. Bill Krasker, the partner sw hae constructed ‘many ofthe fires models, was ats nner markets, ik ing fom one phosphorescent pa tthe est. Krave ciked Irom fvernments to mortgages to fori dc, the eatee atlas of exe Ta xt shot pn, rar my his as hahthought he was oking—Long-Tem 20 longer had the capital to back sch bold alk-—bor Salon respective fortunes: Long-Term wasn't calling the shots anyioe Robert Shasta, Long Terms chi financial officer, was having £0 fick calls everyday from a worried Bear Seams. J?) Morgan heard rumors that Long Ferm wa liquidating posiions—-or atleast ting to Lehosan Brothers eae the rumors, oo. Though Lang Ter bad ‘once snubbed the smalls investment hank, now ie was making mie wth Lehman. "They were coming tous to do more busines,” Jtfeey \Vanderbeck, head of fixed income at Lehman, recalled" remember thinking dha thei ity might be deying up. They wanted mone financing.” As repo loans were coling aver, Wall Strect banks, Lehman among them, were Finally asking the professors for ma Suddenly anxious about their personal well-being, the partners made hurvied calls to their advisers and attorneys, Hans Hush, 4 London partner who was married to a Californian, was about to bid ona house im Malibu. Bur Huth, who had horeowed hess il wo svest sm Long Term, gota ease of nerves, On 3 hunch, he de «ied nor to buy the house, Myron Scholes dl buy 3 four-story home in San Francisco, where his fianede lived. I was 2 fantastic home on Russian Hill with high cclings and 4 terrace overlooking Fisher man’s Whaet Icost $6.5 milion." Bur then, Scholes had money ou side the Fund. Ani he fan’ loses so far had hardly ben sere Meriwether confidently went ahead with a tip to China inthe middle of August. The partners thought they bad reason to he opt mist spreads had widened so mach hey fl that nov, sly they could only natrow: But their optimists had a desperate eg. nv August, Long-Term jumped more heavily into Russia, where it a ready owned hedged Russian bonds a¥ well ox some that were lunhedged. Now, while the etce world was watching Russia, while sts finances were in shambles and its government on bold, Haghani and a researcher named Ayman Hindy. a former profesor at San ford, bought more Russian bond a though they had the nse 00 ‘on that enigmatic Eastern sidde. Nether the Nobel Prize nor all he degrees mattered now; the professors were rolling ee dice. Aevor ing to one trader at Longe Term, the fund went “outright long in Russia—right atthe end.” Said another, miserably “It wa so against i’ traders enjoyed the turaabout in theie THE FALL The gustion 1 heer te LTCM disaster was merely unique ond telat event bad dann fom nate’ ur wheter sh ders “ne the erable consequence the Blak Sebo firma al] and he a my ie ta ll art pact sn bog sy thi at he same ie ROUGH HAE AMDDEE oF August, Langer Capital hal having a had year bur only 9 had your sich a any fo any “aptalistic enterprise, mist soniner or Tater sess reputation, ike itscapital remained intact. ls overall econd sparkled, among che members ofthe financial cognowent who erly knew the wire mame, Firm, often gave rise ro the very term "gens." Long-Term wa ut Ienown to the general public, bur that howe Meriwedber and his boys wanted it, and that, ofcourse, i how they expected the fund to remain. They could hardly have da immer of the Large, eve i ror, events i which they were to play a leading rl or of ow radically their Fortunes would change. Much les could te. have imagined the stunning switness with which such events would un fol tn late summer as Wall Sceters worn tor the Hamptons he prters were among Americas most prosperous, most successful and most highly esteemed investors. Their fund had $3.6 billion in “apital, of which two fifths was personally thers. Ir would take only five weeks for them to lose i alforecast what would osc if Moscow dl default.” To Haghani this was altogether eeasonable. "What we did i rely om experiences” he noted later ofthe portiobo in general. “If you'ee not willing to dea {ny conclusions from experience, you might aswell ston your hands tnd deo nothing," But could a “moe” uly anticipate a hot merely its markets but politi, its eilators it passions, tou? Russia was singularly poor laboratory for Long- Terms typeof trading. Les than @ decade removed from communi and sto ling to bevome a democratic sic, Russia was almost inherent Unpredictable. Haghans knowledge of history should ave told him that. (Churchill had decaved in 193, “Tcannor forecast 10 you the action of Russia, Is a riddle wrapped ina mystery inside an “enigma In 1998, t00, Rusia was hevond the realm of econome Fis, even ofthe computers in Greenwich The Fed was well aware ofthe danger of banks basing preditions| two much onthe past Iman open leer to hanks, the Fes tp bank ing supervisor warned, “Banks should resist any tendency to assume thar the unusually favorable economic environment of the Last few years wil continue indefinitely.” Though che ler deal with commercial loans rather than capital markers, i andersored the need to think about “alternative cearios” such as bankeupicies ad