WHAT WENT WRONG?

The Washington Post FUND'S BIG BETTORS ... https://www.washingtonpost.com/archive/busines...

WHAT WENT WRONG? FUND'S BIG BETTORS

LEARNED THAT RISK TRUMPS MATH, HISTORY

A CHART IN SUNDAY'S BUSINESS SECTION LISTING INVESTMENT FIRMS THAT

CONTRIBUTED TO THE RESCUE OF LONG-TERM CAPITAL INVESTMENT L,P.
OMITTED MORGAN STANLEY DEAN WITTER. MORGAN STANLEY AGREED TO
CONTRIBUTE $300 MILLION. (PUBLISHED 09/29/98)

By Steven Mufson
September 27, 1998

The triumph of intellect over reality has been foiled again.

For diplomats, there was the theory about "the end of history." For economists, there was the end of economic cycles. And
in the investment fund business, there was the end of risk, a method of making money cooked up by the fabled John W.
Meriwether and his merry band of bond traders, physicists, Nobel laureate economists and computer programmers.

The idea was good enough to lure 80 investments -- minimum $10 million -- from some of the most respected names in the
financial world to Meriwether's investment fund, Long-Term Capital Management L.P. Bear Stearns & Co. President
James E. Cayne and his deputy, Warren J. Spector, each chipped in. Merrill Lynch & Co. bought a huge chunk and
marketed pieces of it to some of its wealthiest clients, including the company's chairman, David H. Komansky.

David W. Mullins Jr. quit his prized job as vice chairman of the Federal Reserve Board to become a partner. And last year,
Swiss banking giant UBS AG put hundreds of millions of dollars into the fund both as an investor and with plans to parcel
pieces out to rich clients -- plans that never came to fruition.
1 de 7 9/11/19 3:04 a. m.
But risk, alas, triumphed in the end. Today, Long-Term Capital is fighting for its life, its near-collapse threatening such
 WHAT
chaos WENTmarkets
in global WRONG?
thatFUND'S
14 majorBIG BETTORS
banks ...
and investment https://www.washingtonpost.com/archive/busines...
houses coughed up $3.5 billion in new money to save it.
Investments in the firm are worth a fraction of what they were at the beginning of the year. Though many investors
profited handsomely over the past three years, an investment of $10 million in Long-Term Capital at the beginning of this
year is worth about $400,000 today, bankers estimate.

"There's no free lunch," said one banker who took part in negotiations this week about how to rescue Long-Term Capital.
"Math is not the secret of success. . . . The day a guy comes into my office and says I got a black box and there's no way to
lose,' I fire him."

"It's a classic case of greed overcoming prudence," former Fed chairman Paul A. Volcker said at a conference in Boston on
Thursday, referring to the world's current financial crises. "Maybe this applies to Long-Term Capital. It's a story about
volatility that's as old as markets themselves."

In this latest version of the story, Meriwether's firm mastered the art of the esoteric trade. It feasted on disparities between
the current prices being quoted for bonds, stocks, currencies and other securities and their historical values. His investment
vehicle, known as a hedge fund, also sought to profit from anomalies in prices among different segments of financial
markets around the globe.

One source of profits: taking advantage of differences in yields on government bonds issued by various European
countries. Those differences were supposed to get smaller as the common European monetary system grew closer. Another
common technique was to sell bonds such as 30-year Treasuries -- which have such a huge market that they are easy to
dump in bulk without affecting prices very much -- and buy shorter-term, less-liquid bonds and wait until their values
came closer together. A source close to Long-Term Capital said that about 90 percent of the fund's balance sheet was made
up of government securities issued by members of the Group of Seven industrialized nations.

2 de 7 9/11/19 3:04 a. m.

 WHAT WENT WRONG? FUND'S BIG BETTORS ... https://www.washingtonpost.com/archive/busines...

In most cases, Long-Term Capital was taking advantage of tiny differences in values. That meant Meriwether would have
to take huge positions to produce big profits. The firm, for example, would buy and sell $1 million blocks of U.S. Treasury
bonds to eke out $500 to $1,000 per trade, said a source close to the firm.

Borrowed money was essential to leveraging up the invested capital and increasing returns to investors. At its peak, Long-
Term Capital had contracts involving $160 billion worth of securities -- roughly 30 times its capital.

By buying and selling securities simultaneously, Long-Term Capital's partners believed their risks were tiny. Until Aug. 1,
Long-Term Capital never lost more than $100 million, or about 2 percent of the firm's equity, in any month, said a source
close to the firm. And because the trades relied on relative values between securities, whether the prices of the securities
rose or fell as a group was believed to be irrelevant, the source said.

"Granted, we had a huge balance sheet with lots of positions, but we didn't think we had that much risk," a Long-Term
Capital partner told someone close to the firm. "We were looking at day-to-day and month-to-month swings that were very
small. I know it seems incredible. Maybe we got lulled in after four years."

Then the markets began to move against them and the spell broke.
3 de 7 9/11/19 3:04 a. m.
 WHAT WENT
Long-Term WRONG?
Capital's FUND'S
strategies reliedBIG BETTORS
heavily ...
on quantitative analysishttps://www.washingtonpost.com/archive/busines...
and computer models. Employing "quants" became a
trend on Wall Street in the mid-1980s, as investment firms poured millions of dollars into buying high-powered computers
and hiring people -- many of them with doctorates in physics -- who could crank sophisticated equations through them.
The quants distilled the components' risks and rewards and mixed and matched securities in different markets. Many of
Long-Term Capital's trades, for example, had four or five different "legs," said a source close to the firm.

But their sophisticated equations were built on historical data, and that was their fatal flaw. They never figured out what to
do if there were a simultaneous market meltdown worldwide, because that had never happened before on the scale with
which it has happened -- especially since Aug. 17, when Russia devalued its ruble and defaulted on some of its debt.

The result: a flight from risky markets and securities that threw out of whack those relative values Meriwether had
carefully calculated. Risks that were supposed to offset one another began to double up and move against the fund
together. Differences in bond values that in the past had fluctuated by one or two one-hundredths of a percentage point
lurched by as much as a half a percentage point. In a Sept. 2 letter to investors, Meriwether said that 82 percent of the
firm's losses came from these so-called "relative value" trades that had gone bad.

"You essentially make a model about what's likely to happen in the future based on careful probabilistic studies about what
happened in the past," pointed out Roy C. Smith, a professor of finance at New York University's Stern School of
Business.

4 de 7 9/11/19 3:04 a. m.

 WHAT WENT WRONG? FUND'S BIG BETTORS ... https://www.washingtonpost.com/archive/busines...

Another factor threw off Meriwether's computer models. Since Long-Term Capital opened its doors in 1994, many other
big funds and institutions had started playing the same market, using the same strategy. They all started to build up big
losses together, and they all tried to bail out of their investments at the same time.

"A lot of other people put trades on, and in an uncertain world they wanted to get out," said a source close to the firm.
"They all had risk tolerances and . . . everyone was unwinding at once."

Without the capital base to fund losses from its highly leveraged bets, Long-Term Capital wasn't able to withstand short- or
medium-term turmoil. Ironically, Meriwether had actually turned about $2.7 billion of the fund's capital back to investors
at the end of 1997 because "investment opportunities were not large and attractive enough."

By Aug. 1, the firm's equity stood at $4.1 billion; by Sept. 1, it had dropped to $2.3 billion. In his letter to investors,
Meriwether said the relative-value strategy "may require a relatively long convergence horizon." Translation: It was going
to take a long time before his trades would become profitable again.

He asked investors for more money, but there weren't any takers. The horizon grew dark. Over the next 16 days, the fund's
equity
5 de 7
dropped $800 million more, to $1.5 billion. Five days after that, it cratered to just $600 million. Ninety percent of
9/11/19 3:04 a. m.
the equity was wiped out in just 55 days.
 WHAT
With WENT
panicky WRONG?
creditors FUND'StoBIG
threatening forceBETTORS ...
sales of Long-Term https://www.washingtonpost.com/archive/busines...
Capital's holdings, the Federal Reserve Bank of New York
stepped in to organize a recapitalization of the fund. They were working under an urgent deadline. Long-Term Capital's
contracts were written in a way that if the firm defaulted on one payment, all its contracts -- still standing at roughly $100
billion -- could come due and be liquidated immediately. Even now, after the rescue plan has been forged, uncertainty
about the holdings of the secretive fund makes many of the banks coming to the firm's rescue worry that the new money
will soon vanish as well.

"We've done a hopeless job for our investors," one of the firm's partners told a friend, who spoke on the condition of
anonymity. "We're supposed to be the most sophisticated people in the world on this and we made some serious mistakes."

How sophisticated? The 16 Long-Term Capital partners include much of the former Salomon Brothers Inc.'s swaggering
bond-trading team from the 1980s: Mullins, who was also a former assistant Treasury secretary; and Nobel Prize-winning
economists Myron S. Scholes of Massachusetts Institute of Technology and Robert C. Merton of Harvard Business School.

"Long-Term Capital has always been called the Rolls-Royce of hedge funds," said UBS's chief financial officer, Peter
Wuffli. "It had an extremely successful history, a professional team, Nobel Prize winners. Our people, as well as others,
have been actively looking at their activities and strategies over the past few days and convinced themselves a lot of
potential on the upside in helping them out of a difficult situation."

From the outside, not everyone was so sympathetic. In Hong Kong, where monetary authorities have spent $15 billion
battling to defend the Hong Kong dollar and nearly as much propping up stock markets, officials have blamed hedge fund
speculators and have been trying to track movements of money in and out of the city.

And many analysts noted that original investors could still be ahead of the game, despite the fund's near-collapse. If an
individual or institution invested $10 million in 1994, it would have received $18.2 million at the end of 1997. The
remaining interest in the fund would have been worth an additional $10 million at the beginning of the year, but 90 percent
of that or more has been wiped out.

6 de 7 9/11/19 3:04 a. m.

Investors in other wounded hedge funds wish that they, too, could have had the Fed facilitate a plan to help them out of a
 WHAT situation.
difficult WENT WRONG? FUND'S BIG
Victor Niederhoffer ranBETTORS ... that was forced
a hedge fund https://www.washingtonpost.com/archive/busines...
out of business 11 months ago. If creditors had
given Niederhoffer another day or two, his fund might have survived, his associates say.

"If the Fed acted as an intermediary with my creditors, it would have been delightful," Niederhoffer said. "As a matter of
principle, I don't believe government should be involved. It leads to a statist economy, even if it would have made me a
few hundred million dollars richer. It would have been nice." CAPTION: Legendary bond trader Meriwether attracted a
group of partners sophisticated in the world of finance to his Long-Term Capital Management fund. Scholes and Merton
are Nobel Prize- winning economists, and Mullins is a former vice chairman of the Federal Reserve Board. ec CAPTION:
JOHN W. MERIWETHER ec CAPTION: MYRON S. SCHOLES ec CAPTION: ROBERT C. MERTON ec CAPTION:
DAVID W. MULLINS JR. A BIG HELPING HAND This is what investment and commercial bankscontributed to save
Long-Term Capital Management from collapse. They received 90 percent of the fund's equity in return. $300 MILLION
EACH: Bankers Trust Barclays Chase Manhattan Bank Deutsche Bank UBS AG J.P. Morgan Goldman Sachs Merrill
Lynch Credit Suisse First Boston Salomon Smith Barney $300 MILLION TOTAL: Societe Generale Bank Paribas Lehman
Brothers REFUSED TO PARTICIPATE: Bear Stearns Credit Agricole Source: Staff reports ec

0 Comment s

Steven Mufson
Steven Mufson covers the business of climate change. Since joining The Washington Post in 1989, he has covered
economic policy, China, diplomacy, energy and the White House. Earlier he worked for The Wall Street Journal in New
York, London and Johannesburg. Follow 

We dig deeper.
Original reporting, exclusive scoops and more. Subscribe for $1 .

Get this offer

Send me this offer

Already a subscriber? Sign in

7 de 7 9/11/19 3:04 a. m.