From Slate (October 3-5, 1998)

Explainer Newspapers report that Long-Term Capital Management--the high-profile hedge fund run by a hotshot bond trader and two Nobel laureates--nearly plunged the world into financial ruin last week. And it's not just journalists who say so. Intent on forestalling global financial disaster, a group of big-money Wall Street banks convened by the Fed ponied up almost $3.5 billion to bail out the fund. 

What are hedge funds? Why are their meltdowns so spectacular?

A hedge fund is nothing more than a pool of money which a manager invests for a group of wealthy investors (minimum buy-in is often $10 million). Hedge funds promise an investment strategy that makes money when the market rises and when it falls. The hedge fund manager takes 15 to 20 percent of profits, the rest goes to investors. Sounds grand, but how does it work?

Long-Term's manager, backed by a star-studded research division, dealt in so-called derivatives. Derivatives are financial creations whose value is based upon, or derived from, the price of some underlying item, like stocks, bonds, commodities, or currencies. For example: stock options are a wager on the future price of, say, AT&T stock; commodity futures are a wager on the future price of, say, pork bellies. Both count as derivatives, as do more exotic creations like swaptions and quantos (don't ask). 

Derivatives permit a fund manager to reduce certain kinds of risk. Suppose the manager is holding a portfolio whose value rises when interest rates rise but falls when interest rates fall. Adding an appropriate derivative--one which bets for an interest rate fall--to the portfolio mitigates losses if, in fact, interest rates fall. (Hence the name "hedge funds"--one investment position offsets, or hedges, another investment position.)

Of course hedge fund managers do more than just bet both for and against some outcome. At the end of the day, they must bet on something, right? It seems that Long-Term was betting on the yields of bonds from G-7 countries (no one is sure since Long-Term won't disclose details of its dealings). By analyzing historical data, Long-Term developed predictions about the relative rates of return on different countries' bonds. The firm used a series of hedges--which means buying derivatives--to make sure that they were insulated from general rises and falls in interest rates, stock exchanges etc... That's the beauty of hedging with derivatives--they let you bet on precisely what you want to. In theory, other perturbations are not supposed to affect your assets.

But something happened that the financial "rocket scientists"--so named because many have doctorates in math or physics--either didn't expect or couldn't conceive of. An article by MIT economist Paul Krugman considers just what might have gone wrong. (He thinks the rocket scientists were smart but naïve. In other words, their computer models didn't sufficiently account for extremely unlikely but extremely serious developments, like economic crisis in Russia and political gridlock in Japan.)

Krugman also thinks that investors were naïve to believe that Long-Term offered return without risk. The chance of things going wrong may have been slim, but when things went wrong, they went spectacularly wrong. One key feature of derivatives is they can get you in a pot of trouble very quickly. If you buy stock, and its price falls by 10 percent, you've simply lost 10 percent of your money. But if, for instance, you buy a so-called call option (which is a bet that the stock will rise) and the stock falls by 10 percent, you may lose all your money. (A call option allows you to buy the stock at a specified price, known as the strike price. If the market price falls and stays below the strike price, then the option is worthless.) There are even derivatives--such as futures contracts--with which you can lose more than your original investment if you bet on the wrong horse. No one but Long-Term really knows what Long-Term held, but the fund's asset pool has reportedly shrunk to one-tenth the size it was in January.

By Paul Krugman
(posted Thursday,  Oct. 1, 1998)
Rarely in the course of human events have so few people lost so much money so quickly. There is no mystery about how Greenwich-based Long-Term Capital Management managed to make billions of dollars disappear. Essentially, the hedge fund took huge bets with borrowed money--although its capital base was only a couple of billion dollars, we now know that it had placed wagers directly or indirectly on the prices of more than a trillion dollars' worth of assets. When it turned out to have bet in the wrong direction, poof!--all the investors' money, and probably quite a lot more besides, was gone.

But the really interesting questions are all about why. Why did such smart people--and the principals in LTCM are smart, even if some of them have Nobel Prizes in economics--take such seemingly foolish risks? Why did the world give them so much money to play with? As Akira Kurosawa could have told us, the beginning and end of the story are not enough: We need to know the motivations and behavior in between.

LTCM was secretive about how it made money, but the basic idea went something like this. Imagine two assets--say, Italian and German government bonds--whose prices usually move together. But Italian bonds pay higher interest. So someone who "shorts" German bonds--receives money now, in return for a promise to deliver those bonds at a later date--then invests the proceeds in Italian bonds, can earn money for nothing.

Of course, it's not that simple. The people who provide money now in return for future bonds are aware that if the prices of Italian and German bonds happen not to move in sync, you might not be able to deliver on your promise. So they will demand evidence that you have enough capital to make up any likely losses, plus extra compensation for the remaining risk. But if the required compensation and the capital you need to put up aren't too large, there may still be an opportunity for an exceptionally favorable trade-off between risk and return.

OK, it's still not that simple. Any opportunity that straightforward would probably have been snapped up already. What LTCM did, or at least claimed to do, was find less obvious opportunities along the same lines, by engaging in complicated transactions involving many assets. For example, suppose that historically, increases in the spread between the price of Italian as compared with German bonds were correlated with declines in the Milan stock market. Then the riskiness of the bet on the Italian-German interest differential could be reduced by taking out a side bet, shorting Italian stocks--and so on. In principle, at least, LTCM's computers--programmed by those Nobel laureates--allowed the firm to search for complex trading strategies that took advantage of even subtle market mispricings, providing high returns with very little risk.

But in the course of a couple of months, somehow it all went bad. What happened?

One version of events makes the principals at LTCM victims of circumstance. Their trading strategy, goes this story, was basically sound. But there is no such thing as an absolutely risk-free investment strategy. If the gods are sufficiently against you, if a peculiar, nay, unprecedented combination of events--debacle in Russia, stalemate in Japan, market crash in the United States--comes to pass, even the best strategy comes to grief. According to this version, there is no particular moral to the story, except that **** happens.

Most people in the investment world, however, are not that forgiving of LTCM. Their version of events does not accuse the principals of evil intent, but it does accuse them of myopia. The magic word is "kurtosis," a k a "fat tails." The story goes like this: Everyone knows that there are potential events that are not likely to happen but will have very big effects on financial markets if they do. A realistic assessment of risk should take into account the possibility of these large, low-probability events--in effect, should allow for the reality that now and then **** does indeed happen. But the wizards at LTCM, so the story goes, forgot about reality. They treated the statistical distributions found by their computers, based on data from a period when **** didn't happen, as if they represented the entire universe of possibilities.

As a result, they greatly understated the risk to which they were exposing both their investors and those who lent them money.

However, knowing the people who ran LTCM--who, to repeat, are as smart as they were supposed to be--it is kind of hard to believe that they were really that naive. These were experienced hands (not your typical 29-year-old traders, who don't remember anything before 1994). Anyone who has lived through energy crisis and debt crisis, inflation and disinflation, Reaganomics and Clintonomics, has to know that big surprises are part of life. Which brings us to the third, more sinister version of events: that LTCM knew exactly what it was doing.

Here's the way one investment industry correspondent--who prefers to be nameless--put it to me. Suppose, he says, that someone was willing to lend you a trillion dollars to invest as you like. What that lender has done is in effect to give you a "put option" on whatever you buy with that trillion dollars. That is, because you can always declare bankruptcy and walk away, it is as if you owned the right to sell those assets at a fixed price, whatever might happen in the market. And because the value of an option depends positively on "volatility"--the uncertainty about the future value of the underlying asset--the rational way to maximize the value of that option is to invest the money in the riskiest, most volatile assets you can find. After all, it's heads you become wealthy beyond the dreams of avarice, tails you get some bad press (and lose the money you yourself put in--but when you are allowed to make a trillion-dollar gamble with only $2.3 billion of your investors' capital, that hardly matters). And as my correspondent reminds us, the people who ran LTCM understood all about this sort of thing--indeed, those Nobel laureates got their prizes for, guess what, developing the modern theory of option pricing.

This "moral hazard" version of the story may seem a bit too stark to be believed. Did the managers really sit around saying, "Hey, let's gamble with the money those suckers have lent us"? Actually, it's a possibility: I don't know any of the LTCM players personally, but some of the hedge fund types I do know are, as my correspondent puts it, "about as moral as great white sharks." But anyway, never underestimate the power of hypocrisy. It is entirely possible for a man to act in a crudely cynical way without admitting it even to himself. Given their enormous incentive to take improper risks, it would actually be amazing if the managers at LTCM didn't respond in the normal way.

But we are still not quite there. For the remaining puzzle is why the world provided LTCM with so much money to lose. All those clever strategies depended on counterparts--on people and institutions who would provide cash now in return for the promise of German bonds, or whatever, later.

Why were those counterparts so willing to play along? (LTCM, as a matter of principle, refused to divulge its assets or strategy--so anyone who entered a contract with the firm was accepting an unknown risk.) Were these counterparts--mainly big banks and other institutional investors--simply naive?

Some of my correspondents say no. They think the big boys knew the risks but believed that if LTCM came to grief its creditors would be protected from loss by the government. In effect, they believe the LTCM story is mainly an updated version of what happened to the savings and loans, in which government guarantees underwrote an era of high-rolling risk-taking. True, there is no formal guarantee. But they believe that there was an implicit understanding that any major financial institution is simply "too big to fail."

But I don't buy it. Economists often make the working assumption that the private sector always knows what it is doing, that markets do stupid things only when the government gives them distorted incentives. It's a useful working assumption, but it is no more than that. In fact, everything I can see suggests that the big boys really were naive--that, star struck by LTCM's charismatic leader and his prestigious team, they failed to ask even the simplest questions (such as, "How much money have you borrowed from other people?")

Of course, if you believe that big, supposedly sophisticated players can be that foolish--or, for that matter, if you believe that they are not foolish but do foolish things because the government will always bail them out--you start to wonder whether our whole financial structure is as sound as we like to imagine. Did somebody say "crony capitalism"?

October 12, 1998

                     The big hedge-fund bailout helps some fat cats, but makes our
                     case for free global markets look awfully thin. 

                     By Allan Sloan 

                     The collapse and rescue of the biggest hedge fund in the United States
                     shows how dangerous preaching can be. For 15 months, as financial
                     markets in country after country collapsed like straw huts in a typhoon,
                     the United States lectured the rest of the world about the evils of crony
                     capitalism--of bailing out rich, connected insiders while letting everyone
                     else suffer. U.S. officials and financiers talked about letting market forces
                     allocate capital for maximum efficiency. Thai peasants, Korean
                     steelworkers and Moscow pensioners may suffer horribly as their local
                     economies and currencies collapse--but we solemnly told them that was
                     a cost they had to pay for the greater good of the world. Capital should
                     be free to flow to the places where it gets the highest and best use.
                     Cronyism bad. Capitalism good. 

                     Then came the imminent collapse of Long-Term Capital Management
                     L.P., the quintessential member of The Club, with rich fat-cat investors
                     and rich hotshot connected managers. Faster than you can say "bailout,"
                     crony capitalism U.S. style raised its ugly head--the New York branch of
                     the Federal Reserve Board orchestrated a $3.65 billion rescue by 14
                     banks and brokerage houses. John Meriwether and the rest of the guys
                     who ran the fund onto the rocks got to keep their jobs. The fund's
                     investors, whose stakes would have been wiped out in a collapse,
                     salvaged about seven cents on the dollar, with a chance to recover more
                     if things go well. The rescuers even agreed to pay a management fee on
                     their rescue fund, albeit at less than half of Long-Term Capital's normal,
                     obscene rate. 

                     It may even be that the fund's managers outfaced a team led by Warren
                     Buffett, America's smartest investor (and a board member of
                     NEWSWEEK's parent, The Washington Post Company) and risked
                     setting off a worldwide financial meltdown to get a better deal than a
                     cut-rate Buffett offer that would have ousted them. Long-Term Capital's
                     supporters insist that Buffett's offer had technical glitches, and that it was
                     yanked off the table almost instantly before Long-Term could help solve
                     them. So take your pick. Either Buffett and his partners were trying to
                     use Long-Term's distress to make a good deal for themselves, or
                     Long-Term rolled the dice with the world's financial system. Or both.
                     Either way, it was not one of capitalism's more edifying moments. 

                     How on earth can anyone justify bailing out rich managers and rich
                     investors at the same time that we're insisting welfare mothers shape up,
                     and Congress may soon make it harder for little people maxed out on
                     credit cards to get a fresh start? Not a bad question. Fed Chairman Alan
                     Greenspan argued with passion and at least some justification in
                     congressional testimony last week that the Fed didn't dare let Long-Term
                     Capital go out of business because its failure could have triggered
                     worldwide havoc. Markets are already nervous about the seemingly
                     endless series of financial collapses, which started when Thailand
                     devalued its currency in July of 1997, and have hopscotched across the
                     globe. The International Monetary Fund has thrown billions into the pot,
                     with little success so far. And now, the so-called "Asian contagion" may
                     be about to become the "U.S. mess." 

                     And make no mistake about it: hedge funds are a nob's game. They're
                     restricted to rich investors, and they have to tell little or nothing to
                     anyone, unlike regular mutual funds, which have to make endless
                     disclosures. The idea is that rich investors know what they're doing, and
                     that the banks and brokerage houses that lend money to hedge funds will
                     keep an eye on things. Long-Term Capital was the hedge fund of hedge
                     funds: it had two Nobel laureates on staff, not to mention some of the
                     best and brightest traders and computer jockeys on Wall Street. It
                     wouldn't accept an investment of less than $10 million, and it insisted you
                     commit the money for at least three years. It wouldn't even tell you what
                     it was doing with your money. And talk about snooty. At the end of last
                     year, Long-Term refunded $2.7 billion to investors, many of whom didn't
                     want their money back, in order to maximize returns and to increase
                     Long-Term managers' stake in the fund to 30 percent from about 20

                     When the government orchestrates a bailout of such an outfit, it's
                     tempting just to demonize Long-Term's managers, investors and lenders
                     for greed, foolishness and blindness. Heaven knows, they deserve it. But
                     instead of piling on, let's look at what the Long-Term Capital saga tells us
                     about the way markets work. This account is based on research, public
                     records and background sessions with players and with people familiar
                     with what the players have to say. Sorry to be so vague, but the people
                     who really know what went on aren't exactly shouting it on the record
                     from the rooftops. 

                     Let's start with the offer faxed to Long-Term Capital on Sept. 23 by a
                     group consisting of Buffett, Goldman Sachs and American International
                     Group, a giant insurance holding company. Buffett and partners offered
                     to buy out the fund's investors for $250 million, and to put another $3.75
                     billion into the fund to bring its capital into some reasonable balance with
                     its borrowings, which totaled about $80 billion. The terms Buffett offered
                     were far less favorable to Long-Term's investors--and especially to its
                     managers, whom he would have fired--than what the Fed-led bailout
                     ultimately offered. 

                     Buffett wasn't offering public charity. He was trying to do what he
                     preaches: buy something for much less than he thinks it's worth. Ditto for
                     Goldman Sachs, which made tons of money dealing in bankruptcies,
                     salvaging financially distressed real estate like New York City's
                     Rockefeller Center, and scarfing up property that regulators acquired
                     during the savings-and-loans collapse of the 1980s. American
                     International Group isn't a bunch of cupcakes, either. These folks weren't
                     out to save the world's financial markets; they were out to make a buck
                     off Long-Term Capital's barely breathing body. 

                     The reason Long-Term Capital was in such dire straits was the financial
                     meltdown in Russia this past summer. Ironically, in less than a decade as
                     a capitalist country--make that a pseudo-capitalist country--Russia
                     inflicted more damage on the world's capitalists than it did in 70 years as
                     a communist country. Russia managed the amazing feat of defaulting on
                     ruble-denominated bonds even though it can print rubles. It had promised
                     a week earlier to pay its debts, so its default was a special shock.
                     Investors yanked their money from almost everywhere and sought safety
                     in the United States. Specifically, they bought lots of 30-year U.S.
                     Treasury bonds. That's because, for reasons too involved to go into, it's
                     easier to buy and sell large quantities of 30-year bonds than it is to buy,
                     say, 30-year Treasuries that were issued three years ago and are now
                     27-year bonds. 

                     The enormous buying pressure on 30-year Treasuries made those bonds
                     much more expensive than 27-year Treasuries. So instead of the spreads
                     between 30-year and 27-year Treasuries narrowing, as Long-Term
                     Capital's computer-driven trading strategy predicted, the spreads grew.
                     A similar thing happened in Europe, as investors flocked to German
                     bonds, considered the safest on the Continent. This messed up the bet by
                     Long-Term Capital and many other players that the move to a single
                     currency, the euro, would cause interest rates on bonds of various
                     European countries to move closer together. Instead, spreads widened
                     as investors pounded into German bonds. These things weren't rational,
                     but they happened. And Long-Term, which prided itself on being a clutch
                     of astute traders, couldn't handle it. 

                     If Long-Term Capital had not hocked itself to the eyeballs, it would have
                     lost some money, but its survival wouldn't have been in doubt. But even
                     by the free-swinging standards of hedge funds, Long-Term was a player.
                     The firm convinced itself--and presumably, its lenders--that its strategy
                     was low-risk, and it was safe to borrow 20 or more dollars for each
                     dollar investors had in the fund. It started the year with about $4.7 billion
                     of investors' capital, and it borrowed as much as $120 billion. That's a
                     mighty thin cushion if things go bad--which they did in July, when
                     investors' panicky retreat from Russia picked up steam. And in August,
                     when things got worse. 

                     We'll skip some of the gory details. Suffice it to say that Long-Term
                     Capital looked for money everywhere. But the more it looked, the
                     jumpier potential investors became. Hoping for one-stop shopping, the
                     fund approached megahitters like Buffett and Goldman. Buffett got to
                     examine the books. Others may have gotten a look, too. 

                     By late September, the fund's lenders figured out something was wrong,
                     and were getting ready to pull the plug. By then, the fund had shrunk to
                     $80 billion of assets from the aforementioned $125 billion. But its
                     capital--the lenders' cushion--was down to about $600 million. That's a
                     lot of money, but it's less than one hundredth of the borrowings. A rescue
                     plan mounted by Merrill Lynch and J.P. Morgan came to naught. By
                     Sept. 23, when New York Fed chief William McDonough convened the
                     now famous emergency meeting, things were desperate. People didn't
                     expect the fund to survive past Sept. 24 without some sort of rescue.
                     Rather than risk the consequences of a collapse that could have damaged
                     them in any number of ways, the 14 players forked over their $3.65
                     billion. They got 90 percent of the fund. Do the math, and you see this
                     values the remaining 10 percent at a tad over $400 million. That's much
                     more than Buffett's $250 million. And by staying in the fund, the old
                     investors get a chance to profit when (and if) the fund starts making
                     money again. Meriwether and company don't have to file for
                     unemployment insurance just yet. They've been seriously hurt,
                     considering that their stake in the fund, worth around $1.4 billion at the
                     start of the year, is now valued at around $120 million. But that's enough
                     to keep most of them off food stamps--though some of the partners went
                     into hock to raise investment money and may end up in personal
                     bankruptcy. But they're still employed and get another couple of spins at
                     the roulette wheel. 

                     The new investors are also paying them a fee of 1 percent of assets a
                     year, plus 15 percent of any profit the fund makes above a benchmark
                     currently in the 5 percent range. That's less than the normal fee, 2 percent
                     of assets and 25 percent of profits. But it's a helluva lot of money, even
                     though the new investors get a half interest in the management company,
                     which effectively reduces the fee by 50 percent. Why pay anything? The
                     explanation is that the fund has to keep paying its 170 employees while it
                     works down its positions, and has to give them an incentive to hang
                     around. Just wait until the firm's payroll leaks into the public domain; the
                     shouts will be astounding. 

                     Last week, for the first time in years, a Greenspan congressional
                     performance--he appeared to explain the bailout--evoked criticism and
                     sharp questions rather than the usual adoration. Criticism of the bailout is
                     rising abroad--payback, of sorts, for years of America's boastfulness,
                     triumphalism and preaching of capitalist values that were discarded when
                     they became inconvenient. If Greenspan's political support crumbles, so
                     will America's ability to influence events. Markets run on credibility, and
                     just spewing hot air won't cut it. As the Prophet Hosea observed, "They
                     have sown the wind, and they shall reap the whirlwind."