Rosenfeld, Hawkins, and Leahy celebrated by purchasing a shipment of fine Burgundies ample enough to last for years. In addition to its eleven partners, the fund had about thirty traders and clerks and $10 million worth of SPARC workstations, the powerful Sun Microsystems machines favored by traders and engineers. Long-Term’s fund-raising blitz had netted $1.25 billion—well short of J.M.’s goal but still the largest start-up ever.20
They [Long-Term] are in effect the best finance faculty in the world. –INSTITUTIONAL INVESTOR
THE GODS SMILED on Long-Term. Having raised capital during the best of times, it put its money to work just as clouds began to gather over Wall Street. Investors long for steady waters, but paradoxically, the opportunities are richest when markets turn turbulent. When prices are flat, trading is a dull sport. When prices begin to gyrate, it is as if little eddies and currents begin to bubble in a formerly placid river. This security is dragged with the current, that one is washed upstream. Two bonds that once journeyed happily in tow are now wrenched apart, and once predictable spreads are jolted out of sync. Suddenly, investors feel cast adrift. Those who are weak or insecure may panic or at any rate sell. If enough do so, a dangerous undertow may distort the entire market. For the few who have hung on to their capital and their wits, this is when opportunity beckons.
In 1994, as Meriwether was wrapping up the fund-raising, Greenspan started to worry that the U.S. economy might be overheating. Mullins, who was cleaning out his desk at the Fed and preparing to jump to Long-Term, urged the Fed chief to tighten credit.1 In February, just when interest rates were at their lowest—and, indeed, when investors were feeling their plummiest—Greenspan stunned Wall Street by raising short-term interest rates. It was the first such hike in five years. But if the oracular Fed chief had in mind calming markets, the move backfired. Bond prices tumbled (bond prices, of course, move in the opposite direction of interest rates). And given the modest nature of Greenspan’s quarter-point increase, bonds were falling more than they “should” have. Somebody was desperate to sell.
By May, barely two months after Long-Term’s debut, the thirty-year Treasury bond had plunged 16 percent from its recent peak—a huge move in the relatively tame world of fixed-income securities—rising in yield from 6.2 percent to 7.6 percent. Bonds in Europe were crashing, too. Diverse investors, including hedge funds—many of which were up to their necks in debt—were fleeing from bonds. Michael Steinhardt, one such leveraged operator, watched in horror. Steinhardt, who had bet on European bonds, was losing $7 million with every hundredth of a percentage point move in interest rates. The swashbuckling Steinhardt lost $800 million of his investors’ money in a mere four days. George Soros, who was jolted by a ricochet effect on international currencies, dropped $650 million for his clients in two days.2
For Meriwether, this tumult was the best of news. One morning during the heat of the selling, J.M. walked over to one of his traders. Glancing at the trader’s screen, J.M. marveled, “It’s wave after wave of guys throwing in the towel.” As J.M. knew, panicky investors wouldn’t be picky as they ran for the exits. In their eagerness to sell, they were pushing spreads wider, creating just the gaps that Meriwether was hoping to exploit. “The unusually high volatility in the bond markets … has generally been associated with a widening of spreads,” he chirped in a—for him—unusually revealing letter to investors. “This widening has created further opportunities to add to LTCP’s convergence and relative-value trading positions.”3 After two flat months, Long-Term rose 7 percent in May, beginning a stretch of heady profits. It would hardly have occurred to Meriwether that Long-Term would ever switch places with some of those panicked, overleveraged hedge funds. But the bond debacle of 1994, which unfolded during Long-Term’s very first months, merited Long-Term’s close attention.
Commentators began to see a new connectedness in international bond markets. The Wall Street Journal observed that “implosions in seemingly unrelated markets were reverberating in the U.S. Treasury bond market.”4 Such disparate developments as a slide in European bonds, news of trading losses at Bankers Trust, the collapse of Askin Capital Management, a hedge fund that had specialized in mortgage trades, and the assassination of Mexico’s leading presidential contender all accentuated the slide in U.S. Treasurys that had begun with Greenspan’s modest adjustment.
Suddenly markets were more closely linked—a development with pivotal significance for Long-Term. It meant that a trend in one market could spread to the next. An isolated slump could become a generalized rout. With derivatives, which could be custom-tailored to any market of one’s fancy, it was a snap for a speculator in New York to take a flier on Japan or for one in Amsterdam to gamble on Brazil—raising the prospect that trouble on one front would leach into the next. For traders tethered to electronic screens, the distinction between markets—say, between mortgages in America and government loans in France—almost ceased to exist. They were all points on a continuum of risk, stitched together by derivatives. With traders scrambling to pay back debts, Neal Soss, an economist at Credit Suisse First Boston, explained to the Journal, “You don’t sell what you should. You sell what you can.” By leveraging one security, investors had potentially given up control of all of their others. This verity is well worth remembering: the securities might be unrelated, but the same investors owned them, implicitly linking them in times of stress. And when armies of financial soldiers were involved in the same securities, borders shrank. The very concept of safety through diversification—the basis of Long-Term’s own security—would merit rethinking.
Steinhardt blamed his losses on a sudden evaporation of “liquidity,” a term that would be on Long-Term’s lips in years to come.5 But “liquidity” is a straw man. Whenever markets plunge, investors are stunned to find that there are not enough buyers to go around. As Keynes observed, there cannot be “liquidity” for the community as a whole.6 The mistake is in thinking that markets have a duty to stay liquid or that buyers will always be present to accommodate sellers. The real culprit in 1994 was leverage. If you aren’t in debt, you can’t go broke and can’t be made to sell, in which case “liquidity” is irrelevant. But a leveraged firm may be forced to sell, lest fast-accumulating losses put it out of business. Leverage always gives rise to this same brutal dynamic, and its dangers cannot be stressed too often.
Long-Term was doubly fortunate: spreads widened before it invested much of its capital, and once opportunities did arise, Long-Term was one of a very few firms in a position to exploit the general distress. And its trades were good trades. They weren’t risk-free; they weren’t so good that the fund could leverage indiscriminately. But by and large, they were intelligent and opportunistic. Long-Term started to make money on them almost immediately.
One of its first trades involved the same thirty-year Treasury bond. Treasurys (of all durations) are, of course, issued by the U.S. government to finance the federal budget. Some $170 billion of them trade each day, and they are considered the least risky investments in the world. But a funny thing happens to thirty-year Treasurys six months or so after they are issued: investors stuff them into safes and drawers for long-term keeping. With fewer left in circulation, the bonds become harder to trade. Meanwhile, the Treasury issues a new thirty-year bond, which now has its day in the sun. On Wall Street, the older bond, which has about 29½ years left to mature, is known as off the run; the shiny new model is on the run. Being less liquid, the off-the-run bond is considered less desirable. It begins to trade at a slight discount (that is, you can
