In 1994, Long-Term noticed that this spread was unusually wide. The February 1993 issue was trading at a yield of 7.36 percent. The bond issued six months later, in August, was yielding only 7.24 percent, or 12 basis points, less. Every Tuesday, Long-Term’s partners held a risk-management meeting, and at one of the early meetings, several proposed that they bet on this 12-point gap to narrow. It wasn’t enough to say, “One bond is cheaper, one bond is dearer.” The professors needed to know why a spread existed, which might shed light on the paramount issue of whether it was likely to persist or even to widen. In this case, the spread seemed almost silly. After all, the U.S. government is no less likely to pay off a bond that matures in 29½ years than it is one that expires in thirty. But some institutions were so timid, so bureaucratic, that they refused to own anything but the most liquid paper. Long-Term believed that many opportunities arose from market distortions created by the sometimes arbitrary demands of institutions.7 The latter were willing to pay a premium for on-the-run paper, and Long-Term’s partners, who had often done this trade at Salomon, happily collected it. They called it a “snap trade,” because the two bonds usually snapped together after only a few months. In effect, Long-Term would be collecting a fee for its willingness to own a less liquid bond.
“A lot of our trades were liquidity-providing,” Rosenfeld noted. “We were buying the stuff that everyone wanted to sell.” It apparently did not occur to Rosenfeld that since Long-Term tended to buy the less liquid security in every market, its assets were not entirely independent of one another, the way one dice roll is independent of the next. Indeed, its assets would be susceptible to falling in unison if a time came when, literally, “everyone” wanted to sell.
Twelve basis points is a tiny spread; ordinarily, it wouldn’t be worth the trouble. The price difference was only $15.80 for each pair of $1,000 bonds. Even if the spread narrowed two thirds of the way, say in a few months’ time, Long-Term would earn only $10, or 1 percent, on those $1,000 bonds. But what if, using leverage, that tiny spread could be multiplied? What if, indeed! With such a strategy in mind, Long-Term bought $1 billion of the cheaper, off-the-run bonds. It also sold $1 billion of the more expensive, on-the-run Treasurys. This was a staggering sum. Right off the bat, the partners were risking all of Long-Term’s capital! To be sure, they weren’t likely to lose very much of it. Since they were buying one bond and selling another, they were betting only that the bonds would converge, and, as noted, bond spreads vary much less than bonds themselves do. The price of your home could crash, but if it does, the price of your neighbor’s house will likely crash as well. Of course, there was some risk that the spread could widen, at least for a brief period. If two bonds traded at a 12-point spread, who could say that the spread wouldn’t go to 14 points—or, in a time of extreme stress, to 20 points?
Long-Term, with trademark precision, calculated that owning one bond and shorting another was one twenty-fifth as risky as owning either bond outright.8 Thus, it reckoned that it could prudently leverage this long/short arbitrage twenty-five times. This multiplied its potential for profit but—as we have seen—also its potential for loss. In any case, borrow it did. It paid for the cheaper, off-the-run bonds with money that it borrowed from a Wall Street bank, or from several banks. And the other bonds, the ones it sold short, it obtained through a loan, as well.
Actually, the transaction was more involved, though it was among the simplest in Long-Term’s repertoire. No sooner did Long-Term buy the off-the-run bonds than it loaned them to some other Wall Street firm, which then wired cash to Long-Term as collateral. Then Long-Term turned around and used this cash as collateral on the bonds that it borrowed. On Wall Street, such short-term, collateralized loans are known as “repo financing.”
The beauty of the trade was that Long-Term’s cash transactions were in perfect balance. The money that Long-Term spent going long (buying) matched the money it collected going short (selling). The collateral it paid equaled the collateral it collected. In other words, Long-Term pulled off the entire $2 billion trade without using a dime of its own cash.*
Now, normally, when you borrow a bond from, say, Merrill Lynch, you have to post a little bit of extra collateral—maybe a total of $1,010 on a $1,000 Treasury and more on a riskier bond. That $10 initial margin, equivalent to 1 percent of the bond’s value, is called a haircut. It’s Merrill Lynch’s way of protecting itself in case the price of the bond rises.
The haircut naturally acts as a check on how much you can trade. But if you could avoid the haircut, well, the sky would be the limit. It would be like driving a car that didn’t burn gas: you could drive as far as you wished. What’s more, the rate of return would be substantially higher—if you didn’t have that extra margin tied up at Merrill Lynch.
And from the very start, it was Long-Term’s policy to refuse to pay the haircut or else to substantially reduce it. The policy surely flowed from Meriwether, who, for all his unassuming charm, was fiercely competitive at trading, golf, billiards, horses, and whatever else he touched. Rosenfeld and Leahy, two of the more congenial and laid-back partners, were usually the ones who met with banks, though Hilibrand also got involved. In any case, the partners would insist, politely but firmly, that the fund was so well heeled that it didn’t need to post an initial margin—and, what’s more, that it wouldn’t trade with anyone that saw matters differently. Merrill Lynch agreed to waive its usual haircut requirement and go along. So did Goldman Sachs, J. P. Morgan, Morgan Stanley, and just about everyone else. One firm that balked, PaineWebber, got virtually none of Long-Term’s business. “You had no choice if you were going to do business with them,” recalled Goldman Sachs’s Jon Corzine, J.M.’s admiring rival.
Although Long-Term’s trades could be insanely complex and ultimately numbered in the thousands, the fund had no more than a dozen or so major strategies.9 Some, such as the Treasury arbitrage, involved buying and selling tangible securities. The others, derivative trades, did not. They were simply bets that Long-Term made with banks and other counterparties that hinged on the fate of various market prices.
Imagine, by illustration, that a Red Sox fan and a Yankees fan agree before the season that each will pay the other $1,000 for every run scored by his rival’s team. Long-Term’s derivative contracts were not dissimilar, except that the payoffs were tied to movements in bonds, stocks, and so forth rather than balls and strikes. These derivative obligations did not appear on Long-Term’s balance sheet, nor were they “debt” in the formal sense. But if markets moved against the fund, the result would obviously be the same. And Long-Term generally was able to forgo paying initial margin on derivative deals; it made these bets without putting up any initial capital whatsoever.
Frequently, though not always, it got the same terms on repo financing of actual securities. Also, Long-Term often persuaded banks to lend to it for longer periods than the banks gave to other funds.10 Thus, Long-Term could be more patient. Even if the banks had wanted to call in Long-Term’s loans, they couldn’t have done so very quickly. “They had everyone over a barrel,” noted a senior executive at a top investment bank.
This was where Meriwether’s marketing strategy really paid dividends. If the banks had given it a moment’s thought, they would have realized that Long-Term was at their mercy. But the banks saw the fund not as a credit-hungry start-up but as a luminous firm of celebrated scholars and brilliant traders, something like that New Age “financial intermediary” conjured up by Merton. After all, it was generally believed that Long-Term had the benefit of superior, virtually fail-safe technology. And banks, like some of the press, casually assumed that it was so. Business Week gushed that the fund’s Ph.D.s would give rise to “a new computer age” on Wall Street. “Never has this
