or two very particular aspects, so as to offer a potential for profit. Put differently, in any given strategy, Long-Term typically wanted exposure to one or two risk factors—but no more. In a common example—yield-curve trades—interest rates in a given country might be oddly out of line for a certain duration of debt. For instance, medium-term rates might be far higher than short-term rates and almost as high as long-term rates. Long-Term would concoct a series of arbitrages betting on this bulge to disappear.
The best place to look for such complex trades was in international bond markets. Markets in Europe, as well as in the Third World, were less efficient than America’s; they had yet to be picked clean by computer-wielding arbitrageurs (or professors). For Long-Term, these underexploited markets were a happy hunting ground with a welter of opportunities. In 1994, when the trouble in the U.S. bond market rippled across the Atlantic, the spreads between German, French, and British government debt and, respectively, the futures on each country’s bonds, widened to nonsensical levels. Long-Term plunged in and made a fast profit.17 It also sallied into Latin America, where spreads had widened as well.18 The positions were small, but Long-Term was pursuing every angle—you don’t find nickels lying on the street. Then, Eric Rosenfeld found a few “coins” in Japan, arbitraging warrants on Japanese stocks against options on the Tokyo index—one of Long-Term’s first excursions into equities.
By the mid-1990s, Europe had become a playground for international bond traders, who were hotly debating the outlook for monetary union. Its markets were increasingly unsettled by the prospect—still much in doubt—that France, Germany, Italy, and other age-old nation-states would really merge their currencies, abandoning their francs, marks, and lire for freshly minted euros. Every trader had a different view—just the sort of uncertain climate in which Long-Term thrived. Many investment banks were betting that bonds issued by the weaker countries, such as Italy and Spain, would strengthen relative to those of Germany, on the theory that if union did come about, it would force a convergence of interest rates all across Europe. Long-Term did some of these trades, but as usual, the partners were reluctant to risk too much on a broad economic theory. Long-Term’s expertise was in the details. When it came to forecasting geopolitical trends, it did not have any apparent edge. What’s more, the mostly American partners were Euro-skeptics. With Europe’s highly regulated economies perennially trailing America’s, the Continent seemed hopelessly rigid. A Swiss partner, Hans Hufschmid, tried to push the convergence theme, but the American partners, including Victor Haghani, the free-spirited London chief, resisted.
Haghani preferred to focus on strategies that were confined to single countries, where there would be fewer risk factors. For instance, he arbitraged two issues of gilts, the British equivalent of Treasurys, one of which was cheaper owing to an unfavorable tax treatment. When the U.K. government reversed its stance, Long-Term quickly made $200 million.19
Haghani frequently traded the yield curve of a country against itself. Thus, he might go long on Germany’s ten-year bonds and sell its five-year paper, a subtle trade that required command of the math along with a keen appreciation for local economic trends. But at least it did not require comparing the trends in Germany with, say, the trends in Spain.
Newspaper accounts of Long-Term generally overlooked Haghani, who was intensely private. The press played up Meriwether’s leadership and Merton’s and Scholes’s “models.” But in fact Haghani was a critical player. While J.M. presided over the firm and Rosenfeld ran it from day to day, Haghani and the slightly senior Hilibrand had the most influence on trading. Similarly brilliant and mathematically adept, they spoke in a code that outsiders found impenetrable.
Although the two operated mostly as a team, Haghani was far more daring. A natural trader, Haghani had an intuitive feeling for markets and a volatile, impulsive streak. If a model identified a security as mispriced and if the firm felt it understood why the distortion had occurred, Hilibrand tended to go right ahead. Haghani, who trusted his instincts, might gamble on the security’s becoming even more mispriced first. Barely thirty-one years old when Long-Term started (Hilibrand was thirty-four, Rosenfeld forty, and Meriwether forty-six), the swarthy, bearded Haghani routinely swung for the fences. Though a lively raconteur, he was less direct than Hilibrand: you could never tell if Haghani was challenging you in earnest or playing poker. He had a youthful impetuousness and belief in himself, perhaps the result of his privileged background.
The son of a wealthy Iranian importer-exporter and an American mother, Haghani grew up keenly aware of the political crosscurrents that often overwhelm the best-laid business plans. As a teenager, he had spent two years in Iran with his father, whom he adored; then the revolution had forced them to flee. At Salomon Brothers, Haghani had spent a lot of time in the London and Tokyo bureaus, where he had pushed the local traders to adopt the Arbitrage Group’s model of markets and had exhorted the often bewildered staffers to trade in bigger size. He returned to London with Long-Term Capital Management just as the Continent was bubbling with talk of monetary union.
Haghani shunned the City, London’s buttoned-down equivalent of Wall Street, and rented quarters in Mayfair, a lively fashion district. He ran the office informally, encouraging the staff to join him in give-and-take and spirited banter. His traders and analysts worked long hours, but they were motivated by the lure of Long-Term’s growing profits and humbled by the sight of their boss trundling to the office on a bicycle. When the action abated, the traders would drift to a poolroom off the trading floor, where Haghani would issue challenges to visitors. (J.M., too, on his visits to London, would inevitably pick up the cue stick and take on all comers.) Less introverted than some of his partners, Haghani frequently invited traders home to dinner. After Long-Term’s first big month, in May, he assembled the entire London staff, including the secretaries, and told them how the money had been made. This would have been heresy at the stiffer and more secretive Greenwich headquarters, where a rigid caste system prevailed.
Haghani’s biggest trade was Italy—a bold choice. Italian finance was a mess, as was Italian politics. The fear that Italy might default on its loans, coupled with the still considerable strength of the Italian Communist Party, had pushed Italy’s interest rates to as much as 8 percentage points over Germany’s—a huge spread. Italy’s bond market was still evolving, and the government was issuing lots of paper, partly to attract investors. For bond traders, it was fertile territory. Obviously, if Italy righted itself, people who had bet on Italy would make out like bandits. But what if it didn’t?
The Italian market was further complicated because Italy had a quirky tax law and two types of government bonds—one of which paid a floating rate, the other a fixed rate. Strangely, the Italian government was forced (by an untrusting bond market) to pay an interest rate that was higher than the rate on a widely traded interest rate derivative known as “swaps.” Swap rates are generally close to private-sector bank rates. Thus, the bond market was rating the Italian government as a poorer risk than private banks.
Haghani thought the market was seriously overstating the risk of the government’s defaulting—relative to the price it was putting on other risks. With characteristic derring-do, he recommended a king-size arbitrage to exploit the supposed mispricing. It was a calculated gamble, because if Italy did default, Long-Term’s counterparties might walk away from their contracts—and Long-Term could lose its shirt. To the American partners, who remained skeptical about Italy, this was a major worry. The risk-averse Bill Krasker was especially concerned, and the partners heatedly debated Italy for hours.
In simple terms, the arbitrage zeroed in on the market’s utter lack of respect for Rome. But nothing at Long-Term was ever simple. Specifically, Haghani, who eventually prevailed, bought the fixed-rate Italian government bonds and shorted the fixed rate on Italian swaps. He also bought the floating-rate government paper, a coup for Long-Term because few others could get hold of this thinly traded security. Haghani balanced that with a short
