Tag: Subprime Crisis

Part Three: The Rise of Long-Term Capital Management and the Superportfolio

This is an extremely compressed version of the story of Long-Term Capital Management, perhaps the most written about corporate failure besides Enron of the last two decades.  If you wish to learn more, I highly recommend Lowenstein’s book When Genius Failed, linked below.

John Meriwether launched the limited partnership of Long-Term Capital Management in 1994.  Limited partnerships are the actual name of the entities commonly known as “hedge funds”.  The name hedge fund is in fact a misnomer; they originally developed that name because the funds were designed to “hedge” against losses by being more conservative than mutual funds, but have developed into the opposite.  The appeal of such funds is that limitations on the number of partners and the overall wealth of those allowed to join (no more than 99 people or entities of a total value of over $1 million, or 500 people or entities worth over $5 million – with those worth less entirely excluded) are coupled with a nearly total lack of government regulation.  Mutual funds are forced to disclose their portfolios and to maintain certain levels of diversification and leverage; limited partnerships are not.

Joining Meriwether as the partners of LTCM were former Salomon arbitrage group members Larry Hilibrand, Eric Rosenfeld, Victor Haghani, Greg Hawkins, and three very notable additions: economists Robert Merton and Myron Scholes, and David Mullins, who was the number-two at the Federal Reserve under Alan Greenspan and had previously been considered his heir apparent.  With such a roster, LTCM launched with capital of $1.4 billion, the largest such launch in financial history.  It had such disparate investors as the national bank of Italy and the President of Merril Lynch, and had an elegant and innovative structure, with the company that employed the partners and traders being a Delaware-registered management services company employed by a Cayman Islands partnership (the fund itself) financed by six international dummy corporations from whom investors in different nations would buy their shares.

Part Two: John Meriwether and the rise of Arbitrage

In the first entry of this narrative, we paid attention to the story of Lewis Ranieri and the Salomon Brothers mortgage desk in the 1980s.  We will now focus on another major player at Salomon in the 1980s, one whose fame and influence is even greater than Ranieri’s, and who is as different from Ranieri as could possibly be.  That man is John Meriwether.

Ranieri was a loud, fat, New York-born Italian who started in the Salomon mail room and had never gone to college.  Meriwether, on the other hand, was famous for his quiet and reserve.  Michael Lewis, in his book Liar’s Poker, opens with a famous story about Meriwether that even he has admitted is probably apocryphal: the game of Liar’s Poker, a modified game of poker played using the serial numbers on dollar bills, was vastly popular at Salomon at the time, and the inscrutable Meriwether was the firm’s best player.  The story goes that Salomon’s managing partner, John Gutfreund, challenged Meriwether to a single hand of liar’s poker for the sum of one million dollars, and Meriwether responded that he would only play if the sum for the hand was ten million (Gutfreund turned him down, which Lewis says was the intent).  

His first notable trade at Salomon was a classic bit of arbitrage; a trader named J.F. Eckstein’s firm was failing in 1979, and tried to get Meriwether to buy out his position.  Eckstein had sold millions in US Treasury bills, while buying millions in Treasury bill futures (futures are a contract where two parties agree to the sale of a commodity at a set price at a predetermined moment in the future).  At the time, treasury futures were selling at a discount compared to the actual bills.  What Eckstein had done was place a two hundred million dollar bet that the prices of the bills and the futures would eventually converge, but the longer that took, the more his equity value was disappearing.  If he didn’t sell his position, he would be ruined long before the prices converged.

Most people, and most experts, tend to feel that the US economy is in trouble.  Many news stories are a significant part of this: the subprime mortgage “crisis”, the falling value of the dollar, the restatements of financial earnings from Wall Street.  But the actual narrative of how this happened is very poorly understood, and rarely explained in its entirety.  And much information which contradicts what we think we know exists as well: that subprime mortgages represent less than 2% of the equity market, for example, or that over half of subprime borrowers are still making timely payments.

Due to the failure of most Americans to understand the narrative of how we got here, most of us don’t understand what the problems actually are, nor do the politicians vying to “solve” the problems feel the need to address the actual underlying issues.  It is my feeling that it is therefore important to try to tell the story of how we got here in a narrative fashion.