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 much academic talent been given this much money to bet with,” the magazine observed in a cover story published during the fund’s first year.11 If a new age was coming, no one wanted to miss it. Long-Term was as fetching as a debutante on prom night, and all the banks wanted to dance.
The banks had no trouble rationalizing their easy credit terms. The banks did hold collateral, after all, and Long-Term generally settled up (in cash) at the end of each trading day, collecting on winners and paying on losers. And Long-Term was flush, so the risk of its failing seemed slight. Only if Long-Term lost money with unthinkable suddenness—only if, say, it was forced to dump the majority of its assets all at once and into an illiquid market—would the value of the bankers’ collateral be threatened and would the banks themselves be exposed to losses.
Also, many of the banks’ heads, such as Corzine and Merrill Lynch’s Tully, liked Meriwether personally, which tilted their organizations in Long-Term’s favor. But Long-Term’s real selling point was its connections to other powerful traders around the world. A firm that did business with Long-Term might gain valuable inside knowledge—totally legal in the bond world—about the flow of markets. “How do you get people to come to your party? You tell them that every cool person in town is coming,” said a banker in Zurich who financed Long-Term with a zero percent haircut. “So everyone said, ‘OK, I’ll do it, but if anyone else gets a haircut, I get one too.’” This was especially clever of Long-Term. The partners could say to each new bank, “If we give you a haircut, we have to give it to everyone.” So they ended up giving it to nobody. (On a small number of riskier trades they did agree to haircuts—but very skimpy ones.)
Since the banks, too, were doing arbitrage trading, Meriwether viewed them, not unjustly, as his main competitors.12 Long-Term resembled other hedge funds such as Soros’s Quantum Fund less than it did the proprietary desks of its banks, such as Goldman Sachs. The Street was slowly shifting from research and client services to the lucrative business of trading for its own account, fostering a wary rivalry between Long-Term and its lenders.
Having worked at a major Wall Street bank, J.M. felt that investment banks were rife with leaks and couldn’t be trusted not to swipe his trades for themselves. Indeed, most of them were plying similar strategies. Thus, as a precaution, Long-Term would place orders for each leg of a trade with a different broker. Morgan would see one leg, Merrill Lynch another, and Goldman yet another, but nobody would see them all. Even Long-Term’s lawyer was kept in the dark; he would hear the partners speak about “trading strategy three,” as though Long-Term were developing a nuclear arsenal.
Hilibrand, especially, refused to give the banks a peek at his strategies or to meet them halfway on terms. He would call a dealer, purchase $100 million in bonds, and be off the phone in seconds.13 “I’m just concerned about margin requirement, and I’m not putting up any margin,” he bluntly told Merrill Lynch. Kevin Dunleavy, a Merrill Lynch salesman, sometimes called Hilibrand two or three times a day, trying to pitch strategies he had devised with the clever Hilibrand in mind. But Dunleavy was repeatedly frustrated by Hilibrand’s obsessive secrecy, which made it nearly impossible to service the account. “Rarely could you take your ideas and implement them into LTCM’s strategy,” noted Dunleavy, an unaffected New Yorker with a military brush cut. “It was very unusual, not to take input from the Street. Larry would never talk about the strategy. He would just tell you what he wanted to do.”
The fund parceled out its business, choosing each bank for particular services and keeping a distance from all of them. Chary of becoming dependent on any one bank, Long-Term traded junk bonds with Goldman Sachs, government bonds and yen swaps with J. P. Morgan, mortgages with Lehman Brothers. Merrill Lynch was the fund’s biggest counterparty in derivatives, but it was far down