child.6 Such reticence was a perfect attribute for a trader, but it was not enough. What Meriwether lacked, he must have sensed, was an edge—some special forte like the one he had developed on the links in high school, something that would distinguish Salomon from every other bond trader.
His solution was deceptively simple: Why not hire traders who were smarter? Traders who would treat markets as an intellectual discipline, as opposed to the folkloric, unscientific Neanderthals who traded from their bellies? Academia was teeming with nerdy mathematicians who had been publishing unintelligible dissertations on markets for years. Wall Street had started to hire them, but only for research, where they’d be out of harm’s way. On Wall Street, the eggheads were stigmatized as “quants,” unfit for the man’s game of trading. Craig Coats, Jr., head of government-bond trading at Salomon, was a type typical of trading floors: tall, likable, handsome, bound to get along with clients. Sure, he had been a goof-off in college, but he had played forward on the basketball team, and he had trading in his heart. It was just this element of passion that Meriwether wanted to eliminate; he preferred the cool discipline of scholars, with their rigorous and highly quantitative approach to markets.
Most Wall Street executives were mystified by the academic world, but Meriwether, a math teacher with an M.B.A. from Chicago, was comfortable with it. That would be his edge. In 1983, Meriwether called Eric Rosenfeld, a sweet-natured MIT-trained Harvard Business School assistant professor, to see if Rosenfeld could recommend any of his students. The son of a modestly successful Concord, Massachusetts, money manager, Rosenfeld was a computer freak who had already been using quantitative methods to make investments. At Harvard, he was struggling.7 Laconic and dry, Rosenfeld was compellingly bright, but he was less than commanding in a classroom. At a distance, he looked like a thin, bespectacled mouse. The students were tough on him; “they beat the shit out of him,” according to a future colleague. Rosenfeld, who was grading exams when Meriwether called and was making, as he recalled, roughly $30,000 a year, instantly offered to audition for Salomon himself. Ten days later, he was hired.8
Meriwether didn’t stop there. After Rosenfeld, he hired Victor J. Haghani, an Iranian American with a master’s degree in finance from the London School of Economics; Gregory Hawkins, an Arkansan who had helped run Bill Clinton’s campaign for state attorney general and had then gotten a Ph.D. in financial economics from MIT; and William Krasker, an intense, mathematically minded economist with a Ph.D. from—once again—MIT and a colleague of Rosenfeld at Harvard. Probably the nerdiest, and surely the smartest, was Lawrence Hilibrand, who had two degrees from MIT. Hilibrand was hired by Salomon’s research department, the traditional home of quants, but Meriwether quickly moved him into the Arbitrage Group, which, of course, was the heart of the future Long-Term Capital.
The eggheads immediately took to Wall Street. They downloaded into their computers all of the past bond prices they could get their hands on. They distilled the bonds’ historical relationships, and they modeled how these prices should behave in the future. And then, when a market price somewhere, somehow got out of line, the computer models told them.
The models didn’t order them to trade; they provided a contextual argument for the human computers to consider. They simplified a complicated world. Maybe the yield on two-year Treasury notes was a bit closer than it ordinarily was to the yield on ten-year bonds; or maybe the spread between the two was unusually narrow, compared with a similar spread for some other country’s paper. The models condensed the markets into a pointed inquiry. As one of the group said, “Given the state of things around the world—the shape of yield curves, volatilities, interest rates—are the financial markets making statements that are inconsistent with each other?” This is how they talked, and this is how they thought. Every price was a “statement”; if two statements were in conflict, there might be an opportunity for arbitrage.
The whole experiment would surely have failed, except for two happy circumstances. First, the professors were smart. They stuck to their knitting, and opportunities were plentiful, especially in newer markets such as derivatives. The professors spoke of opportunities as inefficiencies; in a perfectly efficient market, in which all prices were correct, no one would have anything to trade. Since the markets they traded in were still evolving, though, prices were often incorrect and there were opportunities aplenty. Moreover, the professors brought to the job an abiding credo, learned from academia, that over time, all markets tend to get more efficient.
In particular, they believed, spreads between riskier and less risky bonds would tend to narrow. This followed logically because spreads reflect, in part, the uncertainty that is attached to chancier assets. Over time, if markets did become more efficient, such riskier bonds would be less volatile and therefore more certain-seeming, and so the premium demanded by investors would tend to shrink. In the early 1980s, for instance, the spreads on swaps—a type of derivative trade, of which more later—were 2 percentage points. “They looked at this and said, ‘It can’t be right; there can’t be that much risk,’” a junior member of Arbitrage recalled. “They said, ‘There is going to be a secular trend toward a more efficient market.’”
And swap spreads did tighten—to 1 percentage point and eventually to a quarter point. All of Wall Street did this trade, including the Salomon government desk, run by the increasingly wary Coats. The difference was that Meriwether’s Arbitrage Group did it in very big dollars. If a trade went against them, the arbitrageurs, especially the ever-confident Hilibrand, merely redoubled the bet. Backed by their models, they felt more certain than others did—almost invincible. Given enough time, given enough capital, the young geniuses from academe felt they could do no wrong, and Meriwether, who regularly journeyed to academic conferences to recruit such talent, began to believe that the geniuses were right.
That was the second happy circumstance: the professors had a protector who shielded them from company politics and got them the capital to trade. But for Meriwether, the experiment couldn’t have worked; the professors were simply too out of place. Hilibrand, an engineer’s son from Cherry Hill, New Jersey, was like an academic version of Al Gore; socially awkward, he answered the simplest-seeming questions with wooden and technical—albeit mathematically precise—replies. Once, a trader not in the Arbitrage Group tried to talk Hilibrand out of buying and selling a certain pair of securities. Hilibrand replied, as if conducting a tutorial, “But they are priced so egregiously.” His colleague, accustomed to the profane banter of the trading floor, shot back, “I was thinking the same thing—‘egregiously’!” Surrounded by unruly traders, the arbitrageurs were quiet intellectuals. Krasker, the cautious professor who built many of the group’s models, had all the charisma of a tabletop. Rosenfeld had a wry sense of humor, but in a firm in which many of the partners hadn’t gone to college, much less graduate school at MIT, he was shy and taciturn.
Meriwether had the particular genius to bring this group to Wall Street—a move that Salomon’s competitors would later imitate. “He took a bunch of guys who in the corporate world were considered freaks,” noted Jay Higgins, then an investment banker at Salomon. “Those guys would be playing with their slide rules at Bell Labs if it wasn’t for John, and they knew it.”9
The professors were brilliant at reducing a trade to pluses and minuses; they could strip a ham sandwich to its component risks; but they could barely carry on a normal conversation. Meriwether created a safe, self-contained place for them to develop their skills; he adoringly made Arbitrage into a world apart. Because of Meriwether, the traders fraternized with one another, and they didn’t feel the need to fraternize with anyone else.
Meriwether would say, “We’re playing golf on Sunday,” and he didn’t have to add, “I’d like you to be there.” The traders who hadn’t played golf before, such as Hilibrand and Rosenfeld, quickly learned. Meriwether also developed a passion for horses and acquired some thoroughbreds; naturally, he took his traders to the track, too. He even shepherded the gang and their spouses to Antigua every year. He didn’t want them just during trading hours, he