Infectious Greed (44 page)

But structured notes and swaps had drawbacks for banks, including the risk of being liable for “unsuitable” sales, as the losses of 1994 had shown. Federal regulators in the United States had sued Bankers Trust for selling complex swaps to unwitting customers, even though the extent to which U.S. law covered them was unclear. In private legal disputes regarding structured notes and swaps, purchasers had argued that the selling bank was responsible for their losses, either on suitability grounds or because the bank had breached some agreement or duty. Buyers had obtained favorable settlements in these disputes in the United States, and had even won in court in England.

By using a Special Purpose Entity, a bank could ostensibly avoid these problems, and—depending on the type of SPE—create a deal that wasn't taxable or that avoided disclosure requirements. The SPE could be domiciled in a tax and regulatory haven—Cayman, Jersey, Labuan, and so forth—countries whose financial regulations had been shaped by years of transactions in illegal narcotics and money laundering. In simple terms, a bank could put an SPE between itself and an investor, and thereby keep
the details of a transaction hidden from view, while avoiding the problems that had arisen in earlier derivatives deals.

During the mid-1990s, banks began offering elaborate webs of transactions so complicated that it was difficult even to explain the roles of various parties. Economically, the bank was still the seller, but the diagrams and documents for the deals described the bank's role in minimal terms. The buyers dealt directly only with the SPE, not with the bank and, as a result, the bank disclaimed any responsibility. In simple terms, the buyer entered into a swap with the SPE, who entered into a swap with another entity, who entered into a swap with the bank. If the deal went bad and the buyer sued, the bank now had defenses to the arguments that had been raised in earlier cases: the bank didn't breach any contract or duty because there was no relationship between the buyer and the bank. Economically, the bank was the seller, but on paper it was merely a swap counterparty to an SPE, who was a swap counterparty to the buyer.
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And all of these details remained hidden from anyone except the parties to a particular transaction.

In early 1997, as rumors spread that many borrowers in Thailand were in or near default, sophisticated investors reversed their positions in Thailand, betting that the baht would collapse.
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But U.S. banks continued to sell investors derivatives linked to the Thai baht, using SPEs. In May 1997, several large Thai corporations began selling baht and buying U.S. dollars, to ensure they would have currency on hand to satisfy their debts. With all this downward pressure on the baht, the Bank of Thailand itself began entering into over-the-counter derivatives transactions to support its currency. On May 8 and 9, the Bank of Thailand sold $6 billion of forward contracts on the baht, roughly one-fifth of its net foreign-currency reserves. After a few weeks of selling forward contracts, the Bank of Thailand was obligated to deliver $26 billion—all of its U.S. dollar reserves. At that point, it should have been obvious that the Bank of Thailand would not have any money left to support the baht, and that therefore a collapse of both the currency and stock prices was inevitable. (Stock prices would decline following a devaluation of the Thai baht, because Thai companies would need to repay their obligations using less valuable currency.) Investors who knew all of this could have sold off their investments in May 1997. However, neither Thai companies nor the Bank of Thailand disclosed their derivatives positions, and investors in Thailand did not learn the details until it was
too late. Even now, investors do not know the details of derivatives structured using SPEs during this time.

The rating agencies—which had performed so abysmally in the United States, downgrading Orange County only after it was obviously bankrupt—did not warn investors about the various financial problems in East Asia. In fact, both Moody's and S&P continued to give a single-A rating to the bonds of the government of Thailand for several months
after
the devaluation.
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Standard & Poor's did not even put Thailand on its “credit watch” until August, and did not downgrade Thailand's credit rating until late October 1997.

After the Bank of Thailand abandoned its defense of the baht on July 2, investors began worrying about similar problems throughout East Asia. Indonesia, the Philippines, and Malaysia faced similar predicaments and abandoned their currencies a few weeks later. The Malaysian central bank, known as Bank Negara, blamed foreign investors speculating in derivatives. It certainly had reason to know: it had made and lost billions of dollars speculating in currencies, and allegedly had even played a role in Andy Krieger's trading years earlier. In fact, the Malaysian complaints were a near-perfect replay of the supposed battle between Andy Krieger and New Zealand's central bank, the only change being an increase in the size of the bets from billions to tens of billions of dollars.

The International Monetary Fund—led by the United States—engineered a $17 billion bailout for Thailand and a $42 billion one for Indonesia,
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thereby compounding the moral-hazard problems of the Mexico bailout. The economies of Indonesia, Malaysia, the Philippines, and Thailand all soon recovered, as Mexico's had, and investors quickly returned, confident that they would be rescued if another crisis hit.

 

 

J
ohn Meriwether's firm, Long-Term Capital Management (known as LTCM), was the “Rolls-Royce” of hedge funds, and its expenses justified the name.
⁷⁵
LTCM charged a two percent annual fee (double the going average), plus 25 percent of any profits, and the fund required a minimum investment of $10 million. Moreover, investors would not be able to withdraw their money for three years, hence the name “Long-Term.” The idea was that LTCM—unlike other investment funds with a time horizon of, perhaps, a few days—could weather a financial storm, keeping bets it believed in even if they turned bad for months.

LTCM employed many of the top minds in finance: John Meriwether; Robert C. Merton and Myron Scholes, two of Meriwether's finance professors (who later would win the 1997 Alfred Nobel Memorial Prize in Economic Sciences for their work in options theory); David Mullins, a former vice chairman of the Federal Reserve and Merton's first research assistant; a former senior Italian treasury official;
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and a cadre of traders from Meriwether's Arbitrage Group at Salomon. With this staff, investors approached Meriwether more than he approached them. As Roy Smith, a professor at New York University and the author of several important finance books, put it, “Investing in this thing was done on the basis of networking, wanting to do the cool thing and trusting the superstars.”
⁷⁷

The men from LTCM knew they were superstars, too. During one early meeting, Andrew Chow, the head of derivatives at Conseco, an insurance company, questioned whether LTCM really could be very profitable, given how competitive the financial markets had become. When Chow told Myron Scholes he didn't think there were enough “pure anomalies” for LTCM to succeed, Scholes snapped back, “As long as there continue to be people like you, we'll make money.”
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Conseco didn't invest, but plenty of others did. By early 1994, Meriwether had raised $1.5 billion.

In addition, several major Wall Street banks agreed to lend billions of dollars to LTCM, often through
zero-margin
loans, in which LTCM would not even post collateral to assure banks that it would repay the loans. Individual investors had to post collateral of at least 50 percent, and even other hedge funds posted a few percent, but Wall Street was starstruck, too, and gave LTCM special deals. James Cayne, the CEO of Bear Stearns, a second-tier securities firm, was so taken by LTCM that he not only agreed that Bear Stearns would serve as the
clearing agent
for most of LTCM's trades—transferring money and various securities to the parties who were owed them—but he also invested $13 million of his personal funds, even though he had never even met John Meriwether.

LTCM began trading on February 24, 1994, just after the Fed's rate hike. Its prospectus permitted the fund to do just about anything, and warned investors about the volatility of its strategies. The prospectus described
relative-value
and
convergence
trades—essentially, buying a temporarily cheap asset, selling a roughly equivalent, temporarily expensive asset, and waiting for the two to converge in price—and cited a few examples of such trades from Salomon's Arbitrage Group, noting that new strategies were expected and could not be specified in advance. It
also mentioned that the firm was permitted to make directional bets (“Directional trades will tend to occur opportunistically and at times may involve positions of significant size”), although the fund didn't plan to engage in much outright speculation.

In a rare statement, David Mullins explained: “We're not directional investors. We don't take highly leveraged bets in the direction of markets. This is a long-term activity which could last a year or two, although we fine tune the hedging during this period. It's very intensively research oriented, with state of the art valuation models which relate various securities to each other. Normally, we only pursue 10 of these plays a year, so it's not frenetic trading.”
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The prospectus also noted that LTCM intended to form “strategic relationships” with important organizations throughout the world. Mullins would be the point man in these dealings.

LTCM lost money during its first month of trading, but in April 1994 it began an incredible four-year run of profits. It made money during the market chaos of 1994, buying mortgage derivatives that Askin Capital Management and Worth Bruntjen were dumping, and betting that temporarily cheap bonds would move back to their historical levels. In ten months of trading in 1994—a terrible year on Wall Street—LTCM made 28 percent.
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Beginning in 1995, LTCM traded every financial instrument imaginable: arbitrage between Japanese options and stocks, bets that shares of the same company sold in different markets would converge in price, bets that the price difference between French and German government bonds would diverge, bets that interest rates of U.S. swaps were too high compared to interest rates on U.S. Treasury bonds, and even a bet on long-dated British government bonds that, because it was made using over-the-counter derivatives, actually exceeded the size of the entire market. LTCM's trades frequently were in the range of $10 billion to $25 billion
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—ten times the size of Andy Krieger's trades at Bankers Trust.

LTCM's bets were astute, but the fund often got lucky, too. For example, when LTCM followed the earlier Salomon Brothers strategy of buying cheap options embedded in Japanese convertible bonds, it had expected to make small amounts of money over a long period of time, as the bonds matured. Instead, the options skyrocketed in value when the Kobe, Japan, earthquake hit in January 1995, causing volatility to increase 50 percent.
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(This was the same earthquake that had decimated Nick
Leeson's bets on Japanese stocks.) With a combination of skill and luck, the fund made 59 percent in 1995.

Over time, LTCM began taking on the complex risks that other banks shunned. As horror stories spread about how Bankers Trust, and then Salomon Brothers, had been unable to evaluate their complex portfolios, the top managers at many banks instructed their traders to unload such positions.
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LTCM bought them, betting that its finance specialists could manage the risks better than anyone else. Banks continued to sell complex derivatives deals to clients, but instead of keeping all of the fees, they often paid LTCM to take on the more esoteric risks. In other words, the successors to Gibson Greetings were unknowingly buying their trades from LTCM, with the major Wall Street banks acting merely as an intermediary.

But LTCM's most lucrative trades weren't from skill or luck but, instead, from its cozy relationships with central bankers and government officials, which provided the opportunity for the fund to learn about
regulatory arbitrage
trades—essentially, buying and selling to profit from mispricings due to various countries' legal rules and regulations. These strategies hardly required a Ph.D. in finance. For example, the fund took advantage of a quirk in British tax law that treated high-coupon and low-coupon government bonds differently, even though they were economically similar. It also used its connections in Japan to short bonds, even though the Bank of Japan had rules discouraging such practices.
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These strategies were a few of the small number of trades David Mullins had described as requiring so much research and time.

Much of LTCM's activity was in Italy, where it had extraordinary connections. Not only did LTCM employ the former Italian treasury official responsible for debt management, but the Bank of Italy, the country's central bank, had invested $100 million with LTCM. (This investment was highly unusual; imagine if Alan Greenspan invested the Fed's money in a foreign hedge fund.) Meriwether and Mullins also had connections in Italy, and Merton was a near-deity there.

It was no coincidence, then, that in one trade LTCM purchased an estimated $50 billion of Italian government bonds—a bet bigger than any previously described in this book, including Joseph Jett's trading in STRIPS. LTCM owned 25 percent of one segment of the Italian government-bond market. In other trades, LTCM benefited from an Italian tax loophole for foreign investors, and from the prospect of Italy's
entry into the European monetary system, about which it had very good information.