Dream TeamLeah Nathans Spiro
Compared with the frenetic bullpens on Wall Street, what passes for a trading floor at Long Term Capital Management LP is decidedly serene. Sailboats glide gently by the floor-to-ceiling picture window overlooking Long Island Sound. Half a dozen traders in golf shirts and loafers sit at a sleek, semicircular trading desk equipped with computers and chairs for 14. Envision the trading rooms at Morgan Stanley or Goldman Sachs, crowded with bellowing young traders in Hermes ties. Then forget them. Here in Greenwich, Conn., conversation is held in civilized tones. Everyone is usually sitting down.
The frenzied activity that does take place at Long Term Capital is inside the minds of the men gathered around the firm's trading desk. Some of them were trained as economists. Others are experts in mathematics and computers. This group, which is being closely watched by Wall Street, pioneered the art of computer-assisted bond trading: the complex, highly intellectual marriage of math, finance theory, and market smarts. While others use intuition to try to outguess the Fed or react to the consumer price index, these guys use computer-generated models to predict tiny but enormously lucrative discrepancies in bond prices.
They're no strangers to Wall Street. On the contrary, behind the firm's prosaic name and its unlikely address loom some of the most productive bond traders ever to place a buy order. A year ago, most walked the floors of Salomon Brothers Inc., Wall Street's savviest trading firm. But one by one they left, gutting the source of Solly's biggest profits: its legendary bond arbitrage group.
Now, they've reconvened around Long Term Capital's trading desk. Here you'll find Lawrence E. Hilibrand, 35, the reclusive trader whose market prowess earned him a cool $23 million at Salomon in 1990. Next to him is 41-year-old Eric R. Rosenfeld, the laid-back former Harvard business school professor who was a member of Salomon's executive committee before he bolted. Gregory D. Hawkins, 41, and William S. Krasker, 42, both former Salomon traders and economics PhDs from Massachusetts Institute of Technology, sit nearby. They and their colleagues raked in a staggering $3 billion in pretax trading profits at Salomon between 1990 and 1992.
CULT-LIKE DEVOTION. They've been joined in Greenwich by David W. Mullins Jr., the former vice-chairman of the Federal Reserve Board. Another partner is former Stanford scholar Myron S. Scholes, who some believe will win the Nobel Prize in economics for his work on the pricing of options. Harvard B-school professor Robert Merton rounds out the group. He's an expert on derivatives and financial risk management.
The obvious question is why this financial brain trust has forsaken Wall Street and Cambridge for a leafy Connecticut suburb. The answer lies in the presence of the intent, rather ordinary-looking fellow sitting at the desk's far end. John W. Meriwether, the 47-year-old former vice-chairman of Salomon, is an unlikely pied piper. But he enjoys devotion from this band of intellectuals that has the makings of a cult.
A legendary trader in his own right, Meriwether recruited many of them to Salomon in the 1980s and showed them how to earn millions by applying their brainpower to the bond market. "They love the guy," says Craig Coates, a former government-bond trading chief at Salomon. "They worship the ground he walks on." But in August, 1991, Meriwether resigned from Salomon in the Treasury-bond bid-rigging scandal that claimed Solly's CEO, John H. Gutfreund, and president, Thomas W. Strauss. After 21/2 years and $50,000, he settled with the Securities & Exchange Commission and was largely exonerated (unlike Gutfreund and Strauss). But he couldn't reconcile with Salomon's new management and, much to the chagrin of his patiently waiting traders, he never returned to the firm.
Instead, J.M., as Meriwether's friends call him, has gathered his dream team to help orchestrate the biggest gamble of his life. He is out to show that with only 11 partners, $10 million worth of computers, and $1.25 billion in capital, he can earn the same remarkable returns that his group turned out at Solly--a firm that supported them with a $175 billion balance sheet and resources the world over. Clearly, Salomon Brothers misses him already: So far, the firm has lost $371 million pretax this year and its proprietary trading profits have dwindled. But whether Meriwether can withstand the ill winds blowing through the bond markets without his former employer's clout is a wide-open question.
In a series of interviews with BUSINESS WEEK, Meriwether denied that he harbors any bitterness toward Salomon. Indeed, he still trades with the firm. "I was in the wrong place at the wrong time," he says plainly. "If you are in Alaska and you look to the right and see a bear cub and look to the left and see a mother bear, that's exactly how I felt. There's no weapon that will prevent you from going down." He insists, however, that his new firm can succeed on its own. "For what we do," he says, "this organization may be better."
Long Term Capital is a hedge fund: it buys long and sells short using money raised from institutions and well-heeled private investors ($10 million is the minimum investment). But instead of making big bets on sweeping movements in currencies and foreign bond markets like fund operators such as George Soros and Michael Steinhardt, Meriwether sticks largely to a computer-assisted bond strategy called "convergence trading," which plays the thin spreads that emerge in turbulent times between the values of various types of bonds.
Other traders use this quantitative approach. But never has this much academic talent been given this much money to bet with. Despite an unsettled bond market, big losses at other hedge funds, and Long Term Capital's lofty fee structure, Meriwether has been able to trade on the group's outsize reputation to raise $1.25 billion from investors, according to sources. That has turned Long Term Capital into one of the world's largest hedge funds overnight, with a leveraged balance sheet of $15 billion. James E. Cayne, chief executive of Bear, Stearns & Co., is one individual investor who plunked down at least the $10 million minimum to join the fun. "There's no such thing as `the fee's too high' if the returns justify my investing," Cayne says.
Sources close to the fund say that Long Term Capital has posted returns of 15% since Meriwether launched it in February--despite the jarring increase in interest rates. As the name suggests, however, long-term results are what counts. If Meriwether can earn the average 30% annual returns that these sources say he projects, his success could well usher in a new computer age on Wall Street. Big profits would also raise anew a question that continually plagues the Street: Is the something-for-everyone, high-overhead Wall Street firm really just an inefficient anachronism?
Meriwether will miss the security of Salomon's deep pool of capital, not to mention its huge staff and marketing clout. Even as a hedge fund, Long Term Capital is no giant. Meriwether's idea is to combat the size problem by creating a "virtual" trading firm. He figures intellect and computer trading strategies comprise his most important proprietary asset. What other services he needs, he is contracting out: Bear Stearns, for instance, is providing securities clearing, and Merrill Lynch & Co. has helped to recruit
GLOBAL REACH. Capital, indeed, is his biggest need. Besides the money from institutions and wealthy investors raised by Merrill, Meriwether is striking deals with "strategic investors" worldwide, according to a prospectus obtained by BUSINESS WEEK. Mainly, they are foreign financial institutions that can tap into Long Term Capital's trading expertise in return for anteing up an average $100 million each. Those firms can also provide local expertise when it comes to foreign investments and markets. And they can use connections to raise cheap local capital. "They can be our window," Meriwether says. "We want to be global, and we want to have an ability to employ this technology in any country in the world."
So far, Julius Baer & Co., a prestigious Swiss bank, Merrill Lynch, and four others have signed on. Raymond Baer, a member of Julius Baer's management committee, says access to Long Term Capital's technology was too good to pass up. "It's not an intellectual approach that has to prove itself. They've actually done it already [at Salomon]," he says.
Still, the risks are enormous. Meriwether's record through the 1990s benefited from a friendly interest rate environment that has evaporated. Moreover, Long Term Capital's strategies require large chunks of patient capital to pay off. Meriwether's traders exploit small movements in spreads that often take years to develop. Even with a happy group of strategic partners, trading on the scale this group has been used to will be impossible. "At Salomon, you just do as much as you can do because you're Salomon," says Stephen Modzelewski, the former research director for Meriwether's group and now with The Watermark Group fund. "That's harder to do in an investment vehicle."
WIDE SWINGS. Worse yet, profits for a fund like this can oscillate drastically. Sources say Long Term Capital has warned investors to expect swings as high as 80% and as low as -20% in a given year. When you consider Michael Steinhardt this year lost $1 billion over the course of a week, you can see how volatile these markets can be. "There are times when these strategies go very badly, and you have to take the heat and not unwind at the wrong time," says former Salomon trader Coates. "The question is, will clients understand that?"
Managing close relationships is Meriwether's strong suit. It always has been--despite the common perception of him on Wall Street as a swaggering, '80s-type Master of the Universe. Since Meriwether jealously guards his privacy and rarely talks about his trading activity for competitive reasons, the one glimpse most people have of him is the portrait drawn by Michael Lewis in his 1989 book Liar's Poker. There, he epitomized Salomon's macho culture as he stared down his former boss--John Gutfreund--in a $10 million game of liar's poker (a betting game involving the serial number on a dollar bill.)
Meriwether insists the story is apocryphal. More accurate is Lewis' observation that "Meriwether cast a spell over the young traders who worked for him." Most of his followers are at a loss to explain just what his charisma consists of. But it seems to boil down to this: In a Wall Street world of pretension and swagger, Meriwether quietly showed his band mf nerdy intellectuals that intelligence still carries the day. He believed in their abilities and taught them to turn their abstract theories into piles and piles of money. "He has a tremendous belief in investing in people and investing himself in training others," Hilibrand says.
Meriwether grew up on the South Side of Chicago in the kind of extended Irish family where four cousins lived across the alley, and it seemed as
though everyone on the block was somehow related. His father was an accountant, and his mother worked for the Board of Education. John was fascinated by two things: golf and the markets. At age 12, he began investing the money he saved from caddying at nearby Flossmoor Country Club. A competitive golfer in high school, he twice won the Chicago Suburban Catholic League golf tournament.
Meriwether went on to Northwestern University on scholarship and did a short stint as a Chicago public school teacher before getting his MBA from the University of Chicago. In 1974, at age 26, he landed a job at Salomon and packed up for New York. By 1977, he was already making his mark as a crack trader, and he was allowed to establish a small bond-arbitrage group to trade the firm's money. By the early 1980s, he began to see that the emerging markets in futures and options were beginning to change the investment landscape dramatically.
In a move that was unheard of at the time, Meriwether began hiring young, gifted academics schooled in what was then arcane financial theory. He brought them onto the trading floor and taught them about the markets. Before long, others at the firm were complaining that this quirky, secretive group was tying up the research department mainframe for 24 hours at a time. But the quantitative approach gave Salomon a huge leg up. While the group sometimes lost hundreds of millions in a quarter, it often accounted for as much as 90% of the firm's profits in a year.
The trouble with explaining what these PhDs do is that it takes a PhD to understand it. An example helps, but you need some background. Meriwether's forte is a sophisticated form of interest-rate arbitrage he calls convergence, or "relative-value," trading. Instead of a simple bet on whether interest rates are headed up or down, his group uses computers to identify disparities in the yields of various securities whose values fluctuate in relation to Treasury bills. Usually, those relationships are stable, but in turbulent times, they can become skewed. That creates bargains.
PRECISE GUESSES. The computers tell Meriwether's traders exactly how cheap those bargains are, based on historical price data. How? Under different circumstances over time--usually swings in interest rates--bond prices fluctuate. The computers capture that behavior and allow the group to build models that help them predict future movement. With that knowledge they can accurately play the spread between various securities. It boils down to managing risk. "These models enable us to pursue a large position without a severe concern that our strategies are very exposed to interest rates or yield-curve changes," says Hilibrand.
As an example, take a troublesome characteristic of mortgage-backed securities: When interest rates drop substantially, homeowners often prepay the mortgages underlying a bond. This changes the bond's economics and reduces its value. The trick is to figure out precisely how much value it is likely to lose so that if you hold that bond you can design a trading strategy that includes the appropriate hedges (offsetting trades that act as insurance against losses). If you hedge appropriately, it's harder to lose money if prepayments occur. And that allows you the confidence to take a bigger bet. Computers provide that precision.
Because these traders bet on minuscule movements in spreads, they have to put a lot of money on a position to make any substantial profits. Consequently, if things go wrong--and often, they do--hundreds of millions in losses can pile up quickly. Meriwether's great trust in his team to take those risks is part of the reason they revere him so.
It doesn't hurt that he pays them top bonuses--even by Wall Street standards. Indeed, a deal he cut with Gutfreund in 1989 to pay his group 15% of their profits caused a storm of protest within the firm, insiders say. But his followers insist that Meriwether's charisma has more to do with the respectful, collegial atmosphere he creates than anything else. He's no dictator. He encourages open debate on trading and risk-management strategies.
He's also there when they need him. When the stock market crashed in 1987, the arb group saw their profits for the whole year wiped out in two days. "I still remember sitting at the desk and wondering about the end of the whole financial system," says Rosenfeld. Meriwether calmly called his group into a meeting and "questioned you to the 10,000th detail about your positions," Rosenfeld recalls. It took most of the night, but the boss had each of them cut their losses and build new positions.
"FAIRLY SHY." Meriwether is gregarious with his friends but doesn't like being drawn into the open. That was the most painful part of the bond scandal. "I'm a fairly shy, introspective person," he says. "But I became front-page news." He may enjoy the power that accrues to someone as successful as he is, but part of what attracts people to him is his ordinary-guy personality. Until he married his wife, Mimi, in 1981, Meriwether lived in an apartment on Manhattan's Upper East Side with two buddies for roommates. Every day at Salomon, lunch was a bologna-and-white-bread sandwich (without mayo), eaten at his desk.
Meriwether does have his extravagances. Horses, for one. He and Mimi--a former Olympic-level equestrian--keep several riding horses at their home in Westchester County. And John spends plenty of time with partners and friends at Saratoga and Belmont, where he boards several racehorses. Then there's golf. Despite memberships at three of the U.S.'s toniest country clubs--Winged Foot and Shinnecock in New York and Cypress Point near Pebble Beach, Calif.--Meriwether and several partners own a top Irish golf resort called Waterville. Often, he jets over for a weekend on the links with old friends or colleagues from Long Term Capital.
On a whim during one such trip several years ago, Meriwether bought all 12 lobsters on display at a restaurant near Waterville and set up a race on a table. He taped numbers on their backs, and as his friends placed bets, Meriwether called the race like he was the track announcer. For some of the tweedy intellectuals in his group, all the sporting activity is something new. When Meriwether tried to teach Scholes to play golf, jokes James McIntee, a veteran bond trader who likes to rib his academic associates, "Myron read 100 books about it to figure out the physics of the swing."
Meriwether recalls with a shudder the days when the bond scandal unfolded. "It was surreal," he says. "The world had gone crazy from one day to the next." In April, 1991, Paul Mozer, the head of the government-bond desk, told Meriwether that he had submitted a false bid in the Treasury Dept.'s auction. Meriwether told Mozer his actions were "career-threatening" and immediately reported the transgression to Gutfreund and Strauss.
The matter exploded on Aug. 16, when Gerald E. Corrigan, the governor of the New York Federal Reserve, forced Gutfreund and Strauss to resign. At a set of highly emotional meetings, Salomon executives, including several Meriwether loyalists, fought furiously over whether Meriwether should resign as well.
Insiders say Meriwether's most powerful supporter was Warren E. Buffett, the billionaire investor who stepped in as CEO. But Meriwether had plenty of enemies within the firm who resented his arb group and their giant bonuses. Others thought that as Mozer's immediate boss, Meriwether could have prevented the scandal by firing Mozer in April. At 11:30 the next evening, Meriwether went to Buffett's Manhattan apartment and said he was resigning for the good of the firm. "He didn't believe I should resign," Meriwether insists. Buffett didn't return phone calls.
Whether Meriwether would return was an open question until 1993. When he didn't, his group had little reason to stay. In January, 1993, Rosenfeld quit, followed by Hawkins, Scholes, Krasker, Hilibrand, Richard F. Leahy, and Victor J. Haghani, other traders. All of them insist they hold no grudge. "I spent most of my life there, and I can't help but look back and say thank you," Meriwether says.
Sources familiar with the fund say that together, J.M. and his partners have invested $149 million of their own money in Long Term Capital, the majority of their net worth. And over its short lifespan, the fund appears to be prospering. Its 15% rate of return since February is strong, given that everyone from Salomon to Soros has been battered by the quick rise in interest rates. Meriwether will not talk about his current positions, but the source says market volatility has produced a number of mispricings of which Long Term Capital has taken advantage.
The trick has been not betting on the direction of rates but, as usual for Meriwether, setting up hedge strategies to capture the spread in yield between different securities affected by rates. Long Term Capital has been long on mortgage-backeds--which have been driven down by interest rates and the fear that market leader Kidder, Peabody & Co. will dump its huge inventory. And they are short offsetting securities. They also have hedged positions in the major European bond markets and in Japanese equity warrants, sources say.
But raising the remaining half of the $2.5 billion he wants is still a problem. Not only is turmoil in the bond market spooking potential investors, but Long Term Capital's terms are stiff. Investors must lock up their capital for three years--an unusual restriction--and Meriwether is charging a 2% management fee (1% is the norm). Moreover, Long Term Capital will keep 25% of its profits, compared with 20% at most funds.
Meriwether is undaunted. He's beating the bushes worldwide for nine more strategic investors, with special emphasis on the Far East, where he has yet to find a partner. He also just held a training course in London for 20 freshly hired academics, including a PhD in astrophysics from Cray Research.
"I want to build a long-term franchise," says Meriwether. Without Salomon, that's a tall order. Independence has its risks, but J.M. and his dream team are betting the rewards will be a lot richer.