Infectious Greed (20 page)

Compared to Mozer, his supervisors received mere slaps on the wrist. Gutfreund, Strauss, and Meriwether paid fines of $100,000, $75,000, and $50,000, respectively—just a few days' pay, at their salaries.

Gutfreund was barred from running an investment bank for life, although he technically was permitted to work at a lower level than
chairman. Of course, the “King of Wall Street” couldn't be anywhere but the top, and, after the Treasury scandal, most highly regarded firms didn't want Gutfreund as their leader. He became president of Gutfreund & Co.—no mean feat—and ultimately found a job as chairman of Nutrition 21, Inc., a vitamin company.
⁶⁹
Gutfreund also sneaked back into Wall Street in late 2001, at the age of 72, as a senior managing director of C. E. Unterberg, Towbin, a small and struggling investment firm run by Thomas Unterberg.
⁷⁰
Unterberg and Gutfreund had been friends for 60 years, and Unterberg returned from retirement to chair the firm, something Gutfreund was barred from doing. As Gutfreund put it, “All of the geriatrics are calling me for jobs.”
⁷¹

Thomas Strauss, the number-two person at Salomon, was suspended from the industry for six months. After that, he began running Ramius Capital, a successful multibillion-dollar hedge fund named for the renegade captain in Tom Clancy's novel,
The Hunt for Red October.
⁷²

Meriwether was suspended for just three months. He sued Salomon for lost compensation, and received $18 million in a settlement. All things considered, Meriwether did pretty well.

After Meriwether resigned, he worked on his golf game and thought about how he might replicate his Arbitrage Group elsewhere. Although his group had depended on Salomon for capital, it was an otherwise self-contained operation. With the right staff, he didn't need the support of a full-service investment bank. Meriwether began recruiting former employees and talking to potential investors. To re-create the autonomy he had at Salomon, he would require that investors commit their capital for a long period of time, perhaps several years. Given this requirement, he had the perfect name for his new investment fund: Long-Term Capital Management.

Meriwether's loyal traders were happy to leave Salomon to join him. Their work environment would change radically: instead of sitting in the middle of Salomon's cramped trading floor in Manhattan, they would rent offices in a relaxed, private office park in Greenwich, Connecticut.

By August 1993, Meriwether had recruited Eric Rosenfeld, his first academic hire at Salomon, along with Victor Haghani and Greg Hawkins. Larry Hilibrand—the $23 million man—joined a few months later. Meriwether persuaded the famed economists Myron Scholes and Robert Merton—who had worked as consultants at Salomon—to join Long-Term Capital as partners, along with a couple of Meriwether's golfing friends.

Meriwether wanted some new blood, too, especially someone who could navigate difficult regulatory issues. When David W. Mullins Jr.'s term as vice chairman of the Federal Reserve Board ended in February 1994, Mullins also agreed to join. Mullins was a perfect addition, especially given the importance of legal rules in Meriwether's strategies. Mullins was one of the most powerful banking regulators in the world, next to Alan Greenspan. Moreover, as a past critic of derivatives markets, Mullins had credibility with other regulators, especially those outside the United States.

The new group drafted a “confidential private placement memorandum” to give to investors interested in Long-Term Capital. The memorandum had few details. It described the on-the-run/off-the-run trade, which every smart trader on Wall Street already knew, but little else. Meriwether was selling his fund based solely on the reputation of his traders. Long-Term Capital was just as mysterious as the Arbitrage Group at Salomon had been.

It was expensive, too. Whereas typical hedge funds at the time charged a fee of 1 percent annually, plus 20 percent of the profits, Long-Term Capital was asking for a 2 percent fee, plus 25 percent. It was outrageous, really, and numerous investors said no at first. But when a few of Salomon's competitors agreed to invest, including the CEOs of Merrill Lynch, Bear Stearns, and PaineWebber, the money started to flow. As word spread, Long-Term Capital became known as the “hot” investment, and everyone wanted in, from movie stars and professional athletes to major university endowments and international pension funds.
⁷³
The list ranged from Hollywood agent Michael Ovitz to partners in the McKinsey consulting firm, from Nike CEO Phil Knight to Italy's central bank.
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The initial investments topped $1 billion.

February 1994 was an eventful month. Bankers Trust was preparing to close another complex swap with Procter & Gamble. First Boston was preparing to fire hundreds of employees. Long-Term Capital was preparing to begin trading in a few weeks. Paul Mozer—now permanently excluded from Meriwether's inner circle—was preparing to spend several months in a Florida prison. But few people were prepared for what Alan Greenspan, chairman of the Federal Reserve, was planning. Greenspan was about to turn over a rock, revealing just how much the markets had changed during the years since Andy Krieger.

O
n February 4, 1994, Alan Greenspan and the Federal Reserve raised overnight interest rates from 3 percent to 3.25 percent. To most investors, the change seemed insubstantial. Greenspan's reasoning appeared sound: the economy was growing very quickly, and although slightly higher interest rates would hurt investments, they also would help contain inflation. The markets fell in response, but the move was not unusual. Stock prices declined about two percent; bond prices dropped half a percent.

But behind the scenes, it was pure panic.

Most individual investors did not yet know of the swaps Bankers Trust had done with Gibson Greetings and Procter & Gamble, or of the complex financial strategies First Boston and Salomon Brothers had engineered. And no one realized how far and quickly those strategies had spread beyond those firms.

By early 1994, hundreds of money managers and treasurers—from Robert Citron, the 70-year-old treasurer of Orange County, California, to Worth Bruntjen, the aggressive mutual-fund manager at Piper Jaffray in Minneapolis—had secretly bet hundreds of billions of dollars using strategies and instruments that were near copies of those described in the previous chapters. Although the trades were complex, most of them—at their core—were bets that interest rates would stay low. Collectively,
these managers had placed the largest secret wager in the history of financial markets. When the Fed raised rates on February 4, they lost.

Imagine a casino full of gamblers betting on a roulette wheel. Spin after spin, the ball lands on a red-colored number. The gamblers bet on red numbers and win, doubling and feverishly redoubling their bets. As the cheers grow louder, they begin ignoring the fact that the wheel has just as many black numbers as red. They believe they have entered an incredible new world where the roulette ball only lands on red numbers. They bet everything on the next spin of the wheel.

Substitute “low interest rates” for “red numbers” and you have a description of the early-1990s financial markets. Fund managers had been placing huge bets on a financial-market roulette wheel, where the ball kept landing on low interest rates. They insisted interest rates would remain low and increased their bets, frequently borrowing huge sums to do so. Egged on by the Fed's commitment to keep interest rates down in order to boost the economy, they imagined a new world where short-term interest rates were always three percent. Inevitably, on February 4, the ball landed on black.

Why didn't investors learn about the losses that day? One reason was that the bets involved largely unregulated and undisclosed financial instruments, such as structured notes, swaps, and other derivatives. Another was that many fund managers simply hid the losses, not only from investors, but from their bosses as well. After February 4, those managers were scurrying like a colony of ants whose cover had just been kicked over. Given the complexity of the instruments and the lack of regulation, they would be able to hide for quite a while. The public would discover the losses only in dribs and drabs during the year.

In contrast to investors, Wall Street bankers immediately knew the damage caused by the rate hike, for two reasons: first, they had created the various fund-managers' bets, so they knew the hidden details; second, Wall Street traders had hedged the bets by taking “mirror” positions in the market. Traders closely monitored these hedges, and—with a few glaring exceptions, such as Bankers Trust and Salomon Brothers—bank managers generally knew their traders' positions. Various sources estimated the total damage to the bond market at around $1.5 trillion. That made the rate hike more costly than any other market debacle since the 1929 stock-market crash. The
New York Times
took note of the panic among financial specialists on February 5, the day after the
rate hike, saying the Fed's action sent “an Arctic blast through Wall Street.”
¹

During the next few months, the fund managers—one by one—would admit their losses. David Askin was first. His fund, Askin Capital Management, was one of the largest and most sophisticated investors in mortgage securities. Askin was a respected trader—formerly of Drexel Burnham Lambert, Michael Milken's firm—and he was among the most active traders of complex mortgage derivatives. Often, Askin
was
the market. Yet Askin's $600 million fund evaporated within weeks after the rate hike, and Askin filed for bankruptcy on April 7 (more on the details later).

Five days later, Gibson Greetings and Procter & Gamble admitted to losses on their previously hidden bets with Bankers Trust, and rumors swirled about similar losses at other companies. Air Products and Chemicals lost $113 million, Dell Computer lost $35 million, Mead Corporation lost $12 million, and so on.

Various congressional committees immediately held hearings, with much fanfare (just as they would after the collapses of Long-Term Capital Management, Enron, and then nearly every major financial institution in 2008). On April 13, the House Banking Committee called on George Soros, the billionaire investment guru who briefly had employed Andy Krieger. Soros warned that many fund managers were using financial alchemy to make otherwise-prohibited bets. Regarding new financial instruments such as derivatives, he said, “There are so many of them, and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated investors.”

To average investors, the public discussion of these new instruments was impossibly complicated. Professor Jonathan Macey of Cornell Law School suggested that for the ordinary citizen contemplating these new instruments, “it is rational to remain ignorant.”
²
The costs of learning about financial innovation were simply too great, relative to the potential benefits. But as the floodgates opened, and investors learned of billions of dollars of losses at brand-name companies, mutual funds, pension funds, government treasuries, and other organizations, the costs of remaining ignorant began to rise. Even investors who didn't understand any of these new instruments still had to put their money somewhere.

As news spread, it appeared that many of the biggest losers were no more sophisticated than the average investor. The most surprising losses were in the treasurer's office of Orange County, California, and at Piper
Jaffray, the Minneapolis mutual fund. Orange County and Piper were well-respected, supposedly conservative, institutions. Yet the individuals who were blamed for the losses—Robert Citron of Orange County and Worth Bruntjen of Piper—were surprisingly inexperienced and unsophisticated. Citron and Bruntjen didn't have college degrees, much less Ph.D.s, and they lacked the financial training necessary to understand the details of structured notes and mortgage derivatives.

Nevertheless, they had bought billions of dollars of these instruments, feeding the Wall Street firms that created them, and—for many years—generating positive investment returns for their constituents. Citizens of Orange County counted on Citron as a reliable and trustworthy steward of public funds. For investors in Minneapolis, Bruntjen was practically a hero. Citron was the top-performing municipal treasurer in the United States; Bruntjen was the top-performing U.S. government-bond fund manager. In February 1994, citizens of Orange County and investors in Piper had no idea how far their men had fallen.

 

 

T
he story of Orange County, California, was well publicized during late 1994 and early 1995. Everyone read newspaper stories describing the record losses of $1.7 billion; assessing the antics of eccentric Robert Citron, the 70-year-old treasurer whose investment strategy had led to the county's bankruptcy; and speculating about the uncertain future of the wealthiest county in the United States.

But even after all the media coverage, most investors remained baffled by the Orange County story, and few people could explain exactly what had happened, or even answer basic questions about what went wrong with the county's investment strategy. How could an elected official have been secretly gambling with so much public money for so long? And how could he have lost so much money, given that he technically was operating within the county's conservative investment guidelines?

The reason the Orange County debacle made no sense was that few people understood its context. Orange County's losses were the inevitable result of the recent spread of new financial instruments and strategies from Wall Street to much less sophisticated venues. To understand Orange County's collapse, you had to understand the recent wave of financial innovation at Bankers Trust, First Boston, Salomon Brothers, and other Wall Street firms. With that perspective in hand, Orange County's story was a reasonably simple one.