Bank for International Settlements may be against gold

quot;When Genius Failed: The Rise and Fall
of Long-Term Capital Managementquot;
by Roger Lowenstein.

Published by Random House

By JOHN BRIMELOW

When the financial madness of the late 20th century
America fades into history, the saga of Long-Term
Capital Management could well emerge as the
quintessential story. Roger Lowenstein's When Genius
Failed is likely to be a classical primary authority.

Lowenstein is a deeply professional writer, who reduces
the arcane complexities of derivative dealings to lucid
prose, and focuses on the crucial components in a
confusing complex story. He brings the icy precision of
the battlefield surgeon to the deafening chaos of Wall
Street conflict. His chilling assessments of such
phenomena as the appalling Larry Hillibrand, perhaps
the key force at LTCM, a strangely-diminished Alan
Greenspan, and the sinister force of Goldman Sachs, are
likely to prove definitive.

As a member of the Frank Veneroso/www.LeMetropoleCafe.com
circle, and consequently feeling in possession of some
first-hand knowledge of the LTCM smash, I found this book
stimulating and informative. So also would others with
professional involvement. This is not a book to be
ignored.

LTCM was set up to profit from irrational disparities
in valuation between similar financial assets,
primarily bonds. The assumption that these occurred
randomly in a normal distribution pattern had become an
article of religious faith at U.S. Business Schools in
the previous 20 years. Two of the progenitors of the
view, Robert Merton of Harvard, and Myron Scholes of
Stanford (and of the Black/Scholes option valuation
model) were LTCM partners. (Fischer Black had had the
judgment to die an untimely death previously.) Careful
reading of their work reveals that they assumed
continuous markets and stable volatility ranges
(neither always present in reality) and they
acknowledged but ignored the fact that probability
distributions in financial markets often show quot;fat
tailsquot; -- in other words that extreme events occur far
more frequently than a normal curve would predict. But
they nonetheless built a quot;schoolquot; of like-minded
thinkers and disciples. This group had become very
influential on Wall Street by the late 90s.

Wall Street, in a sense, became a victim of the
principal vice of the U.S. academic profession: the
eagerness to set up introspective communities,
dedicated to a dogma, which insulate themselves from
fact-based criticism by exclusion and intimidation
rather than argument. This behavior pattern, more
redolent of Eastern European despotisms than of the
English-speaking empirical tradition, turned out to be
inimical to financial as well as intellectual health.

The life cycle of LTCM was quite simple. Profitability
in the transactions the fund sought out was quite thin,
if reasonably predictable. Therefore, from the start,
the partners sought to maximize size and leverage.
Central to this strategy was relentless, brutal
pressure on credit sources, seeking the cheapest rates
and least encumbering terms. Founded in March 1994,
with equity of $1.25 billion, the fund was able to pay
out $2.7 billion at the end of 1997 to selected
shareholders. This sharply increased the active
partners' share of the pool at the expense of the
investors, some of whom were in effect sent a check and
told they were no longer involved. As LTCM did not
reduce its enormous positions, this move also hugely
increased LTCM's leverage.

By then, however, numerous other operators had entered
the same field and opportunities were growing scarce.

It was widely thought LTCM was working on advanced and
refined versions of Merton and Scholes' theories: this
was not the case. Shortage of opportunity was dealt
with simply by astonishing geographical diversification
-- Lowenstein cites 24 countries -- and by an expansion
into equity risk arbitrage. Up to 30 positions were
carried, some in huge size. LTCM's expertise had little
to contribute in this area. In retrospect, this was a
major strategic error by management.

Consequently, it is not surprising that the Russian
default of August '98 triggered the demise of the firm.
As Lowenstein says, quot;In 70 years, Russia's communists
had not succeeded in dealing markets such a telling
blow as did its deadbeat capitalists.quot;

However, there is much more of importance in the LTCM
saga than the rise and fall of hubristic, if well-
funded, intellectuals. In my view, the most important
document that appeared in the aftermath of the rescue
was published in The Financial Times weekend edition
Oct. 10/11, 1998. (Lowenstein does not mention it.)
This was a leaked credit memorandum from Union Bank of
Switzerland, one of the main losers in the smash,
concerning the reasons the bank chose to do business
with an entity leveraged far beyond the bank's normally
tolerated limits. LTCM was a good credit, UBS hoped,
because quot;eight strategic investorsquot; including
quot;generally government-owned banks in major marketsquot;
owned 30.9 percent of its capital, giving LTCM quot;a
window to see the structural changes occurring in those
markets to which the strategic investors belong.quot;

This appears to be a bald statement that LTCM had
access to inside information (which in the bond market,
as Lowenstein points out, is not illegal) on particular
national credit markets -- because of its involvement
with government institutions.

Who were these quot;generally government-owned banksquot;? Why
would they want to give a foreign institution such
privileges? In the case of the Italians, the only known
Central Bank participant prior to this book, there was
a reason, as Lowenstein reveals. Italian government
bonds were unpopular. quot;The bond market was rating the
Italian government as a poorer risk than private
banks.quot; Investing $100Mn and lending $150 million more,
the Italians obtained the sympathy of a market player
willing to operate on a staggering scale -- quite
enough to move the Italian market. LTCM made 38 percent
of the $1.6 billion it earned 1994-95, its best years,
from the Italian relative value/convergence trade. The
Italian authorities got a bond market that appeared to
be applauding their efforts to reach Germanic standards
of financial probity.

Who knows what other tasks LTCM was performing for its
quot;generally government-ownedquot; investors?

So who were the other quot;strategic partnersquot;? World media
displayed a peculiar lack of interest in this question.
(I can vouch for this; I myself tried to get two major
wire services to follow up.) Indeed, as Lowenstein
remarks, the general press was also quot;stunningly silentquot;
during the period when LTCM's death throes were
starting to disturb markets.

But the author does have some answers: the Bank of
Taiwan, the Government of Singapore Investment Corp.,
the Hong Kong Land Authority and the Kuwait Pension
Fund were names not publicized at the time. Some large
private sector entities were: Sumitomo and Dresdner
Banks, Paine Webber, the Liechtenstein Global Trust,
and of course UBS.

Still, several names are still needed to fulfill the
UBS credit memorandum. Given LTCM's Latin American
interests, one must suspect one or two of that region's
notoriously free wheeling Central Banks were involved.
Similarly, I have always thought the Dutch Central
Bank, perhaps the Austrian, and one of the French para-
statal banks, likely candidates.

The perspective clarifies an obvious puzzle: Why was
the LTCM affair such a crisis? Lowenstein reports that
the ubiquitous Peter Fisher of the New York Fed, when
called in to evaluate the LTCM situation in mid-
September 1998, guessed 17 counterparties might lose
$3-$5 billion combined. While annoying and bonus- (even
department-) threatening, this amount, or several times
this amount, simply was not big enough to create
systemic risk. The Samp;L, Third World debt, and Russian
crises were all far larger.

True, the exposure was all in, or related to, public
markets, which might indeed have had a dramatic few
days. But these were generally not outright risks where
losses might never be recovered. LTCM was quite right
to plead that their convergence or relative value
trades would most likely work out, given time and
enough carrying strength. This is in fact what
happened, enabling the rescuers to recover their $3.65
billion injected in less than two years.

However, if members of the central bank fraternity
stood to be embarrassed, and even surreptitious market
manipulation revealed, the eagerness of the Federal
Reserve to orchestrate a bailout (or coverup) becomes
comprehensible. It must also be said that, although the
likely losses might have been limited, some of the
bonuses and jobs threatened by LTCM exposure and by
involvement in similar trades were located at
politically well-connected private institutions,
notably Goldman Sachs. (Happily, the Treasury official
working with Fisher on the rescue, Gary Gensler, was an
ex-Goldman partner.)

The picture of Goldman Sachs painted by Lowenstein is
perhaps the most significant aspect of the book. After
reading it, and remembering the stories emerging from
the Ashanti disaster of a year later, it is difficult
to understand why any public company would want
involvement with this firm. As Lowenstein portrays it,
Goldman under Robert Rubin and Stephen Friedman in the
1980s dropped the old firm's previous inhibitions
against, for instance, proprietary trading that might
damage client's interests. The sheepdog in effect
turned into a wolf. The dimwitted sheep in Corporate
America have only just begun to realize this. In the
LTCM case, hordes of Goldman people flooded into LTCM's
offices in the guise of evaluating the portfolio for
the purpose of raising capital: quot;Goldman's sleuths ...
had the run of the office. According to witnesses,
[one] appeared to be downloading Long-Term's
positions... Meanwhile, Goldman's traders in New York
sold some of the very same positions. Brazenly playing
both sides of the street, Goldman represented
investment banking at its mercenary ugliest.quot;

Lowenstein dutifully records Goldman's denials, and
their counter-arguments that they did own some of these
trades anyway and were merely being prudent. He also
notes that others appeared to be doing the same thing.
But he seems to accept that LTCM's trades were singled
out, makes clear that the partners - and some outsiders
in the final rescue discussions - believed Goldman
guilty and piles on such detail as to make it clear
they were. Goldman's behavior might be considered
irresponsible, since it, along with others, was also
having a bad time. It lost $1.5 billion in August and
September 1998, and was obliged to put off its own IPO.
A market meltdown must surely threaten all investment
banks. But there were cards up its sleeve. Goldman's
Jon Corzine, having eventually indicated an inability
to raise funds for LTCM, held up the meeting of banks
subsequently summoned by the New York Fed to announce a
vulture bid by Warren Buffet, AIG and Goldman, at less
than half LTCM's hugely eroded net worth. Since LTCM's
assets, once again, were convergence or relative value
trades, virtually certain to recover handsomely once
panic receded, this transaction could have been
extremely lucrative.

It died essentially because Buffet's determination to
humiliate the partners caused the proposal to be
poorly-structured. (No doubt coincidentally, LTCM had
aggressively shorted Berkshire-Hathaway stock.)
Goldman's specially privileged legal representative
spent the rest of the rescue meetings repeatedly
jeopardizing the proceedings seeking (fairly
successfully) improved terms for his client and more
pain for the partnership.

One has to wonder at Goldman's behavior, especially
after the Buffet bid failed. After all, it was still a
partnership. The partners' own money, not that of
anonymous shareholders, would be lost if the financial
system had really crumbled. Morgan and Chase, in
contrast, were quite cooperative. Was it just reckless
selfishness -- or was Goldman confident a bailout would
indeed occur?

This brings us to the interesting question of gold, a
market in which Goldman became peculiarly influential
in the '90s. Eighteen months before LTCM's demise,
Frank Veneroso was told by a prominent hedge fund
manager (unmentioned in this book) that LTCM was short
400 tonnes of gold. This seemed plausible, because we
were aware of a more rapid expansion of Central Bank
bullion lending than could be accounted for by known
borrowers, and it was obvious that a heavy seller had
been active in the market.

Moreover, it was becoming clear that large hedge funds
and bank proprietary desks, having profited enormously
from the quot;yen carryquot; trade (borrowing cheap yen to fund
higher yielding positions in other markets) were
hunting around for similar situations. Since gold
interest costs (quot;lease ratesquot;) were even lower than
Yen, and bearishness was rampant, such a strategy had
logic. I was told by a sophisticated derivatives man
that he doubted LTCM would take the quot;basis riskquot; (e.g.
borrow or short gold with no hedge). But Lowenstein
reveals that the fund took substantial basis risk right
from inception: much of the Italian sovereign risk was
unhedged (merely very closely watched).

We were never able to confirm this story. But given the
manic secretiveness Lowenstein reports was
characteristic at LTCM, this was hardly surprising.
Anecdotal evidence continued to accumulate.

There is no mention of gold in any form in this book.
In response to repeated assertions by Bill Murphy at
www.LeMetropoleCafe.com, LTCM's counsel took the
extraordinary step in June 1999 of sending an affidavit
from LTCM partner Eric Rosenfeld (who seems to have
been charged with being fund spokesman -- he also
answered written questions for Lowenstein) asserting
LTCM had never had any dealings in gold quot;in any ...
form whatsoever.quot; Why it was necessary to respond in
such a way to a obscure dissident website then only 9
months old, when no litigation was in process, is an
interesting question.

Since those early days, LeMetropole Cafe has greatly
extended its network of quot;Deep Throatsquot; supplying
information from all over the world. One of these has
reported a conversation between Myron Scholes and a
boyhood friend in Hamilton, Ontario to the effect that
LTCM was indeed massively short gold, that the position
was relieved by the authorities who swore the partners
to secrecy for which they were indemnified. This
conforms interestingly with otherwise curious behavior
by LTCM partners towards Lowenstein. Davis Mullins and
Eric Rosenfeld initially gave him formal interviews
quot;but such formal co-operation quickly ceased.
Subsequent attempts to resume the interviews and to
gain formal access to ... others of the partners,
proved fruitless.quot;

Since the passage of time has vindicated the partners'
view that their portfolio was capable of full recovery,
and some of them are re-entering the business, this is
precisely the reverse of the behavior one would have
predicted. It must be said that Lowenstein's omitting
dealing with the widespread rumors of an LTCM gold
position is itself somewhat surprising. Gold declined
almost continuously over the life of LTCM. An unhedged
borrowing of cheaply-priced gold credit would have been
a bonanza. The reason for gold's decline was a
substantial shift in the propensity of Central Banks to
sell and lend -- quot;mobilizequot; -- their bullion. This
development was accurately heralded by certain
observers throughout.

It was precisely the sort of quot;structural changequot; that
LTCM quot;generally government-ownedquot; quot;strategic investorsquot;
would have been able to identify. The LTCM partners
were well aware that their competitive advantage lay at
least as much in developing cheap funding sources as in
asset management. They were constantly, aggressively,
searching for lower rates and more liberal terms, and
their tight fistedness with their brokers was notorious
throughout Wall Street. That a fund running over 60,000
positions in at least 24 countries, which had required
considerable ingenuity and inventiveness to identify,
should have overlooked gold borrowing, is simply
incredible.

The Long-Term Capital Management debacle reflects
poorly on their creditor counterparties, and raises
serious questions as to the sagacity with which these
major financial entities are managed. Lowenstein is
justifiably stern: quot;Through their carelessness, their
reckless financing, their vain attempts to ingratiate
themselves with a self important client, the Wall
Street banks had created this fiasco together.... They
too were awed by ... the partners' reputation, degrees,
and celebrity.quot;

Interestingly, quot;When Genius Failedquot; confirms what
LeMetropole Cafe alleged at the time: the Bankers Trust
sale to Deutsche Bank was a distressed merger. What
kind of grooming was necessary to achieve the
appearance of a premium over Bankers Trust's preceding
market price remains a question. Union Bank of
Switzerland, of course, was in the process of ruining
itself with various types of derivative exposure: their
writeoff of $700 million on Long-Term was the largest
announced loss. In large part this was due to an
absurdly-priced warrant on LTCM's equity that the Bank
sold the partners, hoping to improve their business
relationship. (An ex-UBS man told me the delicious
story that having closed the transaction, LTCM promptly
shorted Union Bank's stock.)

Credit Suisse First Boston sold a similar warrant.
Another transaction which seems odd involved Merrill
Lynch. In April 1998, with LTCM still appearing to be
walking on water, Merrill's senior executives
personally purchased most of the firm's stake in LTCM.
This turned out to have the happy effect of getting
Merrill out close to the top: But what would it have
looked like if LTCM had continued to prosper?

Lowenstein judges the derivatives revolution harshly.
He asks penetrating questions about the role of the
authorities. Given that LTCM's quot;stunning losses
betrayed the flaw at the very heart -- the very brain
-- of modern financequot; and that the concept it used
quot;prevails at virtually every investment bank and
trading desk,quot; it is very strange to find Greenspan and
Rubin (when secretary of the treasury) blocking all
efforts to improve transparency and improve regulation
even to the extent of forcing out the former CFTC head,
Brooksley Born.

A ridiculous situation has been allowed to arise where
the balance sheets of major financial institutions have
no reliable relationship to the actual economic
situation of the firm, because of derivatives. Who
benefits from this?

There are few appealing personalities in this drama.
James Cayne, chief executive of Bear Stearns, LTCM's
clearing broker, appears impressive. It was his
inflexible determination to hold the fund to its
promise to keep a $500 million pool of liquidity with
his firm which triggered the final crisis. According to
Lowenstein, he precipitated a near-riot when he told
the assembled rescuing banks that Bear Stearns would
not be contributing to help its formerly lucrative
client. quot;When did we become partners?quot; he asked. quot;They
have a different view of the world,quot; said a
participant. quot;They're completely self-interested.quot;

Cayne personally was an investor with LTCM who had been
allowed to stay in after the capital reduction. In fact
the figure who emerges with the most moral stature
could be the lead perpetrator, John Meriwether, Long-
Term's founding partner. Somehow managing to command
the loyalty of a group of spectacularly arrogant,
selfish and volatile men, and shepherding them from
Solomon to the new vehicle he designed, Meriwether
repeatedly displays in the book an eerie emotional
self-control and discipline which in another era might
perhaps have made him a great fighting general.

A practicing Roman Catholic leading a mainly Jewish
group (everyone compromised -- he professed to be a
liberal Democrat and they played a lot of golf), an
intensely private man who with his wife has apparently
endured the agony of infertility, Meriwether now
appears to be engineering a third Wall Street career.
The reader is left with the feeling that he probably
deserves one.

The implications of the LTCM crisis are ominous for
everybody. That the derivative vogue has undermined and
weakened the world's major financial institutions --
and to an unpredictable extent, courtesy inadequate
reporting procedures mysteriously tolerated by the
authorities -- has been obvious to any sensible
observer for some time. Having an example so skillfully
explicated is nonetheless disquieting.

What is really alarming, however, is the insight into
the modern Wall Street mindset. The Fed despaired of
getting a private-sector banker to lead the rescue.
quot;Wall Street had many bankers but no J.P. Morgan.quot; The
reason for this is that proportionately more activity
is now in the hands of entities with quot;a different view
of the worldquot; -- like Bear Stearns. While Morgan in the
Panic of 1907 was able to dragoon virtually all
significant financial actors, it is notable that no
participation by the other great hedge funds is
reported in LTCM's case -- even though they stood to be
seriously effected by any disruption.

On an operational level, LTCM was notorious for the
atomistic view it took of business. It quot;analyzed every
deal in terms of the profit and loss on discrete trades
rather than in terms of the overall relationship.quot;
Minor technicalities were ruthlessly exploited --
Merrill, which raised the initial capital, was stuck
with a $7 million loss arising from a drafting error in
a transaction document. That Paine Webber's chairman
invested $10 million personally, and the firm $100
million, did not prevent the firm being cut out of
LTCM's trading because it wanted collateral. Complaints
by counterparties about the poor profitability of the
relationship were ignored.

There is obviously a question as to the prudence of
this, since LTCM was such a huge borrower. LTCM's staff
below the partner level -- many highly educated and
skilled professionals -- were treated with similar
brutality. No social activity took place between
partners and the rest, unusual for an American firm.
Partners quot;treated the staff with cool formality. They
were polite but interested only in one another and
their work.quot; Although the associates were encouraged to
invest their substantial pay back into the firm, they
were kept totally in the dark when things turned bad,
despite their being as exposed personally.

quot;Explain to us why we should be ... herequot; demanded an
employee after the rescue. quot;That's a valid question.
We'll get back to youquot; was the answer.

There is no J.P. Morgan to rally Wall Street not
because there are not men of similar financial stature
-- Morgan was not especially wealthy -- but because the
current beneficiaries of the American capitalist system
lack a sense of community. One day we may all regret
this very much.