Meriwether and strange weather: intelligence, risk management and critical thinking.(Defence)

When the tide goes out, we'll find out who's been swimming butt naked. --Warren Buffett

ON AugusT 29, 1994, Business Week ran a feature article entitled "Dream Team". It was about a man called John W. Meriwether and the team of brilliant quants he had gathered around him to conduct what the magazine called "the biggest gamble of his life". The gamble was to see whether, in a partnership calling itself Long Term Capital Management (LTCM), they could outperform his old firm, Salomon Brothers, in the bond markets, with a fraction of Salomons' capital and staff.

Most of his team had worked for him in bond arbitrage at Salomons for up to a decade, raking in up to 90 per cent of the firm's net profit. They included Lawrence Hilibrand, Victor Haghani, Eric Rosenfield, Gregory Hawkins and William Krasker. All except Haghani had graduate degrees from Harvard or MIT in mathematical economics, finance or computer science. Haghani's degree was from the London School of Economics.

They were joined at LTCM by David Mullins Jr, erstwhile vice-chairman of the US Federal Reserve Bank, and two brilliant math-modelling economists from the Harvard Business School, Myron Scholes and Robert C. Merton. Those two were to win the Nobel Prize in 1997 for their work in modelling stock price movements, and had taught many of Wall Street's leading figures at Harvard since the 1970s. Meriwether had gone to the very top of academe in putting together his dream team.

For three years, 1994-97, LTCM made breathtaking profits on its trades and the whole of Wall Street was seduced. In 1997, LTCM made a profit of $2.1 billion--more than corporate giants like McDonald's, Nike, Disney, Xerox, American Express or Merrill Lynch. Then, in 1998, the market began to turn bad on them. Unwaveringly confident in their models and their judgment, the quants increased their exposure, keeping all their own capital in the fund.

At the beginning of 1998, LTCM had $4.7 billion in capital, of which $1.9 billion belonged to the partners. It had ridden out the Asian financial crisis of late 1997 with barely a jolt. It had $100 billion in assets, virtually all borrowed, but through thousands of derivative contracts linking it to every bank on Wall Street, it had over $1 trillion worth of exposure.

In August 1998, the Russian economy went into a tailspin. This was to be the trigger for LTCM's demise, but none of the geniuses there realised what was about to happen. They actually decided to buy big in Russian bonds, calculating that others would sell in a panic but Russia would stabilise. It didn't. And the IMF refused to bail it out. The consequent shock to what amounted to a moral hazard bubble in fragile markets around the world triggered a global securities crisis for which LTCM was utterly unprepared and which left it perilously exposed. You see, it had bought the riskiest bonds everywhere, believing that such diversification would buffer it against any given one going bad.