When Genius Failed: The Rise and Fall of Long-Term Capital Management - Roger Lowenstein

THE RISE OF LONG-TERM
CAPITAL MANAGEMENT

1

MERIWETHER
IF THERE WAS one article of faith that John Meriwether discovered at
Salomon Brothers, it was to ride your losses until they turned into gains. It
is possible to pinpoint the moment of Meriwether’s revelation. In 1979, a
securities dealer named J. F. Eckstein & Co. was on the brink of failing. A
panicked Eckstein went to Salomon and met with a group that included
several of Salomon’s partners and also Meriwether, then a cherub-faced
trader of thirty-one. “I got a great trade, but I can’t stay in it,” Eckstein
pleaded with them. “How about buying me out?”
The situation was this: Eckstein traded in Treasury bill futures—which,
as the name suggests, are contracts that provide for the delivery of U.S.
Treasury bills, at a fixed price in the future. They often traded at a slight
discount to the price of the actual, underlying bills. In a classic bit of
arbitrage, Eckstein would buy the futures, sell the bills, and then wait for
the two prices to converge. Since most people would pay about the same to
own a bill in the proximate future as they would to own it now, it was
reasonable to think that the prices would converge. And there was a bit of
magic in the trade, which was the secret of Eckstein’s business, of Long-

Term Capital’s future business, and indeed of every arbitrageur who has
ever plied the trade. Eckstein didn’t know whether the two securities’ prices
would go up or down, and Eckstein didn’t care. All that mattered to him
was how the two prices would change relative to each other.
By buying the bill futures and shorting (that is, betting on a decline in the
prices of) the actual bills, Eckstein really had two bets going, each in
opposite directions.* Thus, he would expect to make money on one trade
and lose it on the other. But as long as the cheaper asset—the futures—rose
by a little more (or fell by a little less) than did the bills, Eckstein’s profit on
his winning trade would be greater than his loss on the other side. This is
the basic idea of arbitrage.

When Genius Failed: The Rise and Fall of Long-Term Capital Management - Roger Lowenstein