Corzine Forgot Lessons of Long-Term Capital: Roger Lowenstein
Thirteen years ago, when the hedge fund Long-Term Capital Management was desperately negotiating with Wall Street banks for a bailout, Jon Corzine, the chief executive officer of Goldman Sachs Group Inc., called John Meriwether, LTCM’s founder, and read him the riot act. Wall Street would invest, Corzine said, but “JM” would have to accept more controls, including strict supervision over his firm’s trading limits.
Corzine, I wrote soon after, “understood the flaws” at LTCM better than anyone. The firm had no controls over risk limits, no accountability to anyone who wasn’t a trader.
Corzine was also tempted by the upside of high-risk trading -- and by Meriwether in particular. Perhaps his admiration for Meriwether didn’t begin when they were classmates at the University of Chicago Booth School of Business, in the early 1970s, but it blossomed soon after, when Corzine became a bond trader at Goldman and Meriwether one at Salomon Brothers.
Goldman, in that era, was still a firm guided by investment bankers, sometimes in tandem with traders but always with the motto “long-term greedy” rather than short-term. Its primary mission was doing deals for clients. Since Goldman was private, its partners avoided taking too much risk with the firm’s capital -- which, of course, was their own capital.
Salomon was brassier -- perhaps because it didn’t have a gold-plated roster of clients to fall back on. At Salomon, Meriwether built a trading powerhouse, one that Corzine envied. In the early 1980s, Salomon became a public company, and Meriwether’s famous bond arbitragers had more capital to trade with.
Rise of Trading
The shorthand story of Wall Street over the last generation is that every firm -- Goldman included -- became less like the old Goldman, more like Salomon. Old-line commercial banks like JP Morgan and Bankers Trust were converted into derivatives traders. Venerable investment banks like Lehman Brothers and Morgan Stanley became packagers of mortgages -- essentially, shops for buying and selling, assembling and splicing, mortgage securities. And all with other people’s money.
By the mid ‘90s, Corzine was the top executive at Goldman and it, alone among the major Wall Street firms, remained privately owned (it went public in 1999.) But even Goldman was metamorphosing into a trading powerhouse. Corzine knew the risks (Goldman was burned in the volatile market of ‘94) but he was also sensitive to the potential profits. That same year, when Meriwether founded LTCM, Corzine flirted with the idea of buying an investment in the hedge fund.
He didn’t, but Goldman did become a banker to LTCM, and on attractive terms to the fund. Corzine wanted to be close to LTCM -- surely because, if Meriwether’s team was on to a good trade, Corzine wanted Goldman to be there, too.
In September 1998, after Russia defaulted on its debt, LTCM blew up. Some people thought the firm’s arbitrage trades were well-conceived, some thought the firm was arrogant, but everyone understood their mistake. LTCM was too leveraged. If 97 percent of your capital is borrowed, you can’t afford to make a trade that may be correct eventually, because in the meantime creditors will put you out of business.
Strongly cajoled by the Federal Reserve, Corzine and other Wall Street CEOs engineered a rescue of LTCM. Shortly after, Corzine’s Goldman partners forced him out. But Corzine’s romance with Meriwether wasn’t over. The two lions of Wall Street, both in a sort of exile, fantasized that they, together, could buy the hedge fund from the Wall Street banks that had rescued it. They tried to raise money, but the effort fizzled.
The lesson of LTCM was that no trading operation is better than its ability to withstand losses. This lesson was proved in spades, in 2008, at highly leveraged banks such as Bear Stearns and Lehman Brothers.
A History Lesson
A second lesson is that seemingly unlikely events may be more likely than market history suggests. Russia had not defaulted since 1917, but that didn’t stop it from happening in 1998.
And a further lesson of LTCM’s demise was that the widespread belief that liquidity offers safety is, in fact, an illusion, and a terribly dangerous one at that.
Time and again, otherwise canny investors fall for the salve that in a liquid market, they can always get out, therefore what’s the problem? At Lehman, in the mid 2000s, executives took comfort in the notion that that the bank was in the “moving business” not the “storage business.” Then, the mortgage market froze, and everyone was in the storage business.
Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth -- they trust, instead, on their supposed ability to exit. Investors now in low-yielding U.S. Treasury bonds may, one day, discover this lesson for themselves.
It’s hard to overestimate the extent to which the siren of liquidity has seduced even ordinary Americans. During the housing bubble, anyone who took out a mortgage they couldn’t afford, upon advice they could always refinance, was tacitly assuming they could trade their old loan for a new one. They were counting on continued liquidity in the mortgage market--and so were the banks that lent them the money.
Corzine was able to sidestep the subprime madness by becoming a U.S. senator from New Jersey and then governor. As a public servant, he seemed more cautious than in his CEO days. In Trenton, he never quite commanded the stage, nor did he solve the tremendous fiscal woes he inherited as governor. In his re-election bid in 2009, he was defeated by Chris Christie.
I liked him as an executive and as a public official (on one occasion, we shared a classroom at Princeton University). Like few very wealthy banking executives, Corzine saw Wall Street’s shortcomings, had a sense of its role in society. And I wondered, after he was retired from politics, why he chose to return to the Street, taking control of a futures broker, MF Global Holdings Ltd., which collapsed spectacularly this week. It now looks as though Corzine still felt the trader’s itch.
Betting the Firm
MF Global was leveraged 30 to 1, shades of LTCM. And of MF Global’s roughly $40 billion in assets, more than $6 billion were in volatile European sovereign debts. Corzine was the author of the firm’s strategy of risking its own capital. He wanted a firm like Meriwether’s, and he got one. Corzine also approved the strategy of loading up on European debt. According to the Wall Street Journal, he told a company executive that “Europe wouldn’t let these countries go down.” Just as, 13 years ago, traders believed that Russia wouldn’t default.
Corzine’s bet may still prove correct; “these countries” -- Italy and Spain, for instance -- may emerge from the current crisis solvent. But if they do, MF Global will not be around to reap the gains. Because the firm was so highly leveraged, and because it was dependent on short-term financing, its liquidity dried up and it failed. This seems to be the lesson that Wall Street never learns.
The good news is that MF Global was just a brokerage, not a first-tier investment bank. The world will get by without it. Fortunately, thanks to the post-crash Dodd-Frank legislation -- the Volcker Rule in particular -- regulated banks are prohibited from risking their capital in proprietary trading. They will also have to maintain higher capital levels.
There is room for further reform as well. The culture of trading has overwhelmed Wall Street’s economic function, which is simply to provide a conduit for savings into productive use. Instead, too much of Wall Street has become a casino. A tax on financial transactions to slow down trading would be a good place to start. And the collapse of MF Global reminds us why, for all its unfortunate complexity and verbiage, Dodd-Frank was necessary.
Someday, business schools may teach their students about liquidity and risk, about the perils of short-term funding and leverage. Someday the lessons of LTCM may be learned. But don’t hold your breath. Corzine had a ringside seat, and the message didn’t stick. Human nature loves a risk. Best to keep the gamblers where they can’t do so much harm.
(Roger Lowenstein is the author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” He is an outside director with the Sequoia Fund. The opinions expressed are his own.)
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