Authors: William D. Cohan
In 1997, LTCM earned a respectable 17 percent return for its investors, after fees. The performance was the worst of the firm’s short life but hardly fatal. As promised, LTCM returned to its investors $1.82 for every dollar they’d invested, although their original investment stayed in the fund. Meriwether’s concern about the markets and LTCM’s
prospects proved prescient as 1998 unfolded. On August 17,
Russia announced a devaluation of the ruble and a moratorium on the payment of $13.5 billion of its Treasury debt. The devaluation and the moratorium caught many investors off guard, not only at LTCM but at Goldman Sachs, too.
This opened up another fissure in the relationship between Paulson and Corzine, who had been on their best behavior in the weeks following the June IPO announcement. But the events in Russia were reminding Paulson an awful lot of 1994, and he was nervous. Not surprisingly, Corzine—the trader—wanted Goldman’s traders to ride out their positions. Paulson—the banker—was highly skeptical of that strategy. “
Maybe if we hold on to some of these positions as you suggest, Jon, our losses will be less, but we’re not a hedge fund,” Paulson remembered telling Corzine. “We’re Goldman Sachs. And I want to get out of these positions and take our losses.” At this particular moment, Paulson had the upper hand at the firm, having just won the backing of the majority of the Executive Committee to promote him to co-CEO. He also figured that after taking the losses, the firm’s ROE for the year would still be in the very respectable range of 18 percent. Corzine told Paulson to his face that he agreed with the decision to cut and run but the message getting out around the firm was a different one. “Paulson and Corzine would communicate to the traders,” one partner recalled, “and Paulson would be communicating one thing and Corzine would be talking to them behind his back and maybe he was just fuzzy in what he said, but they sure weren’t hearing the same things from Corzine they were hearing from Paulson.” This made Paulson crazy.
On August 21, the full import of Russia’s decision hit world markets, and a massive flight began immediately out of risky investments, such as the debt and equity of emerging markets, into the supposedly less risky Treasury securities of the United States and Germany. “
Minute by minute, Long-Term was losing millions,” Lowenstein wrote. That Friday, LTCM lost $553 million in a single day, or 15 percent of its capital. At the start of the year, LTCM had had $4.67 billion in capital, but after the losses suffered on August 21, the firm’s capital had been reduced to $2.9 billion. When Meriwether got the word of the massive trading losses, he was in China. He took the next flight back to New York. Before he did, though, he called Corzine at home. “
We’ve had a serious markdown,” Meriwether told Corzine, “but everything is fine with us.” But, according to Lowenstein, “everything was not fine.” That weekend, the LTCM partners gathered in Greenwich, Connecticut, and realized quickly that the firm needed a savior. A quick call was placed to Warren
Buffett to see if he would buy LTCM’s $5 billion portfolio of merger arbitrage positions. Buffett declined.
After Corzine got the call from Meriwether, he called back and warned him, “
We aren’t getting adequate feedback. It could hurt your credit standing.” Corzine—and the rest of the market—wanted to know more about LTCM’s positions and the extent of its problems. If it wanted to raise new capital, LTCM had little choice but to begin to reveal its positions, a disclosure that allowed its trading partners—including Goldman—to begin to dump similar trades, exacerbating LTCM’s downfall. On August 27, the
Times
wrote that the “market turmoil is being compared to the most painful financial disasters in memory.”
On Monday, August 24, while Meriwether and LTCM were dialing for dollars, Goldman filed its “long-anticipated” S-1 registration statement with the SEC. As was typical for such preliminary filings, much financial information was left out, including what the implied
valuation of the firm would be based on, the number of shares sold, and the price they would be sold at. What was shared, for the first time, was how obscenely profitable the firm had been since 1993. In the five and a half years between the end of 1992 and the first six months of 1998, Goldman had made pretax
profits of $12.2 billion, an astounding figure by any measure, especially when 1994 was included—as predicted, the S-1 showed $508 million of pretax earnings that year (1994), but that was before paying out distributions to partners, making the year a loss. Essentially, because of the partnership accounting, much of the $12.2 billion had been paid out to the Goldman partners or retained in their capital accounts at the firm. The S-1 filing confirmed what many had long suspected anyway: Goldman Sachs was a gold mine. Corzine had been right to exhort the Goldman alpha males to overcome the events of 1994 and rededicate themselves to the firm. “He was really endlessly optimistic,” one partner said, “and it turned out to be true. Despite all the bad things that have happened, he was right.”
Also remarkable was the S-1’s revelations about the growth in Goldman’s principal lines of business. For instance, since 1982, the volume of worldwide M&A deals had grown at a compounded annual rate of 25 percent, worldwide equity issuance had increased at an annualized rate of 19 percent, and worldwide debt issuance had increased at an annualized rate of 25 percent. Worldwide equity market capitalization had increased at an annualized rate of 15 percent.
Not surprisingly, the S-1 began with Whitehead’s fourteen business principles. Number one, right at the top, was “Our clients’ interests always come first. Our experience shows that if we serve our clients well,
our own success will follow.” But, even inside Goldman Sachs, fewer and fewer people were able to take this seriously. Indeed, several Goldman traders remembered what partner
Peter Briger used to say about this commandment: “Yeah, and when we do, make no mistake about it, it’s a business decision.” Nevertheless, Whitehead’s business principles made good reading, as did the reason Goldman gave for wanting to do the IPO in the first place. “As a public company, we will have greater financial strength, greater strategic flexibility and broader alignment of employee interests with the interests of our shareholders,” the firm wrote. “From a financial perspective, public ownership will give us a more stable capital base, broaden our sources of capital and lower our funding costs. From a strategic perspective, while we expect most of our growth will continue to be organic, public ownership will give us a currency with which we may choose to pursue strategic acquisitions. From an employee perspective, public ownership will help us meet a fundamental objective—to share ownership broadly among the Firm’s employees.”
The S-1 also contained a long list of “risk factors” that most investors ignored, including what would become a very relevant warning about how dependent Goldman—like the rest of Wall Street’s securities firms—was on short-term funding in the public debt markets. “The Firm depends on the issuance of commercial paper and promissory notes as a principal source of unsecured short-term funding for its operations,” according to the S-1. “As of May 1998, the Firm had approximately $16.7 billion of outstanding commercial paper and promissory notes with a weighted average maturity of approximately 100 days. The Firm’s liquidity depends to an important degree on its ability to refinance these borrowings on a continuous basis. Investors who hold the Firm’s outstanding commercial paper and promissory notes have no obligation to purchase new instruments when the outstanding instruments mature.”
Within weeks of Goldman’s S-1 filing, liquidity in the debt markets was drying up. “
The end of August is always a slow time in markets,” Lowenstein wrote, “but this August, trading in bond markets all but vanished. The market for new bond issues simply dried up. Scheduled new offerings were abruptly withdrawn, which was just as well, because there was no one to buy them.”
Despite the increasing shakiness in the markets, Goldman held firm to its IPO schedule. On September 8, in an internal conference call, Paulson said Goldman would continue forward with its plan for the IPO. “
Nothing that’s happening in the markets today, last week, tomorrow or next week should substantially change that objective or our positive outlook we have for our firm in the next five to ten years,” he said. “The IPO
process is still on track.” That same day, Goldman announced that Flowers was “retiring” from Goldman at the end of the year, the consequence of his souring relationship with Paulson and his thwarted attempt to be appointed one of the three co-heads of investment banking and to the firm’s
Management Committee. Paulson asked him to postpone his leaving for a year until the IPO had been resolved because he was afraid that Flowers’s departure at that moment would send the wrong message to the market. But the pissed-off Flowers ignored the request. “Twenty years is a long time to be in one place,” Flowers told the
Times
the next day. Years later, though, he said his unequivocal support of Corzine cost him as Paulson became more ascendant at the firm. “
It was a very bitter disagreement between these guys,” he said, “and I was an important part of the Corzine faction.… But the politics of it had been very bitter and divisive and ugly and I felt that I personally was as far as I was going to get at Goldman. The future was not bright for me there.” (The Flowers-Paulson feud continued for years, including when Flowers was getting ready to do an IPO, in February 2004, of
Shinsei Bank, the renamed Japanese bank he and investor
Timothy Collins bought—and turned around—after Flowers left Goldman. Flowers refused to let Goldman into the IPO, even though Goldman had the best research in the area. When it came time for the secondary sale of shares, a bit later, Goldman again wanted an underwriting role. At first, Flowers said no but then agreed that if Paulson came to his house on a Saturday and begged, Flowers would consider it. Paulson showed up and on bended knee asked Flowers for the order. But Flowers still said no. The Shinsei deal made Flowers and Collins billionaires.)
By mid-September word of LTCM’s losses had leaked into the market, and the laws of self-fulfilling prophecies took over. Late in the day on September 10, the assets that LTCM had “in the box” at
Bear Stearns, its clearing agent, fell below $500 million for the first time, triggering a provision in the agreement LTCM had with Bear.
Warren Spector, the co-president and co-COO of Bear Stearns, called Meriwether and told him Bear would send a team to LTCM’s offices in Greenwich that Sunday to examine the books and make a decision about whether to stop clearing for the firm, which would put LTCM out of business. Out of desperation, Meriwether called Corzine, who was in Venice celebrating his anniversary, and told him LTCM needed $2 billion or else it would go out of business. Meriwether also went to see
James E. Cayne, Bear’s CEO. “
I asked if he had any assets at all, and he said, ‘I’ve got a $500 million line [of credit] at Chase,’ ” Cayne recalled. “I said, ‘Well, take it down.’ He said, ‘It expires in ten days and they know we’re not going to
be able to pay it back.’ I said, ‘I know, but you can take it down.’ He said, ‘How do you know that?’ I said, ‘I don’t know that. Go talk to a lawyer. But to me, if you’ve got a line take it down and let them go whistle or do something, but that’s salvation.” Soon enough, LTCM had taken Cayne’s advice.
Before deciding whether to draw down his line of credit, Meriwether turned again to Corzine. Without Paulson’s knowledge, Corzine offered to have Goldman invest $1 billion of its own and its clients’ money into LTCM in exchange for a 50 percent stake in the LTCM management company, unfettered access to LTCM’s trading positions, and a right to limit its trading. Corzine also pledged to help Meriwether raise the other $1 billion he thought LTCM needed. “
Merely informing the world that Goldman was in Long-Term’s corner might stop the bleeding,” Lowenstein wrote. “Meriwether could not say no.”
The agreement between Goldman and LTCM allowed a SWAT team of traders, led by
Jacob Goldfield—Rubin’s protégé—and lawyers from
Sullivan & Cromwell to comb through every crevice of LTCM during the week of September 14, with LTCM’s permission, of course. According to Lowenstein, citing “witnesses,” Goldfield “
appeared to be downloading Long-Term’s [trading] positions, which the fund had so zealously guarded, from Long-Term’s own computers, directly into an oversized laptop”—a fact that Goldman later denied. In an interview, Goldfield said he did nothing wrong, inappropriate, or unauthorized. “
If it were true,” he wrote in an e-mail, referring to Lowenstein’s claim, “the most interesting story would be my hacking skills given that this was highly confidential data and I was in plain sight.” He was just doing necessary due diligence, with LTCM’s approval, so Goldman could evaluate the potential investment in LTCM. Goldfield shared a spreadsheet that LTCM gave him about its trading positions. LTCM also faxed Goldfield its counterparty positions to help him do the analysis. “The biggest revelation to us,” Goldfield wrote, “when we saw LTCM was how low tech they were. Goldman Sachs was much more sophisticated than they and I had thought it was quite the opposite.”
Meanwhile, Goldman’s traders in New York sold some of the very same positions. “
At the end of one day, when the fund’s positions were worth a good deal less, some Goldman traders in Long-Term’s offices sauntered up to the trading desk and offered to buy them,” Lowenstein wrote. “Brazenly playing both sides of the street, Goldman represented investment banking at its mercenary ugliest.” Meriwether complained “bitterly” to the New York Federal Reserve Bank about Goldman’s alleged “
front-running,” or trading against LTCM based on the knowledge
it had gleaned from looking at its confidential books, but “Goldman was hardly alone,” Lowenstein wrote and then quoted a Goldman trader in London. “If you think a gorilla has to sell, then you sure want to sell first,” the trader said. “We are very clear where the line is; that’s not illegal.” (The idea of not crossing a line about “front-running” was confirmed in an interview by
Eliot Spitzer, the former New York State attorney general who had studied the allegation against Goldman and certainly would have prosecuted the firm had he found the evidence.) Lowenstein noted that the previous “stewards” of Goldman—he must have been referring back to Sidney Weinberg—had disdained
proprietary trading because the temptation to trade on “customer flow” would be too great. “
But by 1998,” he wrote, “Goldman was known as an aggressive, bare-knuckled trader that had long since abandoned any pretense of being a gentleman banker.” Corzine later told Lowenstein that Goldman’s traders “
did things in markets that might have ended up hurting LTCM. We had to protect our own positions. That part I’m not apologetic for.” He said, though, that Goldman did not take the information it had gathered about LTCM in Greenwich and trade on it.