How the dream team slipped up

UNLIKE MORE flamboyant hedge fund players such as George Soros and Julian Robertson of Tiger Fund fame, who relished risk, John Meriwether had a reputation as the safe pair of hands who gave a wide berth to markets like Russia where others came unstuck.

Yet ironically it was his specialisation in building portfolios of G7 government bonds and other "safe as houses" instruments such as mortgage- backed securities that led him and his "dream team" of Nobel maths laureates to believe they were bigger than the market.

Mr Meriwether and his backers, which included UBS, Dresdner Bank and even the Bank of China, made billions of dollars from the "euro convergence play" where they bought cheap Italian bonds on the assumption that they would yield the same as the German bund as monetary union approached.

Mr Meriwether, in playing one market off against another, relied on the fact that, in all but the most abnormal times, when one market or instrument goes up, another somewhere in the world goes down.

You take big bets in one market but they are hedged by mirror positions elsewhere in the world.

However, these are not normal times. When the Russian crisis hit, every single market went the same way. Shares crashed in virtually every market around the globe and most bond prices collapsed except for the safest US Treasuries, UK gilts and German bunds. The result was that the gap between Italian and German bund prices actually widened when Long-Term Credit Management had bet the other way.

This meant that LTCM's derivatives positions, taken out as insurance policies, became ruinously expensive. By Tuesday LTCM was about to run out of money.

Mr Meriwether used complex mathematical instruments to identify the discrepancies between markets. Hence the need for the two Nobel Prize-winners, Myron Scholes and Robert Merton, as advisers. The discrepancies were often small - the trading margins on US treasuries and European government bonds are wafer-thin - but bonds were excellent collateral, enabling Mr Meriwether to borrow up to 20 times his capital base of $8bn before the crisis.

Until now, lending money to fund LTCM's huge bets has proved to be very profitable business for the banks. Much of the lending was on a repurchase or repo basis, where the lender gets possession of the securities bought by LTCM. Also Mr Meriwether, a former trader, paid generous commissions to those who dealt with him.

The huge profits to be made meant that big international banks, including Barclays, Natwest and Abbey National, chose to ignore the fact that they were dealing with a counter-party that never filed accounts and about which next to nothing was known. The big creditors glossed over the fact that LTCM had been technically in breach of its banking covenants and still money flowed in.

"What killed them," said one banker yesterday, "was arrogance, not so much of Meriwether but of his associates. They forgot that, however big you are, the markets are always bigger."

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