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

most of Salomon’s previous profits—more than $500 million a year during his last five years at the firm. However, even this was not enough to persuade investors. And despite Merrill’s pleading, the partners remained far too tight-lipped about their strategies. Long-Term even refused to give examples of trades, so potential investors had little idea of what the partners were proposing. Bond arbitrage wasn’t widely understood, after all.

      Edson Mitchell, the chain-smoking Merrill executive who oversaw the fund-raising, was desperate for J.M. to open up; it was as if J.M. had forgotten that he was the one asking for money. Even in private sessions with Mitchell, J.M. wouldn’t reveal the names of the banks he was calling; he treated every detail like a state secret. With such a guarded client, Mitchell couldn’t even sell the fund to his own bosses. Although Mitchell suggested that Merrill become a strategic partner, David Komansky, who oversaw capital markets for Merrill, warily refused. He agreed to invest Merrill’s fee, about $15 million, but balked at putting in more.

      At one point during the road show, a group including Scholes, Hawkins, and some Merrill people took a grueling trip to Indianapolis to visit Conseco, a big insurance company. They arrived exhausted. Scholes started to talk about how Long-Term could make bundles even in relatively efficient markets. Suddenly, Andrew Chow, a cheeky thirty-year-old derivatives trader, blurted out, “There aren’t that many opportunities; there is no way you can make that kind of money in Treasury markets.” Chow, whose academic credentials consisted of merely a master’s in finance, seemed not at all awed by the famed Black-Scholes inventor. Furious, Scholes angled forward in his leather-backed chair and said, “You’re the reason—because of fools like you we can.”¹¹ The Conseco people got huffy, and the meeting ended badly. Merrill demanded that Scholes apologize. Hawkins thought it was hilarious; he was holding his stomach laughing.

      But in truth, Scholes was the fund’s best salesman. Investors at least had heard of Scholes; a couple had even taken his class. And Scholes was a natural raconteur, temperamental but extroverted. He used a vivid metaphor to pitch the fund. Long-Term, he explained, would be earning a tiny spread on each of thousands of trades, as if it were vacuuming up nickels that others couldn’t see. He would pluck a nickel seemingly from the sky as he spoke; a little show-manship never hurt. Even when it came to the fund’s often arcane details, Scholes could glibly waltz through the math, leaving most of his prospects feeling like humble students. “They used Myron to blow you away,” said Maxwell Bublitz, head of Conseco’s investment arm.

      The son of an Ontario dentist, Scholes was an unlikely scholar. Relentlessly entrepreneurial, he and his brother had gotten involved in a string of business ventures, such as publishing, and selling satin sheets.¹² After college, in 1962, the restless Scholes got a summer job as a computer programmer at the University of Chicago, despite knowing next to nothing about computers. The business school faculty had just awakened to the computer’s power, and was promoting data-based research, in particular studies based on stock market prices. Scholes’s computer work was so invaluable that the professors urged him to stick around and take up the study of markets himself.¹³

      As it happened, Scholes had landed in a cauldron of neoconservative ferment. Scholars such as Eugene F. Fama and Merton H. Miller were developing what would become the central idea in modern finance: the Efficient Market Hypothesis. The premise of the hypothesis is that stock prices are always “right”; therefore, no one can divine the market’s future direction, which, in turn, must be “random.” For prices to be right, of course, the people who set them must be both rational and well informed. In effect, the hypothesis assumes that every trading floor and brokerage office around the world—or at least enough of them to determine prices—is staffed by a race of calm, collected Larry Hilibrands, who never pay more, never pay less than any security is “worth.” According to Victor Niederhoffer, who studied with Scholes at Chicago and would later blow up an investment firm of his own, Scholes was part of a “Random Walk Cosa Nostra,” one of the disciples who methodically rejected any suggestion that markets could err. Swarthy and voluble, Scholes once lectured a real estate agent who urged him to buy in Hyde Park, near the university, and who claimed that housing prices in the area were supposed to rise by 12 percent a year. If that were true, Scholes shot back, people would buy all the houses now. Despite his credo, Scholes was never fully convinced that he couldn’t beat the market. In the late 1960s, he put his salary into stocks and borrowed to pay his living expenses. When the market plummeted, he had to beg his banker for an extension to avoid being forced to sell at a heavy loss. Eventually, his stocks recovered—not the last time a Long-Term partner would learn the value of a friendly banker.¹⁴

      While Merton was the consummate theoretician, Scholes was acclaimed for finding ingenious ways of testing theories. He was as argumentative as Merton was reserved, feverishly promoting one brainstorm after the next, most of which were unlikely to see the light of day but which often showed a creative spark. With his practical bent, he made a real contribution to Salomon, where he set up a derivative-trading subsidiary. And Scholes was a foremost expert on tax codes, both in the United States and overseas. He regarded taxes as a vast intellectual game: “No one actually pays taxes,” he once snapped disdainfully.¹⁵ Scholes could not believe there were people who would not go to extremes to avoid paying taxes, perhaps because they did not fit the Chicago School model of human beings as economic robots. At Long-Term, Scholes was the spearhead of a clever plan that let the partners defer their cut of the profits for up to ten years in order to put off paying taxes. He harangued the attorneys with details, but the partners tended to forgive his hot flashes. They were charmed by Scholes’s energy and joie de vivre. He was perpetually reinventing himself, taking up new sports such as skiing and—on account of Meriwether—golf, which he played with passion.

      With Scholes on board, the marketing campaign gradually picked up steam. The fund dangled a tantalizing plum before investors, who were told that annual returns on the order of 30 percent (after the partners took their fees) would not be out of reach. Moreover, though the partners stated clearly that risk was involved, they stressed that they planned to diversify. With their portfolio spread around the globe, they felt that their eggs would be safely scattered. Thus, no one single market could pull the fund down.

      The partners doggedly pursued the choicest investors, often inviting prospects back to their pristine headquarters on Steamboat Road, at the water’s edge in Greenwich. Some investors met with partners as many as seven or eight times. In their casual khakis and golf shirts, the partners looked supremely confident. The fact was, they had made a ton of money at Salomon, and investors warmed to the idea that they could do it again. In the face of such intellectual brilliance, investors—having little understanding of how Meriwether’s gang actually operated—gradually forgot that they were taking a leap of faith. “This was a constellation of people who knew how to make money,” Raymond Baer, a Swiss banker (and eventual investor), noted. By the end of 1993, commitments for money were starting to roll in, even though the fund had not yet opened and was well behind schedule. The partners’ morale got a big boost when Hilibrand finally defected from Salomon and joined them. Merton and Scholes might have added marketing luster, but Hilibrand was the guy who would make the cash register sing.

      J.M. also offered partnerships to two of his longtime golfing cronies, Richard F. Leahy, an executive at Salomon, and James J. McEntee, a close friend who had founded a bond-dealing firm. Neither fit the mold of Long-Term’s nerdy traders. Leahy, an affable, easygoing salesman, would be expected to deal with Wall Street bankers—not the headstrong traders’ strong suit. McEntee’s role, though, was a puzzle. After selling his business, he had lived in high style, commuting via helicopter to a home in the Hamptons and jetting to an island in the Grenadines, which had earned him the sobriquet “the Sheik.” In contrast to the egghead arbitrageurs, the Bronx-born McEntee was a traditionalist who traded from his gut. But Meriwether liked having such friends around; bantering with these pals, he was relaxed and even gregarious. Not coincidentally, Leahy and McEntee were fellow Irish Americans, a group with whom J.M. always