Opinion

How do you manage a global financial crisis?

When hedge fund Long-Term Capital Management plummeted toward bankruptcy in September 1998, its potential dissolution threatened the financial markets with disaster. Herb Allison, then the president of Merrill Lynch, was one of the few people in a position to avert a crash landing, but first he had to get a cranky coalition of competitive bankers and traders lined up behind his bailout plan.


By Jonathan T.F. Weisberg

"I was one of about six people in the room with an officer of the Federal Reserve one morning as we were trying to figure out what the alternatives were," says Allison, recalling when the leaders of major Wall Street banks and brokerage firms met to first discuss working together to avert a catastrophic collapse at Long-Term Capital.

Long-Term Capital had been launched in 1994. In its first years, it brought its investors annual returns of more than 40%; its partners—accomplished traders and finance scholars (including two Nobel laureates) —became immensely wealthy and renowned in the world of high finance. But in 1998, a number of the fund's bets began to go bad, as world markets tossed in upheaval after Russia halted payment on its debt. The fund was highly leveraged and began to devour its capital to cover daily trading losses. With thousands of positions in derivatives and securities, it held contracts with every major Wall Street bank. The fund's notional value was later calculated at more than $1.2 trillion.

Allison was one of many who thought the whole system was at risk if Long-Term Capital defaulted and its securities were thrown into the market. "They'd wreak havoc in the financial system," he says. As Allison and the other financiers met, that risk was getting perilously closer to reality, as Long-Term Capital hemorrhaged hundreds of millions of dollars a day.

"This situation involved nearly every problem you could imagine," recalls Allison. "We had to make big decisions under conditions of great time pressure, with large financial amounts involved, and large risks, whether we did it or not."

The first decision was how to raise almost $4 billion—the amount they'd figured they would need to rescue the fund. While the Fed had called the firms together, it couldn't act directly. "It was going to be up to the industry itself to try to solve this problem," says Allison. A number of plans were floated: lure in one big investor, for instance, or calculate each firm's exposure to Long-Term Capital and let each cover a proportionate amount of the bailout.

But Allison figured that, with the time pressure and the complexity of Long-Term's positions, the simplest solution was the most practical. "We had about 16 banks that had significant exposure to Long-Term Capital, and they were the world leaders in the capital markets. Some had a lot of exposure, some had very little. What I proposed was that they all put up an equal amount [to fund a bailout] because that's the only way we could make this happen quickly."

How to convince so many different players—all of them used to competing for business, each with different and even divergent interests—to cooperate? Allison appealed to one interest they all shared: the integrity of the financial system.

He asked his fellow financiers how it would look if they chose not to act and Long-Term Capital imploded: "Why weren't these companies, which were very wealthy, willing to put up $300 million each in order to avoid this huge destruction in the markets?... It was really the appeal to their civic responsibility that I think finally caused them to decide this was in their interests and the interests of the industry as a whole—and the public interest as well."

Allison was concerned with more than the sums of dollars, securities, bonds, interest payments, and debts that would hit the firms" balance sheets. He was worried about "the reputational damage that would be caused to the entire financial industry if we didn't take action."

Says Allison, "Ultimately, a company's reputation for integrity and financial soundness and responsible action is its main asset." He points to examples of financial firms that collapsed when their reputations took an irrecoverable blow, invoking names from the corporate graveyard: E. F. Hutton, Drexel Burnham Lambert, Arthur Andersen. "A perceived loss of integrity of a corporation is typically fatal…. The public trust is the basis for their doing business with a particular organization. If you lose the trust, you lose the customers."

While the other firms responded to Allison's argument for the common interest, they remained prickly and defensive of their positions and vulnerabilities. "It took days of persuasion and negotiation to make happen," he says. Firms backed out and were brought back in. One firm demanded concessions, and another threatened to leave in response. Allison kept negotiating.

"They were angry about the situation. There was name-calling around the table about who was really at fault. There were some companies trading against these positions to the disadvantage of the others at the time. So there was a lot of emotion in the room, and we had many meetings that went well into the night."

The huge sums of money at stake complicated every step along the way. "We had to get the companies to go to their boards in 24 hours, call special board meetings, and get approval to invest as much as $300 million in what was a failing company."

Allison put in long days and nights and endured setbacks, because he was convinced reaching a deal was critical to maintaining America's trust in its markets and its financial system. "All the firms were at risk together. The risks we faced if this deal could not be done were much greater than the risks we individually faced in our exposure to Long-Term Capital."

In the end, 14 firms put in a total of $3.6 billion to take a 90% interest in Long-Term Capital. The risk didn't end with the bailout. "It might not have been enough money. We didn't know," says Allison. "I think it was remarkable that these companies could take such a bold step, individually and collectively, in such a relatively short period of time."

With enough capital to survive the coming months and with new risk controls put in place by the coalition of investors, many of Long-Term Capital's positions began to recover. Allison closes his story of near-disaster with a happy ending. "The firms actually made modest amounts of profit on that investment."

Chairman, President, and Chief Executive Officer, TIAA-CREF