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of LTCM, spreads went to historically wide levels. Yet, Japanese asset swap spreads (reflecting the credit distinction between Japanese government and bank credit obligations) actually went to zero. Sussman says this was an anomalous result because it meant that Japanese government bonds (the better credit) were trading at yields equal to Japanese bank bonds (the lesser credit) of the same maturity. Historically when flights to quality occurred (such as in 1994 with the Mexican bank crisis) these spreads widened dramatically, as one would expect they should. Paloma expected this spread would widen during a liquidity meltdown, and this trade was on the books in large size as insurance for other types of fixed-income arbitrage trades in the portfolio. Why, then, didn't it work in 1998?

It turned out that one of the few liquid instruments in LTCM's portfolio was Japanese government bonds, and LTCM needed to sell these to support less liquid parts of its book. Thus, spreads went backward to flat; bank paper had the same yield as government paper. The fixed-income markets were so illiquid that LTCM was unable to move even some medium-sized positions in short-term government bonds. Sussman decided to bail out of his whole-fixed income book when he saw the spreads go backward; he could tell something was happening that he didn't know about at the moment. "The risk system at Paloma worked—we were able to get out."

In 1998, there were three investment managers whose balance sheets were greater than $1 billion—Long-Term Capital Management, Paloma, and D. E. Shaw. Unfortunately, Sussman says, we were two out of the three places. "Competitors weren't big enough to be in the business. That turned out to be an advantage for them."

As a result of 1998, among other things, Sussman learned never to put capital where he is not in control of what's going on, such as in the Shaw situation back then. Based on the multiyear exclusive agreement Paloma had going back to 1993 with Shaw, they mutually locked each other up. Shaw didn't have to listen to Sussman—and he didn't. Yet Sussman couldn't pull his money. Today, the exclusive relationship with Shaw continues, but Paloma has much greater liquidity with him and Shaw has limited the scope of his trading authority.

The current Paloma portfolio has leverage of 3.5:1, which is down about 100 points from earlier in 2000 and much lower than in 1998 when leverage was about 8:1 across the entire book. As a result of Suss-