Rashomon in Connecticut
Rarely in the course of
human events have so few people lost so much money so quickly. There is no
mystery about how Greenwich-based Long-Term Capital Management managed to make
billions of dollars disappear. Essentially, the hedge fund took huge bets with
borrowed money--although its capital base was only a couple of billion dollars,
we now know that it had placed wagers directly or indirectly on the prices of
more than a trillion dollars' worth of assets. When it turned out to have bet
in the wrong direction, poof!--all the investors' money, and probably quite a
lot more besides, was gone.
But the
really interesting questions are all about why. Why did such smart people--and
the principals in LTCM are smart, even if some of them have Nobel Prizes in
economics--take such seemingly foolish risks? Why did the world give them so
much money to play with? As Akira Kurosawa could have told us, the beginning
and end of the story are not enough: We need to know the motivations and
behavior in between.
LTCM was secretive about how it made money, but the basic
idea went something like this. Imagine two assets--say, Italian and German
government bonds--whose prices usually move together. But Italian bonds pay
higher interest. So someone who "shorts" German bonds--receives money now, in
return for a promise to deliver those bonds at a later date--then invests the
proceeds in Italian bonds, can earn money for nothing.
Of course,
it's not that simple. The people who provide money now in return for future
bonds are aware that if the prices of Italian and German bonds happen not to
move in sync, you might not be able to deliver on your promise. So they will
demand evidence that you have enough capital to make up any likely losses, plus
extra compensation for the remaining risk. But if the required compensation and
the capital you need to put up aren't too large, there may still be an
opportunity for an exceptionally favorable trade-off between risk and
return.
OK, it's still not that simple. Any opportunity
that straightforward would probably have been snapped up already. What LTCM
did, or at least claimed to do, was find less obvious opportunities along the
same lines, by engaging in complicated transactions involving many assets. For
example, suppose that historically, increases in the spread between the price
of Italian as compared with German bonds were correlated with declines in the
Milan stock market. Then the riskiness of the bet on the Italian-German
interest differential could be reduced by taking out a side bet, shorting
Italian stocks--and so on. In principle, at least, LTCM's computers--programmed
by those Nobel laureates--allowed the firm to search for complex trading
strategies that took advantage of even subtle market mispricings, providing
high returns with very little risk.
But in
the course of a couple of months, somehow it all went bad. What happened?
One version of events makes the principals at LTCM victims
of circumstance. Their trading strategy, goes this story, was basically sound.
But there is no such thing as an absolutely risk-free investment strategy. If
the gods are sufficiently against you, if a peculiar, nay, unprecedented
combination of events--debacle in Russia, stalemate in Japan, market crash in
the United States--comes to pass, even the best strategy comes to grief.
According to this version, there is no particular moral to the story, except
that **** happens.
Most
people in the investment world, however, are not that forgiving of LTCM. Their
version of events does not accuse the principals of evil intent, but it does
accuse them of myopia. The magic word is "kurtosis," a k a "fat tails." The
story goes like this: Everyone knows that there are potential events that are
not likely to happen but will have very big effects on financial markets if
they do. A realistic assessment of risk should take into account the
possibility of these large, low-probability events--in effect, should allow for
the reality that now and then **** does indeed happen. But the wizards at LTCM,
so the story goes, forgot about reality. They treated the statistical
distributions found by their computers, based on data from a period when ****
didn't happen, as if they represented the entire universe of possibilities. As
a result, they greatly understated the risk to which they were exposing both
their investors and those who lent them money.
However, knowing the people who ran LTCM--who,
to repeat, are as smart as they were supposed to be--it is kind of hard to
believe that they were really that naive. These were experienced hands (not
your typical 29-year-old traders, who don't remember anything before 1994).
Anyone who has lived through energy crisis and debt crisis, inflation and
disinflation, Reaganomics and Clintonomics, has to know that big surprises are
part of life. Which brings us to the third, more sinister version of events:
that LTCM knew exactly what it was doing.
Here's
the way one investment industry correspondent--who prefers to be nameless--put
it to me. Suppose, he says, that someone was willing to lend you a trillion
dollars to invest as you like. What that lender has done is in effect to give
you a "put option" on whatever you buy with that trillion dollars. That is,
because you can always declare bankruptcy and walk away, it is as if you owned
the right to sell those assets at a fixed price, whatever might happen in the
market. And because the value of an option depends positively on
"volatility"--the uncertainty about the future value of the underlying
asset--the rational way to maximize the value of that option is to invest the
money in the riskiest, most volatile assets you can find. After all, it's heads
you become wealthy beyond the dreams of avarice, tails you get some bad press
(and lose the money you yourself put in--but when you are allowed to make a
trillion-dollar gamble with only $2.3 billion of your investors' capital, that
hardly matters). And as my correspondent reminds us, the people who ran LTCM
understood all about this sort of thing--indeed, those Nobel laureates got
their prizes for, guess what, developing the modern theory of option
pricing.
This "moral hazard" version of the story may seem a bit too
stark to be believed. Did the managers really sit around saying, "Hey, let's
gamble with the money those suckers have lent us"? Actually, it's a
possibility: I don't know any of the LTCM players personally, but some of the
hedge fund types I do know are, as my correspondent puts it, "about as moral as
great white sharks." But anyway, never underestimate the power of hypocrisy. It
is entirely possible for a man to act in a crudely cynical way without
admitting it even to himself. Given their enormous incentive to take improper
risks, it would actually be amazing if the managers at LTCM didn't respond in
the normal way.
But we are
still not quite there. For the remaining puzzle is why the world provided LTCM
with so much money to lose. All those clever strategies depended on
counterparts--on people and institutions who would provide cash now in return
for the promise of German bonds, or whatever, later. Why were those
counterparts so willing to play along? (LTCM, as a matter of principle, refused
to divulge its assets or strategy--so anyone who entered a contract with the
firm was accepting an unknown risk.) Were these counterparts--mainly big banks
and other institutional investors--simply naive?
Some of my correspondents say no. They think
the big boys knew the risks but believed that if LTCM came to grief its
creditors would be protected from loss by the government. In effect, they
believe the LTCM story is mainly an updated version of what happened to the
savings and loans, in which government guarantees underwrote an era of
high-rolling risk-taking. True, there is no formal guarantee. But they believe
that there was an implicit understanding that any major financial institution
is simply "too big to fail."
But I don't buy it.
Economists often make the working assumption that the private sector always
knows what it is doing, that markets do stupid things only when the government
gives them distorted incentives. It's a useful working assumption, but it is no
more than that. In fact, everything I can see suggests that the big boys really
were naive--that, star struck by LTCM's charismatic leader and his prestigious
team, they failed to ask even the simplest questions (such as, "How much money
have you borrowed from other people?")
Of course, if you believe
that big, supposedly sophisticated players can be that foolish--or, for that
matter, if you believe that they are not foolish but do foolish things because
the government will always bail them out--you start to wonder whether our whole
financial structure is as sound as we like to imagine. Did somebody say "crony
capitalism"?
