---------- Forwarded message ----------
Date: Sat, 3 Oct 1998 13:31:38 +1200
From: janice <[EMAIL PROTECTED]>
To: [EMAIL PROTECTED]
Subject: Rashomon in Conneticut.
Rashomon in Connecticut
What really happened to Long-Term Capital Management?
By Paul Krugman
(posted Thursday, Oct. 1, 1998)
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.
TCM 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.
K, 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"?
Links
A Reuters article describes the collapse of LTCM. This Slate article
from last year details how those Nobelists at LTCM made the transition
from theorists to players. In "Moneybox," Slate's James Surowiecki
explains how things will change in the wake of LTCM's failure. All
this talk of risk making you nervous?
janice
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