November 14, 1998
Teachings of Two Nobelists Also Proved Their Undoing
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By GRETCHEN MORGENSON and MICHAEL M. WEINSTEIN
T wo months ago Myron S. Scholes made a sentimental journey to the
steel-manufacturing city of Hamilton, Ontario, to be honored as a
local boy made good.
He had recently been awarded, with Robert C. Merton, the Nobel
award in economics, for breakthrough work in finding a way to value
risky financial investments known as options. Those formulas,
devised 25 years ago, made sophisticated investing more of a
science and less of an art, encouraging the growth of a host of new
securities markets. Many people made millions.
The trip home was one of a number of personal appearances that
amounted to, in Scholes's words, a victory lap. As the star guest
at a party in Hamilton, he described his trip to Sweden to accept
the Nobel and spoke fondly of the local people who had looked after
him in his youth. At the end, he nearly broke down in tears.
Certainly, it was an emotional moment. But there was something
else. Back home in Greenwich, Conn., the situation was grave.
The giant investment fund in which Scholes and Merton were
partners, Long-Term Capital Management, was on the edge of
financial ruin. The fund had made a variety of big, risky bets that
had gone terribly wrong. The Federal Reserve Bank of New York would
within a week organize a private takeover to prevent the fund's
outright failure and a rout in the world's financial markets.
In the end, the very thing that the two economists had taught the
world to understand -- managing investment risk -- proved their
undoing.
Indeed, that a fund with so much brain power could crash so
ignominiously is the decade's most powerful reminder yet of the
chasm between devising investment models and turning them into
profitable trades.
Neither Merton, 54, nor Scholes, 57, agreed to comment for this
article. But interviews with dozens of friends, academics and
people close to Long-Term Capital paint a picture of two economists
who after years in academia were hired by some former students who
had made it big on Wall Street. The credibility of the two
economists made the firm something of a legend, attracting
heavyweight investors, lenders and trading partners. Scholes, who
had the charisma of an ace salesman, went on the road to help the
firm raise money.
But for all the brilliance of their theory, it was based on an
assumption that the future performance of bonds would mirror their
past movements.
When Russia decided to stop paying its debts in August, investors
in many markets panicked in a way that a mathematical model could
not have anticipated. And for all their prominence as architects of
the theories on which traders placed their bets, Scholes and Merton
in fact were not directly involved in the firm's trading; they were
therefore somewhat removed from the firm's daily operations. And
they were ultimately powerless to stop the fund from running
aground. Suddenly, they were worth a whole lot less.
The Speculator: A Salesman Who Loves Risk
M yron Scholes is a natural salesman with a penchant for taking
risks.
He was born in 1941 in Timmins, a small mining town in northern
Ontario. His father, a dentist, moved the family south to Hamilton
when Myron and his little brother, David, were young. Myron
received a Bachelor of Arts from McMaster University in 1962. He
then headed to the University of Chicago, where a master's in
business was his stepping-stone to a doctorate in finance and
economics, awarded in 1970.
Even while pursuing an academic career, Scholes was an avid
investor. In an interview with The Ottawa Citizen a year ago, he
recalled a sobering experience speculating on stocks in the late
1960's.
"I would take my salary and invest it in the stock market," Scholes
told the newspaper. "Then I'd use the securities to borrow from the
bank to live. I always told my wife that we were investing, not
borrowing."
A bear market in the early 70's ravaged his stock portfolio. With
his loans coming due, he recalled, he pleaded with his banker for
an extension and got it. Stock prices recovered, allowing him to
repay his debts.
In the early 70's, he was on the faculty of the Sloan School at the
Massachusetts Institute of Technology. Scholes elicits tales of
brilliance from colleagues and students at M.I.T, as well as the
University of Chicago, where he taught finance and banking from
1974 until 1983, and Stanford University, where he was a professor
in the business and law schools.
"He was very charismatic," said Carol Levenson, a University of
Chicago graduate who is now editor of Gimme Credit, a high-grade
corporate bond investment advisory service in Chicago.
"He was so far over our heads that nobody was smart enough to have
any interaction with him. We felt like we were studying with
Einstein."
At M.I.T., Scholes teamed up with Fischer Black, an economist who
had his own consulting firm. The two developed a formula for
valuing stock options, pioneering work that gave rise to an
explosion of futures contracts, options and other securities known
as derivatives, whose value is derived from some other instrument
like a stock or a bond. At the time, though, the men could not get
their work published.
Merton, also an economist at M.I.T., examined their formula,
applied some high-powered mathematics and produced an elegant
elaboration that was quickly accepted for publication. Ordinarily,
the story would end there -- publication would have led the formula
to bear forever Merton's name.
But Merton refused to publish his effort until the work of Black
and Scholes was published, which happened in 1973. So the formula
for placing a price on stock options is now known throughout the
financial world as Black-Scholes. This formula, with Merton's
elaboration, produced Nobel awards for Scholes and Merton. Black
died in 1995, and the Nobel is not awarded after death.
The work of the three economists "created an entire new industry,"
said Zvi Bodie, a finance professor at Boston University and a
textbook author with Merton.
They devised a trading strategy that could take the risk out of
buying and selling stock options. An investor with a stock option
could offset the ups and downs of its market price by buying and
selling shares of the underlying stock in a precise manner.
In the process of devising this strategy, the economists
demonstrated how to put a market price on options, futures and
other derivatives. Once traders had that knowledge, they began
aggressively trading stock options on the Chicago Board Options
Exchange, and began creating hundreds of other derivative
securities, like those backed by the stream of payments from home
loans.
One of Scholes's former students marvels at the fact that the men
who came up with the options pricing formula did not sell it to the
private sector or trade with it themselves.
While the formula made their reputations, the three economists
initially were content to carry on their academic pursuits,
consulting here and there, but largely ignoring the sirens of Wall
Street.
The Mathematician: An Ordered Mind And a Poker Face
R obert Merton looked for order all around him, whether in the
stock market or on the poker table. Known for his integrity and
brilliance, he has spent his career applying high-powered
mathematics to the real world.
Born in 1944, Merton has had a lifelong fascination with numbers
and markets. By the age of 10, he was dabbling in stocks.
He is the son of Robert K. Merton, a renowned professor at Columbia
University, who founded the sociology of science and coined such
phrases as deviant behavior, self-fulfilling prophecy and role
model. He grew up in the Westchester town of Hastings-on-Hudson.
The young Merton received an undergraduate degree in mathematical
engineering from Columbia and pursued mathematics studies at the
California Institute of Technology. But his interest in stocks and
other securities led him to drop mathematics in favor of economics.
The idea was to apply the mathematical machinery he had mastered to
complex situations. Because his background was not in economics,
several graduate schools rejected him.
M.I.T. accepted him in 1967 only after Harold Freeman, a
statistician and the only member of the economics department
without a Ph.D., intervened on his behalf after taking note of the
recommendations from impressive mathematicians.
There Merton quickly hooked up with Paul A. Samuelson to work on
pricing financial securities. Samuelson, America's first Nobel
laureate in economics and the leader of the university's economics
department, said, "Bob was one of the best graduate students we've
ever had and one of the youngest people we have ever tenured."
Samuelson -- who pioneered the application of mathematics to
economic analysis -- added: "Bob and I were working on some of the
same problems.
One of the joys of teaching was to watch him surpass my work."
After earning a Ph.D. in economics, Merton taught at M.I.T.'s
business school, where Scholes had been appointed assistant
professor of finance after leaving the University of Chicago. Among
others, Merton taught Lawrence Hilibrand, David Mullins and Eric
Rosenfeld. All would later become partners of Long-Term Capital.
Merton and Scholes did research on options pricing and other
projects at M.I.T., and became close friends. They also did some
consulting, including a project for Donaldson, Lufkin & Jenrette to
develop models for pricing options for the over-the-counter market
and for the new Chicago Board Options Exchange.
They even had a joint mutual fund venture in the mid-1970's. It was
not "a commercial success," Merton said last year, but "a
broadening experience."
Of the two economists, Scholes is clearly the extrovert and loves
telling jokes and stories. Unlike many in academia, he does not
take himself too seriously. Friends say he would be more likely to
be mistaken for a salesman than an academic.
Scholes can also be impetuous. Richard Roll, Allstate chair of
finance at the Anderson School at U.C.L.A., recalled an incident in
1970, when Scholes spoke at Carnegie Mellon in Pittsburgh. "I'd
just bought a new motorcycle," Roll said. "He wanted to get on it
to see how it felt to drive. I said, 'Wait a minute, that's a big
engine there,' and before I knew it he had laid rubber, hit a curb
and landed in my neighbor's yard in a mangled heap." Later that
afternoon, Scholes sprained his ankle diving into his friend's
swimming pool.
Merton, who built cars and drag-raced in his youth, spends his
spare time playing poker -- so seriously, says a colleague, that he
tries to throw off his opponents by looking into a light bulb to
constrict his pupils before playing his cards.
Good players are said to be able to determine by the dilation of
their opponents' eyes whether their cards are a blessing or a
curse.
The Marriage: Wall Street Finds Ideas It Can Use
T he ideas of Scholes and Merton had an immense influence on Wall
Street. Still, the two did not work for a big investment firm until
late in their careers.
Marrying top economists to top traders was the brainchild of John
W. Meriwether, a managing director of Salomon Brothers in the
1980's and the leader of the firm's bond arbitrage group. In 1988,
one of Meriwether's lieutenants, Rosenfeld, helped bring Merton to
Salomon as a consultant to John Gutfreund, then the chairman.
Merton, who also moved from M.I.T. to Harvard University that year,
provided advice on business matters and changes in global financial
markets.
While Merton remained at Harvard full time, Scholes took a
sabbatical from Stanford two years later to join Salomon as a
senior adviser to the bond arbitrage group, a group that had had
great success. Although Scholes had met Meriwether socially, it was
Rosenfeld who persuaded the academic to come to Salomon. Scholes
subsequently became a managing director.
He worked not on trading strategy but on a problem the firm had:
Salomon's management was disturbed that it was losing derivatives
trades to rival firms. The reason? Some competitors -- such as J.
P. Morgan and American International Group -- had top ratings from
the big credit rating agencies; Salomon did not. A top-notch rating
provides comfort since one of the biggest risks in a derivatives
trade is that the firm entering into the transaction will not be
solvent or able to meet its financial obligations when the contract
expires.
Over about two years, Scholes figured out a way to use some of
Salomon's capital for a separate subsidiary that landed a top
rating from the agencies. The stamp of approval cleared the way for
a greatly expanded derivatives business at Salomon.
Scholes was also interested in identifying tax strategies. He
scoured the world for ways to turn an investment that generated
income into a capital gain, since gains are taxed at a lower rate
than income. He also looked for ways to turn pre-tax losses into
after-tax profits. "He saw that as a new frontier," said a partner
at a rival Wall Street firm who recalled discussing the strategies
with him. "By sheer dint of his brilliance, he could be in a
position to take advantage of tax loopholes or create some himself
that would open up vast opportunities even if the trades didn't
look so profitable on the surface."
A Fresh Start: Founding Fathers Of a Big Fund
A fter a scandal involving fraudulent bids for Treasury bonds in
1991, Meriwether and other top executives resigned from Salomon.
Three years later, when Meriwether started his own firm, Long-Term
Capital in Greenwich, Scholes and Merton joined him as founding
partners.
In Long-Term's early days, Scholes acted as a salesman, meeting
with potential clients. "When they first started out he was
instrumental in helping them raise funds, go out on the road," said
Matthew Richardson, associate professor of finance at the Stern
School of New York University and a research assistant to Scholes
at Stanford.
By all accounts, Scholes was a natural. "Myron is always talking,"
said Roll, the professor of finance at U.C.L.A.
"If you met him on the street, the last thing you'd think was he
won the Nobel Prize for academic research. You'd think he was a
salesman." In just a few months, Scholes and others raised $1
billion for the fund.
Once the money was in hand, however, Scholes became less active in
operations. He did not sit on the trading desk, but in the back of
Long-Term's offices, contemplating the big picture. In the last
couple of years he and Merton had been studying ways to expand into
other businesses, like managing money for individuals.
From the beginning, Merton was even more distanced than Scholes
from the fund's daily operations, venturing to Greenwich from his
office at Harvard once every two weeks or so. Often, his
contributions to the firm's operations were made by electronic
mail.
Many outsiders have assumed that the economic models used by
Long-Term Capital to identify trading opportunities were the
creation of Merton and Scholes. But even there, the academics did
not dominate. People close to the fund said that while Scholes and
Merton laid the foundation for the models through their early work,
most of the refinements were done by the traders, who also
determined how much in securities to buy and when to sell.
As any academic will attest, putting investment models into effect
is far different from creating them. The Black-Scholes
option-pricing model, as extended by Merton, is a theory based on
assumptions that stock and other trades can be executed without
cost and -- crucial to the fall of Long-Term Capital -- that the
volatility of stocks and bonds can be known from their past
movements.
Unexpected events in the real world -- such as Russia's decision to
stop paying its debts in August -- can wreak havoc on these models.
In fact, the spread in prices between similar securities rose to
three times their historical levels after the Russian debt
moratorium. Long-Term Capital had made bets that these spreads
would ultimately narrow; the fact that they widened caused giant
losses.
While Merton and Scholes were not responsible for building
Long-Term Capital's models, they did serve as a sounding board for
the fund's traders. As members of the firm's risk management
committee -- all the partners were -- they questioned the trades
and discussed the size of various positions. The risk management
committee met every Tuesday, and Merton sometimes communicated by
conference call from Cambridge.
According to people close to Long-Term Capital, Scholes and Merton
posed demanding questions to their partners. For instance, they
asked about the size of specific trades and the risk that getting
out of them would be difficult if investors fled certain markets
for safety.
But operations like Long-Term Capital Management do not run by
consensus. Disagreements over policy are a way of life. So even if
the economists asked tough questions, it is likely that they got
reasonable answers in return. After all, if a trader has taken a
position, he ought to know how to defend it.
It is a bit surprising that the firm had risk management meetings
only once a week. For a firm its size, daily meetings would be more
typical. But having made so much money for so long, the partners
could easily have been lulled into complacency.
The first realization that they were in trouble came in June, when
the fund lost 15 percent of its value. Emerging markets were
starting to look dicey; in mid-June, the Russian Government
canceled two if its planned debt sales owing to lack of investor
interest. July was quiet. Then, on Aug. 14, disaster struck.
Markets everywhere froze as it became clear that Russia was about
to default on its debt.
Many of the firm's partners were out of the office, either on
vacation or business. Meriwether was on a plane to China, Rosenfeld
was on Nantucket, Hilibrand was out. Scholes was in the office,
part of a skeleton crew who watched in horror as markets around the
world tumbled.
According to people close to the firm, the partners returned to
Greenwich as soon as they could. Their capital was dwindling fast
and there was no sign of relief from the markets. Nevertheless, the
traders continued to believe that their positions were sound and
would ultimately be profitable.
It did not take long, however, for them to realize that the large
size of their positions presented an insurmountable problem in
markets seized up by fear of risk. But no one at the firm realized
how many other firms across Wall Street had mimicked the broad
outline of Long-Term's trades for their own accounts. As a result,
when Long-Term tried to liquidate some of its big positions to
raise capital, it found too few buyers. Everyone on the Street was
trying to sell at the same time.
"A series of events occurred that were outside the norm," said
Martin Gruber, Nomura Professor of Finance at N.Y.U.'s Stern School
and a friend of both men. "These catastrophes happen. The fault
isn't with the models."
The Long-Term partners decided that raising money was the only way
out of the mess. They wanted more cash not to abandon their trades
-- though they did jettison some of what they called nonessential
positions -- but to see their bets through, according to people
close to the fund.
Fresh money failed to materialize in an acceptable form, despite
talks with several investment firms and such moneyed investors as
Warren E.
Buffett and George Soros. Unable to meet calls for more collateral
from its trading partners, Long-Term was forced into the arms of a
Wall Street consortium, aided by the Federal Reserve Bank of New
York. To save their fund, the partners sold 90 percent of their
equity to a group of banks and brokerage firms for $3.6 billion.
The personal fortunes of many of the partners were immediately
wiped out. Some partners, having borrowed to invest in their firm,
are facing bankruptcy. Scholes and Merton are not, but each man's
net worth has taken a substantial blow.
While Long-Term's near collapse does not look good on a résumé, the
economists remain well regarded in academia and will surely be in
demand as consultants. Scholes had hoped to set up a foundation and
retreat somewhat from the firm. Those plans are on hold now.
What Merton and Scholes are learning firsthand is just how humbling
markets can be. It is a lesson that investors repeatedly learn but
always manage to forget.
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Copyright 1998 The New York Times Company
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