Teachings of Two Nobelists Also Proved Their Undoing (FWD from NY Times)

James Farmelant farmelantj at juno.com
Sat Nov 14 06:02:00 PST 1998


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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