Roshomon Vibrations from Krugman

James Devine jdevine at
Thu Oct 1 09:04:49 PDT 1998

here's Krugman's interesting column on Long-Term Capital Management from SLATE:

Rashomon in


What really happened to

Long-Term Capital


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.

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 it


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

such things 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


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


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


Paul Krugman is a professor of economics at

MIT and the author, most recently, of The

Accidental Theorist and Other Dispatches

From the Dismal Science. His home page

contains links to many of his other articles

and essays.

Jim Devine jdevine at &

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