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.
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
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
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
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"?
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 popmail.lmu.edu & http://clawww.lmu.edu/Departments/ECON/jdevine.html