Roshomon Vibrations from Krugman

[James Devine]

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

 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