[I thought this was a very interesting explanation of why Long Term Credit Management failed. MacKenzie gives a very precise description of how VAR techniques can become perverse in a way one can imagine repeating. And then he goes on to say that even this wouldn't have been enough to bring down LTCM, that what finally brought them down was a simple run on the bank. Not hubris, not bad calculations. It makes a good case that you don't need advanced math to understand the risk that will never go away: the simple run on the bank will be forever by nature an unavoidable and incalculable risk to every sort of financial institution of whatever size.]
The entire article is at http://www.lrb.co.uk/v22/n08/mack2208.htm Has a long summary for Black-Scholes for non-economists that I found helpful as well.
Excerpts follow:
>From The London Review of Books Vol 22, No 8 | cover date 13 April 2000
Fear in the Markets
Donald MacKenzie writes about the ways in which 'finance theory' becomes part of what it examines
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The key general point was made fifty years ago, not by an economist, but by a sociologist, Robert K. Merton, father of the finance theorist [Robert C. Merton, who co-won the nobel prize for developing Black-Scholes, and was one of the principals of LTCM]: beliefs about social institutions are a constitutive part of those institutions, not simply an external description of them. Merton's first example - in retrospect a poignant one - of what he called 'self-fulfilling prophecy' was a run on a bank: a rumour that a bank is about to fail causes depositors to seek to withdraw their funds, making what was actually a sound financial institution unsound.
Alone among the commentators on LTCM, Dunbar notes Merton's article, but even he does not explore its full significance. To do so, we must free ourselves from the assumption that a self-fulfilling prophecy is necessarily pathological. In some cases it is: Merton gave the example of the racist belief that black workers were strike-breakers, which was used to justify their exclusion from trade unions, and often left them in the position of having to take whatever work was available. In other cases, however - probably the vast majority - self-validating belief is perfectly rational. In the case of money, for example, the widely-shared belief that dollar bills will continue to be exchangeable for goods and services makes them usable for such purchases (that it is beliefs that ultimately constitute money becomes plain when those beliefs become precarious, as in times of social collapse or hyper-inflation). More generally, as Barnes has pointed out, all stable social institutions are underpinned by self-validating beliefs, and that is no criticism of the institutions or the beliefs: it is what constitutes their stability.
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[LTCM]'s market positions were varied, but a common theme underlay many of them. Using extensive statistical databases and theoretical reasoning, the firm identified pairs of financial assets the prices of which ought to have been closely related, which should over the long run converge, but which for contingent reasons had diverged: perhaps one was temporarily somewhat easier to trade than the other, and therefore more popular, or perhaps institutions had a particular need for one rather than the other. The fund would then buy the underpriced, less popular asset, and borrow and sell the overpriced, more popular one. The close relation between the two assets would mean that general market changes such as a rise or fall in interest rates would affect the prices of each nearly equally, and long-run convergence between their prices would create a small but low-risk profit for LTCM. The partnership knew perfectly well that over the short and medium term prices might diverge further, but the risks and the consequences of them doing so were carefully calculated by using statistical 'value-at-risk' models, which measure the potential losses from adverse market movements and are now used by all the sophisticated players in the financial markets. As Dunbar notes, LTCM also 'stress-tested' its trading positions to gauge the effect on them of extreme events not captured by standard statistical models, such as the failure of European Monetary Union or stock exchanges crashing by a third in a day.
The Russian default was just such an extreme event, though one that no one had anticipated: the surprise was not that Russia was in economic trouble, but that it defaulted on debts denominated in roubles, rather than simply printing more money, and also that it temporarily blocked some foreign exchange transactions by Russian banks. LTCM itself had only a minor exposure to events in Russia, but the precise form of Russia's actions caused significant losses to Western banks. An investment fund called High Risk Opportunities failed, and (quite unfounded) rumours began to circulate that Lehman Brothers, an established investment bank, was also about to do so. Suddenly, market unease turned into self-feeding fear. A 'flight to quality' took place, as a host of institutions sought to liquidate investments that were seen as difficult to sell, and potentially higher risk, replacing them with lower risk, more liquid alternatives. Because LTCM's 'convergence arbitrage' generally involved holding the former, and short selling the latter, the result was a substantial market movement against the fund.
Although the evidence is still largely anecdotal, three additional factors seem to have worsened the effect of the flight to quality. The first was the simple fact that it took place in August, when many traders and managers are on holiday and markets tend to be thinner and less liquid than usual. The second factor was that LTCM was by no means the only market participant involved in convergence arbitrage: many of the world's leading banks, notably Wall Street investment banks, had broadly similar large positions. The third factor was that, as Dunbar points out, these banks employed value-at-risk models not just as LTCM did (to gauge the overall risks faced by the fund), but also as a management tool. By allocating value-at-risk limits to individual traders and trading desks, big institutions prevent the accumulation of over-risky positions while giving traders flexibility within those limits. However, if adverse market movements take positions up to or beyond the limits, the traders involved have no alternative but to try to cut their losses and sell, even if it is an extremely unfavourable time to do so. In August 1998, widespread efforts to liquidate broadly similar positions in roughly the same set of markets seem to have intensified the adverse movements that were the initial problem. Crucially, they also led to greatly enhanced correlations between what historically had been only loosely related markets, across which risk had seemed to be reduced by diversification.
Used as management tools, value-at-risk models (intended to describe the market as if it were something external) thus became part of a process that magnified adverse market movements, which reached levels far beyond those anticipated by the models. For example, if Dunbar's account of LTCM's risk modelling is correct, the probability of the fund's August 1998 losses was so low that its occurrence even once in the lifetime of the universe was very unlikely. Furthermore, though the use of such models was perfectly rational at the level of, say, the individual investment bank, it may have helped to produce a collectively irrational outcome. As 'spreads' (the difference between prices of related assets) widened, and thus in a certain sense arbitrage opportunities grew more attractive, arbitrageurs did not move into the market, narrowing spreads and restoring 'normality'. Instead, risk models used as management tools forced potential arbitrageurs to flee, widening spreads and intensifying the problems of those who remained, such as LTCM.
LTCM, however, was constructed so robustly that, though they caused major losses, these problems were not fatal. In September 1998, though, a social process of a different kind got underway, in effect a run on a bank. LTCM's difficulties became public. On 2 September Meriwether sent a private fax to the company's investors, describing its difficulties and seeking to raise further capital to exploit what he described (quite reasonably) as attractive arbitrage opportunities. The fax was posted almost immediately on the Internet and seems to have been read as evidence of desperation. The nervousness of the markets crystallised as fear of LTCM's failure. Almost no one could be persuaded to buy, at any reasonable price, an asset that LTCM was known or believed to hold, because of the concern that the markets were about to be saturated by a fire sale of the fund's positions. In addition, LTCM's counterparties - the banks and other institutions that had taken the other side of its trades - tried to protect themselves as much as possible against LTCM's failure by a mechanism that seems to have sealed the fund's fate. LTCM had constructed its trades so that solid collateral, typically government bonds, moved backwards and forwards between it and its counterparties as market prices moved in favour of one or the other. Under normal circumstances, when prices were unequivocal, it was an eminently sensible way of controlling risk. But in the fear-chilled, illiquid markets of September 1998, prices lost their character as clear facts. As was in effect their contractual right, LTCM's counterparties marked against it: that is, they chose prices that were unfavourable to LTCM, seeking to minimise the consequences for their balance-sheets of LTCM's failure by getting hold of as much of the firm's collateral as possible. Fearing the failure, they made it inevitable by draining the firm of its remaining capital.
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Donald MacKenzie, who teaches at Edinburgh University, is beginning research on the historical sociology of modern finance.
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