Rashomon in Connecticut
What really happened to Long-Term Capital Management?
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?
O ne 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 **** 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 **** 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.
Paul Krugman writes a twice-weekly column for the New York Times and is professor of economics and international affairs at Princeton University. His home page contains links to many of his other articles and essays.