video uploaded by automatedtrader on Sep 15, 2007
In 1973, three brilliant economists, Fischer Black, Myron Scholes, and Robert Merton, discovered a mathematical Holy Grail that revolutionized modern finance.
The elegant formula they unleashed upon the world was sparse and deceptively simple, yet it led to the creation of a multi-trillion dollar industry.
Their bold ideas earned Scholes and Merton a Nobel Prize (Black died before the prize was awarded) and attracted the elite of Wall Street. In 1993, Scholes and Merton joined forces with John Meriweather, the legendary bond trader of Salomon Brothers. With 13 other partners, they launched a new hedge fund, Long Term Capital Management, which promised to use mathematical models to make investors tremendous amounts of money.
Their money machines reaped fantastic profits, until their theories collided with reality, and sent the company spiraling out of control. The crisis threatened to bring markets around the world to the brink of collapse.
excerpt: (though read it all, the drama!) :
STAN JONAS: It was as though the world was behaving exactly the way it had been writ on the blackboard. Long Term Capital thought that they had discovered the path to Nirvana. Here they are doing their day-to-day activities, playing golf in lush Greenwich or attending hedge fund conferences in Bermuda, or raising funds in Cannes. And then slowly and totally unexpectedly, a change in the market dynamics began to become apparent.
LOWENSTEIN: The first hint of trouble was at 1997, LTCM's returns fell from 40-ish% to 17. There was a reason why the returns fell, which is that when someone discovers a good game on Wall Street, he's bound to be imitated after a while. And that had happened to LTCM, so there was less room for them to exploit these little market discrepancies where they were drawing their profits from. And at the end of 1997, they returned much of the partners' capital. However, they did not reduce the size of their assets, so that they now had the same level of assets and investments, but less capital. That meant that if there were trouble, the trouble would hurt them much more quickly.
NARRATOR: In the summer of 1997, across Thailand, property prices plummeted. This sparked a panic that swept through Asia. As banks went bust from Japan to Indonesia, people took to the streets - events so improbable they had never been included in anyone's models.
BEN SCHWARTZ: Everyone in the marketplace thought the sky was falling, and there was instant reaction. The market broke, then rallied, then broke, then rallied. We didn't know what to believe.
NARRATOR: As prices leapt and plunged as never before, the models traders used began to give them strange results, so they relied instead on their instincts. In a time of crisis, cash is king. Traders stopped borrowing and dropped risky investments.
LEO MELAMED: You've got to be able to get out while the getting out is good, but that's true for any investment you make. That's true for real estate, that's true in every sort of business. You can't ignore an error. Once you realize that you've made an error, the best thing is to get out of that error and start again fresh, and that's what a good trader does.
NARRATOR: But at LTCM, the models told them everything would return to normal soon. There was no reason to panic. After all, they were hedged. With enough time, their bets would converge. All they needed was patience. But their bets diverged. As LTCM lost money, its ratio of assets to liquid capital reached 30 to one. The fund's debts exceeded $100 billion.
STAN JONAS: If I have $100 billion of a position and I lose one percent, I've lost a billion dollars. And if all I have to start out with is three billion dollars, if I lose three percent on my portfolio, in aggregate I'm going to be wiped out.
NARRATOR: Despite its extreme leverage, LTCM could continue to hedge - as long as the economic upheaval in Asia did not spread.
LEO MELAMED: That's an old market rule: the market will test you and do what you don't expect it to do.
NARRATOR: In August, Russia* suddenly and without explanation refused to pay all its international debts. LTCM's models had not accounted for this unprecedented event. As frantic investors all sought liquidity, LTCM could not unload its positions which continued to diverge.
MYRON SCHOLES: In August of 1998, after the Russian default, you know, all the relations that tended to exist in a recent past seemed to disappear.
MERTON MILLER: Models that they were using, not just Black-Scholes models, but other kinds of models, were based on normal behavior in the markets and when the behavior got wild, no models were able to put up with it.
ROGER LOWENSTEIN: Although their models told them that they shouldn't expect to lose more than 50 million or so on any given day, they began to lose 100 million and more, day after day after day till finally there was one day, four days after Russia defaulted, when they dropped half a billion dollars, 500 million in a single day.
NARRATOR: In Greenwich, LTCM faced bankruptcy, but if the company went down, it would also take with it the total value of the positions it held across the globe - by some accounts $1.25 trillion, the same amount as the annual budget of the US government. The elite of Wall Street would suffer heavy losses. The Federal Reserve Bank called upon the world's top financial regulators to discuss the crisis.
ROGER LOWENSTEIN: Suddenly they seemed to be staring at this nightmare where one firm linked up to every major firm on Wall Street was going to be seized up and markets might just stop working. That was the great fear.
NARRATOR: On Sunday, September 20th, officials of the Federal Reserve and US Treasury headed for Greenwich, Connecticut.
PETER FISHER: What really was the shock for me when we went up to Long Term Capital and the partners gave us an overview of their positions and the risks and the pressures they were under, was the extraordinary scope of the risks that they had taken on, the breadth of the portfolio, and yet how utterly their effort to diversify the portfolio had failed them, how - that this wide set of positions across all markets had all come in, were all behaving the same way. Everything had come up heads.
NARRATOR: Fearing a global economic collapse, the Federal Reserve organized a bailout of LTCM with Wall Street's biggest power brokers. 14 firms put up $3.6 billion to buy out the fund. This consortium would now oversee all trading and had power to veto decisions made by the partners. Meriwether, Merton, and Scholes lost millions. So did their investors. Then the public recriminations began. go. readayvoo.
(*Mr. Gorbachev! Tear down this wall! Reagan also made the sun rise. Mourning in America.)