What really happened to Long-Term Capital Management?

SYNOPSIS:Explains the crash as a combination of moral hazard and bad luck.

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.

TCM 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 **** 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.

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"?