Every now and then I run across some important finance type saying something so patently crazy, such a complete howler, that it just stops me little brain. The most recent one of these was from Myron Scholes in the New York Times magazine this weekend. The theme of the mag was ‘debt’ in various forms, and Scholes was the subject of a snappy, short interview where he made the comments that put me on the floor.
First, though, who is Myron Scholes? Well, he’s a nerd’s nerd, the co-creator of the Black-Scholes model for pricing derivatives, for which he won the Nobel Prize in economics. After years as an econ professor he was invited along with a number of other finance nerds to build their very own hedge fund, the spectacularly misnamed Long Term Capital Management (LTCM for those in the know), which was founded in 1994 and went bust four years later. LTCM was initially famous for spectacular returns and legendary secrecy about their trades, using multiple brokers to hide their methods even from the people accessing the markets for them.
In 1998 the firm developed a new notoriety for being the first hedge fund to very nearly blow the entire financial system sky motherfucking high. Scholes was not a day-to-day trader for LTCM, but he brought acadenuc cred to the table. Scholes believed that if equations can predict to perfection the movements of photons or traffic, then equations should also be able to predict the actions of markets and the people who move money in and out of them. But his equations failed when panic hit the market. The combination of the Asian economic crisis and the Russian debt default produced a hurricane of panic and fear, and the model took no account those emotions. It’s arguable that panic and fear simply can’t be modeled, though there are those who try. As a result a number of positions run against them at the same time and their leverage was so vast that it put them in serious danger of default. Fearing an unprecedented shock to the system, the New York Fed more or less forced the big brokers and banks to sit down and work out a deal to avoid a Short Term Capital Blowup.
In the end, LTCM lost $4.6 billion in a couple of months. A good run for a Nobel Laureate, no?
The story of LTCM is told brilliantly in ‘When Genius Failed’ by Roger Lowenstein, a book that would easily make my top five on a list of finance books that every civilian should read. The Cliffs Notes version is that a combination of slavish devotion to risk models, massive leverage (before the meltdown LTCM intentionally maintained 20-1 leverage or greater), off-balance sheet exposure (with derivatives, the firm was often levered well over 200-1), derivatives, and near zero transparency to outsiders or regulators, the same factors that took us to the brink of collapse last year. The fact that Mr. Scholes was a decade ahead of the rest of his peers shows why he needed to be recognized for his pioneering investment strategies.
With Wall Street in ruins, one might expect Scholes to be, at least, a bit cautious and circumspect about what he and the risk quants hath wrought. Not so. Here are two of the questions posed by reporter Deborah Solomon.
Solomon: Some economists believe that mathematical models like yours lulled banks into a false sense of security, and I am wondering if you have revised your ideas as a consequence.
Scholes: I haven’t changed my ideas. A bank needs models to measure risk. The problem, however, is that any one bank can measure its risk, but it also has to know what the risk taken by other banks in the system happens to be at any particular moment.
Solomon: What good is a theory of risk management if it applies to one tree instead of the forest?
Scholes: Most of the time, your risk management works. With a systemic event such as the recent shocks following the collapse of Lehman Brothers, obviously the risk-management system of any one bank
appears, after the fact, to be incomplete. We ended up where banks couldn’t liquidate their risk, and the system tended to freeze up.
Does this man have no shame? It’s disorienting, listening to such lame absurdities from a genuinely brilliant man. I’ve heard Scholes speak and he’s impressive, with that super smart guy forcefield that makes you believe stuff you know damn well is nonsense. Listen to him and after 30 minutes or so you start thinking, ‘Hey, maybe those U of Chicago efficient market guys ARE right.’ But Scholes’s reply to Solomon’s first question is just plain stupid. It’s like a racing consultant telling an Indy 500 driver, ‘I have a great model for you for winning the race, but it only works if there is nobody else on the track.’ That model might even be useful in some sense, for practice or planning strategy, but once the flag drops it’s not going to work.
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